Excessive corporate debt has historically served as a harbinger of economic troubles, often preceding financial crises and exacerbating economic downturns. This phenomenon is evident in past crises, witnessed during the Asian financial crisis, which was associated with imprudent private borrowings coupled with currency mismatches, and the prolonged balance sheet recession in Japan, triggered by the burst of property bubble in the 1990s.

This concern is genuine in China, where non-financial corporate (NFC) debt has surged since the global financial crisis, reaching a record high of 158 percent of GDP in Q4 2022. Often referred to as “China’s Great Wall of Debt”, this towering financial burden has raised significant concerns. In comparison, NFC debt in Japan and Korea are about 120 percent of GDP, and less than 60 percent of GDP in Brazil, India, Mexico, and South Africa.

The policymakers have acknowledged the problem and have initiated efforts to address it. However, these attempts were not comprehensive and were partly disrupted by the COVID-19 pandemic outbreak.

Elevated NFC debt is not a new issue in China. The first official mention of “deleveraging” was found in the 2015 Central Economic Work Conference statement. The initial focus of the deleveraging campaign was aimed at reducing overcapacity and phasing out “zombie” companies in state-owned enterprises (SOEs). More recently, attention has shifted to the real estate sector, marked by the introduction of the so-called “three red lines” policy on developer borrowings in August 2020.

All these efforts were successful in phasing out some “shadow” financing issues, enhancing the transparency of reported debt, and curbing the rapid growth of NFC debt. However, the pandemic derailed some of these efforts, where the options to establish precautionary liquidity buffers resulted in opportunities to accumulate more debt to cover revenue losses.

The real estate sector stands out as one of the primary sectors burdened by corporate debt, accounting for 24 percent of total NFC debt in China, according to Moody’s Orbis firm-level data. Companies deemed at risk have a debt-servicing ratio (DSR) below 1—indicating the need for external funding to maintain corporate viability—and/or an interest coverage ratio (ICR) below 1.25 that indicates a credit rating of CCC or below. Almost 45 percent of the real estate firms in China have a DSR below 1 and/or an ICR 1.25, indicating an alarming potential risk for the sector.

Analysis shows that at least one-fifth of the debt in other sectors could be at risk, including larger, listed firms, some of which are SOEs. Most of the corporate debt are concentrated in raw materials, utilities, manufacturing, as well as transport and communications industries, which collectively represent 54 percent of China’s corporate debt. Therefore, it is imperative for authorities to broaden their surveillance beyond the property sector, considering that corporate debt is not concentrated within a single firm type or sector.

Another critical aspect of debt vulnerability lies in foreign currency debts.

Chinese NFCs have issued a sizable amount of US dollar bonds in the offshore market, amounting to $590 billion, which represents 34 percent of USD-denominated NFC bonds from emerging market economies as of October 2023. These offshore US dollar bonds are highly concentrated, with local government financing vehicles and real estate developers accounting for approximately 42 percent of the total issuance. Since these NFCs are primarily in non-traded industries, they have limited or no foreign currency income, making them highly susceptible to currency mismatches in the face of a strengthening US dollar.

Notably, defaults of Chinese NFC offshore dollar bonds have surged during the recent period of aggressive tightening of US monetary policy, together with a downturn in the Chinese property market. These defaults reached a record high of $52 billion in 2022, primarily involving real estate developers.

The near-term risks for heavily leveraged property developers are likely to remain elevated if the US dollar continues to strengthen and weakness persists in the real estate market. A total of $84 billion worth of US dollar bonds from property developers will mature by the end of 2025, bringing the total maturing US dollar bonds of all Chinese NFCs to $270 billion. Difficulties in refinancing these bonds can lead to insolvency for vulnerable firms and major losses for highly exposed investors.

Addressing excessive corporate debt is critical for the country to return to a sustainable growth path, as it fosters financial stability, encourages investment in productive ventures, and bolsters economic resilience against future shocks. With the worst of the pandemic now behind us, policymakers should shift their focus from crisis management to addressing structural issues related to economic growth.

As noted by American business magnate Warren Buffet, “It’s not debt per se that overwhelms an individual corporation, but rather the continuous increase in debt relative to income that causes trouble.” Indeed, borrowed money is not inherently problematic; the problem arises when imprudent corporates accumulate debt that they cannot manage in a slower growth environment.

Therefore, there is a pressing need for a comprehensive strategy to curb corporate leverage effectively.

First, the deleveraging efforts in China should be broad-based due to the widespread involvement of various sectors. Support for non-viable firms should be gradually phased out to prevent further debt increase and encourage improvements in corporate efficiency.

To prevent hasty decisions and minimize social costs, especially concerning systemically important corporations, a more gradual approach should be adopted, particularly during economic downturns. For instance, in the initial phase, debts of troubled large developers should be restructured, involving actions such as lengthening borrowing tenures, and cutting of interest rates where feasible. These initiatives should be executed through coordinated efforts from regulatory bodies, creditors, and local governments, followed by careful loss recognition and financial restructuring. If a firm really proves to be non-viable, the overall size should be scaled down through the sale of assets and business lines, alongside the gradual discontinuation of other operations, and finally followed by an orderly liquidation or winding down of residual activities.

Second, banks should exercise caution in their lending practices. They should ensure loans are extended to deserving corporates, while imposing covenants related to debt-to-equity ratios and interest coverage ratios that promote prudent financial behavior.

Furthermore, corporates should promptly report changes in their business strategies and financial statements, enabling banks and investors to detect financial issues early. Simultaneously, regulations pertaining to Chinese NFCs’ foreign currency debt should be continuously refined, such as inserting terms and conditions on use of hedging tools and allocation of funds, to instill discipline in offshore financing and enhance risk management.

Lastly, at the macro level, government initiatives aimed at enhancing economic growth and ensuring macro and financial stability are crucial. Measures focused on stabilizing the real estate market will instill confidence, ensuring that transaction demand and construction supply continue unhampered.

More broadly, industrial policies facilitating productivity growth, along with trade policies leveraging initiatives like the Belt and Road Initiative, Regional Comprehensive Economic Partnership (RCEP) and other free trade agreements, can help NFCs expand their business globally. These efforts will create more favorable operating conditions, which are critical for effectively resolving the high NFC debt problem over the medium term.