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China's Deleveraging Will Likely Take Longer Than the Official Three-Year Time Line

Singapore, Aug. 20 2018 — China's longest credit cycle since the beginning of the reform period is now over. However, China will have a hard time achieving a meaningful reduction in credit risk within the current, official three-year horizon.

Measured peak to peak on a credit-to-GDP basis, China has now completed its longest credit cycle in the reform period: thirteen years (2004-2017). Nearly all the key credit ratios have peaked, with the exception of those of the household sector, where leverage should continue to gradually rise to support the rebalancing of the economy. The ratio of total credit to GDP hit its maximum of 211% in the first quarter of 2017. On the sourcing side, non-bank credit peaked in the first quarter of 2017 at 54% and, somewhat surprisingly, bank credit also peaked, at 158% of GDP in the second quarter of the year. Corporate credit peaked at 167% of GDP in mid-2016.

"For a long time the question was: When will China begin deleveraging?" said Paul Gruenwald, S&P Global Ratings' chief economist. "Now the questions are: How much does China have to deleverage? How long will this take? What are the headwinds? And what are the macro and sectoral implications?"

In the report, we look at recent Chinese credit cycles and analyze various measures of the size of the credit-to-GDP gap to be closed, as well as the speed at which deleveraging can close these gaps. We also consider the partial slowdown in deleveraging this year to date in response to larger-than-expected potential macro effects as well as uncertainties around the still-escalating trade war with the U.S.

"In order to achieve a meaningful reduction in risk, the authorities may need to extend their current three-year horizon for deleveraging and to more clearly articulate their objectives," said Mr. Gruenwald.

After examining a number of scenarios, we conclude that the deleveraging process will likely stretch beyond three years, and could even take up to seven years, depending on the objectives. Non-financial corporations will likely continue to reduce debt burdens by the greatest proportion, and the government may increase deficit spending to partially offset slower corporate spending.