China: Rising risks of a balance-sheet recession

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15 June 2023 Global macro, Fixed income, Solutions

China’s property sector is in a structural slowdown that could last for years.

Executive summary

The pandemic response has caused a period of severe economic volatility; corporate and local government balance sheets have become impaired, and the property sector appears to be in a structural slowdown that could last for years. This has led to fears of a balance-sheet recession in China.

Although aggregate debt levels are concerning, and growth is structurally weakening, there are still significant policy options available.

Comparisons with Japan in the late 1980s suggest some similarities, but key differences are also apparent.

We do not believe that China is in a balance-sheet recession yet, but the risks are meaningfully higher than they were a few years ago. A transfer of leverage from corporates and local governments to central government seems a likely solution.

A balance sheet recession

A balance-sheet recession is a recession driven by high levels of private-sector debt rather than fluctuations in the business cycle. It is characterised by a change in private sector behaviour where debt repayment is prioritised above spending and investment, which ultimately leads to slower growth. This can become a self-reinforcing spiral, as slower growth can make debts appear even less sustainable in the medium term, and the debt overhang can depress economic activity for a prolonged period. Typically, such events are characterised by the bursting of an asset bubble following a period of excessive borrowing. Japan in the early 1990s and the US subprime crisis in 2007 are often cited examples. Falling asset values can compound the impact if debts have been secured on those assets.

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