These days, if investors ever want a break from fretting over the euro zone or US jobs, they can always look east. China’s bubbling debt problem has become a source of genuine anxiety and a potential threat to global recovery. Trouble is, the pill being prepared to cure it might be even tougher to swallow for some.
The fragility in China’s economy exists partly as a result of the response to the global financial crisis. As exports to the western economies collapsed, China responded with policies designed to take up the slack by boosting domestic demand. Banks were encouraged to lend in support of this objective; local governments took the opportunity to borrow to fund local schemes, notably in new infrastructure. As they are not allowed to borrow from banks themselves, they set up affiliated companies – thousands of them across the country – that borrowed the money and did the investing on their behalf.
The plan worked; the target of 8% growth for 2009 was surpassed, and the IMF called the Chinese response “quick, determined and effective”. But as time has passed, questions have begun to be asked.
The original strategy was for a 4 trillion yuan (US$660 billion) stimulus package over two years. But more than this was pumped into the economy in the guise of new bank loans in 2009 alone, before accounting for the stimulus. All told, over 2009 and 2010 the total injected ended up at just below 18 trillion yuan.
As early as 2010, China’s banking regulators and the national audit office began to express concern as the majority of these local government affiliated loans were simply not generating enough returns to even pay the interest due. Was what started as a crisis in the real economy – job losses in export industries – transforming itself into a Chinese financial crisis through the expansion of credit? The answer is probably not in the short term; but the Chinese financial system is in rather urgent need of reform.
China’s National Audit Office reported all local government debt (including that of their investment companies) at 17.9 trillion yuan in 2013 – up from 10.71 trillion in 2010. But a Chinese Academy of Social Sciences report on debt to year end 2011 (though not published until December 2013) suggested total local government debt had by then already reached 19.94 trillion yuan.
Even if you take the official audit figures at face value, sceptics point to the practice of new loans being taken out to cover debt repayments when old loans become due. Others argue that these figures don’t include corporate debts that could eventually fall on local governments if they step in to support loss-making local enterprises as they have in the past. For some, the potential for a local government financial crisis has not just been simply delayed, but issuing new loans and more recently local government bonds to cover existing debts will only make things worse when the bubble finally bursts. Foreign currency borrowing stores up it’s own, wider problems.
Banking with the state
That Chinese GDP in 2013 reached 56.9 trillion yuan gives the size of the debt some context: advanced economies are running government debt-to-GDP ratios of around 100%.
The close relationship between the Chinese state and the banks is also important here. The state has, in the past, spent vast amounts of its money clearing bad debts off the banks’ books and recapitalising them, and the expectation is that they will do so in the future. The state used the banks in 2008 and 2009 but now it seems that everybody is banking on the state to not let this become a crisis; either for local governments or the banks.
Rather than focus on the short-term manifestations of financial problems, it is probably more sensible to look at longer-term structural issues. And here, recent discussions over a potential new reform agenda give us a clue to what the Chinese leadership think the key issues are.
The first is the concern that the Chinese economy has become addicted to credit and whether this is a sustainable source of growth in the mid- to long-term (with the answer seeming to be a resounding “no”). The second, and very much related, is the way the Chinese banking system functions – or in some respects, doesn’t function.
Smaller businesses and investors, frustrated by the lack of financing or meagre returns on their money, have driven the growth of a shadow banking industry to fill the gaps. And recently, the banks have been joining in by setting up wealth management products that don’t appear on their formal lending books. They have thus been able to continue pumping money into the economy, including in ways that allow local governments to roll over old loans, even when the central government is trying to restrain credit growth. Third, and again very much related, there is growing concern over the quality of a number of the projects that trusts have invested in in recent years. The only reason that a number of them haven’t gone bust so far is because they have been bailed out. The question is, though, for how long?
To Beijing, the spoils
Getting the financing of local governments right is not just an important economic issue, but a political one as well.
For a number of years, many local governments not only used the loans that the crisis provided, they increasingly turned to their control and ownership of land and selling land-use rights to raise finances. This includes some cases of simply taking back land from existing tenured users and selling on the right at a higher price – a practice that has sparked mass protests against local governments. And it is not just about finances. Unsurprisingly, local governments often pursue their own industrial strategies irrespective of national goals. This has led to overcapacity on a national scale as support gravitates to favoured local producers.
The central leadership has explicitly targeted the abolition of local protectionism, reform of centre-local financial relations, and fiscal reform as key goals. A commitment to a more efficient allocation of resources and breaking down monopolies will also impact on local governments’ ability to set their own agendas (particular if I am right in guessing that local monopolies will be targeted more forcefully than national level ones).
This is part of a broader agenda to centralise control, and centralise it apparently in the hands of Xi Jinping. So while we see manifestations of a financial crisis (of sorts) in China, at its heart lie questions of governance; and crucially, what the best site of effective governance should be. This could well prove to be much harder question to find a solution to, and one with far deeper implications, than that of how to deal with the short term growth of debt.
If Xi’s intention is to centralise power first as a means of giving the market a greater role, then there may well be greater opportunities for foreign investors to penetrate the Chinese economy in the future. But history tells us that trying to centralise control over a country and economy as big and increasingly diverse as China’s tends not to end well. Indeed, it tends to end with power being devolved back down to local governments again.
There are also many people with much invested in the status quo – not just in monetary terms – who will be reluctant to be reformed out of power and influence. The selective fight against corruption can also be seen as a way of targeting those who oppose Xi’s agenda. It could well make for a couple of interesting, but turbulent, years.