Xi Jinping may feel secure enough politically to embark on his first foreign visit since the outbreak of Covid, but he should be seriously worried about the dire straits of China’s economy. A new analysis by Enodo Economics shows severe credit losses in 2021, with more to come this year.

Investor worries about China’s mounting bad debt reached a premature crescendo in 2015-16, inuring them to its subsequent rise. At that time, I argued that Beijing had not reached the end of the road, but our estimate of credit losses for 2021 should be ringing alarm bells now. 

Enodo Economics has combined bottom-up analysis of China’s quoted sector loans with a top-down macro evaluation of the returns on credit to estimate expected loan losses following its post-GFC borrowing binge. 

Taking into account 2021 figures for impairment rates, we estimate credit losses at a startling 26% of GDP for 2021. 

Our estimates are conservative, based on the share of loans to firms with an interest coverage ratio of 1.5 times to total loans. If we are to use an interest coverage ratio of 2 times, the respective impairment rates and credit loss estimates surge to 31% of GDP.* 

Dealing with China’s bad debt is a daunting challenge. Not just because of the enormous size of losses, but also because the pandemic has delayed efforts to speed the clean-up and get on with the necessary banking recapitalisation. Moreover, Xi’s dynamic zero-Covid policy has hobbled growth. Beijing is yet again relying on boosting credit to pump prime the economy. 

Looking at impairment rates by sector, it is noteworthy that consumer staples is the sector most at risk after utilities, surpassing real estate. The impairment rate of both consumer staples and real estate has surged well above their 2016 level while that of utilities is as high as it was that year. These three sectors account for over 30% of all quoted sector loans. 

This is yet another piece of evidence that the Chinese consumer is in the doldrums, and the much-needed rebalancing of the economy has stalled if not rapidly reversed.  

Worse still, about a quarter of all corporate bonds are due to mature between now and the next session of the National People’s Congress, held in March next year. Both the utilities and consumer sectors rely more on bank loans than corporate bonds. Financials account for over 74% of those bonds maturing in the next 6 months, so beware of those institutions exposed to the utilities and consumer staples sectors. 

Both the amount and number of corporate bond defaults decreased in the year to August 2022 compared with the same period last year.

 We expect this decrease to reverse in the coming months. While allowing more corporate bond defaults is a good sign that China is learning to price risk properly, the size of likely credit losses bodes ill for growth. 

This is surely the last time China can backstop the fallout from its chosen mode of credit-driven development without ultimately triggering major economic, if not political, upheaval.

* The impairment rate was calculated on the basis of firm-level data, following the approach of the International Monetary Fund. We select companies for which the interest coverage ratio is relatively low (below 1.5 and 2.0, respectively). These companies are defined to be “at risk”. The share of loans to firms with a low interest coverage ratio in total loans is calculated to be 20% (ICR below 1.5) and 24% (ICR below 2.0%), respectively. These shares are used as a proxy for the impairment rate.