China's massive bank financed stimulus was intended to keep the economy moving. It may instead lead to economic disaster.
Financial collapses may have different immediate triggers, but they all originate from the same cause: an explosion of credit. This iron law of financial calamity should make us very worried about the consequences of easy credit in China in recent years. From the beginning of 2009 to the end of June this year, Chinese banks have issued roughly 35 trillion yuan ($5.4 trillion) in new loans, equal to 73 percent of China's GDP in 2011. About two-thirds of these loans were made in 2009 and 2010, as part of Beijing's stimulus package. Unlike deficit-financed stimulus packages in the West, China's colossal stimulus package of 2009 was funded mainly by bank credit (at least 60 percent, to be exact), not government borrowing.
Flooding the economy with trillions of yuan in new loans did accomplish the principal objective of the Chinese government — maintaining high economic growth in the midst of a global recession. While Beijing earned plaudits around the world for its decisiveness and economic success, excessive loose credit was fueling a property bubble, funding the profligacy of state-owned enterprises, and underwriting ill-conceived infrastructure investments by local governments. The result was predictable: years of painstaking efforts to strengthen the Chinese banking system were undone by a spate of careless lending as new bad loans began to build up inside the financial sector.
When the Chinese Central Bank (the People's Bank of China) and banking regulators sounded the alarm in late 2010, it was already too late. By that time, local governments had taken advantage of loose credit to amass a mountain of debt, most of it squandered on prestige projects or economically wasteful investments. The National Audit Office of China acknowledged in June 2011 that local government debt totaled 10.7 trillion yuan (U.S. $1.7 trillion) at the end of 2010. However, Professor Victor Shih of Northwestern University has estimated that the real amount of local government debt was between 15.4 and 20.1 trillion yuan, or between 40 and 50% of China’s GDP. Of this amount, he further estimated, the local government financing vehicles (LGFVs), which are financial entities established by local governments to invest in infrastructure and other projects, owed between 9.7 and 14.4 trillion yuan at the end of 2010.
Anybody with some knowledge of the state of health of LGFVs would shudder at these numbers. If anything, Chinese LGFVs are known mainly for their unique ability to sink perfectly good money into bottomless holes in the ground. So taking on such a huge mountain of debt can mean only one thing — a future wave of default when the projects into which LGFVs have piled funds fail to yield viable returns to service the debt. If 10 percent of these loans turn bad, a very conservative estimate, we are talking about total bad loans in the range of 1 to 1.4 trillion yuan. If the share of dud loans should reach 20 percent, a far more likely scenario, Chinese banks would have to write down 2 to 2.8 trillion yuan, a move sure to destroy their balance sheets.
The Chinese government, to its credit, was also aware of the danger of this ticking debt bomb. Unfortunately, it used a solution that merely delayed the inevitable. In the first half of this year, Beijing announced a policy of mandating banks to extend by one more year the deadline for local governments to repay their bank loans that were about to mature.This move was taken, in all likelihood, to conceal the festering problem in the financial sector during the year of leadership transition. But it did nothing to defuse the debt bomb.
If debt taken on by LGFVs was the one shoe that has dropped, what about the other shoe?
Obviously local governments were not the only culprits during China's credit bubble in 2009-2010. There were other participants in this frenzy of borrowing and spending. With the slowdown of the Chinese economy, these participants are, like the proverbial naked swimmers exposed by falling tides, coming out of the woodworks.
Over-leveraged real estate developers, for example, are struggling to stay a step ahead of bankruptcy. The Chinese media has reported several instances of suicides of bankrupt real estate developers. Some bankrupt businessmen simply vanished. According to a story in the South China Morning Post in May this year, 47 business owners disappeared in 2011 to avoid repaying billions in bank loans.
Chinese manufacturing companies, state-owned and private alike, could be next in line. Their profit margins are notoriously thin. With excess capacity a systemic problem in the Chinese economy, a slowdown in economic growth will result in a rapid build-up of inventory and a glut of unsold goods in all industries. Getting rid of their inventories at a discount will wipe out their slim profits and incur financial losses. Some of the loans extended to them in good times will surely go bad.
But the potential risk for a financial tsunami is greatest in China's shadow banking system. Because of very low-yield for savings by Chinese banks (since deposit rates are regulated) and competition among banks for deposits and new fee-generating businesses, a complex, unregulated shadow banking system has emerged and grown significantly in China in the last few years. Typically, the shadow banking system pushes something called "wealth management products," which are short-term financial products yielding a much higher rate than bank deposits for investors. To evade regulatory oversight, these products do not appear on a bank's balance sheet. According to Charlene Chu, a highly respected banking analyst for Fitch ratings, China had about 10.4 trillion yuan in wealth management products, about 11.5 percent of the total bank deposits, at the end of June this year.
Since borrowers that use funds provided by wealth management products tend to be private entrepreneurs and real estate developers denied access to the official banking system, they have to promise a higher rate of return. Obviously, higher return also means higher risks. Although it is impossible to estimate the percentage of non-performing loans extended through wealth management products, using a conservative 10 percent baseline would mean another 1 trillion yuan in potential bank losses.
The shadow banking system has another function: channeling funds to borrowers or activities explicitly banned by government regulation. In the last two years, the Chinese State Council has tried to deflate the real estate bubble by limiting bank loans to real estate developers. But banks can skirt such restrictions by ostensibly lending to each other, with the funds ultimately going to financially stretched real estate developers. Chinese banks do this out of their own survival instinct. If they do not lend to effectively delinquent real estate developers who have borrowed large amounts, they would have to declare these loans non-performing and suffer losses. On the balance sheets of Chinese banks, such loans are technically classified as claims on other financial institutions. According to a recent report in the Wall Street Journal, inter-bank loans today account for 43 percent of total outstanding loans, 70 percent higher than at the end of 2009.
Disturbingly, none of these huge risks are reflected in the financial statements of Chinese banks. The largest state-owned banks have all recently reported solid earnings, high capital ratios, and negligible non-performing loans. For the banking sector as a whole, non-performing loans amount to only 1 percent of total outstanding credit.
One things is evident here. Either we should not believe our "lying eyes" or Chinese banks are trying to hide the mother of all debt bombs.
Photo Credit: Flickr (bsterling)
Reddit
Digg
StumbleUpon
Delicious
Technorati
Yahoo
Google
Plurk
desert voice
I have never studied economy, so my perception is novel. Economic problems come in many forms, and I can see that China is not immune. Her main advantage, and problem, consists in that she can print trillions of yuan without having to fear that someone outside China might demand the equivalent in gold or in dollars! This uncommon advantage, not available to the U.S. nor any other nation, has propelled China to unprecedented heights. So, how is this dangerous for China? I don't know. This area belongs to the experts. Can China enjoy this colossal advantage for ever? I do not know the laws that govern currency laws. As long as she gets dollars from trade, it appears that she is immune to financial collapse. She practically lives not from her yuans, but from her dollars. Any nation could try this as long as it has a positive trade balance!
glittering
Shadow banking, or OFF BALANCE SHEET FINANCING was taught to the Chinese by the financial geniuses in Wall Street.
It is estimated there are $600-800 TRILLION notional amount of derivatives,96% of which are held by the top 5 western banks and all off balance sheet.
The insurances bought to hedge these position, in the form of credit default swaps, have no capital as backup, should there be a payout (e.g AIG).
The Chinese could do what they did in the last Asia financial crisis(1997): set up asset management corps., and move all the non-performing loans there. They could just used the existing four AMCs from the last financial crisis.
faatmaan
China never fails. Working with China since 1994 there has been a constant prediction that China would fail. But it never comes to force. Reasons for this 1) the government is "good with money" i.e. keeping a nice positive trade balance, high national savings rate, living within its means, spreading risk, relatively speaking. 2) overcapacity in a country with 1.3 billion people is a fleeting impression as Roads, ports, airports etc are built, to the massive bevilderment of the people living here, as in "what in the world should this airport be used for" only to be filled to capacity a few years later. Roads, bridges-to-nowhere, subway systems etc have followed this pattern for years. Watch the new train systems filling up last couple of months. Of course there are some ghost town, empty industrial parks etc, where some of these probably will be failures – as with any commercial enteprice, which most of these are, and where there is risky investment involved, will see some mistakes, but overall things turn out much better than anticipated. I remember the empty office shells in many cities around 1998, now all prime real estate. We used to sit in Shanghai and marvel at the stupidity of the Zhangjiang high tech zone – which since has been filled to the rim of companies eager to do business year in and year out. Substitute Suzhou, Chengdu, Zhengzhou – same thing. 3) there is still a massive gap to be filled – Go to any 2nd tier city and they are busy turning themself into the 1st tier city levels, same 3rd tier, 4th tier. Take the "filling the gaps" logic to other fields – are health facilities, enviromental controls, roads, houses, resturants, factories, private and public schools at a level where there will be no more investments needed the next 1-3-5-8-10-20 years? They are not. Can/will public and public/private funds be founds to make these investments? In China, which is almost addicted to self improvement, on a personal and national level? Of course they can and will. Only problem for the government is needing to find the balance where all the activity is not turned into inflation or too loose intrepretation of the usefulness of these investments 4) Single Child policy — what do we think will happen when the government let loose on the population control? and will that loosening happen within the next 1-3-5-8-10-20 years? There will be changes, and when they come the naysayers whom point to low birthrates ex. in Shanghai will again be proven wrong by the cultural preference for having on average a larger familiy than 1 child (or for those whom are single children themselves now the allowed 2 children). Main (only serious?) complaint in China over close to 20 years here from Chinese people is on the population control. The average birth rates will go up sharply. Hospitals, schools, food, property – all the dynamics will change. All the government has to do is "not hold back" i.e. allow one more kid and there will be another one-generation boom economically speaking. Can China house and feed these people? Looking at resource starved Japan (which China for sure is doing) – there are endless things that the Chinese can and will do to house and feed their population. Seeing the massive infrastucture projects China has put on, do we really think they can't pull of large scale agri, aqua, energy, desalination, etc etc projects needed? And which in the public/private model will attract skills and capital? China is on a growth path for generations – some local credit issue is but a mere blip, something the highly skilled, responsive and quite frankly rather entreprenoural and desentralized government will deal with in the blink of an eye. And for which we complain that they don't share the data – why would they? Bullish on China? Hasn't failed, will not fail.
James
@faatmaan
"China never fails. Working with China since 1994 there has been a constant prediction that China would fail. But it never comes to force."
1994 was 18 years ago. Now, you may want to point out that China has a long history. However, everything is relative. When you compare the long history of China to the longer history of the Earth. Why do I think this is relevant? Well, it just seems striking to me that your thinking is inline with the likes of an engineer or a financier. Sure, I could agree that over the next decade no collapse is imminent. However, when you take a more holistic approach to long term stability or sustainability, the equation seems to fall down.
You may argue that such environmental factors are debatable and unproven. Well, again, like most things, the proof is in the pudding, so to speak. Nothing is proven until after the fact and the results come out of the oven. The problem does not lie in China's ability to count or manoeuvre itself into advantageous positions, more that, now it has done so (to China's credit), it is now faced with the same problem the rest of the world shares, and unfortunately these problems nullify any serious argument that living standards or any sense of prosperity have increased for the masses.
The gains China has made which you have pointed out, have been factored in, the profits have been taken, and like you say, what is left is overcapacity. It remains to be seen when or who will be covering those bad loans. This is important because today despite the lack of transparency, there are data (i.e: energy consumption), which can be considered as a concrete signal which infallibly mirrors industrial activity and fiscal stimulus. With no more suckers parking cash to fuel growth, it's left to someone else to do so. Who? China?
Let's say China has the capacity to keep growing, maintain wage growth, an expanding population, or even a declining one. Underneath all of the economic indicators is a very real threat which is unfortunately far more complicated and quite obviously far more out of control than any financial or political landscape. Demographics can be controlled to an extent, but alas the wheels have already been set into motion which underpin a declining natural infrastructure to support civilization on any reasonable scale.
It may take time as currently we are in the early stages. Yet, you have not even witnessed the tip of the iceberg of what's to come in terms of problems humanity will face in the years to come. We are talking, threats from radioactive fallout, contamination and degradation of the food supply and eco-system, (water, air, tectonic stability, climate volatility. Extinction of species one by one).
I agree, things are humming along quite well in China. Please let me know how it's going in ten years from now in terms of large scale agri, aqua, energy, desalination. It's not really a problem of debt in a fiscal sense. Time to dust off those science-text books.
JAMES
actually japan is directing the anger to outside. look at japan’s deficit. you know they are going to cause a war to save their country.and they are targeting china
Kastus
I think numbers of debt are underestimated. But.
As China's GDP keep rising so fast in crisis as there is no problem if it has debt about 70-80% of GDP. Or even 200%.
In future it can be real problem, but not now. There so many areas where China isn't on peak, economics really do need money.
So China will have at least 10 peaceful years for unbreakable rising.
deebee
I totally agree with the writer's analysis of what is happening in China but keep wondering why the big deal. Unlike the US dollar, the Chinese currency is not convertible and hence has little impact on the world economy. In essence China could print as much yuan as she likes and it will have no impact on any country at all.