Government debt soars to ‘European’ levels following massive stimulus programme
As the global economy lurches towards renewed recession and financial turmoil, concerns are growing over the state of China’s largely state-owned banking system. For more than two years an unprecedented surge of bank credit has powered the biggest construction boom in history, sucking in raw materials from around the globe and ‘supersizing’ GDP (gross domestic product) growth rates for commodity exporters. But the chickens are now coming home to roost as Beijing’s mega-stimulus also sent debt levels soaring.
For over a year the government has imposed a credit squeeze to rein in rising debts especially at local government level, and to bring inflation under control. But Beijing’s clampdown has in turn led to a dramatic growth of the shadow banking system – of so-called underground banks (which are illegal) but also ‘off-balance sheet’ lending by state-owned banks.
By Vincent Kolo, chinaworker.info
The shadow banking system now accounts for a staggering 40 percent of all loans in China, as banks and financial institutions seek ways to bypass government controls. The growth of informal or ‘shadow’ finance also represents what some commentators call a “stealth liberalisation of financial markets” – as banks chase after “market-determined” interest rates much higher than those set by the central bank.
This explosive growth of informal lending compounds the problems for China’s government as it struggles to avert a massive bad loans crisis. In a December poll of global financial speculators (or ‘investors’ as they prefer to be called) by Bloomberg, 61 percent said they anticipate a crash in China’s financial sector within the next five years, with only one in ten predicting China’s banks will escape trouble.
When the debts of local governments, the railways, and other items such as unfunded pension liabilities are factored in, China’s overall debt levels have rocketed. Standard Chartered Bank’s chief economist for Asia, Nicholas Kwan, calculates that China’s current debt levels are now similar to European countries at around 70-80 percent, compared to about 20 percent of GDP three years ago. He argues it would not take much extra spending to push China close to the debt-to-GDP level of the United States, of 100 percent.
Stimulus, inflation and economic imbalances
For over two decades, as the Chinese regime shifted from the former model of a bureaucratically planned economy to a form of ‘state capitalism’, the banks have been its main tool for setting the pace of economic growth. When the global financial crisis struck with full force in 2008, it was an unprecedented splurge of bank credit that financed the regime’s stimulus measures.
This credit expansion, channelled mostly through local governments and state-owned companies, not only lifted China out of recession but also, alongside stimulus programmes in most major economies, helped avert or postpone a global ‘Great Depression’. Although the method and forms of state-financed investment differ, China’s lending programme came, as in other countries, with a gigantic price tag. The masses have paid for this through an upsurge in inflation, nightmarish property speculation and other effects that combine to reinforce China’s record-low level of domestic consumption (just 35 percent of GDP, compared to 57 percent even in India).
Bank credit expanded 71 percent during the two-year stimulus period, or by 26.7 trillion yuan (US$4.12 trillion), while China’s credit-to-GDP ratio rose to 166 percent by March 2011, from 120 percent at the end of 2008, according to Credit Suisse.
One effect of this credit tsunami has been an additional and unwanted surge in the money supply, a key factor causing inflation. According to Southern Weekly, China’s broad money supply (M2) rose to 71.03 trillion yuan (US$10.71 trillion) at the end of 2010, larger than that of the US and almost double the size of China’s GDP. This excess liquidity has flooded into the property market and other financial assets – sending prices for land, housing, and commodities skywards.
This massive expansion of bank credit has therefore introduced further serious distortions into the Chinese economy, which already suffered from severe imbalances (overinvestment, overcapacity, inefficient use of energy and natural resources, a widening incomes gap and suppressed level of consumption due to extremely low wages).
Far from a conscious and directed policy, this explosion of credit took place in a frenzied and haphazard fashion, with few controls or checks either by the banks or by central authorities; enabling local governments and state-owned companies to milk their access to easy credit in order to indulge in everything from the extravagant (‘vanity’ projects such as lavish sporting events and ten storey police stations) to the purely speculative (a huge proportion of stimulus funding was syphoned into the property market and other forms of speculation).
Average house prices nationwide have risen 140 percent since 2007 (that is the average increase, with prices in some major cities more than tripling in the same period). A widely reported figure is that China has an estimated 64 million empty apartments, bought as financial investments, not as homes, by wealthy individuals (including a great many government officials) and by companies. Meanwhile, in the capital city alone an estimated one million ‘mice people’ live in underground tunnels and converted cellars due to the lack of affordable homes.
Record profits for banks
As Credit Suisse (June 2011 report) pointed out, “… the problem is that while the central government originally planned for about 4 trillion yuan stimulus investment in two years, total infrastructure investment during this period was 18.3 trillion yuan, four times the size of the stated stimulus programme. Of this amount, we estimate about 14.5 trillion yuan was invested by local governments. In case such lending becomes problematic, it is doubtful whether the central government will foot the entire bill, and if the central government does not bail them out, this will become a private sector problem, and it will impact the banking system.”
The banks rushed to extend new loans in the stimulus period not least because it was hugely profitable. Chinese banks’ profits soared by 95 percent over the three years 2009-11, and now account for over a fifth of global banking profits, according to The Banker magazine. ICBC’s profit of US$32.5bn in 2010 eclipsed all other banks worldwide. Second came China Construction Bank, with profits of US$26.4 billion. In third place globally was JPMorgan with $24.9 billion (Wall Street Journal, 13 October 2011).
Providing the borrowers were government-linked entities such as state-owned enterprises (SOEs) or local government financial vehicles (LGFVs), the banks cared little for the viability or even authenticity of the projects concerned. In Western banks such behaviour invokes what is called ‘moral hazard’ – reckless lending in the belief that the state will step in to cover any losses. In China, corruption and misuse of funds has reached new record levels. This was symbolised by the former heads of the Railway Ministry who were purged in February, accused of corruption on a massive scale while also piling up unprecedented debts (see box below).
Local government debt has ballooned from negligible levels before the stimulus package, to an estimated 10.7 trillion yuan, or 27 percent of GDP. An altogether new network of over 10,000 largely unregulated local government financial vehicles sprang up in the past three years to tap the cheap credit available under the stimulus package. The central government acknowledges that 3 trillion yuan (US$472bn) worth of local government debt is unlikely to be repaid, while Standard Chartered estimates that 9 trillion yuan (US$1.41 trillion) is at risk of default. “In other words, the potential defaults could be even larger than the US$700 billion US bailout programme during the 2008 crisis,” warned Reuters (24 October, 2011).
Local government debt is not the only category causing alarm, however. Loans to property developers (many of whom may go bust in coming months), to industries with high levels of overcapacity, to home buyers and to businesses that diverted funds into property or stock market speculation – these are all areas harbouring significant default risks.
In an attempt to avert a banking crisis, the Chinese government has since last year imposed tighter controls on bank lending and on real estate transactions. This has led to many infrastructure projects being axed due to insufficient funds and banks cutting credit lines to local governments and their financial vehicles.
The railway sector is the most glaring example, with cutbacks to around a third of planned projects and many of the industry’s six million casually employed migrant construction workers going unpaid for months. At the same time, the debt crisis is being used to push the envelope on privatisation, with the ‘reformed’ railway ministry in the wake of February’s purge launching proposals for more private investment, joint ventures and asset sales in exchange for new funding.
Roads and expressways are another example of indebted infrastructure projects. Despite the ‘Great Leap’ in motor vehicle usage (China overtook the US as the biggest auto market in 2009), vehicle numbers in no way justify the untrammelled growth of toll road construction. There are many stories of gleaming new highways without any traffic. Recent reports from 12 provinces reveal a combined debt of 759.3 billion yuan (US$118.65 billion) from building toll roads, usually built under partnership deals between road operators and local governments. In just one province, the Beijing municipality, are the roads generating a profit. The fear is, according to Shenzhen Daily (19 October 2011), that “the payback time could linger and create a persistent burden for local governments, which are already burdened with other debts.”
Monetary tightening gives way to ‘fine tuning’
Since 2010, with the State Council (China’s cabinet) applying the monetary brakes, the central bank has increased interest rates five times and reserve requirements (the amount of a bank’s capital that it must deposit with the central bank) nine times. Last month, the central bank lowered the reserve requirement for the first time in three years – with a 0.5 percent cut – perhaps signalling a shift towards loosening policies as the accelerating economic downturn adds to the regime’s anxieties. For now, however, Beijing insists its restrictions on the property market will stay in place.
While the central government may now be ‘fine tuning’ its tight monetary policies, partly claiming that inflation has been beaten, the problem of excessive levels of credit remains. Fitch Ratings predicts total lending including non-bank credit will run to 18 trillion yuan in 2011, dwarfing the government’s 7 trillion target. This is further fuelling tomorrow’s bad loans crisis.
In order to get around Beijing’s credit curbs and maintain their profits, the banks have innovated new practises – massively expanding their ‘off-balance sheet’ activity and rolling out new ‘investment products’ that ape the financial trickery of Wall Street. The staggering scale of these financial ‘innovations’ has only recently begun to emerge and set alarm bells ringing in China and globally.
Zhejiang private sector crisis
The last period has seen a phenomenal expansion of the shadow banking system, in which many state-owned companies and local governments are active players. Part of the shadow banking system is comprised of private ‘underground’ banks and trusts that charge usurious rates of interest mainly from privately owned small and medium enterprises (SMEs).
These illegal financial institutions have grown rapidly, exploiting the government squeeze on the state banks. According to the central bank, underground banks hold around 2.6 trillion yuan (US$410bn) in loans, but this is likely an underestimate. They attract investments from other capitalists and from wealthy government officials (who also provide protection), drawn by the high returns from interest rates of up to 100 percent. Xinhua quoted the owner of an 800-million yuan illegal bank, who said that 80 percent of her depositors were local government officials.
It has also become increasingly common for state-owned companies (with much easier access to bank credit) to muscle in on this ‘market’. Due to low returns in their core businesses as a result of excess capacity and raging price wars, many state-owned companies have this year switched – in response to Beijing’s clampdown on the property market – from property speculation to ‘loan shark’ activity in order to boost profits. This would be illegal accept that it is increasingly carried out under the auspices of the banks themselves, acting as middlemen for ‘entrusted loans’ between one (usually state-owned) company and another (usually privately owned).
Recent developments in Zhejiang province, with its high concentration of private companies, have lifted the lid on this phenomenon. The central government recently announced a 160bn yuan (US$25bn) bailout for the SME sector in Zhejiang, which is being bled white by its dependence on shadow finance. Over 200 highly indebted Zhejiang company bosses have fled in the first nine months of this year, owing wages to 15,000 workers. Some of the province’s private capitalists have committed suicide. In the manufacturing city of Wenzhou, one-fifth of 360,000 SMEs have reportedly stopped operations this year due to cash shortages, and many Wenzhou capitalists are demanding the underground banks should be legalised so that the market can be regulated.
Unofficial estimates suggest that at least half the loans from underground banks have been channelled into financial speculation: “Several entrepreneurs in Zhejiang said the unreasonably high interest rates levied by the underground banks meant that no one could afford to borrow from them from a manufacturing point of view…” reported Daniel Ren (Yangtze Briefing, SCMP, 15 October 2011).
Zhejiang is far from unique. A recent survey from the Pearl River Delta (Guangdong province) reported that 72 percent of SMEs would not make a profit in the coming six months. “Many SME owners say business is now worse than during the depths of the global financial crisis in 2008,” reported the South China Morning Post (15 October). Economists warn that Inner Mongolia could be the next province to experience a wave of collapses in the private corporate sector.
According to the State Council’s Development and Research Centre, SMEs create 80 percent of urban jobs, develop 70 percent of China’s patents, and contribute 60 percent of its GDP. The economic weight of this sector is such that the government is now rushing out a series of bailout measures, as seen in Zhejiang, and ordering banks to increase their lending to this sector, while stepping up controls to prevent more capitalists absconding to escape their debts.
Growth of shadow banking
“Shadow finance in China has been around for years, but the recent surge in such lending is unprecedented,” noted the Wall Street Journal (13 October). According to this newspaper the shadow banking system has more than doubled in size since the end of 2009, accounting for 17 trillion yuan in outstanding loans – or 40 percent of GDP. This means that four-tenths of the credit generated in China in the last 18 months has come from the shadow banking system.
Interest rates charged in this wholly unregulated sector are running at 25 percent or more (some loan sharks charge 180 percent), raising the prospect of a wave of defaults by private borrowers as property prices begin to fall and manufacturing output slows.
The following are some of the financial innovations widely practised by banks – private and state-run alike – to circumvent Beijing’s credit controls and reap greater profits from higher, ‘market-determined’ interest rates:
• Wealth management products
The growth of off-balance sheet lending in China has taken a number of forms. These include so-called wealth management products, which are ‘securitised’ debts (existing loans repackaged as ‘investments’) often for local government-linked infrastructure projects. These are sold by the banks to trust companies, which resell them, commonly with a guarantee from the bank of high yields. For the banks this is good business as it removes loans from their balance sheets, allowing them to lend more without formally breaching Beijing’s credit quotas. The banks themselves often control the trust companies they work with, managing funds for wealthy individuals.
The use of wealth management products has exploded in China, with commercial banks issuing 8.5 trillion yuan worth in the first half of 2011. This is more than the total loans (8.36 trillion yuan) issued by banks in the whole of 2010. By way of an international comparison, 8.5 trillion yuan is 1 trillion euros – the sum sought by European leaders for their European Financial Stability Facility (ESFS) to ‘save’ the Eurozone and its banks.
Not surprisingly, many commentators including government spokesmen warn of ‘subprime’ risks, especially given the speed and scale at which banks are rolling out these complex and poorly understood financial products and the total lack of regulatory controls. How does government regulate a phenomenon that hardly existed just months ago?
• Entrusted loans
These are another form of off-balance sheet lending in which the banks act as middlemen between two external parties. As these loans do not formally involve banks’ own capital, this allows them to keep within government lending quotas while charging fat fees for arranging entrusted loans. In reality, however, the banks are “the ultimate source of the funds in the company-to-company loans, lending at low rates to state-owned corporations, which lend it on to the private sector at much higher rates,” as the South China Morning Post pointed out (Monitor, 12 October 2011).
Cases are also coming to light of banks forcing clients to buy their wealth management products as a condition for obtaining entrusted loans. The growth of entrusted lending over the first part of 2011 almost cancelled out the government ordered slowdown in normal lending.
• Hong Kong’s increased exposure
US ratings group Fitch warned in October it could downgrade the credit standing of Hong Kong’s banks because of increased exposure to mainland China. Mainland banks and corporations now account for 24 percent of the Hong Kong banking system’s total assets, double the level of two years ago. Especially Hong Kong-based subsidiaries of Chinese state banks are rapidly increasing their lending on the mainland. This is also partly a response to Beijing’s credit curbs (which do not apply to Hong Kong banks) but also involves speculation in ‘arbitrage’ given the lower interest rates in Hong Kong and its currency’s falling value against the yuan.
Bad loans crisis
China is therefore heading for a new bad loans crisis and very probably the need for a banking system bailout in some form. The effects of this can be a long-term drag on economic growth, by soaking up funds that would otherwise be used for investment or to finance basic welfare provisions that have been promised for many years, but remain largely undelivered. The likelihood of this rises as the economy slows, property prices fall and local governments sink deeper into debt.
The shaky state of the banks as a result of ‘stimulus overreach’ has spooked the speculators, triggering a collapse in the value of Chinese bank shares. The equivalent of 128 billion US dollars has been wiped off share values of the four largest banks this year, with the MSCI China Financials Index falling 43 percent. The stock market slide for Chinese banks has been bigger than for European banks – despite widespread expectations of bank collapses on that continent in the coming period.
For Beijing, the collapse in share prices matters, because it plans more multi-billion-share offerings to help the banks replenish their capital and make provision for eventual debt write-offs. The biggest banks may need to raise up to 500bn yuan in additional capital in the next five years, according to Wu Xiaoling, a former central bank official.
Non-performing loans (NPLs) will probably increase to 8 to 12 percent of total debt in the “next few years,” according to Credit Suisse. Moody’s however give a much higher estimate of 18 percent. Zhang Yi, an analyst at Moody’s, says the government estimates of local government debt may be 3.5 trillion yuan too low. The current official level of NPLs is just 1 percent of total debt, according to the central bank, a figure that cannot be taken seriously.
This raises the prospect of a re-run on a much larger scale of China’s banking bailout at the turn of the century, when the central government spent US$650 billion (around 40 percent of GDP) on recapitalising the banks and writing off bad loans. This time around all the financial sums are much greater as the economy, bank assets, but also credit-to GDP levels, have ballooned. Another crucial difference this time around is the global environment: of an economic system mired in sovereign debt crises, stagnation, and with national protectionism on the rise, limiting China’s possibilities to export its way out of crisis, as it did in the period 2000-07, when its exports more than tripled.
China’s own debt crisis is unfolding alongside an economic slowdown, with its current investment-heavy growth model no longer sustainable. Barclays Capital warns the Chinese economy may be heading for its first hard landing in two decades, with growth slowing to around 6 percent next year. Nouriel Roubini recently said that avoiding an economic hard landing was “mission impossible” for China.
This has major implications for global capitalism, not just for the Chinese economy, which has accounted for around 30 percent of global GDP growth in the last three years. The rise in problem loans within the banking system means it may not be possible for the Chinese regime to repeat its stimulus feat of 2009-10, at least not in the same way. This makes it highly unlikely that China can be the ‘white knight’ to again rescue global capitalism, something Europe’s leaders in particular seem to be hoping for. The unfolding crisis at the heart of Asia means all sectors of the global economy are threatened with upheaval and crisis in the period ahead. The need for a working class response – a mass party with a socialist alternative – is greater than ever.
Railway ministry’s high-speed debts
In October, the central government was forced to launch a ‘bailout’ of the railway ministry of 200bn yuan (US$31bn). This underlines the shaky finances of the ministry, especially following the Wenzhou train disaster (23 July 2011), with state-owned banks reportedly refusing to issue loans or buy bonds for new railway projects.
Over the past five years the debts of the Ministry of Railways have tripled as it forged ahead with an unprecedented expansion of the rail network. But with many Chinese unable to afford increased ticket prices, especially for the new ‘white collar’ high-speed lines, revenue has fallen far short of projections.
“In the past few years, railway construction has expanded too quickly and on too big a scale. Some [long-distance] lines being built are parallel to short-distance lines,” said Li Hongchang, a professor of economics at Beijing Jiaotong University.
Unbalanced and poorly coordinated growth, commodity speculation that has inflated raw material costs, and endemic corruption in awarding contracts have frittered away vast sums of money. This has driven up the ministry’s debt to 2.1 trillion yuan (US$330bn) – more than 5 percent of China’s GDP.