Is China broke?
Seems a silly question right? China’s foreign exchanges reserves stood at $2.4 trillion at the end of 2009. Yes, China announced that its proposed annual budget for 2010 would have a record deficit, but the deficit is just $154 billion or 2.8% of China’s GDP (gross domestic product). By contrast, the U.S. budget deficit for the 2010 fiscal year is projected at $1.3 trillion by the Congressional Budget Office. That’s equal to 9.2% of GDP.
But remember the theme of my post http://jubakpicks.com/2010/03/09/the-lesson-of-the-greek-crisis-everybody-government-cheats-and-no-one-wants-to-know/ on Tuesday March 9: All governments lie about their finances. At the worst, as in Greece and the United States, the lies are bold and transparent. Everybody knows the emperor has no clothes but no one want to say so. At the best, as in Canada and China, the lies are more subtle. More like a magicians misdirection than a Viking raider’s ax. Look at these great numbers, this lie goes, but don’t look at those up my sleeve.
There’s a good argument to be made that if you look at all the numbers, instead of just the ones the budget magicians want you to see, then China is broke.
Want to see how that could be?
If you look only at the current position of China’s national government, the country is in great shape. Not only is the current budget deficit a tiny 2.8% of GDP, the country’s accumulated gross debt is projected at just 22% of GDP by the IMF (International Monetary Fund) for 2010. In comparison, U.S gross debt is projected at 94% of GDP in 2010. The lowest figure for any of the G7 developed economies is Canada’s 79% gross debt to GDP ratio.
But China has a history of taking debt off its books and burying it that should make us poke and prod these numbers. If we go back to the last time that China cooked the national books big time, the Asian Currency Crisis of 1997, we’ll get an idea of where the debt might be hidden.
The currency crisis started in 1997 with the collapse of the Thai baht—and then, like dominos, with the collapse of the currencies of Indonesia, Korea, Malaysia and the Philippines. In each case these countries had built up export-led economies financed by foreign debt. When the hot money that had flowed in, flowed out, it sent currencies, stock markets, and economies into a nose dive.
China escaped Stage 1 of the crisis because the country’s tightly controlled currency market had kept overseas hot money out of its currency and stock markets, and its economy. China had built its export-led economy instead on domestic bank loans. The majority of bank loans, then as now, went to state-owned companies—about 70% of the total, the Congressional Research Service estimated, looking backward, in 1999. Those loans were all that kept the doors open at many of China’s biggest state-owned companies. In 1999 the Congressional Research Service estimated about 75% of China’s 100,000 largest state-owned companies lost money and needed bank loans to continue operating.
That became a problem when in the aftermath of the currency crisis, China’s exports fell. That sent the revenue at already money-losing state-owned companies plunging. Suddenly China’s banks were sitting on billions and billions of debts that anybody with Bookkeeping 1 in high school could tell were never going to be paid. That was especially a problem for China’s biggest banks, all of which had ambitions to raise more capital—and their international profile—by going public in Hong Kong and New York. But no bank could go public with this much bad debt on its books.
What to do? What to do?
Why not bury the bad debt?
The Beijing government created special purpose asset management companies for the four largest state-owned banks, Industrial and Commercial Bank of China (IDCBY), the Agricultural
Bank of China, the Bank of China (BACHY) and the China Construction Bank (CICHY). These asset management companies, China Cinda, China Huarong, China Orient and China Great Wall, would ultimately wind up buying $287 billion in bad loans from state-owned banks. The majority of those purchases were at book value.
So how did the asset management companies pay for the purchase of that $287 billion in bad loans? They certainly didn’t pay cash. Instead they issued bonds to the banks in exchange for the bad loans. The bonds, of course, were backed by the promise that the asset management companies would gradually sell off or collect on the bad loans in time to redeem the bonds. And in the meantime, they’d pay the banks interest on those bonds.
Neat, huh? In one swell foop, the state-owned banks got $287 billion in bad loans off their books, and turned dead beat loans that would never pay off into a stream of income from these bonds. (If you want to read more on this neat bit of financial engineering, check out this paper by Min Xu http://w4.stern.nyu.edu/glucksman/docs/Xu_2005.pdf )
Of course that still left the little issue of where the asset management companies were going to get the approximately $30 billion in annual interest they had promised to pay the state-owned banks. And how they were going to pay off these bonds when they came due in 10 years? (Especially since the cash recovery rate on these bad loans would run at just 20.3% in the first five years of the 10-year period.)
But who really cared? The Beijing government and the state-owned banks had kicked the problem ten years down the road. (A favorite tactic of politicians, Republican, Democrat or Communist is to punt so the today’s problem becomes somebody else’s problem in the future.) The bonds issued by the asset management companies didn’t have an explicit government guarantee but everybody assumed that at some future date the government would either pay up or punt again.
The 10-year punt of 1999 came to earth in 2009 and lo-and-behold, more magic.
In some cases (China Huarong, for example) the asset management companies simply declared that they’d done disposing of bad debts, that profits were soaring, and that they were seeking strategic partners in preparation for a public offering.
In others cases the magic was more complex. In October 2009, for example, China Cinda said that it had secured government approval for a restructuring plan that would create a new company to dispose of the $30 billion in bad loans still on Cinda’s books. Then the company would look for strategic partners in preparation for a public offering.
Who in their right minds would be a strategic partner and investor in one of these asset management companies? Well how about one of the original state-owned banks, China Construction Bank, that Cinda had bought the bad loans from in the first place. “The hardest thing,” China Construction Bank chairman Guo Shuqing said in an October 17 interview, “is evaluation.”
Really? When the government runs the books, does all the accounting, and decides what asset to send where, I think evaluation would be very easy.
Any wonder, then, that today’s huge run up in loans—and bad loans—by China’s banks is making some critics nervous?
This time, though, the problem isn’t so much China’s big banks but the country’s local governments.
By now everyone who has a nickel in China (or a dime itching to get into China) knows that the country’s banks went on a lending spree in 2009. On top of official government stimulus spending of $585 billion, banks—encouraged by the government—doubled their lending in 2009 from 2008 to $1.4 trillion. (Please remember when judging these figures that China’s economy was an estimated $4.8 trillion in GDP in 2009, according to the CIA World Factbook. Estimated U.S.GDP was about three times larger at $14.3 trillion in 2009. So bank lending of China in 2009 of $1.4 trillion is equal to lending of $4.2 trillion in the United States and China’s $585 billion government stimulus package is equal a $1.7 trillion package, more than twice the size of the actual U.S. stimulus package of February 2009.)
And the banks hit the ground running even harder in 2010. Banks lent out another $309 billion in January and February. If they had continued at that rate, the country’s banks would have passed the official lending ceiling of $1.1 trillion by August. (For more on the lending boom and its results see my post http://jubakpicks.com/2010/01/15/china-isnt-an-asset-bubble-waiting-to-burst-its-worse/ )
And then China’s banking regulators, spooked by the speed of bank lending tightened the reins. For 2010they set a lending target 20% lower than 2009 lending levels. They raised reserve requirements so banks would have less capital to lend. And they told banks to hit the capital markets to raise an estimated $90 billion through 2011. (See my post http://jubakpicks.com/2010/02/25/chinas-banks-need-to-raise-90-billion-in-capital-through-2011/ )
It’s not clear that those steps will be big enough to balance the huge number of bad loans that China’s banks made during the lending boom. But China’s regulators have clearly learned a lot about how to address a bad loan problem in the banking system since the Asian currency crisis of 1997.
But as our own Federal Reserve has so amply demonstrated over the last decade, regulators tend to gear up to fight the last war. Which leaves them vulnerable to the next crisis precisely to the degree that it differs from the last one.
China’s new debt problem is the thousands of investment companies set up by local governments to borrow money from banks and then lend it to local companies. By law China’s local governments can’t borrow directly
But the incentives for local governments to set up investment companies were huge. By making loans to local companies, local governments could produce thousands of new jobs and drive up the value of local enterprises. By funding commercial and residential construction, they could drive up the price of land. Those results were important for local officials who often profited personally but also essential to the survival of local governments. By law those units aren’t allowed to raise their own taxes for local expenditure. To met local demands—and to fulfill the directives issued by Beijing—local governments are dependent on frequently inadequate revenue transfers from Beijing and what they can collect in from such things as local real estate sales.
So how much did these investment companies borrow and then lend?
Local-government investment companies had a total of $1.7 trillion in outstanding debt at the end of 2009, estimates Victor Shih, an economist at Northwestern University and the author of “factions and Finance in China. That’s equal to about 35% of China’s GDP in 2009.
In addition, banks have agreed to an additional $1.9 trillion in credit lines for local investment companies that the local investment companies haven’t yet drawn down, estimates Shih.
Together the debt plus the credit lines come to $3.8 trillion. That’s roughly equal to 75% of China’s GDP.
None of this, Shih points out is included in the IMF calculation of China’s gross debt to GDP ratio of 22%. If it were, the ratio would be closer to 100%.
Exactly how important is this number?
It depends on how many of those loans at local investment companies will go bad. Shih estimates that about 25% of current loans outstanding—or $439 billion—will go bad. (For comparison, remember that in the aftermath of the 1997 current crisis, the newly established asset management companies swallowed just $287 billion in bad loans.)
And it depends on how much of China’s huge reserves and its huge base of personal savings are available to offset this debt. So far, I’ve been talking about gross debt but China, like Japan, has a huge domestic pool of savings that it can credit use to buy this debt. Economists point out that Japan has carried what looks like a crippling gross debt to GDP ratio for years—188% in 2007, 197% in 2008, 219% (estimated) in 2009, and 227% (projected) in 2010—without disaster because the country funds its debts internally from savings.
China, the argument goes, could easily do the same, so what’s the problem?
The problem for both China and Japan is that it’s not clear exactly how much of their huge pools of domestic savings is actually available in the long run to buy debt. Japan has a woefully underfunded retirement system and it’s by no means clear how the population of the world’s most quickly aging country is going to pay for retirement.
China has, for all intents and purposes, no public retirement system. As a result of its one-child policy the country is aging rapidly and by 2030 its population will be as old as that of the United States.
What’s the correct accounting for that problem?
In the United States the national accounts deal may lie about the effect of the problem by putting Social Security and Medicare off budget on the argument that since these programs have their own dedicated revenue streams they don’t count as part of the national debt. But that lie aside, because the benefits of these programs are defined (with all the uncertainty that comes with forecasting inflation, of course), it is possible to put a dollar figure on the government’s future liabilities in this area.
China isn’t hiding any future liability for pensions or retiree healthcare off the books. The government hasn’t promised future payments. In an accounting sense then, there is no future liability that ought to be on the national books.
But that doesn’t mean that China won’t have to consume some portion of its accumulated savings to pay for its post-65 population in 2030. The country, either through the government or through private citizens, will have to cover the costs of old age, however it defines that cost. And any savings it will need to use to pay for those costs really aren’t available now to pay current debts.
I think the Chinese leadership is profoundly aware of the need not to waste money today that the country will need tomorrow. That’s one reason that Beijing has taken steps recently to reign in local investment companies. On March 8 the Ministry of Finance announced plans to nullify all guarantees by local governments for loans taken out by their investment company vehicles. And the national government plans to sell $29 billion in bonds for local governments this year so that local governments have an alternative to setting up local investment companies.
But the big job—the reform of China’s tax system so that local governments don’t have to rely on a real estate and stock market bubble for funding—didn’t make it into the to-do list announced by the National People’s Congress this week and last. And I don’t think it’s likely to with Communist Party leaders jockeying for position to replace President Hu and Premier Wen in 2012. (For more on the effect of politics on economics in China see my post http://jubakpicks.com/2010/03/04/is-that-duck-i-see-being-served-at-chinas-national-peoples-congress/ )
By the time China’s leadership team has sorted itself out in 2013, China’s finances will certainly look different. There’s little chance that they’ll look better.
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