For the past decade the rapid escalation of debt in China has led to fears that the country could be causing immense problems for itself. The country's regional governments and banks and shadow bank sector have all seen debt levels increase, in part to support an ongoing rate of economic growth that nearly hit 7% last year. 

There is a rising concsensus that China cannot keep expanding its debt by this pace forever, but efforts to bring it down again risk having an impact on economic growth. This led us to ask for this year's outlook predictions: 

Will China’s debt burden become a major drag on the economy?

Answer: No

China’s credit growth is indeed alarming and, with an overall debt amount that stands as a major source of financial risk. The country's debt-to-GDP ratio reached 256% of GDP as of second quarter of last year, versus an average of 175.4% for emerging market economies. It’s been growing fast; at the end of 2012 China’s debt-to-GDP ratio was 195%, according to the Bank for International Settlements. 

In view of this, President Xi Jinping and his administration have vowed to deleverage the economy, causing some investors to worry that doing so will be a major drag on the growth of the world’s second largest economy.

However, most market participants believe the Chinese authorities can reduce the debt levels at a calculated pace to avoid a plunge in its GDP growth rate. In the words of one regional insurance chief investment officer, “They will not want to have a Minsky Moment (a sudden collapse in asset prices) or rip the band aid off”.

To be sure, the debt burden remains alarming. China has underpinned its impressive GDP growth of the past decade with an expansion in debt, particularly in infrastructure projects. In recent years the country has started seeking to switch to a consumption-led economy, but this transition is taking time to manage. 

So far at least it has not led to a reduction in borrowings. And analysts are quick to point out that no country in history has experienced the kind of credit expansion that China had in last 10 years. More ominous still, none have managed to weather even lower rates of debt-fuelled economic growth without an eventual debt crisis.

Beijing is taking a calculated gamble: it appears to have ramped up its debt to lock in economic expansion, and will now forgo some future growth in order to stabilise the growth in debt and then to gradually deleverage, an analyst said.

As part of this strategy the government is now looking to improve the quality of economic growth, not just pursue economic expansion for its own sake. As part of this, Beijing has introduced various measures to curb the rapid growth of leverage over the past 13 months. This is seen as a generally positive development, as it should ensure more enduring long-term economic growth, despite some dampening more immediately.

China can also control how deleveraging will proceed, especially most bonds are held in the hands of local institutional investors and local governments. As long as the government wants to keep its provincial economies alive, high levels of risk are not expected. 

But while observers are generally sanguine, there are still sizeable risks. It would not take very much of an economic slowdown beyond Beijing’s standing annual target of 6.5% to panic the government. If GDP growth slipped under 6% it’s quite possible the government could upend its policies and reopen the debt sluice gates, in an effort to re-irrigate the economy. 

Fortunately, the Chinese authorities have some wiggle room. China’s economy grew by 6.9% in 2017, well above the government’s full year target. It can still slow some way before the apparatchiks of the Communist Party start sweating.

Previous Year of the Dog predictions: 

Will Bank of Japan's quest to create inflation succeed 

​Are European and UK securities a good bet this year?

Will the US Treasury yield curve invert?

Will Donald Trump still be president at the end of 2018?

What will be the best performing asset class, on a risk-adjusted basis?