In 2019, China’s macro-leverage ratio was up six percentage points, half the annual average growth rate from 2008 to 2016, according to our Report on China’s Leverage Ratio in 2019. In the latter three quarters of 2019, in particular, China’s leverage ratio only increased by one percentage point, reflecting policymakers’ resolve to keep the leverage ratio stable.

The leverage ratio of the financial sector fell for three straight years, and started to stabilize in 2019. Shadow banking operations and the off-balance-sheet assets of banks have fallen to a reasonable level - a sign that the current cycle of financial deleveraging is about to end.

1. Overall Assessment: The Leverage Ratio of the Real Economy Jumped in Q1 but the Growth Slowed in Q2-Q4

In November 2019, the National Bureau of Statistics (NBS) revised China’s 2018 GDP data upwards based on the results of the fourth economic census, which led to a reduction in the overall leverage ratio. According to the revised statistics, the leverage ratio of China’s real economy was 245.4% in 2019, which is 6.1 percentage points higher than in 2018 or up 5.1, 0.7, 0.9 and -0.6 percentage points in the four quarters respectively. That is to say, China’s leverage ratio increased quickly in Q1 2019 and moderately in Q2 and Q3, but started to fall in Q4. Given the external shocks, growth stability topped the policy agenda in Q1, as reflected in the newly-issued renminbi loans worth 6.3 trillion yuan. The steep rise in the leverage ratio was curbed in Q2, when newly-issued renminbi loans started to decrease year-on-year. The macro-leverage ratio growth remained tepid in Q3 and turned negative in Q4.

Sector-wise, the household sector remained the primary driver behind China’s rising leverage ratio. The non-financial corporate sector, on the other hand, saw its leverage ratio fall for three straight quarters. The household sector’s leverage ratio increased by 3.7 percentage points year-on-year to reach 55.8%, or 1.0, 1.1, 0.9 and 0.7 percentage points in the four quarters, respectively, exhibiting a downward trend. The non-financial corporate sector’s leverage ratio increased by 0.3 percentage points year-on-year to reach 151.3%, or 3.4, -1.2, -0.7 and -1.2 percentage points in the four quarters, respectively. The government sector’s leverage ratio rose by 2.1 percentage points year-on-year to reach 38.3%. Specifically, the central government leverage ratio was up 0.6 percentage points for the whole year, or -0.3, 0.3, 0.2 and 0.4 percentage points from Q1 to Q4, respectively. The extent and pace of the leverage ratio’s increase are similar to those of previous years and determined mainly by the progress of Treasury bond issuance. The local government leverage ratio increased by 1.5 percentage points for the whole year, or 1.0, 0.5, 0.5 and -0.5 percentage points in the four quarters, respectively. Most of the local government bond issuance quota was used in Q1-Q3, and local government bond issuance almost came to a halt in Q4, resulting in a falling local government leverage ratio in Q4.

In 2017, China’s macro-leverage ratio only increased by 2.4 percentage points, followed by a reduction of 1.9 percentage points in 2018. Given this, it is safe to say that the “rapid increase of the macro-leverage ratio has been initially contained.” The unexpected rise in the macro-leverage ratio in 2019 stands in sharp contrast to the policy agenda to stabilize and even reduce the leverage ratio in the previous couple of years. Yet such a rapid increase is justifiable given the growing downward economic pressures in the context of rising domestic and international risks and challenges, along with the excessive deleveraging in 2018. Nevertheless, China’s macro-leverage ratio was up only six percentage points, less than half of the annual average growth over the period of 2008-2016, and only grew by one percentage point from Q2 to Q4, reflecting policymakers’ resolve to keep the leverage ratio stable.

2. Analysis of Sector-Specific Leverage Ratios

2.1 The Household Sector’s Leverage Ratio Remains a Key Driver of the Overall Leverage Ratio

By the end of 2019, China’s household sector leverage ratio stood at 55.8%, up 3.7 percentage points over 52.1% at the end of 2018. The household sector remained the key driver of China’s rising macro-leverage ratio. From Q1 to Q4, the household sector’s leverage ratio rose by 1.0, 1.1, 0.9 and 0.7 percentage points, respectively, showing a slowing upward trend.

Short-term consumer loans and household consumption: Short-term consumer loans, which comprised auto loans and the bulk of credit card loans, were a direct reflection of potential consumer purchasing power. By the end of 2019, China’s short-term household consumer loans amounted to 9.9 trillion yuan, accounting for 18% of total household debt. The growth rates of both household short-term loans and social consumer goods retail volume fell sharply. The year-on-year growth of the balance of short-term loans dropped from 29% in 2018 to 13%, and the year-on-year growth of total social consumer goods retail volume slipped from 9% to 8%. While keeping the household leverage ratio in check, falling consumer loans and retail sales volume will also crimp consumer demand. The novel coronavirus (COVID-19) outbreak in 2020, in particular, is expected to weigh on household spending, likely to result in a further decline in the household leverage ratio.

Housing loans were a key determinant and variable of the household leverage ratio. By the end of 2019, China’s total household loans amounted to 55.3 trillion yuan, including 34.0 trillion yuan in mid- and long-term consumption loans, or 62% of total household debt. The balance of personal housing loans was about 30.0 trillion yuan, accounting for 54% of total household debt. From a long-term perspective, household loans and housing mortgage loans share a roughly consistent trend of cyclical volatility, and the household sector’s leverage ratio is also influenced by real estate cycles. In 2020, China’s real estate market will be subject to two critical variables. First, the policy priority of keeping growth stable: The government has identified investment, traditionally a key driver of growth, as one of the “six pillars” for shoring up growth. In 2019, China’s infrastructure investment grew by 3.3% year-on-year, which is 1.5 percentage points higher than the previous year but nonetheless remained low. The external economic environment and expectations still weigh on manufacturing investment, which has yet to recover to its full potential. Despite the draconian real estate regulation policy enacted by local governments since 2017, real estate investment in China continued to grow by around 10%. In 2020, slowing growth, structural reforms and the effects of previous stimulus policies present growing downward pressures on China’s economy. Under the policy priority to maintain a steady growth rate, there are strong expectations for relaxing real estate restrictions.

Another variable is the policy guideline that “housing is for living in, not for speculation.” In many ways, China’s housing market is already too expensive. Measured by the rent-to-price ratio, in particular, return on housing investment is paltry. After close to three years of steadily rising house prices, expectations for stable housing prices are in the making. As indicated in an array of policy statements since 2019, the top policymakers have resolved to prevent housing prices from rising too quickly. The policy assurance that “housing is for living in, not for speculation” will, to some extent, discourage households from splurging on real estate investment and is conducive to a stable household leverage ratio.

With its impact on the economy, the COVID-19 outbreak may prompt some local governments to ease housing market policies. But given the policy stance that “real estate should not be used as a tool for stimulating the economy,” together with market expectations for stable housing prices, we forecast China’s household debt growth to stay flat or slow down. However, a potentially more significant slide in the growth of GDP as the denominator may still lead to a rapid increase in the household leverage ratio.

2.2 Deleveraging for Non-Financial Corporations Is Underway

Non-financial corporations (NFCs) stayed on the deleveraging track. In 2019, their leverage ratio increased from 151.0% in 2018 to reach 151.3%, up only 0.3 percentage points for the whole year, or 3.4, -1.2, -0.7 and -1.2 percentage points from Q1 to Q4, respectively. In 2016, the leverage ratio of NFCs reached a record high of 157.6% before falling by 1.0 and 5.6 percentage points in 2017 and 2018, respectively. Over the period of 12 quarters from 2017 to 2019, except for the first quarter of each year, China’s NFCs saw their leverage ratio decline in all the rest of the nine quarters. The falling leverage ratio of NFCs is fully in line with the policy direction of structural deleveraging.

First, the structure of financing instruments: NFCs saw their off-balance-sheet financing decline year by year after peaking in 2017. The aggregate of trust loans, entrusted loans and undiscounted bank acceptance bills reached 26.9 trillion yuan by the end of 2017 before decreasing. In 2018 and 2019, this figure dropped by 2.9 and 1.8 trillion yuan, respectively, reaching 22.2 trillion yuan by the end of 2019. These three types of debt as a share of nominal GDP decreased from the peak of 33% in 2014 to 22% at the end of 2019, which is the main reason behind the falling leverage ratio of NFCs. Decrease in the off-balance-sheet financing stems from tightened regulation over shadow banking in the past couple of years. With the financial leverage ratio showing signs of stabilizing from Q3 to Q4, 2019, the off-balance-sheet financing of the corporate sector is expected to stabilize as well.

With shrinking off-balance-sheet financing, bank loans as a share of corporate sector debt increased from 62% in 2017 to 66% in 2019. Meanwhile, mid- and long-term loans as a share of non-financial corporate loans rose from 53% in 2016 to 58% in 2019, which is a sign of an improving financing structure. First, the rising share of loans reflects a reduction in costlier and riskier shadow banking operations. On-balance-sheet lending effectively prevents off-balance-sheet credit arbitrage and helps reduce financing costs. Second, mid- and long-term loans are more stable, giving rise to expectations for macroeconomic stability and a more stable cash demand. Third, implementation of the loan prime rate (LPR) loan pricing mechanism as part of China’s interest rate liberalization reform has led to a fall in the overall lending interest rate. Rising mid- and long-term loans in the corporate financing structure will further drive down financing costs for the corporate sector.

Second, the structure of financing entities: According to data released by the Ministry of Finance, the assets and liabilities of Chinese state-owned enterprises (SOEs) stood at 195.0 trillion yuan and 125.8 trillion yuan, respectively, by the end of June 2019, with a debt-to-asset ratio of 64.5%. Since Q3 2019, the Ministry of Finance has ceased to publish SOE assets and liabilities data aside from the SOE debt-to-asset ratio, which stood at 63.9% at the end of 2019. Based on our estimate, SOE debt makes up about 70% of the total debt of NFCs.

After 2017, the SOE debt-to-asset ratio was on the decline. According to data released by the Ministry of Finance, the debt-to-asset ratio of SOEs peaked at 66.3% in mid-2016 before decreasing to 63.9% by the end of 2019. Similarly, the debt-to-asset ratio of industrial SOEs peaked at 61.7%, also in mid-2016, before sliding to 56.9% by the end of 2019. Meanwhile, the debt-to-asset ratio of private enterprises was on the rise. Industrial enterprises, particularly private industrial enterprises that comprise the bulk of them, saw their debt-to-asset ratios increase. Yet this upward trend slowed in 2019 and remained relatively stable for the whole year.

Total SOE debt continued to rise despite the falling SOE leverage ratio, and still accounted for a major share of non-financial corporate debt - a large chunk of which was implicit local government debt.

Small and micro businesses saw their loans increase as a share of total corporate loans. By the end of 2019, the balance of inclusive small and micro business loans totaled 11.59 trillion yuan, up 23.1% year-on-year, or 7.9 percentage points higher compared with the end of 2018. The annual increase of 2.09 trillion yuan in 2019 was 852.5 billion yuan higher compared with the annual increase in 2018. The rising share of small and micro business loans at falling interest rates was vital to shoring up growth and reducing the leverage ratio. In 2019, the progress of lending to small and micro businesses was achieved largely thanks to the efforts of large state-owned commercial banks. In 2020, the share of small and micro business loans is expected to rise further, as greater financial support is needed to help small and micro businesses survive the COVID-19 outbreak.

3.3 Government Sector Leverage Ratio Nudged Up

The government sector leverage ratio increased from 36.2% in 2018 to 38.3% at the end of 2019, up 2.1 percentage points, or 0.7, 0.8, 0.7 and -0.1 percentage points from Q1 to Q4, respectively. Compared with a few years before, there was a sharp rise in China’s government leverage ratio. Specifically, the central government leverage ratio rose from 16.2% in 2018 to 16.8% in 2019, up 0.6 percentage points for the whole year, or -0.3, 0.3, 0.2 and 0.4 percentage points from Q1 to Q4, respectively. The local government leverage ratio rose from 20.0% in 2018 to 21.5% in 2019, up 1.5 percentage points for the whole year, or 1.0, 0.5, 0.5 and -0.5 percentage points from Q1 to Q4, respectively.

First, the central government’s Treasury bond stock was dwarfed by local government bonds. Based on our estimate, China’s Treasury bonds totaled 16.7 trillion yuan at the end of 2019, or 16.8% as a share of the GDP. According to data released by the Ministry of Finance, the balance of central government debt amounted to 1,597.3 billion yuan at the end of Q3 2019, including 1,595.5 billion yuan in Treasury bonds, or 99.9% of the central government debt balance. Specifically, local government bonds swelled after 2016, reaching 21.1 trillion yuan by the end of 2019 and accounting for the largest share of government bonds. Central government bonds totaled 16.7 trillion yuan. The gap between national Treasury bonds and local debt was huge.

By international comparison, China’s central government bonds were a relatively small share of the GDP. At the end of March 2019, the central government bonds of Japan, the US, the UK and Germany as a share of the GDP stood at 187.7%, 87.7%, 73.3% and 33.9%, respectively, all higher than China’s Treasury bonds as a share of the GDP. There was still large room for China’s central government to raise the leverage ratio and play a bigger role in structural deleveraging.

Second, the key to addressing local government debt was to resolve the implicit debt. By the end of 2019, China’s local government bonds totaled 21.1 trillion yuan as the second-largest bond in China’s bond market, next only to financial bonds. In 2019, the National People’s Congress (NPC), China’s legislature, approved additional local government debt of no more than 3.08 trillion yuan, including additional general debt of no more than 930 billion yuan and additional special debt of no more than 2.15 trillion yuan. Bond issuance for 2019 was completed by the end of Q3 2019, and no additional bond was issued in Q4. For the whole year, new bond issuance did not exceed the NPC’s approved quota.

By broad and narrow scopes, we have estimated local government implicit debt to be 50 trillion yuan and 15 trillion yuan by the end of 2018, or 55% and 20% of GDP in the same year, respectively. The real local government implicit debt should be somewhere between these two percentages. Even by the narrow scope, local government implicit debt was close to the current volume of Treasury bonds.

2.4 Financial Sector Deleveraging Is Likely to Come to a Close

In 2019, China’s asset-side financial leverage ratio was 54.8%, down 4.6 percentage points year-on-year, or -0.1, -1.8, -2.8 and 0.1 percentage points from Q1 to Q4, respectively. The liability-side financial deleveraging ratio was 59.9%, up 0.2 percentage points year-on-year, or -1.5, -0.7, 0.6 and 1.8 percentage points from Q1 to Q4, respectively. After regulation tightened in 2017, China’s financial leverage ratio, particularly the liability-side financial leverage ratio, started to fall, but stabilized in 2019. In our view, China’s financial sector leverage ratio already reached a fairly reasonable level, meaning that the current cycle of financial sector deleveraging is likely to come to a close.

First, shadow banking operations and the off-balance-sheet assets in the formal banking sector both returned to a reasonable level after three years of financial deleveraging. In 2019, trust loans, entrusted loans and undiscounted bank acceptance bills as a share of the GDP reached 22% in 2019, down 10 percentage points compared with 2017, or more or less back to the 2010 level. According to the China Banking and Insurance Regulatory Commission (CBIRC), China’s shadow banking operations shrank by 16 trillion yuan compared with the historical peak.

Second, China’s financial regulation is expected to relax in 2020 amid rising pressures for maintaining stable growth. The new asset management regulations released in 2018 provide a transition period for financial institutions, which is three years from the end of 2017 to the end of 2020, for asset management products, especially existing ones. Yet, based on the recent regulatory statements and media reports, this transition period is likely to be extended for another year. A marginal relaxation of regulatory policy will help stabilize the financial leverage ratio.

Third, structural adjustment will dominate China’s financial supply-side reforms. In the banking system, future priority would be to nudge small and medium-sized banks to lend more to the local economy, small and micro businesses, and urban and rural households. The capital markets will continue to implement the registration-based reform to increase the share of long-term capital and institutional investors and the percentage of direct financing, facilitate corporate financing, reduce the corporate debt-to-asset ratio, and promote the sound development of the non-financial corporate leverage ratio.

3. Policy Priority for 2020 Is to Strike a Balance between Economic Growth and the Leverage Ratio

In 2019, China’s macro-leverage ratio deviated from the deleveraging track of the previous couple of years, reflecting the challenges of keeping the leverage ratio stable. The COVID-19 outbreak has made it more difficult to maintain a stable growth rate in 2020 without raising the leverage ratio.

Restaurants, hotels, tourism, manufacturing, construction, cinemas and financial services are among the hardest-hit sectors. But healthcare, textiles, online gaming and online application have flourished. Under the joint effect of these factors, China’s nominal GDP growth is expected to slide in Q1 2020. Considering the priorities of fighting the COVID-19 outbreak and shoring up economic growth, China’s debt growth is likely to be slightly higher than in 2019. When both the numerator (debt) and the denominator (nominal GDP) are taken into account, China’s leverage ratio is projected to rise by 10 percentage points in 2020.

The short-term policy priority is to balance epidemic control with the resumption of work. For the whole year, the goal is to keep both the economic growth rate and the leverage ratio stable. In our view, policymakers should be more tolerant of a further uptick in the leverage ratio stemming from slowing growth and focus on the structure of the leverage ratio by raising leverage ratios for small and micro businesses and the central government. The basic policy direction is to extend greater support to small and micro businesses and increase the share in loans to NFCs. In addition, the central government should continue to raise its leverage ratio. Compared with other sectors, the central government and private enterprises still have the potential to raise the leverage ratio. Issuing more Treasury bonds is also conducive to improving the bond market. An increase in Treasury bonds helps promote the soundness of the central bank’s balance sheet. The key to the central government’s leveraging operation is to break through the 3% limit of the fiscal deficit ratio.