Debt is the economic scourge of our time.
First it buried American banks and mortgage holders. Then we learned that euro zone governments such as Greece, Portugal and Ireland were in hock over their heads. Japan’s debt is twice the size of its annual economy. And in Washington this month, Republicans and Democrats are engaged in brinksmanship over the American taxpayer's $14 trillion hole.
Through it all, China has been seen as the stalwart of financial prudence. But we now know that the country faces its own challenges.
As GlobalPost has reported in the past, China's banks have been engaging in risky “off balance sheet” lending somewhat reminiscent of Enron’s shenanigans. Last week, Beijing released a national audit revealing that local governments owe an estimated $1.65 trillion in outstanding loans. This week, Moody’s has indicated that the problem is significantly worse, by as much as $540 billion. And that's only local government debt. It doesn’t include the central government’s huge obligations, or those of banks that are essentially guaranteed by Beijing.
Even for a miracle economy like China's, that’s a lot of debt.
To put this in perspective, GlobalPost interviewed Victor Shih, an expert in China’s economy, who has been following the debt situation closely. Shih, an assistant professor of political science at Northwestern University, holds a Ph.D. in government from Harvard. (The interview has been condensed and edited by GlobalPost.)
GlobalPost: Put this in perspective for us: How much debt does China have?
Victor Shih: That depends on what you include. Large sectors of the Chinese economy are owned by the government. The debt of these state-owned enterprises is what’s called a “contingent liability” — ultimately it’s the responsibility of the government. If you count all of these liabilities, then you get to an extremely high number, something like 150 percent of the Chinese gross domestic product, or more.
A more restricted definition is debt that's owed by either the central or local governments. That is about 80 percent of China's GDP.
If China's central and local governments are responsible for the companies’ debts, is that the more prudent number to use?
It depends on the prevailing economic conditions. When the economy's strong, then there's no need to look at the wider contingent liabilities, because there's plenty of money to go around. If the business environment begins to deteriorate, state-run enterprises could go bankrupt. In those cases, you do need to look at the broader liabilities. If growth slows down substantially, people may find that the Chinese government in fact owes a lot more than 100 percent of GDP.
How sound are the businesses that owe all this money in China? A lot of China’s outstanding loans were made in a rush after the crisis began in 2008, correct?
Yes, loans under the crisis-era stimulus program were very rushed.
In China, there are two different kinds of government-related investment projects: centrally directed ones and locally directed ones. The centrally directed projects are a little bit better, though in some cases, also very wasteful. They involve things like building a high-speed rail, or a major airport, or expanding Beijing. These projects tend to bring more benefits to the national economy, and so trillions [of yuan] in loans have been provided to the centrally directed projects.
What about the local projects?
The locally directed projects, in many cases, are extremely wasteful projects, such as building an Olympic-sized stadium in a city with 800,000 people, or building hugely expensive government buildings. The local governments have all of these cockamamie projects which got approved when the central government panicked in 2009.
When you build an Olympic-size stadium in a city with 800,000 people, that stadium is not going to generate a lot of cash flow. The banks, so far, are rolling over a lot of this debt: rather than declaring it non-performing, they say “okay, we'll give you a new loan, and part of the new loan you'll use to repay the old loan.” This is why you see a relatively low non-performing loans ratio in China.
Why does China's debt matter to its central government in Beijing, and why does it matter to Americans and others outside China's borders?
Americans probably wouldn't be hurt that much. Some people worry that if there's a debt bubble that somehow bursts, then China will redeem its large holding of U.S. Treasuries to bail out Chinese banks. That is a possibility. I think that if that were the case, others would snap up those Treasuries. Interest rates may go up a little bit, but probably not by that much.
As for the Chinese government, the current leadership steps down from power next year. They don't want to look bad by revealing that they got China into so much debt. On the other hand, the new leaders will want to do more to reveal the problem, because otherwise there's some risk that they will be blamed. So we do see this kind of conflicting tendency within the Chinese government to disclose how much local debt there is.
How bad is the problem? What are the chances that China could suffer a debt crisis like the one the US faced in 2008 or certain euro zone countries are facing now?
I’d say zero, because the Chinese banking system is different from in the U.S.
The Central Bank of China has already explicitly said that it would bail out all the distressed financial institutions, so there's no Lehman Brothers problem, where a big financial institution could get wiped out. But this creates a problem of moral hazard: You're telling the banks that they'll always get bailed out, so they never need to improve their performance.
The problem is inflation. Every time you bail out a bank, the Central Bank essentially prints new money and gives it to the banks, so everything remains liquid. If you do this year after year, you drive up prices, by flooding the economy with new money.
Over the next two to three years, there's unlikely to be any kind of credit crunch causing a financial crisis in China, but you will see fairly significant inflation. If inflation persists, you erode people’s savings because their money will buy less. So consumption (in real terms) will never be a main engine of growth in China if this continues. That would be a problem when their exports slow down.
Is slow consumption growth a problem for the U.S.? During the crisis the U.S. government wanted China to consume more rather than depending on exports for growth?
Definitely. China can now only grow either through investment, which drives up commodities prices, or through exports, which competes directly with the U.S., Europe, and other countries. That is a problem of the Chinese growth strategy for countries that are not China.
China blames the Federal Reserve for the quantitative easing program that it has used to stimulate the economy. They say that exports inflation to the rest of the world. That may be true, but China also exports inflation.
The Central Bank of China prints 15 percent to 25 percent in new money supply every year, and that drives up commodities prices around the world. The U.S., being a commodities rich country, is relatively immune to that inflation. But in other countries, where people mainly consume commodities like corn and soy beans, prices have gone up tremendously. People in those countries suffer in part because of Chinese printing of money.
The downside of all this debt, it seems, is that the government's legitimacy depends on its ability to continually improve the standard of living of its people. Could inflation and debt provoke instability in China?
There is already a huge amount of instability in China. There have been 80,000 mass incidents, some of them are very peaceful sit-ins, but there are thousands of riots in China. But all of these incidents have been very isolated to one or two places, there has not been any sort of inter-regional unrest.
When you have such a powerful apparatus to maintain control, why do you need legitimacy?
Some Arab governments these days may have a tough time with that question.
The Chinese government would say that that's because they allowed social media to operate freely, which is not the case in China.
Do we know which local governments face the biggest debt burdens? Who's the Greece of China?
The biggest problems lie in middle income provinces, which aspire to be the next Beijing, Shanghai, or Guangdong. These places, like Tianjin, Wuhan, Chongqing and Chengdu have borrowed an enormous amount of money to finance infrastructure construction, but at most, there will be one, maybe two new Shanghais. These middle income places with high aspirations will ultimately run into some serious issues, which they’ll have to work out with the central government.
How could China, the world's second biggest economy, make so many inefficient decisions, without suffering serious repercussions?
The magic is that the government controls all the banks, and capital controls prevent people from moving money out. The Chinese people don't have any choice — they put their money in the bank, then the bank uses the money to lend to state-owned enterprises. Or you invest in the stock market, but most of the companies listed in the stock market are state-owned enterprises. You buy real estate, and the proceeds from real estate largely go to state-owned companies. The money always ends up in some entity controlled by the government. This is why it's been very sustainable.
So essentially the debt is owed to Chinese families who have put money in the bank, and they're likely to get bailed out. Nobody's going to lose the way we saw people lose in recent years in the U.S.
They're not going to lose their deposits, but there's an inflation tax every year. Right now, there's what's called negative real interest rates in China. Inflation rates are nearly 6 percent, but deposit interest rates are only 3.5 percent, so every year that you leave your money in the bank, you lose almost 3 percent, in real purchasing power. So that's basically a tax.
So the Chinese consumer is taking the brunt of this.
Yes. Households are being taxed left and right, in many different [hidden] ways. This creates a lot of insecurity in your average household, which means that they're not going to spend a lot of money. A lot of services — even though they're supposed to be free — actually cost a lot of money. So people with children, people with sick relatives, have to pay a lot of money to send their kids to school, or to send their relatives to the hospital.
There's also an explicit government tax, and high prices that Chinese consumers have to pay to state-owned monopolies and oligopolies, so certain sectors are highly uncompetitive. Prices are set by the planning authorities in many cases, so that also constitutes a kind of a tax on households.
With all of these different kinds of implicit and explicit taxes, it will be extremely hard for the Chinese consumer to really pick up the slack and that's where China’s growth will run into some serious issues in the coming few years.
Meaning that when China exhausts its export potential, consumer spending won't be able to pick up the slack because of these many hidden taxes that the people face?
What’s the near-term effect of all this?
The biggest potential problem comes from the elite. There are some very wealthy people in China. They're not going to sit there while their savings are eroded away at a rate of 3 percent or 4 percent a year. They're going to do their best to find a high return, as rich people around the world do. Even China's capital controls are not going to stop them. So I think, in the future it may become more apparent that China is experiencing net capital outflows.
But moving your money abroad is not legal in China.
It's not legal, but it happens all of the time. There are hundreds of underground money changers who help people move money out. You just give them a million dollars worth of Chinese Yuan, and in Hong Kong you can take out a million U.S. dollars. They just charge a small fee.
Another concern in China is the real estate debt, given how quickly property prices have risen. In your view, is the real estate market in a bubble, and if it bursts, what would the effect be on government debt?
It's not such a serious problem yet. If real estate sales slow temporarily, developers may still keep on buying land, because land prices have gotten cheaper, and some of the larger, well-financed developers see it as a good chance to buy land. If the slow down in real estate persists for half a year, you may begin to see even the well-financed developers slow down their buying. The local governments will not be able to sell land, which is the main source of cash that they use to repay the banks. If there's another half a year after that, then these loans may become non-performing. The chances of that is relatively low over the next few years.
At 150 percent of GDP, that’s a debt rate similar to Greece’s. Obviously Greece's growth rate is much lower than China's. But it’s surprising to hear that things seem as sustainable as they are.
Well, Greece has German bankers, and China has Chinese bankers, that's the difference. Japan has a debt-to-GDP ratio of 200 percent, but they owe it all to Japanese households.
That makes it sound like capital controls aren't such a bad idea after all.
Well, if they're used to finance all these state monopolies and oligopolies, then it's extremely bad for the economy in the medium term.
Visit Victor Shih's blog, or follow him on Twitter @vshih2.
Follow David Case on Twitter @DavidCaseReport.