Is China on the Brink of a Recession?

In the early 1990s, Japan’s economy, which was then the second-largest economy in the world, started to decline into a long-term recession. This economic story was a notorious reputation known worldwide, but at its onset, it wasn’t entirely clear what was happening.

The presence of a group of enthusiastic financial analysts who warned that the country’s debt problem was much worse than announced and argued that economic growth would not be able to magically solve this problem, caused frustration for the Ministry of Finance in Japan, according to Bloomberg.

Recently, the estimations made by former advisor to the Chinese central bank, Li Daokui, regarding the debt of local Chinese governments caused quite a stir. Daokui estimated that the debts of these governments would reach 90 trillion yuan (12.6 trillion dollars) by the year 2020, a number that greatly exceeds previous estimations.

These debts primarily arise from the construction of infrastructure, which is unlikely to generate sufficient revenue to repay the obligations. Additionally, the significant decrease in China’s growth rate in recent years imposes an additional burden on local governments.

The Chinese central government possesses the necessary resources to solve this problem, but it requires a major reconsideration of economic policy. Without strategic transformation, China faces the risk of entering a recession similar to the one Japan experienced in the 1980s.

Kuai, who has a degree from Harvard University and works at Tsinghua University in Beijing, explained that one of the main errors in previous estimations of local debts was the failure to consider the significant reliance on “paid-in capital” in funding major infrastructure projects. For example, in the case of the massive transportation loop in the city of Zhongqing, nearly one-fifth of the total cost of $29 billion came from “paid-in capital”.

China’s domestic debt is larger than thought

According to Kui, the “paid capital” is not actually capital, but rather financing obtained through debt or by issuing shares by companies owned by local governments. Therefore, Chinese local debts are much larger than previously believed.

He pointed out that the local authorities’ financial resources needed to service their debts have sharply declined by 2020. Additionally, local governments are forced to take on new debts to repay existing ones, which is not sustainable in the long term. Given the decline in economic growth rate in recent years, it is likely that the ability to service the debts is now lower.

Similarly, the economic growth achieved by Japan in the 1990s was not sufficient to repay the mountain of debt that had accumulated during the 1980s bubble, which was based on overinflated real estate guarantees. In response, the Japanese government directed banks to give companies the opportunity to tolerate, in order to avoid cases of bankruptcy the American way, with all the severe social and economic consequences that come with it.

As part of its response to weak economic growth, Japan continued to lower interest rates in an attempt to encourage new borrowing for investment. However, the desire to borrow was limited, leading to low interest rates being seen as a sign of the country’s diminishing capabilities.

The decrease in interest rates in China is not considered to be sudden. It was observed last year how the decrease in interest rates on savings accounts threatened the confidence of Chinese families. Last month, major government banks in China further reduced interest rates.

This week, the yields on Chinese government bonds for a 10-year term dropped to a record low of less than 2.5%, which is the level it reached during the initial “COVID-19” crisis. In the case of Japan, the yields on 10-year bonds dropped to 2.5% in 1997 and have not risen since then.

Solve the debt issue

I propose a solution consisting of three parts to address China’s domestic debt, which reached 88 percent of the gross domestic product in 2020, greatly exceeding previous estimates from the International Monetary Fund. (In the worst-case scenario, I estimated that domestic debt could reach 14 trillion dollars.)

The first solution is for the central government to take on some of the responsibilities of local authorities. The central government has already started considering this option in recent months, although it has long sought to maintain a relatively low ratio of debt to GDP.

Secondly, he suggests extending the debt period, which is already being implemented through a variety of swap programs, some at the local level and others involving the central bank.

As for the third part, it is the most fundamental and requires a major ideological transformation, which entails selling state assets. This was one of the elements of the final solution to Japan’s mounting debt crisis during the reign of Prime Minister Junichiro Koizumi before the global financial crisis.

However, Xi Jinping’s system tends to elevate the role of the state instead of privatization, so it seems hard to envision following Margaret Thatcher’s policy in the 1980s, which focused on reducing debt and stimulating the private sector.

All of this can lead to the exacerbation of the risk of a dynamic in the Chinese financial system that hinders economic potential in the coming years.