In the years since the 2008 financial crisis China has posted
impressive growth in gross domestic product (GDP), in spite of a lackluster
global recovery. The country managed to do this by creating an investment boom,
which in turn was powered by a surge in credit. Total debt, private and public,
rose from 125% of GDP in 2008 to 215% in 2012. Corporations alone have racked
up debt worth 111% of GDP.
A lot of that capital has been misallocated. China has built
more ports, railways, smelting plants and residential complexes than it should
have, given its productivity level. Because those projects will not deliver
significant returns for a long time, if ever, bad debt is piling up. As a
result, the balance sheets of Chinese banks are laden with dubious assets.
The official reported rate of non-performing loans (NPL) is
less than 1%, which belies the actual quality of bank assets. Financial
institutions use all kinds of maneuvers to inflate profits and dress up their
balance sheets. In 2012 there was evidence of misclassification of dud debts as
“special-mention loans,” which do not need provisioning but are expected to
face difficulties. Loan officials enjoy substantial discretion in such
classifications. More recently banks have introduced shady financial
innovations. As an example, one instrument now on the rise are “trust
beneficiary right investments,” according to a recent report by HSBC research. These
quasi-loans circumvent the loan-deposit ratio requirement and the provisioning
requirement that applies to regular loans. In one year, the balance of these
trust rights has almost doubled for the largest Chinese banks, according to
HSBC Research. The upshot is that balance sheets, especially those of mid-sized
banks, are increasingly opaque.
Another type of fudging consists of rolling over loans that
are in danger of falling behind schedule. This rescheduling of bad debt can be
done directly in the books, by extending maturities. It also happens
indirectly, by repackaging it as wealth-management products (WMP) offered to
individual investors. WMP’s are sold by banks at much higher yields than bank
deposits and have attracted a lot of buyers among small savers. They also have
short maturities, which means that they are less reliable as a source of
funding than traditional deposits. The groundwork for a bank run has been laid
out.
The financial system may be reaching a breaking point. Twice
in 2013 the interbank interest rate spiked above 10% when the central bank
initially provided less funds than the wholesale loan market initially expected.
Each time the liquidity crisis could have set off a domino of defaults,
resulting in a systemic solvency crisis. Both times the central bank saved the
day, pouring more money into the system, and allowing the economy to keep
investing, borrowing, re-financing and accumulating bad debt. China is unable
to stop this merry go-round.
Stories of financial excess seldom have a happy ending, as Carmen
Reinhart and Kenneth Rogoff documented extensively in their book “This time is
different.” It is hard to characterize the end of an episode of financial
excess, because so much depends on how debt was accumulated in the first place.
A financial crisis, in particular, may or may not occur, depending on monetary
and fiscal responses by policymakers. But at a very minimum history suggests
that China’s economic growth should decline sharply as the economy starts deleveraging,
whether a hard landing happens or not.
China optimists not only downplay the possibility of a
crisis, but make five-year projections of growth between 6% and 7%, just a
notch below the current 7.5% pace, and much higher than what a deleveraging China
would allow: most likely below 4%. Some of these high-growth projections depend
on two arguments. At best, I find that they overestimate China’s strengths. At
worst, they are completely irrelevant.
The first argument is that the level of China’s total
government debt, which includes central, provincial, and local jusrisdictions,
is modest. Direct obligations stand at just under 40% of GDP, using recent data
from China’s National Audit Office. That is a modest amount by the standards of
most large countries in the world. But if one adds explicit and implicit
guarantees the figure rises to a less flattering 60%. Even at that level,
optimists might say, China’s government has less debt than those of most
advanced economies. Beijing, the argument goes, has plenty of room to bail out
its financial sector and cope with a recession if a financial crisis strikes.
Problem is: healthy public finances did not help the U.S.,
Spain, or Ireland to dodge the 2008 crisis. In 2007, U.S. general government
debt was a modest 64% of GDP, according to the International Monetary Fund's World Economic Outlook database.
Spain’s and Ireland’s were 36% and 25%, respectively. Japan in 1991, arguably a
better parallel to present-day China, had government debt of just 66% of
domestic output, and still suffered a 20-year malaise as a consequence of the
excesses of the 1980s. The level of government debt does not predict the
occurrence of a banking crisis or a real estate crash.
The second argument is that China can rely on a strong external
position. China’s debt is presumed to be mostly domestic, i.e. denominated in
renminbi and held by Chinese investors. That is less true than what the
official numbers show. Over the last couple of years a significant share of China’s
“shadow financial system” has been taking advantage of low interest rates on
the dollar to borrow abroad and speculate in the property market at home. To
circumvent capital controls, that external borrowing is disguised as export
revenue or foreign direct investment, so it does not show up in the official
statistics as what it really is: short-term external debt. Estimates of this
debt are hard to come by, but ballpark guesses are terrifying. According to
Bank of America, in the first four months of 2013 China’s actual trade surplus,
after removing fake exports, was one tenth of the official number.
Not only is China’s current account surplus smaller than it
appears, but the country is more vulnerable to flows of “hot money” than
generally recognized. When quantitative easing in advanced economies goes in
reverse, capital will leave China, pulling the rug under property prices.
What China’s ultimate fate will be is highly uncertain. Bad
debt, rampant speculation and the unregulated shadow financial system could precipitate
a sudden collapse. Alternatively, Chinese authorities might be able to reign in
credit growth and engineer a gradual reduction of investment growth. I
certainly hope for the second outcome. But one thing I have little doubt about
is, as China deleverages one way or another, GDP growth over the next five
years will be substantially lower than what most people seem to expect.
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