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You’ve heard that China has a debt problem.

Likely without fail, every quarter you read an article about how the country’s debt-to-GDP ratio is rising to a dangerous level, now 284%, or has reached an unsustainable level. This, you read, is the beginning of the end. This is what will bring down the Chinese economy.

In a note on Thursday, Macquarie analyst Larry Hu took a helpful step back to remind us that there is a reason why that ratio keeps rising, and it’s that reason that will take China down. The debt is just a symptom — “State Capitalism,” he writes, is the problem:

China’s high debt is just a reflection of the problem instead of the problem itself. On the surface, China’s high debt is inevitable due to its high savings rate (47% of GDP) and low equity financing. But, at a deeper level, a high savings rate is the outcome of a system we call “State Capitalism”, under which the state extracts resources from the private sector through three channels: financial repression, SOE monopoly and land controls. As the result, the system suppresses consumption and thereby boosts savings. This is the root cause of China’s debt problem.

Here’s why understanding this is important. If you’re just watching China’s debt-to-GDP ratio climb and waiting for an explosive finish — like a banking-system collapse — you could be waiting forever. State Capitalism creates a specific kind of bad economy, a specific kind of stagnation, that you’re going to miss if you’re simply watching debt pile up.

As Hu says, what State Capitalism with Chinese characteristics can do is put the country’s economy in a trap.

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The trap Hu is talking about is this: As more of China’s massive state-owned enterprises (SOEs) show signs of failing, the government bails them out by lowering their interest payments.

More from Hu:

For example, it could use debt-equity swaps in converting loans to equity. Over the process, most likely depositors would remain confident on the banking system which is backed by the state. Therefore, money would continue to flow into banks. So the system could still function if banks don’t have liquid funding problems. For certain banks with liquid funding problems, most likely the government would issue bonds or simply print money to inject to them. Money printing might increase inflation or currency depreciation pressure. If so, the government needs to raise tax or sell assets. But it is not necessarily so. In Japan’s case, the Bank of Japan has monetized trillion dollars of government debt but inflation or depreciation pressure has yet remained muted.

We’ve talked about the “Japanification” of China before. China does not want to become Japan because it is not Japan. It is not rich. It has millions of people to lift out of poverty, and the government needs the economy to grow to fulfil that promise.

Direction

But we already see China heading in this direction. For one, the government has already bypassed regulation in order to engage in non-performing loan (NPL) debt to equity swaps. We highlighted a Bank of America note on why that can get messy back in March:

“[B]y giving banks more ‘flexibility’ in dealing with their NPLs, we suspect that it may cause a more rapid accumulation of bad debt,” the analysts wrote. “This is using liquidity to paper over solvency issue in our view. As a result, we consider this unconfirmed new policy, if it comes to pass, to be a long term negative for the market, and particularly for banks and the Asset Management Companies (AMCs), aka the bad banks (due to reduced business scope). In the long term, we are also concerned about the potential forming of a banking-industrial complex in China.”

In other words, these swaps could create a money-sucking monster that kills growth and feeds on more debt. All of this will be backed by the state, allocating its resources to keep this going so that the system doesn’t have to collapse.

Jim Bourg That’s Chinese President Xi Jinping in the center. He’s a more control kind of guy, not less.

The private sector could help, if it weren’t getting squashed by the government. Usually, even SOEs that do default are bailed out by local or state governments. Right now everyone is watching how unusually long it’s taking the state to get involved with Dongbei Special Steel, now on its fifth bond default since March, according to Deutsche Borse Group.

If the government does take a hard line on Dongbei’s debt, then it will be a surprise, but we’ll have to see many more powerful SOEs go down before we can declare that Xi Jinping’s government is committed to creating a real free market in the country.

There’s another way

None of this is to say that there’s no hope. Hu says that the government could reform the economy, but it would have to get out of its own way. It would have to reform the SOEs, sometimes letting them fail so other players can drive the market, and reform its system of local governments. It’s the local governments that fund China’s infamously endless infrastructure projects.

From Hu:

However, both are very difficult politically because these reforms need to take on SOEs and local governments, who are exactly the two most important players in the current State Capitalism. Over time, they have also become the most powerful vested interests in China.

And again, we’re not seeing it move in the right direction with any kind of gusto. The government has talked about taking more of a stake in SOEs, not less. It’s talked about taking a stake in China’s privately owned tech companies too.

So what will ultimately stand in the way here? The government’s own politics.

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