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
thing is evident here. Either we should not believe our "lying
eyes" or Chinese banks are trying to hide the mother of all debt bombs.
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