China’s debt crisis is only a part of greater challenges

China’s burgeoning debt crisis, a focal point of global economic discourse, has recently been underscored by Moody’s decision to downgrade the country’s credit outlook. This development, however, is just the tip of the iceberg in terms of the challenges facing the world’s second-largest economy.

The International Monetary Fund (IMF) has brought to light that China’s debt-to-GDP ratio has skyrocketed since the 1980s, particularly over the last decade. Such an unparalleled rise in debt, making up over half of the global economy’s debt-to-GDP ratio increase since 2008, indicates deep-seated issues within China’s economic framework.

Unraveling the True Nature of China’s Debt Challenge

The surge in China’s debt is alarming, but it is merely a symptom of a more profound problem – the misallocation of investments over the past decade. Significant capital has been channeled into excess property, infrastructure, and increasingly, manufacturing. This misallocation has led to cumulative, yet unrecognized losses, masking the true health of the economy.

Much of the discourse surrounding China’s debt crisis has revolved around minimizing disruptions in the banking system and addressing balance sheet liabilities. However, the root of the problem lies not in the liabilities but in the asset side of these balance sheets.

The investments that have led to these debts were capitalized instead of being recognized as losses. This improper capitalization of losses has led to inflated earnings and asset values, creating fictitious assets that are unable to generate returns or service the debts that funded them.

The Ripple Effects of Misallocated Investments

China’s economic strategy of capitalizing losses rather than recognizing them has profound implications. In a hard-budget constraint environment, entities that misallocate investments face bankruptcy, leading to asset write-downs and loss recognition.

However, in sectors operating under soft-budget constraints, such as state-owned enterprises and local governments, state-sponsored credit access sustains non-productive investments. This situation has led to years of unrecognized investment losses, during which both earnings and recorded asset values far exceeded their real values.

The moment these soft-budget entities can no longer roll over and expand their debts, they will be forced to acknowledge that the real value of their assets is less than their recorded value. This recognition is a massive and intractable problem for China, as it involves acknowledging the full extent of losses and quickly allocating them in economically and politically efficient ways.

Postponing this recognition, akin to Japan’s approach in the 1990s, only exacerbates the economic cost. Beijing’s focus should therefore be not just on managing the liability-side consequences of excessive debt but also, and more importantly, on the asset-side consequences. The key to resolving China’s debt crisis lies in recognizing and efficiently allocating these losses.

In essence, China’s debt crisis, while significant, is only a part of the country’s broader economic challenges. The real issue lies in the years of investment misallocation and the resultant fictitious assets. As China grapples with these challenges, the global economy watches closely, understanding that the resolution of these issues is critical not just for China but for the world economy at large.