The Chinese are so good at copying, they’ve taken Keynesian stimulus to new dimensions. Those vacant cities, unused superhighways and empty malls were all built with debt issued by the government controlled banks. Loans get repaid based upon the cash flow of the projects built. No cash flow – no repayment. No repayment = DEFAULT.
How about loan losses of $1 trillion? The governments of the world can try to hide the debt, shuffle the debt, disguise the debt, rename the debt and pretend the debt doesn’t exist. But in the end, someone takes the loss. The ponzi scheme is eventually revealed and the house of cards collapses.
China’s Bank Reckoning Approaches
A large part of China’s economic miracle was built on ill-considered lending and accounting sleight-of-hand.
The first wave of problem loans originating from the 2009 economic stimulus is about to hit the banking system. If the reports citing anonymous officials are true, Beijing is considering assuming responsibility for some 2-3 trillion yuan ($300-450 billion) of these loans that were made to local government borrowing vehicles.
The scale of such a rescue is staggering–at about 7% of GDP it is bigger than the U.S. TARP program. It also comes out of the blue; the banks’ audited accounts still show that their nonperforming loans have fallen dramatically. Yet the bailout would nearly equal the total amount of bad loans spun off from the four major state banks during their restructuring in the early 2000s.
Ironically the proposed bailout also approximates the size of the original 4 trillion yuan stimulus of 2008. China survived that disease, but it’s now clear that the cure made it sicker.
How did this happen? When the global financial crisis impacted China’s exports in 2008, Beijing ordered its banks to support a massive credit expansion to create jobs and stimulate growth. The banks eagerly went into action and in 2009 and 2010 made new loans amounting to a total of 20 trillion yuan ($3.1 trillion). Of these a significant amount went to local government borrowers. Estimates of how many of these loans would go bad range from 25% to 30%, which suggests a total figure of 8-9 trillion yuan.
The machinery to remove bad loans from the banking system is already in place. In 1999 Beijing created four asset management companies to acquire nonperforming loans. These “bad banks” were supposed to exist for only 10 years, during which the government expected them to complete the sale or disposal of their portfolios.
The results didn’t go according to plan. After a decade, the AMCs were able to achieve only about a 20% recovery rate across their entire portfolios, almost entirely loans to state enterprises. Since more than one-third of the bad loans were acquired at face value, the AMCs from the start were bankrupt; their modest recovery rate was far too little to repay the financing extended by the central bank and commercial banks.
Any write-off of these worthless “assets” would either have forced the Ministry of Finance to assume the AMCs’ debts or forced the banks, which hold AMC bonds, to take losses large enough to wipe out big chunks of their capital. So for political reasons nothing happened. In 2009, bank financing to the AMCs was rolled forward for another decade and the AMCs have survived.
If these vehicles are pressed into service to buy these local government loans, the scale of new financing required makes this shell game ever more precarious. The 2-3 trillion yuan in bad loans would require an equal amount of financing if banks are to avoid loan losses. But the major “commercial” banks don’t have spare capital; they have only just finished another round of fundraising to offset the stress put on their balance sheets by the lending binge. The China Development Bank, also an aggressive local lender, is in the midst of restructuring in search of its own successful IPO.
But Beijing has a second choice of techniques. Instead of using the AMCs the Ministry of Finance might establish special “co-managed accounts,” as was done in the restructuring of Agricultural Bank of China. The special account would acquire at face value the bad loans, using only the ministry’s IOU as payment. These IOUs are carried as “restructuring receivables” on bank balance sheets.
From the ministry’s viewpoint these are only contingent liabilities and so not part of China’s national budget; repayment comes from bank dividends rather than tax revenues. As such, they are likely approved only by the Standing Committee of the National People’s Congress. One can imagine the embarrassing questions about the national debt that would be asked if such arrangements were put before the full NPC.
China’s national debt narrowly defined is 20% of GDP, but if all obligations of the sovereign were added up it is closer to 80%. This is before this round of local government loan acquisition and before considering the other 70% of the stimulus loans made to state enterprises, which history has repeatedly shown are bad credits.
With few voices able to question its actions, it seems that Beijing will continue along the path of increasing systemic financial leverage. The weight of its inability to halt profligate spending by local governments and state enterprises will be put squarely on the backs of future generations.
The fact that China may have just wasted $400 billion should put an end to reflexive praise for Beijing’s great economic planners. If that money had been added to the National Social Security Fund China might be several steps further along the path of creating an economy driven by domestic consumption rather than infrastructure investment.
Perhaps Beijing’s willingness to assume a portion of local government debt shows the political will to act decisively. But it must be remembered that the central government approved these loans in 2008 and 2009 in the knowledge that many projects were of questionable quality. The experience of these two years shows that a large part of the Chinese economic miracle has been built on a foundation of ill-considered lending and accounting sleight-of-hand.
Messrs. Walter and Howie are coauthors of “Red Capitalism: The Fragile Financial Foundations of China’s Extraordinary Rise” (Wiley, 2010).