China has been one of the most resilient economies in the past 5 years. The whole world especially the United States and Europe have been reeling under economic turmoil and posting less than impressive growth rates to their economy, while China on the other hand posted double digit growth. How can that be possible? Isn’t that the question on your mind?
This article is an analysis of what happened to the Chinese Economy and how things might pan out for them.
So, let’s get started!!!
How did China post such impressive economic growth rates?
China’s remarkable economic rebound after the global economic crisis in 2008-2009 has been a source of envy and puzzlement for the rest of the world. Instead of recession, the Chinese economy has recorded double digit growth, and is actually showing signs of overheating, a sharp contrast with the stagnation in most Western countries. How did the Chinese do it?
"Did Beijing find a secret formula of economic success that has eluded the West?"
Actually No. They did not have any secret formula. They just did a few things that made it look like they are on a boom while the West is trying to recover itself from the financial mess it got itself into...
The Secret Formula
It turns out that Beijing has managed to keep its economy growing during the global slump by resorting to massive bank lending to local governments, which then went on an infrastructure spending. (This might come back to haunt the country for years to come). If we remember the causes of the economic crisis that has ravaged the United States and Western Europe, the most important cause is termed ‘credit boom’. In simpler terms excessive lending and borrowing that fuelled housing bubbles and unsustainable consumption. Read my earlier article on Subprime Mortgage Crisis (http://anandvijayakumar.blogspot.com/2008/10/subprime-mortgage-crisis.html) to know more about how the bubble burst in the United States, triggering a worldwide meltdown.
China seems to have contracted the same disease, with only one major difference: much of the debt incurred in China has gone into the infrastructure sector and not consumption (like the United States).
Based on the figure released by the National Audit Office (NAO) at the end of June, local governments have accumulated debts totalling 10.7 trillion renminbi (RMB) or US$1.65 trillion, about 27% of China’s GDP in 2010. Because the NAO’s figure was based on a sampling of 6,500 local government-backed financial vehicles (out of more than 10,000 such vehicles nationwide), the actual magnitude of local government debt is probably much higher. The People’s Bank of China, the central bank, recently estimated that local government debt totalled 14 trillion RMB (most of which was lended out to banks), almost 30% higher than the NAO figure.
Is this the Ground Reality?
First and foremost, it has shown that public finance in China is in much worse shape than previously thought. On paper, China’s debt to GDP ratio is under 20%, making Beijing a paragon of fiscal virtue compared with their Western counterparts. However, if we factor in various government obligations that are typically counted as public debt, the picture doesn’t look so pretty any more. Once local government debts, costs of re-capitalizing state-owned banks, bonds issued by state-owned banks, and railway bonds are included, China’s total debt amounts to 70 to 80% of its GDP, roughly the level of public debt in the United States and the United Kingdom. Since most of China’s debt has been borrowed in the last decade, China is on an unsustainable trajectory at the current rate of debt accumulation, particularly when economic growth slows down, as it’s expected to do in the coming decade.
Secondly, we need to ask a harsh question - can local governments service the debts and repay the loans.
If they have made sound infrastructure investments that generate income streams, debt accumulation isn’t a problem. Unfortunately, that doesn’t appear to be the case for most infrastructure projects built by local governments. Typically, such projects are highly leveraged, with local governments putting in little equity capital and borrowing nearly all the costs. This makes debt-servicing a huge burden.
There are only two sources of income to service such debts. One is to sell land controlled by local governments (land is used as collateral for securing bank loans). The other is to use the cash flow generated by these projects (power plants, ports, and toll roads). With the Chinese real estate market not doing so well, local governments shouldn’t count on land sales to come to their rescue. The economic viability of their newly invested infrastructure projects is even worse. It is believe that only one third of these projects can produce enough cash flow to service their loans. This implies that local governments won’t be able to recoup the bulk of their infrastructure investments – or repay the banks.
Essentially, China is now sitting on a ticking time bomb called the "Debt Bomb" that exploded in the United States just a few years back.
What will be the economic consequences of this debt bomb?
Because about half of the bank loans borrowed by local governments will come due in the next two years, we can expect a short-term repayment crisis. Chinese state-owned banks will have to roll over these loans, pretending that they are still performing. They may even have to lend local government’s new money to pay the interests on these loans. The net effects of such accounting gimmicks (which the US did and is paying dearly now) would be reduced profitability for Chinese banks. We may say that reduced profitability isn’t much of an issue considering the overall economy, but, such accounting tricks can only delay the inevitable.
The longer term effects of massive non-performing loans owed to state banks by local governments are likely to manifest not in the form of a banking crisis, but in other ways. Because the Chinese state owns trillions of RMB in assets (land, natural resources, state-owned monopolies, and $3 trillion in foreign exchange), Beijing should have enough resources to bail out local governments when these loans have to be repaid. But there’s no free lunch. Bailing out local governments with valuable financial resources in the coming decade, a decade in which China will experience the end of the demographic dividend, rising costs of healthcare and pensions, and slower economic growth will mean China will have less capital to invest. For an investment-led economy, this implies even more sluggish growth.
Who is to blame for all this?
It’s very easy to blame irresponsible and corrupt local government officials for wasting the country’s precious capital. That would be grossly unfair. While there are no doubt unscrupulous local officials who see Beijing’s bank-funded stimulus plan as a golden opportunity to fill their own pockets, the behaviour of local governments is perfectly rational: they would have been foolish if they hadn’t jumped on the gravy train of freely available bank loans in the last two years. In their defence, China’s system of public finance is grossly unfair to local governments. Beijing collects the bulk of taxes (60% of all taxes), but spends little on social services, which the local governments must fund. Unlike their Western counterparts, local governments can’t issue bonds to borrow money. So if they want to develop local infrastructure (which Beijing doesn’t fund, either), the only source of financing is bank loans.
For all practical purposes, bank loans borrowed by government entities are actually free money – they don’t have to be repaid even when they go sour. Beijing has always come to the rescue, something local government officials are fully aware of.
But, don’t we all know what happens when people get to spend free money? (I assume you read the article on Subprime Mortgage Crisis. If not, I humbly suggest you do to understand what happens when people get their hands on free money)
The Bottom Line:
The Chinese Growth Story is still a reality but not as much as it was a few months back. Beijing has to take some strong measures to ensure that they don’t do the same grave mistakes that our friends in the United States did. Let’s hope they don’t...