China's Effort to Control Debt Loses Steam

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Shoring up growth to keep a huge workforce employed and meet expectations for rising standards of living is a priority for China’s leadership. Above, a billboard adorns the wall of a construction site in Beijing's central business district on Thursday.

Shoring up growth to keep a huge workforce employed and meet expectations for rising standards of living is a priority for China’s leadership. Above, a billboard adorns the wall of a construction site in Beijing’s central business district on Thursday.


Photo:

GREG BAKER/AGENCE FRANCE-PRESSE/GETTY IMAGES

BEIJING—China is letting up on its drive to keep a lid on debt growth as it faces a softening economy at home and escalating trade tensions with the U.S.

Senior Chinese leaders led by President

Xi Jinping

have been sending unmistakable signals that the campaign to rein in financial risk isn’t the overriding priority it has been. Financial regulators are delaying the release of rules to curtail risky lending by banks and other institutions out of concern that the regulations would choke off a source of funding and rattle financial markets already shaken by worries over trade and the economy, people familiar with the decision said.

In a turnabout, the State Council, China’s cabinet, stopped hectoring city halls and townships to restrain spending and instead last week launched an inspection to urge them to speed up already approved investment projects to re-energize growth. The central government often uses inspections as a way to evaluate local officials and get top-level directives across.

Debt Drag

China faces financial risks including borrowers struggling to repay loans and banks shouldering bad debt.

Corporate bond defaults, 1H

25

billion yuan

20

15

10

5

0

’15

2014

’16

’17

’18

Banks’ nonperforming loan ratio, quarterly

%

2.0

1.5

1.0

0.5

0

’16

’17

’18

2014

’15

Total debt as a percentage of GDP

250

%

200

150

100

’15

’05

’10

2002

Note: 10 billion yuan = $1.5 billion

Sources: Wind Info via Macquarie (default, NPL); Macquarie (debt)

An April meeting of the Politburo, the inner sanctum of power, offered an initial sign of the shift in government priorities toward growth. Mr. Xi, who presided over the meeting, called for expanding domestic demand as authorities continued to contain financial risks. Such pro-growth emphasis had been absent in Politburo meetings since 2015.

China’s economic growth has been on a controlled descent for most of this decade, propped up at times by shots of easy credit that have helped make debt a long-term threat for the world’s second largest economy. With growth still buoyantly above the government’s 6.5% target, Mr. Xi has taken aim at debt and other financial risks the past two years to put the economy on sounder footing.

Now, that campaign is taking its toll. Signs are building that the economic expansion is losing steam—from weakening investment in factories to anemic household consumption and rising corporate defaults.

The trade fight with the U.S. puts growth further at risk, making Mr. Xi’s initiative look unsustainable, government advisers said.

“There is a feeling that the deleveraging campaign has gone a bit too far this year,” said a government adviser, pointing to recent drops in total credit growth and anemic investments in factories, highways and other fixed assets. “Now we’re going to see some policy adjustments.”

The central bank in April began freeing up more funds for banks to make loans. The Chinese leadership is expected to further loosen China’s fiscal and monetary stance at a meeting later this month of the Politburo, government advisers and economists said.

“The deleveraging effort should be let up somewhat,” said

Sheng Songcheng,

a senior adviser at the People’s Bank of China. As a result of policy loosening, Mr. Sheng expects the amount of money in circulation to expand, with M2—a measure of the money supply that includes cash and most deposits—growing 8.5% this year, from 8.1% last year.

Shoring up growth to employ a huge workforce and meet expectations for rising standards of living is always a priority for China’s leadership. Trade conflict with the U.S. raises the stakes.

Strong exports, especially those to the U.S. and other developed nations, have buoyed China’s economy, which grew 6.9% last year. Exports are expected to take a hit from the intensifying trade fight: The U.S. and China have slapped levies on $34 billion of each other’s exports. Trump administration threats of additional tariffs on over $200 billion in Chinese goods would shave 0.3% off China’s economic growth by 2020, estimates Oxford Economics.

The trade fight with the U.S. brings a new challenge for Chinese policy makers. Above, a woman hails a taxi cab in the central business district in Beijing on Thursday.

The trade fight with the U.S. brings a new challenge for Chinese policy makers. Above, a woman hails a taxi cab in the central business district in Beijing on Thursday.


Photo:

MARK SCHIEFELBEIN/ASSOCIATED PRESS

The gathering economic gloom in recent weeks has been driving down the Chinese yuan. The U.S. has complained in the past that China keeps the currency artificially low to give its exporters a boost; early Thursday the yuan weakened past 6.7 against the dollar—a level closely watched by investors—before rebounding to end roughly flat.

On Thursday night, China’s Commerce Ministry accused the U.S. of flip-flopping on trade issues and denied its allegations that Beijing has engaged in unfair trade practices such as pilfering and pressure tactics to acquire U.S. technology. “China has done its best to prevent the trade friction from escalating,” the ministry said.

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Debt levels, especially for companies and local governments, have soared since China unleased a massive financial stimulus to ward off the 2008 financial crisis. Debt stood at 242% of economic activity at the end of 2017, according to Macquarie Group. While analysts said that the ratio isn’t rising as in past, they don’t expect a decline soon. A less determined approach to tackling debt, some said, would allow risks to accumulate further.

“If China has an across-the-board loosening up again, borrowing by state-owned enterprises might get more relentless,” said

Zhu Chaoping,

a market strategist at JP Morgan Asset Management. “This is the risk here.”

Defaults in the corporate bond market—a barometer of business conditions—ticked up before the first major round of trade tariffs hit this month. Chinese firms defaulted on 19 billion yuan ($2.9 billion) in debt in the first half of the year, compared with 14 billion yuan in the same period last year.

In the prosperous eastern province of Zhejiang, manufacturing firm DunAn Group was on the verge of default this spring until local financial regulators intervened to coordinate talks between creditors to keep the company afloat and from cutting its workforce.

Smaller banks have been feeling the stress, too. A rural bank in southwestern Guizhou province saw its bad loans surge by fourfold to 20% after, acting on requests from regulators, it classified loans overdue for more than 90 days as nonperforming. Commercial banks’ bad-debt ratio—currently less than 2% overall according to official data—would be much higher if regulators pressed banks harder to come clean, according to analysts.

On a recent trip to Beijing,

David Loevinger,

a managing director of asset manager TCW Group’s emerging markets division, said he observed Chinese officials digging in for a protracted economic battle and questioning the pace of their efforts to rein in debt: “Are they going too fast on deleveraging? At the margin, should they go a bit slower?”

Write to Chao Deng at Chao.Deng@wsj.com and Lingling Wei at lingling.wei@wsj.com