Connect to share and comment

China’s mountain of debt, explained

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

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?

Yes, exactly.

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.