China Economy: 2012 and beyond (Part 3) – Debts7 March, 2012, 16:35. Posted by Zarathustra
Tags: Debt, Economy
This is part 4 of 5 in the series China Economy 2012 and Beyond
Real estate bubble seems to be invariably tied to debt. It is almost as if you could not have any real estate bubble without debt. In China’s case, however households debts are probably relatively small as (especially after the Chinese government tried to curb home prices) it is difficult for households to borrow to buy properties. Thus this has been one of the major bulls’ arguments on why the real estate market of China is not a bubble. However, for a number of times, I have been pointing out that real estate developers in China are quite highly indebted, thus I have correctly predicted that it would be struggling real estate developers who would start offering flats at lower prices, setting up for the burst of the bubble. Besides that, government’s finance may not be as good as it seems.
More than anyone would know
The truth about the debt problem in China is that no one really knows the truth, and just because households’ balance sheets appear healthy does not mean that there is no debt problem, and that by no means suggests that real estate bubble can’t burst, or that there is no real estate bubble at all.
Since the 2008 financial crisis, the Chinese government has pledged to put in RMB4 trillion to stimulate the economy. The size of the Chinese economy at the time was roughly RMB40 trillion, so the stimulus was more than 10% of the economy. The Chinese government has basically encouraged banks to lend as much as possible (just like old time), and allowed local government to borrow as much as they wish through the local government financial vehicles (LGFVs), which is the centre of the first big debt problem in China.
To stimulate the economy, these local governments got their funding from state-owned banks through LGFVs and started investing, mainly in infrastructure and others. At the time when the developed world was still trying to get banks to lend, banks in China have already lent billions and trillions of RMB. It sounded like something pretty enviable, but the potential threats of such lending spree only surfaces recently.
Professor Victor Shih was among the first to raise the question on the practice of LGFVs borrowing. He first estimated that by the end of 2009 there was RMB11.4 trillion of LGFVs debt, with additional 12.8 trillion credit lines. That figure was shockingly large at the time, but it only raised the eyebrows of very few people, and even the government had very little clue on the matter. It wasn’t until earlier this year when 3 government agencies audited the debt and come up with 3 completely different estimates. As it turns out, the estimate by Prof. Victor Shih was pretty near it.
The highest end of the estimate is from the People’s Bank of China (PBOC), of which they later denied such an interpretation of the number. In the 2010 China Regional Financial Operation Report, they suggested that overall banks’ lending in different regions to LGFVs did not exceed 30% by the end of 2010. Based on the total loans outstanding of Chinese banks by the end of 2010, the upper limit of LGFVs borrowing would have reached RMB14.4 trillion. But to be fair, it could mean that there were no banks in the entire country which lend more than 30% to LGFVs, which meant banks in some regions can be lower than that. The second estimate was by the CBRC, which came up with the number RMB 9.1 trillion. Finally, the National Audit Office’s estimate was RMB4.97 trillion, which I believed was an understatement. However, the National Audit Office figures also told us that there are other kinds of debts outstanding which are not LGFVs debts, and non-LGFVs debts amounted to RMB5.746 trillion.
No one really knows how much loans there are in reality, and even government agencies couldn’t settle. The definitions of those loans in different reports also make things less comparable. Thus, if one would like to be optimistic, the LGFVs debts along with other local government debts would amount to RMB12-13 trillion range. If one would like to be more conservative (i.e. more pessimistic), the higher end would be closer to RMB20 trillion. At the higher end, the local government debt-to-total-GDP ratio would be about 50% of 2010′s GDP.
So what these LGFVs are supposed to do in order to repay its debt? Local governments sell land to property developers. As the real estate market boomed, property developers were more than willing to bid up the price of prime spots, thus these governments are able to raise money to repay its debt.
On top of looking at government debts, which should actually be closer to 100%, we could also gauge the leverage in the system regardless of what type of debts they are – whether they are to the governmental entities or not. Below is a quick comparison between China and the US in terms of bank credits, bank assets, and money supply. As you can see, all of those measures in China exceeded similar measures in the US. Of course it is not completely comparable as China does not have a significant bond market yet, while many of large US corporations raise debts financing from the bond market. It nevertheless gives an idea that China has a lot of debts within the economy. Certainly there are more debts than people who think Chinese like to save can ever imagine.
Monetary tightening and that shadow banking system boom
While households in China have relatively strong balance sheets (at least it appears so on the surface anyway), that is not the case for many real estate developers, as some of the fund raising in the debt market early this year and last year has shown. The effect of massive fiscal stimulus and ultra-loose monetary policy was high inflation. Not surprisingly, this self-inflicting “credit crunch”, while necessary as far as inflation and real estate bubble is concerned, creates some problems for local governments, real estate developers, and small businesses.
Real estate developers, as pointed, are quite leveraged. With tightening in-place, developers have been finding it difficult to obtain financing. Some bigger names have been able to raise money from the Hong Kong debt market at very high coupon rates, and these bonds have been sold-off. Smaller names, however, would not have that luxury of getting any funding.
As real estate market cools, local governments are also raising less money from land sales as developers are becoming less keen to bid up prices. So as these LGFVs debts come due in the years to come, it will not be surprising to see some defaults of LGFVs as the returns on their investments are low. In fact, some have already attempted to default, previous mentioned here and here. To avoid downright defaults, the government has basically resort to the old tactics that Japan has been trying out after the burst of Japan’s own real estate bubble: it asked banks to roll-over loans.
The side-effect of credit tightening last year, perhaps somewhat unexpectedly, was the growth of the shadow banking system, which has been outside of the formal banking system, thus not much regulated and not well understood.
The components of the shadow banking system includes trust loans, which are how many real estate developers get financing as banks are less willing to lend to the real estate sector. It also includes the underground/informal lending, which offers loans to businesses, primarily small and medium businesses. The reason why these businesses are unable to get funding is that banks have preferred to lend to state-owned companies as credit is tightened. As a result, these small businesses are forced to get loans from these underground channels, which often charge 20% or more in interest. Some of these businesses are also involved in real estate market speculations in hope to make a quick buck to repay the debt. Unfortunately, things are turning against them.
Another interesting bit is on the sources of fund. Some of the funding of these shadow banking are from depositors, who have been apparently quite unhappy about the low rate of return on bank deposits. Banks themselves have been packaging high-yield retail products, which were probably lent to real estate developers. Some funding of the underground lending might be from banks, so some people who can still obtain loans from banks have managed to re-lend the money at even higher interest rates. Some state-owned enterprises have also been involved in the shadow banking system lending.
There is little concrete statistics of how large the shadow banking system has become. Société Générale, for instance, estimated that the entire shadow banking system was RMB14-15 trillion large, of which 3.95 trillion is in entrusted loans, 1.49 trillion is in trust loans, 5.26 trillion is in bank acceptance bill, and 3-4 trillion is in underground lending. Thus on top the 20 trillion mystery of LGFVs debt, we have another 14-15 trillion mystery of the shadow banking system.
It might be tempted to think that the Chinese government has very little debt as the official number (~26%) would have led you to believe. Adding the local government debts (especially if you choose to pick the pessimistic case, which is 50% of GDP), Ministry of Railways (5%), policy banks (12%), asset management companies (4%), etc, the debt-to-GDP ratio would be close to 90%. Given the size of the state-owned sector in the economy, and assuming that the debts owed by state-owned enterprises are ultimately the obligation of the government, one can argue even argue that the public sector debt-to-GDP ratio on a consolidated basis could reach more than 200%.
The table below lists out some of the estimates of debts which are ultimately obligations of the government. Note that some of the figures below, while latest available, are not all for 2011 year-end, thus there is likely a slight understatement.
Debt deflation? Or just massive roll-over and over and over?
In a capitalist economy, a private entity would try to get more cash to reduce debt during economic uncertainties. A private entity (let us assume it is an individual for the moment) would probably sell assets to raise cash if it is desperate to reduce debt. If everyone is doing the same, collective selling of assets will drive asset prices lower, making more entities facing financial troubles, and more entities will have to sell assets to stay liquid.
The banking system creates money by extending credit. When one entity decided to repay its debt, money is extinguished by the action of repayment of debt. In normal time, it is alright for the economy as it is quite likely that someone else would borrow money to make up the fall in credit as debts are being repaid, so the overall money supply would be maintained. However, in a situation where debt has become unsustainable for the economy as a whole, most people would be selling assets and repaying debt (or going bankrupt). These actions would reduce money supply, and hence general price level. Because debt level became unsustainable, borrowing would be weak. The only possible way to counter the contraction would need central bank to create money, such that the purchasing power of money could be maintained, not increasing.
Of course, a central bank under a fiat currency regime (as the People’s Bank of China is, and particularly as it is not that independent) can create as much money as it wishes if it does not care about the long-term consequence. That may give optimists an illusion that the PBOC can manipulate the economy or the real estate market, the illusion that the Chinese government can stop the fall of real estate prices at 20-30% and let them stabilise, the likelihood of reality operating in that manner is next to impossible. When one asset bubble went bust, that asset wouldn’t come back strong easily. American house prices, for example, have not bounced back even with two rounds of quantitative easing. So did the burst of dot-com bubble, real estate bubbles in Asia in 1997, gold bubble in early 1980s, just to name few. They ended, and did not come back, sometimes for decades.
The coming burst of real estate bubble in China will not be stopped simply by printing money. It will just be the same. The central bank, however, does have the ability to print a lot of money such that purchasing power of each yuan can be maintained by countering the debt deflation spiral brought by the burst of bubble.
Series: China Economy 2012 and Beyond
- China economy: 2012 and beyond
- China Economy: 2012 and beyond (Part 1) – Demographics
- China Economy: 2012 and beyond (Part 2) – Real Estate Bubble
- China Economy: 2012 and beyond (Part 3) – Debts
- China Economy: 2012 and beyond (Part 4) – Rebalancing The Economy