More Cool Charts: China, Germany and the US

In the class I teach on Country Risk at NYU, this month we convened a model corporate Country Risk Committee, to review the “firm’s” largest country exposures in China, Germany and the U.S., among other countries.

Here are five cool charts and tables the students and I discussed.

China

China suffers from a debt overhang. As the country has powered ahead as an exporting and innovation juggernaut, it has also experienced excessive credit growth resulting in bad debts.

Credit is “Total Social Financing” (TSF), including bank loans (>60% of total), shadow banking, corporate bonds & equities, govt bonds, etc., a metric the Chinese authorities track. IMF forecasts. Sources: IMF Article IV reports & WEO, Scher GE presentation 2015, Haver

The chart above shows that when credit (the green line) grows faster than GDP (the red line), then credit-to-GDP (the blue bar) rises inexorably. China’s credit-to-GDP ratio has exceeded what we see in nearly every large advanced or emerging market country. See chart below (pre-pandemic levels).

The debt metric in this chart is somewhat different from China’s TSF above. It includes domestic credit to the private sector, as reported by the IMF, and general government debt as reported by Fitch. Sources: Fitch, IMF. Rating medians are Fitch.

Still, the debt binge around the world as a result of the pandemic (in countries like the U.S.) could cause more countries to move ahead of China in the dubious “leaderboard” of credit-to-GDP.

China’s banking system is not well, friends. Fitch assigns a low “bb” viability rating to China’s banking system, reflecting a high average default risk for Chinese banks, absent government support. By contrast, the rating agency rates the government of China A+, which is a much better rating, indicating that the Chinese authorities have the wherewithal to fix the country’s bad debt problem.

That is the good news. The bad news is that the government is not doing so; instead it is using banks to grow the economy again. Not only through monetary policy, as central banks around the world might do in a recession by lowering interest rates or buying bonds. China juices its economy through “directed lending”, that is, the government directs banks where to lend and how much. When banks lend based on politics, loans are more likely to go bad.

So, non-performing loans will have to be recognized, instead of refinanced, losses taken and banks recapitalized, and China’s moribund state-owned enterprises (SOEs) cleaned up or closed down. This must occur before this energetic nation on the rise can boast the accoutrements of a great economic power — which include open capital flows and market-determined interest rates, as well as a currency that is widely used in international transactions.

Right now, capital flows are tightly controlled, notably preventing Chinese residents from seeking higher returns abroad. And, interest rates are not market-determined, especially not for bank deposits. Furthermore, only 2–4% of the world’s central bank FX reserves and private sector FX transactions are denominated in China’s currency, the CNY, compared to nearly 60% and 90% for the USD, respectively.

Sequencing reforms correctly will be critical. You cannot open your capital account first, lest Chinese households and firms flood out of the country seeking better returns around the world. First, you must clean up your bad debt problem. Then, you recapitalize your ailing banks. Then, you allow the market to determine interest rates, so that depositors can get a fair return. And only then, can you open your capital account.

Instead, China has been increasing credit to unproductive SOEs in order to make it through the pandemic as smoothly as possible. This is not unwise, given the unprecedented nature of the shock; however, cutting back on credit growth should become a policy priority soon.

China should correct its other negatives in order to ensure future success, such as its human rights abuses, especially against the Uighers, its extensive domestic security apparatus that hampers pluralism, and its tense relations with its economic partners.

Germany

Germany boasted a comparatively low government debt ratio at the end of 2020 (69% of GDP vs. the U.S.’s 127%). The country deploys a fiscal rule (the “debt brake”) which in normal times limits government deficits to very low levels. This is something the U.S. should consider.

Last year, Germany temporarily suspended the fiscal rule in order to sharply increase fiscal support amid the pandemic. The plan is to go back to this stringent rule in 2022. The IMF forecasts that German debt will be 77% of GDP below U.S. debt by 2026. See discussion in a previous post.

Nevertheless, we must understand why the Germans have to be frugal. This is due in part to German claims on other Euro Area countries, which total over €1 trillion, or 27% of German GDP. This figure is driven by its claims on big deficit countries, Spain and Italy. (The German claim on Spain and Italy arises from the Target 2 balances that Euro Area countries run with the Eurosystem of central banks.) See chart below.

Notes: Target 2 balances are claims that Euro Area national central banks have on each other through the Eurosystem, driven by a country’s balance of payments and by liquidity provision of the European Central Bank (ECB). A positive figure (like Germany has) represents a claim on the system; a negative figure (like Spain and Italy have) represents a liability to the system. Since the European sovereign debt crisis that began in 2010, German claims on the system, and Italian and Spanish liabilities to the system, have risen. A failure of the Euro Area, no doubt an extreme event, would put at risk Germany’s net claim of over €1 trillion, or more than one-quarter of German GDP, which represents a portion of the “contingent liabilities” that the German government might have to assume in a severe crisis, one reason for Germany’s responsible fiscal policy. During the pandemic, Spain’s liabilities rose €121 billion, to make Spain the largest debtor to the system, replacing Italy, whose liabilities only rose €27 billion, from end-2019. Source: ECB

When you add this potential liability of the rest of Europe to Germany’s government debt (assuming Spain and Italy don’t pay what they owe in the event of a breakup of the Euro Area, albeit an extreme event), Germany’s debt figure becomes 96% of GDP.

In “rating agency speak”, this is what is known as a “contingent liability”, or a debt that can revert to the government, in this case the German federal government, contingent on another party having its own debt problems and needing a bailout. The parties requiring a bailout could be domestic entities — e.g. banks, state-owned enterprises, Fannie Mae and Freddie Mac, or Germany’s development bank (KfW) — or foreign countries, e.g. Spain and Italy, or, say, the government of Mexico, to which President Clinton gave access to the U.S. Treasury’s Exchange Stabilization Fund in the 1990s during the peso crisis. So, this sort of thing doesn’t only happen in Europe.

In sum, these liabilities of Spain and Italy, when added to Germany’s debt stock, put Germany within striking distance of the U.S.’s woeful government debt to GDP ratio. Something to think about. Not too much, but at least a little. Germany’s sovereign balance sheet remains relatively pristine, but a little less so when you consider Target 2.

United States

A discussion of U.S. strengths and weaknesses relative to other countries has been a feature of this column. America’s innovative businesses and flexible markets have been highlighted as favorable factors. Yet, this column has also suggested strategic planning, led by government and partnering with the private sector, as a way to reverse the recent deterioration in U.S. competitiveness.

To correct course, the U.S. government should roll out a “whole-of-government” plan to confront such negatives as: poor education outcomes, political polarization, rising government debt and borrowing abroad, the inability to mobilize revenues to fund important public goods such as basic R&D and green tech, heavy greenhouse gas emissions, poor social outcomes, and substantial income and wealth inequality.

The table below speaks to inequality. Specifically, it shows data by race, ethnicity and income level. The National Science Foundation, the U.S. agency that funds basic R&D and reports on national and international trends in science and engineering, produced the following table showing data on the unequal access of American students to math education, by level of minority enrollment and eligibility for social assistance at schools.

If access to education remains unequal, income and wealth inequality will persist into the future. This argues for ramping up the federal education budget, especially the line item, Title I funding (for disadvantaged schools).

Public school students with trained math teachers, 2015, %

Table shows percentages of students receiving instruction from highly trained math teachers by percentage of minority enrollment and by income level driven by eligibility for the School Lunch Program. Source: US NSF, Science & Engineering Indicators 2020, at https://ncses.nsf.gov/pubs/nsb20196/teachers-of-mathematics.

One more cool table from the Country Risk Committee’s China discussion…

Notes: Higher score is better for Democracy, WGI, WEF, Social Progress ranks. Democracy score is the average of World Bank Voice & Accountability, EIU and Freedom House democracy ranks, 1–100. WGI is the World Bank’s overall World Governance Indicator average, including V & A, Govt effectiveness, Political stability, Rule of law, Control of corruption, and Regulatory quality. All 2020, except WEF (2019) and Fitch ratings (2021). WEF is the World Economic Forum’s Competitiveness Index, which seeks to reflect a country’s capacity for productivity and prosperity. Social progress reflects a country’s ability to meet its citizens’ basic needs & wellbeing, and to provide equal opportunity. Ratings are Fitch Ratings’ sovereign ratings. Sources: Fitch, WB, Freedom House, EIU, WEF, Social Progress Initiative, IMF WEO, April 2021.