The 2 Trillion Dollar Hole in the Chinese Economy

Do you remember the Article titled "S & P Downgrades US Credit Rating"? I had mentioned in that article that China is the largest holder of US Debt. They hold over $ 1 Trillion worth of US Treasury Bills. With the World Economy moving at a sluggish pace and Major economies like US and European Union reeling under pressure, Growing Economies like India & China are significantly affected. This article is an Analysis of the Current Soup that China finds itself in!!!

Chinese Economy - A Quick Refresher

The People's Republic of China (PRC) is the world's second largest economy after the United States. It is the world's fastest-growing major economy, with growth rates averaging 10% over the past 30 years. China is also the largest exporter and second largest importer of goods in the world. They Exports Goods value at around US$ 1.9 Trillion every year to countries around the Globe. USA is the largest consumer of stuff exported by China. A little over 20% of all goods produced by China end up in USA.

Experts feel that, if China can grow at the current rate it could overtake USA as the Largest Economy in the World in the next 10 to 15 years.

China - The Single Largest Holder of US Treasury Debt

China is considered the Single Largest Lender/Creditor to the United States. Nearly 21% of US Treasury Debt is held by China. They hold around $1.1 Trillion worth of Treasury Bills issued by the United States of America. This effectively means that

"The United States of America owes the People’s Republic of China more than US$ 1 Trillion in Debt and has to pay both Interest & Principal on the Same"

What Does China Holding $1 Trillion in US Treasury Bills Got to do with this Article?

Did you think of this my friend? Well, to Answer your question "EVERYTHING"...

China holds close to US $ 3.3 Trillion worth of Forex Reserves. As suggested in the previous paragraph, roughly one-third of it is in US Treasury Bills. Apart from this China also holds hundreds of billions of dollars’ worth of foreign currency - Especially the US Dollar. So, around 60% of all their foreign exchange holdings is in United States Dollar (Roughly around 2 Trillion). So, with the United States Economy being as volatile as it is, the value of the Dollar has come to Question. So, at this Juncture, the price movement of the United States Dollar can make or break the Chinese Economy.

Now, go back to the paragraph heading and ask yourself the Question again "What Does China Holding $1 Trillion in US Treasury Bills Got to do with this Article?"

How Will the De-Valuation of the US Dollar Affect China?

As of the Writing of this article 1 USD (United States Dollar) = 6.3 CNY (Chinese Yuan Renminbi). So, USD 2 Trillion in Dollar denominated assets works out to CNY 12.6 Trillion in their local currency.

Let us say due to some problems in the US Economy, the value of the USD Falls and goes to 1 USD = 5 CNY, the value of this $ 2 Trillion Forex Reserves comes down to only CNY 10 Trillion in their local currency. Practically speaking, the Chinese Government stands to lose a hefty amount of their investment if the US Dollar depreciates...

Repayment Risk or Default Risk

On top of the Dollar getting Devalued there is one more, even bigger problem "Default Risk"

Default Risk is the risk that you face when you lend money to someone and the other party fails to repay the same. In this case, if the US Government fails to honor the Interest or Principal repayment on these Treasury Bills China stands to lose $1.1 Trillion.

Before we go any further, 1 Trillion = 1,000,000,000,000. and 1 Trillion USD = INR 53 Lakh Crores. This is a loooooooooottttttttttttttttttttttttttttt of Money. Isn’t it???

A Real Life Example:

If the above explanation wasn't too clear, think this way. Let us say, you bought a House in Chennai, India last year for INR 50 lakhs. Now, it is found that, due to dumping of poisonous chemicals in the ground by a neighboring factory, the ground water is heavily contaminated. As a result, people are avoiding that locality and the property prices have plunged in the past one year and the value of your house is roughly around INR 25 lakhs. Here, with no mistake of yours, the value of your investment (House) has come down and you will lose a lot of money if you sell the house now.

This is China's Situation. Because of Problems in the US Economy, if the value of the US Dollar goes down, the value of their investment will go down and they will lose a lot of money...

Has China done anything to reduce its Forex Exposure to US Dollar?

The answer is YES. But, sadly, China has tried practically every trick known to get into non-dollar assets. It has set up a $300 billion sovereign wealth fund to invest excess foreign reserves in foreign companies. It has encouraged state-owned companies to acquire assets abroad, such as natural resources and firms. It has launched an experimental scheme to settle foreign trade in the Renminbi, instead of the dollar. It has dabbled in purchasing distressed European sovereign debt. The list goes on.

Unfortunately, these efforts to diversify Forex holdings have yielded disappointing results. Chinese attempts to acquire natural resources have met with strong resistance in most parts of the world (except in Africa). China’s sovereign wealth fund’s investments overseas haven’t been successful either, mostly due to political opposition. Chinese state-owned firms seem to have done better. But the tens of billions of dollars they have spent on projects may not generate economic benefits. Expanding the use of the Renminbi to settle trade reduces currency risks, but does little to restrain the growth of China’s dollar holdings. In the two years since China began this experiment, Chinese Forex holdings grew more than 50 percent.

A Trillion Dollar Question!!!

US Treasury Bills are debt obligations that the United States promises to settle when redeemed. So, if today China surrendered its over 1 Trillion dollars’ worth of US T-Bills and asked the US to pay up, what will happen?

The answer is very simple.

"The United States of America will most probably declare Bankruptcy"

Anyways, the chances of that happening are very very remote. Because:

1. China has invested nearly 6 Trillion worth of their Currency in this US $ 1 Trillion worth of T-Bills. If they surrender their investments, the value of the US Dollar will crash and their investment may not be worth even 50% of what they invested (If you don't understand this, go back to the house buying example a few paragraphs away. Will you do anything to diminish the value of your house??)
2. If such an event happens, US will stop importing goods from China (They won’t have money to pay for it), and China can’t sell that much stuff to any other country. So, their economy will be crippled beyond repair.

So, considering the impact this will have on the Chinese Economy, I personally do not think that China can afford to take this drastic step. However, they can definitely use this 1 Trillion Dollar leverage as a bargaining chip during negotiations!!!

Contrary to the fears harbored by many Americans that China would use its mammoth Treasury holdings as a financial weapon of mass destruction against the United States, China is being taken to the equivalent of the financial cleaners in the US debt scenario.

The 2 Trillion Dollar Sized Hole in the Chinese Economy

For the moment, China finds itself in a $2 trillion hole it has dug for itself over the last decade. It watches the political situation in Washington and the resulting economic uncertainty in complete helplessness. All they can do is "Wait and Watch" and hope that the Financial Scenario in the United States Improves.


China's Economic Future

It’s easy to accuse the Americans, of behaving recklessly with their Finances. But for Beijing, the more meaningful thing to do is to figure out how to get out of its $2 trillion mess it is in right now. Allowing a more rapid pace of revaluation of the Renminbi is clearly one. Diversify the Forex Portfolio is another... The list is long and I am sure the Chinese policy makers are scratching their heads trying to find the right cure for their problem…

Since China has strong fundamentals in terms of Manufacturing & Production, the near-term impact will be minimal. However, how the Political & financial scenario in the United States pans out in the forthcoming months will have significant impact on the Chinese Economy in long-term.

So, just like the Chinese, all we can do is "Wait and Watch"...

Is Chinese Economy really booming?

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...