By Keith Edmund White
Editor-in-Chief
Today's Diplomat features Minxin Pei's alarming article over a suspected debt bomb lurching in China. To keep the Chinese economy humming during the 2008 economic crisis, China had their own stimulus plan--one that relied heavily (~60%) on making it easier for local governments to borrow money. So what's the worry today? Massive local government infrastructure projects are likely to have a loan bounce rate of 10-20% (~$2 trillion give or take .4 trillion). Along with a shadow banking system that is probably hiding the extent of its own bad loans, China may just be hiding "the mother of all debt bombs." But is this bad, or just a correction that can be managed--and is actually a good thing? Well, there's no consensus--but, one thing's for sure: we all need to be watching China.
Watch out--China's banking system might be a ticking time bomb. And if there is a financial crash in China, it's clear that it will be the defining economic development of 2013--and have a impact on the recovering American economy and softening Canadian economy.
From Minxin Pei's article, Are Chinese Banks Hiding "The Mother of All Debt Bombs"?: [Note: Pei's answer--yes.]
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.
To get a sense of China's debt problem, visuals can help:
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| The first graph compares China debt to GDP to Japan's debt to GDP 1988 by sector. The second graph shows the growing wave of dark blue (loan growth) and the failure of this to correspond to a growth in money supply. What does this suggest? That even though there's a lot of cheap money in the Chinese economy, a lot of this is being eaten up by bad investments. |
(1) Local government financing vehicles (LGFV)--financial entities created by local governments to encourage investment in infrastructure projects--owed 9.7 - 14.4 trillion yuan (~$1.5 trillion - $2.26 trillion) in 2010. The problem: "Chinese LGFVs are known mainly for their unique ability to sink perfectly good money into bottomless holes in the ground. So taking on 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 debt." The result: Chinese banks may have to "write down 2 to 2.8 trillion yuan, a move sure to destroy their balance sheets."
(2) Biggest worry: China's wealth management products, or WMPs. Think of WMPs' effect on China's economy like derivatives effect on the U.S. economy in 2008. In the U.S., then-newly created financial instruments called derivatives--which were tools that let people bet on an investment (you could 'hedge' your investment by finding someone to buy your bet against the investment). The real problem, big firms over-leveraged in derivatives and didn't have the money to cover their bets when the economy soured--and, worse yet--financial assessments of firms did not consider this financial risk exposure when grading their credit-worthiness.
China has a similar problem. Instead of derivatives, China has a shadow banking system, where--off the books--they provide loans to "private entrepreneurs and real estate developers denied access to the official banking system...." Why are these attractive? Because China controls returns from the official banking system. The result, 11.5 percent of the total bank deposits are in "wealth management products" that invest in riskier/higher return investments. Pei states that conservative estimates put 10% of these investments as utter flops, which means "another 1 trillion yuan in potential bank losses."
Why are analysts worried? Chinese banks are now reporting "that non-performing loans are only 1 percent of total outstanding credit." With the flood of cheap money and suspected 'true' amount of non-performing loans estimated as actually 10-20%, we are led to the most worrisome conclusion of Pei's piece:
"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.(3) The real estate market bubble: 47 business owners of real estate companies disappeared in 2011 to avoid repaying billions in bank loans.
(4) Loans to Chinese manufacturers may not be paid back. Chinese manufacturing firms (a) have slim profits even in good times and (b) make too much stuff. The result? A Chinese slow down will likely lead over-stocked manufacturers to flood the market, but still not able to pay back their loans.
Now, naturally, there's a quick rejoinder to these concerns: Doesn't China have so much money, that it can easily write off $1-3 trillion in bad loans? The Economist isn't worried, but others aren't so sure.
Michael Pettis, a Senior Associate at Carnegie Endowment for International Peace, isn't so sure:
Is Debt a Problem?In sum: China has a considerable debt problem. Whether China can absorb this debt in a manageable fashion will be seen over the coming months. In either case, pushing worries aside, readers should take solace: We've found the one thing that bring the world's largest economies together--debt.
The rest of the [Economist] article argues in part that China can easily manage its debt problems because debt levels are actually relatively low and China has room to increase its net indebtedness:
China’s economy does need help, and its government has ample scope to provide it. Some local governments took on more debt than they could handle. But their liabilities never endangered the fiscal position of the country as a whole. The combined debts of China’s central and local governments add up to about 50% of the country’s GDP (including bonds issued by the Ministry of Railways and China’s policy banks, intended for state-directed lending). Even if local debts are understated, China has fiscal room for error.
I am not sure I agree. First, to make a minor point, I don’t think real estate has necessarily been the “biggest fear hanging over” China. I have always argued that the biggest worry is the unsustainable increase in debt, which historical precedents suggest is an almost automatic consequence of an aging investment-driven growth miracle. While the real estate bubble gets most of press, I would argue that several of the analysts who have been in the skeptic’s camp for many years, like Logan Wright of Medley Advisors or Victor Shih, now with Carlyle, usually agree that debt is the most worrying problem.
Of course borrowing money to fund a real estate bubble is an important source of bad debt, but I have argued for many years, and continue to believe, that economically non-viable infrastructure investment has been a much greater source of bad debt, by which I mean debt whose servicing cost (excluding of course interest rate repression) exceeds the debt servicing capacity created by the investment (excluding subsidies and including externalities). Empty buildings may be much easier to visualize, and much more photogenic, and many people still have an impossibly tough time understanding why it is possible to overinvest infrastructure (isn’t all infrastructure spending good?), but I would argue that sharply reducing infrastructure investment, or at least diverting it into more useful – if less glamorous – projects, is more important than reducing excess real estate development, although this too is clearly a problem.
But that aside, my disagreement with the article is really about whether or not China has a low enough debt level that we can relax about the “fiscal room for error.” Is the relevant debt really just 50% of GDP?
Want to learn more?
China's 'Little' Debt Problem, Business Insider, Sept. 5, 2010
China bank risks on the rise, analysts warn, Chris Oliver, MarketWatch, Sept. 7, 2012.
China's Local Debt Is No Problem, [Chinese Premier] Wen Says, Bloomberg Businessweek, March 14, 2012.
Despite Growth, China Too Faces Debt Problems, Frank Langfitt, NPR, Dec. 12, 2011.
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