China’s credit risk problem

The Bank for International Settlements (BIS) now publishes a data set on the credit to GDP gap for 43 countries, including Australia. The credit-to-GDP gap is designed to identify the build-up of excessive credit and is calculated as the difference between the ratio of private non-financial credit to GDP and its long-run trend.

" We still view China’s rapid credit growth as a downside risk to Australia’s outlook."
Kieran Davies, Economist, ANZ

The gap provides an early warning signal for financial crises, which is why it is used by authorities in setting countercyclical capital buffers for banks under the Basel III framework.

In Australia the gap reached a record high of 19 per cent when the global financial crisis hit in 2007, but aggressive action by the Reserve bank of Australia avoided further trouble The gap slumped to a record low of -12 per cent in 2012 before recovering to a modest 5 per cent in early 2016.

China’s gap recently reached an extreme of 30 per cent, which is the highest level in the 21-year history of the series and the highest current reading of any of the countries monitored by the BIS.

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In assessing this high reading, we are mindful some analysts have questioned whether the credit-to-GDP measure is a good early warning indicator for emerging markets, particularly when a developing economy is undergoing a period of financial deepening.

However, we think this criticism is tempered by an expanded BIS analysis of both advanced and emerging economies that shows the gap is still a useful and robust indicator for emerging markets, albeit with not quite the same performance as for advanced economies.

More importantly, it is worth noting a high reading for the credit to GDP gap does not always correctly foreshadow a crisis.

With these caveats in mind, we still view China’s rapid credit growth as a downside risk to Australia’s outlook given China’s credit-to-GDP reading is comparable to the peaks seen in other countries in the years before their respective financial crises.

Kieran Davies is an economist at ANZ