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China’s mountain of debt, explained

Beijing may be even more indebted than Washington. But thanks to communism, don’t expect any Lehmans.

China local government debt crisisEnlarge
The building in the center is the 101-floor World Finance Center in Shanghai's Pudong district. China's construction boom and appetite for bold buildings have given architects the chance to push design boundaries, amid a slowdown in Europe and North America. But is China's boom sustainable? (Philippe Lopez/AFP/Getty Images)

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?