Liu Shangxi: Debt risk from the perspective of risk trade-off|macroeconomics

By Liu Shangxi, a member of the China Finance 40 Forum (CF40) and a senior researcher at the Chinese Academy of Fiscal Sciences

A market economy is a debt economy, don't try to say no to debt. In a market economy, debt is a financial tool for creating assets, and it is also a tool for the government's macroeconomic regulation and control. Whether debt risks spread or converge depends on whether two virtuous cycles can be realized: the cycle of debt and assets at the micro level, and the cycle of debt and economic growth at the macro level, and whether the micro risks are public and macro, and whether the macro risks are long-term and micro. To deal with debt risks, it is necessary not only to use fiscal and monetary policy tools to deal with and resolve risks, but also to carry out deeper structural reforms. Financial structure is an important variable affecting macro debt risk, and financial structural reform is the key to controlling debt risk.

How to judge debt risk is a technical job, and it is a high-tech job. In fact, the market economy is a debt economy, and how to identify, judge, and control risks requires a new cognitive framework. There are three main issues involved: First, the market economy is a debt economy, and don't try to reject debt. Second, the two cycles determine whether debt risk spreads or converges. Third, financial structure is a key variable in macro debt risk.

Before proceeding in concrete terms, it is necessary to establish three basic understandings. First, we live in a world of uncertainty where risk is conserved. Second, risks can be dispersed and transferred, but they cannot be eliminated, and it is difficult to transfer risks at the macro level unless they are transferred to other countries; There is a view that risk should be eliminated, and there is even a view that there is no risk in some areas, in some aspects, in some things, the underlying implication is that risk can be eliminated, which is actually impossible. Third, what people can do is weigh the risks and make the right choice. At different levels, such as micro and macro levels, the rules followed to weigh risks are also different.

A market economy is a debt economy, don't try to say no to debt

First, the smallholder economy sees debt as a bad thing.

It has not been a long time for the mainland to switch from a planned economy to a market economy, and many traditional concepts are deeply rooted. The concept of the smallholder economy is that debt is a bad thing, and that "debtlessness is light". Equate debt itself with risk, and debt growth with increased risk. Therefore, we often judge changes in risk based on the size of debt and the rate of growth, and this way of judging risk is undoubtedly one-sided.

At the macro level, there is still a tendency to realize that smaller debt is better. But in fact, debt is not as small as possible, nor is it bigger as better, but in moderation. How can it be moderate? The optimal and appropriate debt ratio varies from country to country and at different stages of development, and there is no one-size-fits-all standard.

Although at the micro level, there is a disorderly expansion of debt, but to look at the debt problem, it is necessary to distinguish between the macro and micro levels. In the smallholder economy, debt is seen as a bad thing, and debt is involuntarily rejected. Although sometimes forced to form a lot of debt, there is always a perception that it is better to have less debt.

However, there are risks associated with rejecting debt in practice. One is that in a world of uncertainty, making choices is risky. Rejecting debt is an option, and the risk is that there is an opportunity cost. Second, there are limitations in risk measurement indicators. For example, indicators such as leverage ratio and government debt balance as a percentage of GDP have obvious limitations, and sometimes we can be misled when we are not careful in measuring risk. Because these risk indicators have a pro-cyclical character, and some of the underlying assumptions are static, they do not take into account the correlations between the numerator and the denominator. In some cases, not only is it not possible to control the risk based on the results tested by the indicators, but it can also backfire and magnify the risk. Therefore, treating debt as a bad thing and not daring to use it effectively will actually put you at a disadvantage in international competition, which will lead to increased risks.

Developed countries generally use fiscal and monetary policies in an integrated manner, which is actually a new understanding of the debt problem, which is different from the traditional view of economics and finance. Of course, there is a lot of controversy, but a new understanding of the debt problem and the bold use of debt can actually help to enhance the competitiveness of the country.

Second, from the perspective of market economy, debt is a financial tool for creating assets, and at the same time, it is a tool for the government's macroeconomic regulation and control.

First, debt is an option when the expected return is stacked with the expected risk. Debt implies opportunities for returns, but it also implies risks, and benefits and risks are stacked before the outcome occurs. The outcome of debt financing decisions is uncertain, and in fact whether to borrow or choose other financing methods is the result of risk trade-offs.

Second, the debt issue can be discussed at the micro and macro levels. From the perspective of micro risk trade-offs, debt is a tool to hedge market risk. There are three ways to finance a business: relying on its own funds, equity financing or debt financing. The MM theorem in the field of finance discusses the optimal capital structure and the maximization of corporate value. Among them, there is a tax shield income on borrowing, and the interest on the debt can be deducted before tax, while equity financing does not have such income. Therefore, corporate borrowing has to weigh the benefits of tax shields against the cost of risk (the cost of financial distress).

From the perspective of macro risk trade-off, debt is a tool to hedge public risk. Public risk is a macro risk, including economic risk, employment risk, currency risk, banking risk, fiscal risk and external risk. From the perspective of the government, there are two main trade-offs.

The first is the trade-off between government debt risk and public risk. There are many trade-offs to consider: Should I borrow or not? Is the economy up or down? What is the employment situation? If public risks, such as economic risks, increase, then there is a need to borrow to hedge risks.

The second is the trade-off between macro-financial risks and public risks. For example, a looser monetary policy is used to hedge economic risks and employment risks, but if there is too much money, it may bring financial risks such as high inflation and affecting exchange rate stability. Another example is the provision of window guidance to state-owned financial institutions to increase loans, which will also bring about the financial risk that the non-performing rate may rise. In fact, any type of fiscal policy, monetary policy, and their combination are the product of risk trade-offs.

Two cycles that determine whether debt risk is spreading or converging

Is debt risk spreading or converging? It really depends on two levels of circulation: the debt-to-asset cycle at the micro level and the debt-to-economic growth cycle at the macro level.

At the micro level, debt creates assets, assets bring income, and the proceeds repay debts, forming a cycle. A virtuous cycle is possible, in which debt forms high-quality assets, provided that the cash flow from the assets is greater than the principal and interest. It can also form a vicious circle, in which debt forms inferior assets, on the condition that the principal and interest are repaid with debt.

Under certain conditions, the two cycles can be reversed, and macro uncertainty is the biggest influencing factor. For example, the real GDP growth rate in the first quarter of 2024 is 5.3%, and the nominal growth rate is 4%. A lower nominal growth rate than a real growth rate implies a depreciation of assets, which can create a trigger that turns a virtuous circle into a vicious one. Macro uncertainty is not only a matter of economic fluctuations, but also uncertainty about government policy.

At the macro level, a virtuous circle is likely to emerge, in which debt promotes economic growth and leverage tends to decline, conditional on financial deepening. It is also possible to create a vicious circle, in which debt inhibits economic growth and leverage tends to rise, conditional on financial repression. Therefore, debt is a double-edged sword, and how to achieve a virtuous circle and avoid a vicious circle requires knowing the conditions behind it.

Will the risks of debt growth spread or converge? It depends on two things:

The first is whether the micro risk is public and macro. The spillover of debt risk of enterprises and financial institutions is very important, and the debt risk of systemically important enterprises should be of particular concern. In risk management and control, special attention should be paid to this butterfly effect, depending on the strength of the balance sheet correlation. For example, the real estate sector has a highly correlated balance sheet and should be particularly careful about its risks. This requires improving the ability to supervise risks preventively, establishing a macro risk management framework, and effectively identifying risk evolution. The second is whether the macro risk is long-term and micro-level. Once systemic risks and macro risks are formed, whether they can be dealt with in a timely and effective manner. There are two ways to deal with it, one is to respond shallowly, using fiscal and monetary policy tools to deal with risks and resolve risks; The other is a deep response, that is, structural reform. I'm afraid both are needed. At present, we prefer the former, and it is more difficult to avoid long-term and micro-macro macro risks through structural reforms, and it is necessary to optimize the top-level design. Financial structure is the key variable of macro debt risk: First, the degree of financial deepening. The market-oriented reform of the mainland's financial sector has been slower than the marketization of commodities. The market-oriented allocation of capital as a factor of production is insufficient.

From the perspective of urban and rural areas respectively, urban finance is actually replacing the capital market with loans. Loans account for 62% of social finance, while corporate bonds account for less than 5%, and the financing function of the capital market is weak. Rural finance is an inclusive alternative to marketization, and the mortgage, valuation, and trading conditions of rural property are restricted.

How to reform the form of collective ownership in rural areas is still being explored, and there is no clear path, which involves the accumulation of wealth by more than 50% of the population. At present, the urbanization rate of household registration on the mainland is about 47%, and more than 50% of the people are farmers, making it difficult to release the demand potential of the majority of the population.

Second, direct financing and indirect financing.

First, direct financing has shrunk, while indirect financing has expanded and dominated. The trend of expanding indirect financing has further distorted the financial structure and reduced financial efficiency. This is inconsistent with the objective of our financial reform to expand direct financing.

Second, debt risk is concentrated in banks. Banks have become the main creators of financial assets and the main bearers of debt risk. When the nominal economic growth rate is lower than the real growth rate, the depreciation of mortgage assets has become the main channel for debt risk transmission, although it is not directly reflected in the depreciation of bank assets.

Third, the structure of government debt. Government bonds, especially government bonds, are risk-free assets and are the foundation of the financial structure. At present, the structure of government debt needs to be optimized, showing the characteristics of a small central government and a large local government, which is actually not conducive to risk control, and debt risks cannot be curbed by administrative control.

Therefore, speeding up financial structural reform and adjusting and optimizing the financial structure is the key to controlling debt risks.

Source丨China Finance 40 Forum

This article is edited by Zhou Mingyi

Editor-in-charge丨Ding Kaiyan, Lan Yinfan

Preliminary trial丨Xu Lanying

Final Review丨Zhang Wei