Why China won't suffer a 'debt crisis'

Inaccurate articles sometimes appear in the Western media claiming China faces a "severe debt crisis." Factually these are easily refuted. Changyong Rhee, the IMF's Asia and Pacific Department director, pointed out that China's national and local government debt is only 53 percent of its GDP, compared to U.S. government debt which is roughly as big as GDP, or in Japan where government debt is 240 percent of GDP. Foreign debt is 9 percent of China's GDP – insignificant set against the world's largest foreign exchange reserves.

Factually, it is therefore unsurprising that China's predicted "Lehman" or "Minsky" moment, a financial collapse, invariably fails to occur. But there is another, even more fundamental, reason why China's economy does not suffer severe financial crises of the type that struck the Western economies in 2008 or wracked the Eurozone. As this illustrates a way that China's economic structure is superior to the West's, it is worth analyzing.

Starting with fundamentals, the way the argument is constructed that China faces a "serious debt crisis" violates the most elementary accounting rule – more precisely that of double entry book keeping, which was invented in Italy "merely" eight centuries ago! This is that for every debit entry there has to be a credit one, and vice versa. Discussion of only of one side of a balance sheet without the other is financial nonsense. Claims, such as in the Financial Times, that the big story of 2014 is "the black cloud of debt hanging over China" are financially meaningless given they do not discuss assets to be set against debt.

To illustrate this elementary accounting principle, take a simple example. A company borrows $100 million at 5 percent interest, uses it to build houses, and sells them at 15 percent profit. To declare "there is a crisis – the company has a $100 million debt" is evidently nonsense. The company has debts of $100 million but assets of $115 million. It can repay $105 million and make $10 million profit – there is no "debt crisis" whatever. That its assets are greater than its debt illustrates why it is financially illiterate to discuss only debt without assets. A "balance sheet" is called that because it has two sides, not one.

Apply this to China and the West's financial systems. Evidently no financial problem exists in either if a borrower makes a profit on a loan – they repay it. A problem only exists if the borrower does not make sufficient money to repay the debt.

If the borrower is a small or medium one, again there is no difference between Western and Chinese financial systems. In both cases the borrower partially or fully defaults and, if necessary, goes bankrupt.

Specific criticisms can be made, which this author would tend to agree with, that in the West's system companies are sometimes too easily allowed to use bankruptcy to escape debts, and China has propped up some companies that would have been better allowed to go bankrupt. But these are detailed points, not affecting the essence of the matter. China is also now taking a more robust line in forcing into default small and medium borrowers that cannot repay loans – recently Shanghai Chaori Solar Energy Science and Technology defaulted without a bail out.

But, by definition, individual bankruptcies by small and medium companies do not affect the financial system's viability – they are a normal part of market functioning. The key difference between China's and the Western financial system comes with debts by large institutions – "system making" ones to use technical economic terms. Here Western and China's systems differ – and China's is superior.

First take Western government debt. As Western governments ideologically oppose state investment, Western state borrowing is overwhelmingly used not to finance investment but consumption – via social security payments, unemployment pay etc. For example, in the United States at the depth of the post 2008 Great Recession, annual government borrowing was 13.6 percent of GDP but state investment was only 4.5 percent – borrowing overwhelmingly financed consumption. As Western government debt primarily finances consumption it therefore creates no lasting asset. That is why in the West it is not wholly misleading to look at state borrowing purely from the debt point of view – even if it is wrong conceptually.