By KEITH BRADSHER
SHANGHAI — China has gone on a spending spree, borrowing money to build cities, create manufacturing giants and nurture financial markets — money that has helped drive the economic powerhouse in recent years. But the debt-fueled binge now threatens to sap the energy of the world’s second-largest economy.
With its economy maturing, China has to pile on ever more debt to keep its growth going, at a pace that could prove unsustainable. And the money is increasingly flowing through opaque channels that operate outside the regulated banking system, leaving China vulnerable to blowups.
A major credit agency sounded the alarm on Wednesday, saying the steady buildup of debt would erode China’s financial strength in the years ahead. The agency, Moody’s Investors Service, cut the country’s debt rating, its first downgrade for the country since 1989.
China’s debt problems stem from the global financial crisis in 2008. As world growth faltered, China unleashed a wave of spending to build highways, airports and real estate developments — all of which kept its economic engine chugging.
To finance the construction, local officials and state-run companies borrowed heavily. Even after the worst of the crisis passed, China continued to rely on debt to fund growth.
But debt no longer packs the same economic punch for China. An aging work force, smaller productivity gains and the sheer math of diminishing returns mean it must borrow more money to achieve less growth.
China’s debt has been increasing lately by an amount equal to about 15 percent of the country’s output each year, to keep the economy growing from 6.5 percent to 7 percent. Overall debt in China, by the same measure, barely changed from 2001 to 2008, when the country achieved some of its fastest double-digit growth rates.
As a percentage of economic output, China’s total debt — including the government, households and businesses — is now high for a developing country. It has similar levels to those of many developed Western countries, though its debt load is still considerably smaller than Japan’s, according to the Institute of International Finance, a trade group of global banks. Some economists now compare China to Japan, where a lack of willingness to deal with its deeply indebted companies has led to what is commonly called the Lost Decade, a period of sluggish economic activity there.
Against that backdrop, Moody’s on Wednesday lowered its rating on China’s sovereign debt by one notch, to A1 from Aa3. The move brings it in line with another major ratings company, Fitch Ratings. A third, Standard & Poor’s, rates China a notch higher but with a negative outlook, which means its next move is also likely to be downward. Moody’s changed its outlook for further rating changes to stable from negative.
“The downgrade reflects Moody’s expectation that China’s financial strength will erode somewhat over the coming years, with economywide debt continuing to rise as potential growth slows,” the credit rating company said.
China criticized the move within hours, saying that Moody’s failed to understand China’s legal or financial systems and underestimated the country’s efforts to restructure its economy to achieve more sustainable growth. More broadly, experts inside and outside China believe Beijing probably has the power to stop a meltdown of the kind that slammed the United States and much of the rest of the world a decade ago, thanks to the Chinese government’s considerable financial firepower and ironclad grip on the country’s banking system.
Economists at the International Monetary Fund and at Goldman Sachs have issued a series of increasingly strong warnings about the pace at which the debt is rising. China’s financial system has traditionally been firmly under the control of the central government, giving many economists confidence that Chinese officials could contain a crisis of the sort that gripped the world in 2008. Still, fast growth and signs of fragility in the financial system have given pause to economists and Chinese regulators alike.
Chinese corporate debt has been mounting, and China’s banks show little inclination to force companies to do something about it. China’s banks have kept lending to the country’s state-owned companies, even to those in trouble, to help them make payments on previous loans. That helps those companies stay in business and helps the economy keep growing despite mounting debt.
Regulators and economists are also questioning where China’s lending comes from.
Traditionally, China’s lending has come from four big, state-controlled banks with a solid deposit base. But in recent years, local and provincial banks that lack the deposit base and nationwide branch network of their bigger brethren have grown rapidly, and they now account for half of the assets in the banking system.
Many of these smaller banks raise money partly through borrowing the deposits of the big four banks and partly by selling lightly regulated investments — called wealth management products — to their customers. A growing number of nonbank financial firms also market their own wealth management products and invest the money with little disclosure of where the money goes.
The worry is that if the public loses confidence and stops buying these wealth management products from smaller banks and nonbank firms, a wave of defaults could spread across the economy.
In a series of interviews over the last two weeks, current and former Chinese officials contended that the structure of their country’s debt made it inherently much more stable than the debts of other nations.
For starters, China owes little to other countries. Brad Setser, a former Treasury official specializing in China’s finances who is now a senior fellow at the Council on Foreign Relations, said that China’s $3 trillion in foreign reserves far exceeded the country’s overseas debts and gave it a large financial cushion.
Within China, most households also appear to have manageable debts, in contrast with the United States before its mortgage crisis. Only in the past year and a half has China allowed rapid growth in mortgages to help the construction industry as well as its suppliers, like steel mills and cement factories. Overall mortgage debt is still fairly low.
The central government in China also owes little over all, with total debts equal to less than 40 percent of the economy. That means the government has a lot of capacity to borrow money and bail out troubled borrowers.
By far, the biggest category of debt in China is corporate debt, which equals almost 170 percent of annual economic output. This debt consists overwhelmingly of loans by state-owned banks to state-owned enterprises.
On Wednesday, the Finance Ministry said the downgrade was a mistake because it applied to China’s central government bonds, even though the central government was not on the hook for the debts of local governments and state-owned companies.
Still, China could end up paying the tab. The central government could decide to tell the state-owned banks to write off a lot of their bad loans, and then recapitalize the banks by providing money to them. Mr. Setser, at the Council on Foreign Relations, said he thought that a large, government-led recapitalization of the banks was likely but that the central government had the financial strength to handle it.
Stock markets in China and Hong Kong opened lower on Wednesday on the news but soon recovered their losses and closed with little change. The Australian dollar, which is widely considered a barometer of investor sentiment about China because Australia sells such a large amount of its raw materials to that country, weakened against the United States dollar.
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