In the last 200 years, there have been more than 250 cases of sovereign-debt default and 68 cases of domestic-debt default. None of these was an isolated incident. Indeed, such defaults - combined with factors like large current-account or fiscal deficits, overvalued currencies, high public-sector debt and insufficient foreign-exchange reserves - have always triggered financial crises, from the Mexican peso crisis in 1994 to the Russian ruble crisis in 1998 to the American subprime mortgage crisis in 2008.

Since China's era of reform and opening up began, the country has experienced three instances of large-scale public-finance problems. In the late 1970s, the country faced a debilitating fiscal deficit. In the 1990s, its corporate sector was plagued by "triangular debts" (when a manufacturer that has not been paid for its product is unable to pay its suppliers, which in turn struggle to pay their suppliers). Later that decade, financial institutions were burdened by bad debts generated by state-owned enterprises.

Now China is experiencing a fourth instance of elevated debt risk, this time characterised by high levels of accumulated local-government and corporate debt. To be sure, China's national balance sheet, which boasts positive net assets, has garnered significant attention in recent years. But, in order to assess China's financial risk accurately, policymakers and economists must consider the risks that lie in the country's asset structure - and the liabilities that are not included on its balance sheet.

The current problems are rooted in the government's response to the 2008 global financial crisis. The first round of fiscal stimulus, supported by credit easing, led local governments and the financial sector to increase their leverage ratios. As a result, by 2010, China's overall leverage ratio had risen by 30 percent.

In 2011, local-government debt totalled 10.7 trillion yuan ($1.7 trillion), with only 54 of more than 2,500 county governments debt-free. Debts incurred by local government investment vehicles (LGIVs) totalled almost 5 trillion yuan - 46.4 percent of overall debt.

At the end of 2011, China's Treasury-bond debt stood at 7.2 trillion yuan, and its ratio of foreign debt to foreign-exchange reserves reached 21.8 percent, having grown by 27 percent since 2010. But, while this represents an increase for China, it remains well below the widely recognised danger threshold of 100 percent.

Likewise, China's debt/GDP ratio is rising, though it remains within the "safe" boundary of 60 percent - and is considerably lower than the ratio in most developed economies. At the end of 2011, China's central-government debt amounted to 16.5 percent of GDP, and overall government debt totalled 18 trillion yuan, or 38 percent of GDP.

Judging from its balance sheet, then, the Chinese government has a relatively large stock of net assets and a low debt ratio, and thus seems to be in a solid position to manage its liabilities. Indeed, according to China's Academy of Social Sciences, China's sovereign net assets increased every year from 2000 to 2010, reaching 69.6 trillion yuan - enough to cover the government's obligations.

China economy

But positive net assets are not sufficient to eliminate financial risk, which also depends on asset structure (the liquidity of assets and the alignment of maturities of assets and liabilities). If a large proportion of a country's assets cannot be liquidated easily, or would be greatly depreciated by a large-scale sell-off, the fact that assets exceed liabilities would not rule out the possibility of debt default.

In China, this proportion of fixed, illiquid assets exceeds 90 percent. Resource assets account for roughly 50 percent of total government assets, with operating assets amounting to 39 percent and administrative (or non-operating) assets comprising another 6 percent.

The latter two are difficult to liquidate. And, given that resource assets are scarce and non-renewable, the traditional practice of auctioning and leasing land to keep the fiscal deficit under control is unsustainable - especially at a time when external shocks or a domestic economic downturn could easily trigger a short-term solvency crisis or debt default. While fiscal revenues are on the rise, they account for only about 6 percent of China's total assets - and their growth rate is slowing.

China faces additional debt risks from contingent liabilities and inter-departmental risk conversion, especially in the form of implicit guarantees on debts incurred by local governments and state-owned enterprises. Indeed, such guarantees constitute the most significant medium- and long-term financial risks to China.

In recent months, there has been a surge in LGIV bond issuance, aimed at supporting local governments' efforts to stabilize economic growth through stimulus-style investment projects. But the implicit guarantees on these bonds - as well as on existing bank loans - amount to hidden extra-budgetary liabilities for the central government.

Local governments have also accumulated massive amounts of non-explicit debt through arrears, credits and guarantees. Once this debt's cumulative risk exceeds a local government's financial capacity, the central government is forced to assume responsibility for servicing it, directly endangering its own financial capacity.

At the same time, China's corporate sector relies excessively on debt financing, rather than equity. China's non-financial corporate debt accounts for roughly 62 percent of total debt - 30-40 percent higher than in other countries. According to GK Dragonomics, China's total corporate debt amounted to 108 percent of GDP in 2011, and reached a 15-year high of 122 percent of GDP in 2012.

Many of these heavily indebted enterprises are state-owned and have borrowed from state-controlled banks. The implicit guarantees on this debt, too, suggest that the government's liabilities are much higher than its balance sheet indicates.

China is not too big to fail. In a fragile economic environment, policymakers cannot afford to allow the size of China's balance sheet to distract them from the underlying structural risks and contingent liabilities that threaten its financial stability.

Zhang Monan is a fellow of the China Information Centre, fellow of the China Foundation for International Studies, and a researcher at the China Macroeconomic Research Platform.



A version of this article first appeared on Project Syndicate.