Stabilising China’s leverage ratio

• China’s goal of stabilising its leverage ratio in 2021 has raised fears monetary policy will be tightened sharply to the detriment of risk assets
• In 2020, China’s debt-to-GDP rose significantly from 259% to 285% as the authorities loosened fiscal policy and promoted faster credit growth to counter the shock from the pandemic.
• But last year’s rise in China’s leverage ratio was exaggerated by its slump in GDP growth while China’s increase in total debt was modest.
• For 2021, China’s strong rebound in GDP will help stabilise its leverage ratio if borrowing only slows moderately. Thus monetary policy should not need to be tightened sharply to keep China’s debt-to-GDP stable this year.

China’s strong rebound from the pandemic is allowing policymakers to focus again on curbing the growth of debt in the economy.

Last month, the National People’s Congress officially set the goal of stabilising China’s leverage ratio this year. Controlling debt accumulation will strengthen the economy’s resilience in the long term. But in the near term, financial markets have become concerned the People’s Bank of China may raise interest rates to slow the build-up of debt and thus hurt risk assets.

Total Debt, China

Source: Bank of Singapore, Bloomberg

The chart above shows China’s debt-to-GDP ratio increased sharply from 259% to 285% last year. The central government budget deficit widened from 3.0% of GDP to 3.6% and local government borrowing also rose significantly to counter the shock from the pandemic in 2020.

Total Debt Growth, China

Source: Bank of Singapore, Bloomberg

But last year’s rise in China’s leverage ratio was exaggerated by the slump in GDP growth. In 2020 growth fell to 2.3% after the economy expanded by 6.1% in 2019. In contrast, the increase in debt was modest. Total debt rose by around 12%YoY last year, far below the pace of debt accumulation incurred after the 2008 global financial crisis as the chart above shows.

For 2021, policymakers should be able to stabilise China’s debt-to-GDP without having to tighten monetary policy sharply. This year we forecast China’s GDP will expand strongly by 8.1% in real terms. Moreover, the leverage ratio compares debt to the overall size of GDP in nominal terms. We expect China’s nominal GDP to grow by more than 10% when including inflation in 2021.

Fast growth will help to stabilise China’s debt-to- GDP ratio if the pace of debt accumulation slows down towards the rate of China’s nominal GDP growth. For this year we expect broad credit growth will ease as local governments cut borrowing as China’s recovery requires less public spending now on infrastructure to support economic activity. A measure of debt growth - total social financing (TSF) - is currently running at 13.3%YoY. We expect lower local government borrowing will reduce TSF growth to around 11.0%YoY in 2021.

Thus, faster GDP growth and moderately slower debt accumulation should help stabilise China’s leverage ratio without the need for sharply higher interest rates hurting domestic risk assets.