China’s foreign debt has been rising rapidly, and that’s becoming an increasingly big problem — for the country and, potentially, the world. Officially, China lists its outstanding external debt at $1.9 trillion. For a $13 trillion economy, that’s not a major amount. But focusing on the headline number significantly understates the underlying risks.
According to official data, short-term debt accounted for 62 per cent of the total as of September, meaning that $1.2 trillion will have to be rolled over this year. Just as worrying is the speed of increase: Total external debt has increased 14 per cent in the past year and 35 per cent since the beginning of 2017.
External debt is no longer a trivial slice of China’s foreign-exchange reserves, which stood at just over $3 trillion at the end of November, little changed from two years earlier. Short-term foreign debt increased to 39 per cent of reserves in September, from 26 per cent in March 2016.
The true picture may be more precarious. China’s external debt was estimated between $3 trillion and $3.5 trillion by Daiwa Capital Markets in an August report. In other words, total foreign liabilities could be understated by as much as $1.5 trillion after accounting for borrowing in financial centres such as Hong Kong, New York and the Caribbean islands that isn’t included in the official tally.
Circumstances aren’t moving in China’s favour. The nation’s companies rushed to borrow in dollars when there was a 3 per cent to 5 per cent spread between Chinese and US interest rates and the yuan was expected to strengthen. Borrowing offshore was cheaper and offered the additional bonus of likely currency gains. Now, the spread in official short-term yields has shrunk to near zero and the yuan has been depreciating for most of the past year. Refinancing debt in dollars has become harder, and more risky.
Beijing’s policies have exacerbated the build-up of foreign debt. To promote Xi Jinping’s Belt and Road Initiative, the President’s landmark foreign policy endeavour, China has been borrowing dollars on international markets and lending around the world for everything from Kenyan railways to Pakistani business parks.
With this year and 2020 being the peak years for repayments, China faces dollar funding pressure. To repay their dollar debts, Chinese firms will either have to draw from the central bank’s foreign-exchange reserves (a prospect Beijing is unlikely to allow) or buy dollars on international markets. This creates a new set of problems. There are only 617 billion yuan ($90 billion) of offshore renminbi deposits in Hong Kong available to buy dollars. If China was to push firms to bring debt back onshore, this would necessitate significant outflows that would push down the yuan’s value against the dollar.
International dollar investors need to be wary of Chinese-linked investments. Local government financing vehicles and Belt-and-Road borrowers may seem quasi-sovereign quality, but any shift in the willingness to roll over dollar debt could create a funding crunch. With the US Federal Reserve raising rates and reducing its balance sheet, Chinese companies could face paying more for capital in dollars than in yuan.
Bulls have long argued that China’s financial risks are contained because of the country’s low levels of external debt and large foreign exchange reserves. That has changed. China’s external debt has been rising by an average of $70 billion per quarter since the start of 2017. If it continues, Beijing will have the unpalatable choice of burning through its reserves or letting the yuan fall, both of which would carry additional risks.
China and the world need to think clearly about this growing dollar debt dependence. Any cessation of funding could have severe and unforeseen consequences.