The rapid increase in leverage in the emerging markets of Asia, particularly China, has become a concern for many investors globally. What is the source of the debt buildup? How will it play out? Japan’s experience in dealing with high levels of debt can offer insight.
Since the global financial crisis, most countries around the world have increased their debt levels, including those that were already highly indebted, such as Japan.
Emerging Asian countries also increased leverage, and the growth of debt has been notably high. Most Asian countries are already approaching a number of developed countries in debt-to-GDP terms (see Figure 1).
In the developed markets, the public sector has been the main contributor to debt growth since the financial crisis, while private debt, especially in the U.S., has declined. The story in emerging Asia is quite different.
Compared to the rest of world, emerging Asia stands out in terms of leverage growth since 2007. It is not just the fast pace in credit growth that is a concern; credit growth has been faster than GDP growth. Thus, emerging Asian economies need more credit to generate the same amount of economic growth as in the past.
Against this backdrop, external sovereign debt is not a big risk, in our view. In 1997‒1998, external debt was a contributing factor to the Asian financial crisis. Today, Asia as a whole is less vulnerable externally. China’s external debt-to-GDP ratio, for example, is one of the lowest among emerging countries. PIMCO, in fact, foresees improving fundamentals in many emerging markets (see “A Constructive Case for Emerging Markets”).
Malaysia is one of the few exceptions in Asia; its external debt metrics have deteriorated since 2007. Indonesia is the most stretched in terms of external debt to foreign exchange reserves and foreign currency debt exposure relative to GDP. But even these countries are in a better position compared with other emerging market countries, such as Argentina, Turkey and South Africa.
However, banking liquidity, viewed as loan-to-deposit ratios, has worsened in some countries in Asia since 2007. As a result, even if external imbalances may be improving, internal imbalances are becoming more visible.
As for household indebtedness, emerging Asia is diverse, suggesting different degrees of upside potential for household consumption and policy flexibility. Malaysia and Thailand are of special concern. Not only is household debt to GDP high compared with other countries, but it is also high relative to their stage of economic development (measured as GDP per capita). On the other hand, households in other countries in the region – including China and India – are in better shape and have the potential to lever up and consume more.
With sovereign debt relatively benign and consumer debt a mixed picture, where then is the problem in emerging Asia? The corporate sector. Corporate leverage accounts for around half of the region’s debt to GDP. Companies in China are the most extended both in absolute terms and in debt relative to GDP, which well exceeds 100%. India’s listed corporates are also highly levered with equity-to-debt ratios as high as their Chinese counterparts (see Figure 2).
China: Problems and policy options
Given the size of its economy – and the high stock of debt for a country at its stage of development – China’s leverage will be a global issue in the future, not just a China issue.
Total debt to GDP in China was around 250% at the end of 2015, the highest among emerging economies (see Figure 3), and we think China’s debt ratio is on track to reach 280%‒300% of GDP by 2020. This assumes that reforms in the state-owned enterprise (SOE) sector will make only partial progress and that the gap between credit and GDP growth does not narrow substantially. Over the medium term, we expect more debt creation in China: Leverage is unavoidable for China to achieve its growth targets.
Corporate debt – at more than 120% of GDP – remains the key cause for concern in China (see Figure 4). Its corporate debt ratio increased by 70 percentage points from 2007 to 2015, as credit growth consistently exceeded GDP growth by a wide margin. Meanwhile, declining corporate profitability has generally eroded companies’ ability to service their debt. Profitability has deteriorated more sharply for SOEs than in the private sector.
In PIMCO’s view, China’s nonperforming loans (NPLs) will trend higher in the next three to five years from a reported NPL ratio of 1.4% at the end of 2015. If China can successfully manage through the deleveraging process in its corporate sector, then the NPL ratio in the banking system should peak at around 6%; otherwise, the NPL ratio will likely continue to rise.