China’s Debt Explosion

21 Feb

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China is becoming increasingly indebted. This is a big problem for the future. China’s bank lending has skyrocketed in the past five years and now the banks bad debts have reached a new high. According to recent figures released by the China Banking Regulatory Commission (CBRC), “non-performing loans rose by 28.5 billion yuan ($4.7 billion) in the last quarter of 2013 to 592.1 billion yuan, the highest since September 2008” (Bloomberg, 2014). On official data, non-performing loans are 1% of total lending. This might not look much but the reality is likely much, much more because many banks, especially those owned by the state, tend to roll over loans that are due if they know that the borrower is having difficulties repaying. That means they do not demand immediate repayment when the loan falls due but carry forward the liability as if it is still going to be repaid, just later. This is a process called ‘evergreening’, and is a way for the banks to disguise the extent of problem loans they hold on their books. According to Investopedia, evergreening is “loans usually in the form of a short-term line of credit that are routinely renewed leaving the principal remaining outstanding for the long term” (Investopedia).

Another problem for China is that, just like in the west before the financial crisis, it is not just bank lending that is fuelling the debt bubble. There are non-bank institutions, known as shadow banks, which are less tightly regulated, and which are likely to have far looser lending rules. This combination is pretty toxic. Charlene Chu, the ex-China banking analyst for Fitch ratings “has explained the creation – from a standing start just five years ago – of a shadow banking industry in China that today is responsible for as many loans in terms of volume as the country’s entire mainstream financial system” (Wilson, The Telegraph, 2014).

Any failure of a shadow bank or a bank will have knock-on effects. The bank’s depositors will lose their money, and – eventually – anyone taking a loan from it would still have to repay, possibly all in one go. Probably state banks will not be allowed to fail – the government would just bail them out – and private banks will have some sort of depositor guarantee. That will be a cushion, but there would still be serious consequences.

Meanwhile, a lot of the bank lending has been for things that were arguably not the best use of resources. Research by the McKinsey Global Institute comparing the performance of China’s banking system with international benchmarks shows that “although the country’s banks have come a long way, they are not yet out of the woods. Chinese banks still lend too much of their money to underproductive state-owned enterprises (SOEs)” (Farrell et al., McKinsey and Company, 2006). So lots of property and construction, funded by borrowing, yet many new-build properties are left empty because the buyer just wants them for investment, while some people are living in poor or overcrowded conditions. But the asset looks good on a balance sheet. However, there may have been better uses for the funds.

So the 1% bad debts that the banks declare to be problems may be a fraction of the real total of problem loans. In the worst case, just like in the west, the government might have to step in to provide a troubled bank with more capital, rather than risk a run on a bank or a wider liquidity crisis like in 2008 whereby the flow of money freezes and economic activity grinds to a halt. “Credit flows to the private sector were choked off at the same time as consumer and business confidence collapsed. All this came after a period when high oil prices had persuaded central banks that the priority was to keep interest rates high as a bulwark against inflation rather than to cut them in anticipation of the financial crisis spreading to the real economy” (Elliot, The Guardian, 2011).

For example, in 2008/9, some economies, like Taiwan, saw their exports fall by 40% in six months because credit stopped being available. Chinese policy makers would be horrified if that were to happen again. Just think of the social unrest. Stephen Roach claims that “one of modern China’s deepest economic dilemmas – (is) the interplay between stability and growth” (Roach, 2014, p. 67). Roach continues that Wen Jiabao, ex-Chinese Prime Minister, “worried about the trade off between China’s rapid development and the need for economic and political stability … He pondered whether an increasingly unbalanced and unstable Chinese economy could stay the course. But, he also worried about the social instability that had arisen from China’s mounting income inequalities – ultimately the greatest threat to the socialist dream of what Chinese leaders call a ‘Harmonious Society’ (Roach, 2014, p. 68).

And the impact on the rest of the world, especially as it is so worried already about China’s growth rate slowing to 7.7%, “the slowest pace since 1990” (Anderlini, The Financial Times, 2014) following three decades of some 10% a year, would be acute. Markets would crash, hitting economies round the world and possibly bringing a new global crisis. This would be a disaster just as the world economy emerges from the last crisis. Disappointment can carry political consequences.

Now the world economy is increasingly interconnected through the global supply chain and international capital lows. Who holds most of US government debt? China. So if China withdrew some of that, then interest rates in the US would have to be higher, aborting the recovery there.

Positively, though, China’s government has less debt outstanding than was the case in the UK or the US before the banking crisis. So it can afford to bail out a banking problem, even including the shadow banks. And the regulator is trying to clamp down on the activities of the shadow banks, to gradually solve the problems rather than having them explode. Lets hope they can.

Word Count: 990

Anderlini, J. (2014) China economic growth continues to cool, Available at: <http://www.ft.com/cms/s/0/1aa3450c-8176-11e3-95aa-00144feab7de.html#slide0> (Accessed 21st February 2014).

Bloomberg News (2014) China Banks’ Bad Loans Reach Highest Since Financial Crisis, Available at: <http://www.bloomberg.com/news/2014-02-14/china-banks-bad-loans-rise-to-highest-since-financial-crisis.html> (Accessed 21st February 2014).

Elliot, L. (2011) Global financial crisis: five key stages 2007-2011, Available at: <http://www.theguardian.com/business/2011/aug/07/global-financial-crisis-key-stages> (Accessed 21st February 2014).

Farrell, D., Susan Lund, and Fabrice Morin (2006) The promise and perils of China’s banking system, Available at: <http://www.mckinsey.com/insights/financial_services/the_promise_and_perils_of_chinas_banking_system> (Accessed 21st February 2014).

Investopedia, Available at: <http://www.investopedia.com/terms/e/evergreen-loans.asp> (Accessed 21st February 2014).

Roach, S. (2014) Unbalanced: The Codependency of America and China, New Haven, Yale University Press.

Wilson, H. (2014) The $15 trillion shadow over Chinese banks, Available at: <http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/10611931/The-15-trillion-shadow-over-Chinese-banks.html> (Accessed 21st February 2014).

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