Wednesday, November 11, 2009

Let’s Look at China’s Liabilities Again

Recently, on a China specialist bulletin board, the debate on “the China collapse” hypothesis flared up again. As you can imagine, things got pretty heated between my colleagues. I have learned that predicting the future is a losing game, but we can certainly look at facts and bring in some skepticism. Incidentally, I am working on a project to calculate the extent of borrowing from local government investment entities, which are discussed below. I am about half way through the provinces, but will update interested readers on my findings in the coming months. Below is my contribution to the “collapse” debate.

Chiming in among the skeptics, I think we tend to focus on the asset side of China’s balance sheet, which is quite impressive to be sure. However, the Chinese government is also good at hiding its various liabilities (in the accounting sense) through various entities and strategies. Let’s ignore human costs like reduced life expectancy from the environment, lack of social services and work safety for the moment and only focus on financial liabilities. Among the OECD countries, we see that public debt escalated tremendously due to stimulus programs and financial bailouts. However, it would be mistaken to argue that China accomplished 9% growth without getting into massive debt. In fact, it got into much more de facto public debt as a share of GDP than the US or Europe did. If Cpolers remember a conversation about the rise of deficit this year in China, which put official debt this year at a modest 25% of GDP. However, the reason growth is so high this year is due mainly to investment. In addition to the 4 trln RMB central government package, local governments also rolled out additional trillions in investment projects. In OECD countries, much of these projects will be financed through the official budget, but in China, local governments set up urban development companies to raise this money as “corporate loans” from banks. Thus, around 70-80% of this trillions in investment was financed through bank loans.

More will have to be spent to finance these projects. Local governments learned long ago (possibly in the 50s) that when the central government is feeling generous, start as many projects as possible as oppose to spend money to complete projects. This is because they know that the central government will retrench one day, but the center is still reluctant to cut off funding from on-going projects, which result in total loss. On this basis, Nomura Securities, typically a very bullish outfit, estimates that new lending will again have to be 10 trln RMB for both 2010 and 2011 to fully finance existing construction projects. This means local governments will need to get into trillions more in debt (probably 10 trln in addition to what ever the current amount is).

Does this mean a collapse? certainly not necessarily as the government holds a lot of assets. However, as with any country, we should also pay attention to the liabilities.

Sure, China has more fiscal room to buy time, and this is what another injection of bank credit next year will achieve. But this also means that rapacious local officials are likely to squeeze all they can out of local businesses - especially private ones that are easier to 'tax' - to get around the constraints that accompany actual changes or uncertainty regarding policy. Without factionalism rising in Beijing, and without strong and clear top-down leadership where it comes to policy, local officials are going to be increasingly bold, mostly because no one is watching. This is hard to capture on any balance sheet, but follows the balance sheet effects. That is to say as debt levels rise to fund assets like bridges and speculative business ventures that do not generate adequate cashflows, the degree of 'liumang' in local government also increases. This will not subside until there is a more solid recovery in the economy the produces adequate local fiscal resources to reduce the need for bureaucratic predation on local economic interests.
Given the control over assets that top officials have, how much would actually be left over for the administration of government, if there were a "collapse?"

On a related subject, while there have been at least a handful of runs on local bank branches in the 1990s, one has not read of any in the Chinese press in the past 5 years or so. The last I can recall, and my memory may be faulty, was 2003.

Surely, the Chinese public, who believe 中央絕對不會讓它倒 don't ascribe to the possibility of collapse. In itself, this mitigates against panic.


Rich Kuslan, Editor
I am not sure that 中央絕對不會讓它倒 is an effective risk mitigation technique. The question is really about who eats the losses. The last time around it was the people at large, as national savings cum foreign exchange reserves were used to bail out the banks that had to realize the costs of bad lending to inefficient and corrupt SOEs. Recapitalization is like hitting the financial re-set button, and now the local officials are at it again. Will the public accept a repeat of the last recapitalization exercise? Probably not. The scale factors here are also much larger, and we are talking about literally thousands of local governments and their investment vehicles. What is left for local officials forced to clean up their financial messes is the rest of the economy - generally private - that they have not 'taxed' in the past. They system will survive intact by dragging other interests down with it.
I didn't write of "risk mitigation techniques." Do you mean that the pervasive belief in the stability of the center doesn't contribute in itself to that stability? If not, of what import is public acceptance of a second bail-out?
Mitigating public financial risk in China would seem to be related to mitigating the risks of a "panic". The approach has always been to deal with social/political risks first, and then assign an economic cost. Presently, if local companies and financial institutions (such as city-level banks and cooperatives) are left to bear the costs of wasteful local spending, which everyone knows includes rampant cronyism, and eventually go under, then people may well take to the streets. One of the latest avenues for raisiing funding for local public financing platforms is to create a trust company of sorts to borrow money, which is then invested/capitalized under the umbrella of a captive government investment company. This is a clear no no, but one that is harder to trace and regulate. Having seen a number of local marches (peaceful) protesting after the collapse of similar schemes in the past (such as guaranteed fixed high interest returns - bosses flee the country - local left with nothing - city government eventually pays out something to quell the discontent), I think at present the public tollerance for such results has come down. So has the ability of the local governments to clean up the mess, measured in fiscal terms. For the laobaixing the risk is not collapse. For them the risk is getting stiffed with no resourse. Another macro-level bailout of the banking sector as during the Zhu Rongji era is less likely than a series of localized flare-ups when local financial alchemy goes sour. The former case involves national level policy that is set in a realm completely divorced from the lives of laobaixing. The latter case involves local interests, local public funds and other resources. The next round of bailouts is going to occur more at the local level, and thus the import of public acceptance of a second bailout should be obvious.
Belief in the stability of the center has nothing to do with what locals do when they get stuck with debts that are being piled up by their leaders. That is what is going to happen.
Great comments guys! Keep it up; I just twitted this link so more people can read it. My comment is that the PBOC guys are very cocky at the moment. They know of the problem, but they believe they can just form various asset management companies and carry out "relending" operations to recapitalize all of the distressed institutions. I am skeptical that the same tricks can work twice, but I may be wrong.
So pleased to find this great site. Not being an economist, but being aware of the numerous tensions gaining strength in China in 09, I would like to pose the big "collapse" question, esp in relation to what appears to be a massive Ponzi scheme in the housing market. ie debits turned in credits to leverage additional loans. Would anyone like to forecast what a collapse would look like, and how it would connect with other social tensions in Chinese society. As far as a trigger mechanism goes. I would (and I don't have any strong evidence) vote for rumour via net and text message leading to a run on the banks. Esp since a large percentage of people are extremely exercised about the massive increases per sq metre in last few years, without commensurate salary increases. Think of the tv show Small Houses.
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