Rising leverage ratio shows there's no balance sheet recession

The government should raise leverage as appropriate while analyzing the balance sheet issue in a static manner, as well as a dynamic manner.

The leverage ratio in the real economy increased by 10.8 percentage points during the first half of the year, according to data from the Institute of Finance and Banking under the Chinese Academy of Social Sciences.

Specifically, the leverage ratio of the nonfinancial enterprise sector climbed by 6.9 percentage points, the government sector by 2.3 percentage points and the residential sector by 1.6 percentage points.

This means that, statistically speaking, there is no balance sheet recession in China, as is evident by the still-rising leverage ratio observed in the corporate, residential and government sectors.

China's balance sheet is steadily expanding overall. Due in part to the aftereffects of the COVID-19 pandemic, the leverage ratio in non-bank businesses has been increasing at a faster pace.

The central government is currently issuing special treasury bonds worth 1 trillion yuan ($139.8 billion) to increase its leverage, while local governments need to scale back their leverage by properly addressing their debt issues.

China's macro leverage ratio is at a pretty high level, but from a dynamic perspective, it should continue to expand its balance sheet and raise the leverage ratio for the following three reasons, to ensure steady economic growth.

First, a lengthy cycle has seen China's real estate begin a downturn phase. Even though the current decrease in home prices is not that great, the adjustment in the real estate sector is expected to take longer, given the rapid aging of the population and a slowing urbanization process.

Regarding real estate cycles in the United States, the European Union, and Japan, the adjustment period exceeds 10 years, so departments concerned should plan ahead and be ready to handle any eventuality.

Second, local government debts are under more strain. On the one hand, various subnational authorities now have to worry about whether their mature debts can be paid back as scheduled. On the other hand, they face a challenging debt servicing burden that will only worsen with time, and interest payments on debt will further impact their present spending, investing and other financial decisions.

Third, the aging of the population is quickening. The second baby boom generation, which started in the early 1960s, has reached its retirement phase since 2022.

As a result, China's population aged over 60 has increased dramatically, and this trend is expected to continue until 2034. The aging population will put more strain on China's healthcare, social security and pension expenditure, necessitating further government spending.

Therefore, it is imperative to consider how to fix any future problems in addition to focusing on the issue of whether or not the balance sheet is currently in recession.

China's current predicament is not like that of Japan's in the past, when its gross domestic product per capita was about $40,000 in 1994 — three times higher than China's today.

But in 1994, the leverage ratio of the Japanese government was at a relatively low level compared to the Chinese government's current leverage ratio, which could be above 100 percent when combined with local governments' hidden debts.

Growing debt

An aging population and growing debt before China becomes a developed country are therefore the two main stresses the country is experiencing.

In addition, China should step up efforts to improve its government debt structure when discussing balance sheet issues in both aggregate and structural terms.

China has a lower level of government leverage than the US, Japan and other developed economies. The writer's projection of the US federal government plus state governments' leverage ratio is approximately 145 percent, and China's overall leverage ratio, including that of both central and local governments, is approximately 110 percent.

In contrast to most developed economies, China's government debt has a structural issue — namely, a disproportionately high share of local government debt. At present, the leverage ratio of China's central government is roughly around 20 percent, and that of the local governments could be as high as 90 percent.

Therefore, it is essential to improve the structure of government debt, which will not only reduce the debt pressure on local governments, but also bring down the government's interest payment cost.

Since the central government has the best creditworthiness, it can raise debt at the lowest interest rate. On the other hand, local governments have very high financing expenses, particularly when it comes to the financing costs of hidden debt through local government financing vehicles, which average at about 6 percent based on the writer's calculations.

As a result, the debt swap should be implemented by the issuance of more special treasury bonds or by increasing the amount of local refinancing bonds. This will enhance the structure of government debt and considerably lessen the burden of debt servicing on local governments.

Because macroeconomics is a systemic and all-encompassing field, solving critical issues China faces at the moment and will face in the future will require more than simply increasing the central government's leverage ratio and decreasing that of local governments.

Thus, it is vital to advance the reform of State-owned enterprises, especially those managed by the central government, with the optimization of equity financing as one of the key goals.

For example, it is a viable option to increase the proportion of SOE equity allocated to the country's social insurance program to partially close the pension gap in the context of the rapidly aging population.

In order to enable the equity of centrally managed enterprises to enhance the valuation level and to better play the role of centrally managed enterprises in resource integration, mergers and acquisitions, and restructuring, relevant authorities proposed at the end of last year that a valuation system with Chinese characteristics should be explored.

The market capitalization of central enterprises represented 50 percent of the entire A-share market in 2010, but by 2022, that share had almost halved and came in at 27 percent. This decline in market share may be attributed to the ongoing listing of private enterprises as well as the fact that central enterprises' valuation levels have been falling for the previous 10 years or so.

Government data showed that by 2022, China's SOEs had assets valued at approximately 339.5 trillion yuan, or nearly the entire market value of the real estate sector. Better mobilizing State-owned assets might thereby optimize the balance sheet.

The many SOEs across sectors can also fine-tune their governance framework — for example, through equity operations — to raise their valuation level, which will optimize both the government's and the corporate sector's balance sheet structures.

In general, China does not have a balance sheet recession problem now. However, from a forward-looking perspective, it is in urgent need of structural optimization, which will help facilitate economic transformation, guard against systemic risks, enhance investor confidence and spur consumption.

The writer is chief economist at Zhongtai Securities.

The article is a translation of the writer's speech during a recent seminar of the China Macroeconomy Forum, a Beijing-based think tank.

The views do not necessarily reflect those of China Daily.