A clear consequence of rapid credit expansion is a certain level of non-performing loans (NPLs), and with China’s bank lending up over 100% year-on-year in 2009, it is inevitable that a larger proportion of debts will turn bad.
Just how bad remains to be seen. There is a rising wave of suspicion that lenders are far more exposed to credit risk than was originally thought – largely thanks to irresponsible borrowing by local governments (see Question of the Month, p14).China’s national accumulated gross debt is 22% of GDP, compared with 94% in the US. However, the national figure ignores the borrowing of local governments, which Victor Shih, a professor of political science at Northwestern University in Illinois estimates have accumulated US$1.7 trillion in debt as of 2010. This is well above the official government estimate of US$770.6 billion.
Ordered by Beijing to stimulate their economies, local governments – which are unable to raise taxes or borrow directly on their own – set up financing vehicles to fund enterprises and infrastructure projects. They also guaranteed up to US$1.9 trillion in credit lines for local firms. If these loans were included in national debt calculations, China’s gross debt would be close to 100%.
Still, the situation might not be as dire as the worst forecasts suggest. The central government has started to ease off lending to keep risks under control and local governments have been banned from guaranteeing bank loans in an attempt to curb excessive investment. And even with 20-25% of the country’s loans predicted to go bad, substantial national reserves and a high savings level will insulate China from the sort of debt crises that afflicted its Asian neighbors in 1997.
Nevertheless, handling the fallout will be painful. The boom that local governments have produced through their financial manipulations won’t be followed by a bust so much as an anemic deflation that places saving reputations ahead of efficient resolution and restructuring. The central government will bail out major lenders, but life may not be so easy for local financial institutions and commercial banks in poorer provinces. These local players will be forced to sell their property holdings, the prices of which they have already inflated through extensive residential and commercial construction. With the nation in the midst of what is widely considered to be a housing bubble, a slowing property market would increase the amount of holdings that local institutions have to shed.
China has faced NPL problems before. A decade ago Beijing recapitalized the major banks and moved their bad debts to asset management corporations that were supposed to resolve, or sell off, what they could. As it is, more than US$200 billion of those loans are still in limbo.
This time, the problem is smaller: NPL numbers will grow, but the coming wave will likely not reach the levels China faced at the turn of the century, and will be focused in specific areas. Yet the process of resolution – rolling over debts to avoid foreclosure and bankruptcy, spiriting away assets that are beyond repair into off-balance sheet entities – is likely to be more or less the same.
This does little to build confidence in China’s opaque financial sector. Risk management at major banks may be improving and Beijing is doing its best to reform local government fund-raising, but what are the chances of a repeat performance in a few years’ time?