China’s bad debts will fuel next crisis
THERE can be no doubt that China’s story is one of astonishing economic success. Ever since they started to embrace capitalism in the late 1970s, the authorities in Beijing have presided over the greatest, most extensive wealth creation and poverty reduction experiment in history. But the remaining elements of central planning at the heart of the Chinese model have allowed massive misallocation of resources to take place.
Inevitably, such excesses eventually lead to a bust – which is why the West, which is now dependent on Chinese growth, needs to worry.
The government still controls the direction, volume and pricing of loans; it caps deposit rates and ensures minimum lending rates, thus preventing real competition, in a bid to bolster the industry’s margins. State firms are supplied with unlimited credit from state-owned banks; neither ever go bust. China maintains capital controls; its increasingly prosperous public is forced to keep most of its growing wealth in domestic bank accounts (now worth 75 per cent of GDP). This means that the stock of money to be lent out to often insolvent firms keeps on growing, and the mad machine keeps going. Roughly two-thirds of total bank lending goes to the central and local government via special off-balance sheet vehicles or to state owned companies.
As an excellent report by Diana Choyleva of Lombard Street Research explains, wherever one looks, state-directed liquidity is hiding insolvency. There have been waves of recapitalisations of the banking industry, and regular attempts at removing vast amounts of bad debt from the system. Yet it remains crippled by the legacy of the bad loans of the 1980s and 1990s, as well as by huge amounts of excessive and misallocated lending during the past 12 years. Bank credit surged in 2002-03 to prop up Chinese firms after the dot.com bubble burst; it jumped in 2006 after China’s domestic demand growth slumped; and it surged in 2009-2010 to shield the economy from the financial crisis. Official figures are useless; they don’t provide reliable estimates of bad debt, which must be massive. Lombard Street cites one study which suggests bad loans to the local governments’ special financing vehicles could alone be worth as much as 6.4 per cent of GDP.
China’s total debt remains sufficiently low: it could still just about recognise and absorb bank losses on its balance sheet. Household debt is 29 per cent of GDP, net company debt 76 per cent and gross government debt 79 per cent. When massive reserves of 43 per cent of GDP are factored in, net government debt falls to 36 per cent. China’s total debt is thus 141 per cent of GDP, less than many other countries. If one imagines that half of all debt in the economy is bad and is written off, and the state recapitalises banks accordingly, China’s net government debt would surge to 108.5 per cent of GDP – bad, on par with Japan, but still just manageable.
For the time being at least, the show can go on. But unless China finally turns its banks into real commercial entities, accepts the existence of massive bad debt, writes it off and moves on, the current malinvestment will continue. China is already at the limit of what it could absorb in the event of a crisis: another couple of years of this and the situation would become unmanageable. Time is running out for Beijing to tackle the biggest time bomb beneath the world economy.
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