China: Rising Debt, Lower Growth and Financial Imbalances Test Shift to Consumption-led Economy

The difficulty of this balancing act was central to Scope Ratings’ recent decision to downgrade China’s credit rating from “A+” to A/Stable Outlook in May 2023 given the continuous upward trajectory of public debt and decline in growth expectations over the coming years.

The worsening medium-term economic outlook is putting even more pressure on China’s public finances, while reform momentum has slowed. Debt levels were rising in the decade before the pandemic. Under the IMF’s narrow definition, China’s general government debt increased to 60% in 2019 from 34% of GDP in 2010. The fiscal stimulus in response to the pandemic raised debt to 77% of GDP in 2022. We now expect debt to exceed 100% of GDP by 2027.

Under the IMF’s broader definition, which includes local government financing vehicles (LGFVs) and other off-balance-sheet entities, debt is substantially higher while the medium-term debt trajectory is steeper. The latest IMF projections show this measure of public debt, which stood at 99% of GDP in 2020, will rise to 147% by 2027 (Figure 1).

Figure 1. Trajectory shift: changing forecasts for China’s public debt (broad definition), 2017-27F
% of GDP

China’s Centralised Economic Model Can Facilitate Structural Reform

But we should not underestimate how China’s centralised economic model can facilitate effective structural reforms given the government’s tight control over large parts of the domestic economy, including the banking sector. Without this degree of control, the recent troubles in China’s real estate sector would have likely resulted in a more significant systemic shock.

The authorities can steer the economy by restraining or increasing credit growth in specific industry sectors. This was recently demonstrated by the “three red lines” policy introduced in 2020 to moderate lending to real estate firms and the subsequent 16-point plan in 2022 to ease restrictions and support credit growth again.

However, the risk of policy mistakes has increased.

The large non-bank financial institutions sector – often referred to as shadow banks – and the importance of LGFVs complicate the government’s ability to forecast and then guide the transmission of shocks through financial markets and the wider economy.

Market reaction that catches authorities off guard and weakens economic growth therefore becomes increasingly common and the more muted stimulus package announced this summer reflects the high degree of policy uncertainty.

While the Chinese authorities stress that LGFV debt should not simply be treated as government debt, the importance of this sector to the wider economy means that central or local governments are likely to directly or indirectly support LGFVs whenever there is a risk of systemic spillover.

China’s Growth Prospects Are Diverging From the Government’s Target

At the same time, China’s growth prospects are diverging from the government’s target, also driven by important demographic shifts. In 2022, China’s population fell by around 850,000 according to National Bureau of Statistics estimates, the first decrease since 1961. The UN expects the population to shrink by 8% or 113m by 2050, although under more adverse scenarios, the population decline could be even starker at around 200m.

We estimate China’s sustainable medium-term growth potential at around 4%, which is below the government’s self-imposed goal of doubling the size of the economy between 2021 and 2035, implying average annual growth of around 4.8%.

Lower, more sustainable, economic growth targets could ease pressure on authorities to generate growth based on increased credit. We therefore note positively the historically low growth target of around 5% for this year. Still, lower growth might come at the cost of lower domestic political credibility.

To maintain this credibility and achieve sustainable growth, the authorities need to make good on the economic transition towards a more consumption-led economy.

Necessary structural reforms include i) introducing more neutral competition between large State-owned enterprises and privately-owned enterprises; ii) education reforms such as narrowing the urban-rural gap in years of schooling; iii) reducing local protectionism and administrative borders between prefectures; and iv) labour market reforms such as raising the retirement age and increasing female workforce participation as the population ages.

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Eiko Sievert is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH. Alessandra Poli, Analyst at Scope Ratings, contributed to writing this commentary.