Key Takeaways
- China used stimulus as a way of digging itself out of trouble twice already this century, but we don’t think the conditions are right for it to repeat the trick a third time.
- Although Chinese authorities have been slowly dealing with the legacy of those previous binges, we believe the country hasn’t properly acknowledged the scale of the problem – around half of the delinquent loans from the global financial crisis still sit on the books.
- Although all the lending is in local currency and the capital account is closed, thereby reducing the chance of a classic emerging market debt (EMD) crisis, there could be trouble if Chinese depositors begin to lose faith in the country’s financial stability.
With delinquent loans from the global financial crisis still sitting on its books, we don’t think the conditions are right for China to repeat its stimulus trick for a third time.
What exactly is China’s problem?
Figure 1: China surges ahead - Size of banking sector ($trillions)
Source: CEIC / US Federal Reserve / ECB / Autonomous data, as of January 2025.
These bad loans aren’t new; China just hasn’t dealt with the legacy of the previous two credit binges. We estimate that around half of the delinquent loans written following the global financial crisis (GFC) are still on bank balance sheets today. The system has simply not cleared. If all the losses were recognised today, the small and medium-sized banks would be insolvent (at least by Western regulatory standards).
Why hasn’t China fixed the problem sooner?
Can the banks increase loan loss recognition?
Can the government borrow and leave the banks out of it?
It’s not that straightforward in China. The German fiscal stimulus will be paid for with funds borrowed on the international capital markets. Yes, the local banking sector will buy some of the debt, but it will also go to investors all over the world. The interest rate at which Germany can borrow will be set by the market.
In China, the government borrows almost exclusively from the banking sector, which is mostly state owned. This allows the government to set its own borrowing cost. It also means that as the government fiscally stimulates, the banking sector balloons. What’s more, the borrowing is typically not from central government coffers but from local government (entities such as local government financing vehicles, about which little is known). This doesn’t tend to get paid back, which ultimately means we end up with even bigger banks with yet more bad debt.
Pumping the credit pedal again might add back a few much-needed percentage points to GDP growth in the short term, but it will create a bigger problem with the banks in the longer term. Without first fixing the engine, by recapitalising the sector, stimulus will only make the financial system more unstable.
Does it matter?
Nothing to worry about then?
Not quite. It goes back to how big the banking sector is, but this time let’s compare it to currency reserves. Over the past decade China’s currency reserves have remained steady, hovering around $3-$3.5 trillion, while the banking sector has doubled in size to $60 trillion. That means there is the equivalent of $60 trillion of liabilities (or funding) in the Chinese banking system.
Of course, China prevents that money from leaving the local system via tight capital controls, but it is possible – especially for corporates involved in international trade – to get money out. It is this risk, we believe, that is making the Chinese authorities think twice about turning on the stimulus taps. Instead, we think the government will focus on targeted ways to encourage local depositors to funnel those funds into consumption.
The bottom line
China might be tempted to follow Germany and get the stimulus bazooka out, but a broken banking sector makes it a high-stakes gamble. We are not doomsayers about China. We believe the Chinese authorities will continue with a pragmatic approach focussed on domestic consumption growth over the longer term. That means a policy of targeted, piecemeal stimulus. And if that is not the path taken – keep an eye on the currency.
