China’s Chronic Debt Problem, Explained
A question and answer with Fraser Howie
Shadow banking, wealth management products, real estate speculation, local government debt — all these are some of the primary channels through which debt is being accumulated in China in the pursuit of economic growth. The problem rose to prominence after credit-driven stimulus spending in 2009 in response to the global financial crisis, and has continued since, with some modulation.
Taking off from the collapse in July of a wealth management product sold by the Industrial and Commercial Bank of China, the largest bank in the world by market capitalization, Epoch Times spoke with Fraser Howie, co-author with Carl Walter of Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise, about China’s debt problem and how the situation is likely to evolve.
The transcript has been edited for clarity and length.
Epoch Times: What do you make of the recent default of a small wealth management product at the Industrial and Commercial Bank of China?
Fraser Howie: In and of itself this is neither big enough nor public enough to sink the ship. This is not the catalyst, not Lehman Brother’s collapse which caused the crisis – but it is another example of a wealth management project going pear-shaped.
Within a regular bank loan framework, the loans are generally longer term and less transparent. If the company can’t pay, they go to the bank and say, “Look, let’s just roll this over or extend the term,” and the only people who know are the bank and the company. And banks are creative in their ability to define bad loans.
With wealth management products, individuals invest in these things, they’re offered to the public, sold at bank branches, and they are much more short term in nature. So it’s much more public when they go under.
What we’re seeing is a growing number of these things failing to pay, or only paying the interest, or having to call upon the guarantor. You basically are seeing in real time bad loan defaults actually happening. We will see more of them.
Ultimately the biggest problem behind all of this is that money is being lent to businesses that cannot repay it. That business may be connected with infrastructure and local government or some sort of property investment. You have an asset underlying the product that cannot pay back in the timeframe that’s involved.
Even if your infrastructure is not wasted — you build houses in the middle of the desert, ultimately people use it — the problem is that the investment will not pay back in the timeframe of the wealth management product. So it defaults.
At the moment the number of defaults are small enough that they can be locally managed, someone steps in. It could be the bank, it could be a guarantor.
Epoch Times: Who are these guarantors?
Mr. Howie: Guarantee companies, which are companies with a relatively small capital base which will issue a guarantee for a small fee, an investment group, anybody who’s prepared to provide guarantee. Often people provide guarantees because they assume the worst will never happen. Even if the guarantor steps in to pay off the bad loan, or to pay off the wealth management product, that’s good news for the investor, who gets his money back or at least gets the principle back. But still, all you’ve done is shifted risk somewhere in the system.
If the underlying game was to have quality product generating cash flow, generating productive return, and that’s not happening, then that’s a problem.
Epoch Times: Are there systemic issues preventing productive investment?
Mr. Howie: I think at the moment we’re still too early in the cycle. What we know is that for a number of years now credit has been bountiful and more and more credit and more and more creative ways of getting credit out into the economy have been created. So up until now, credit’s not really been the problem. There’s always been some greater fool. You’ve been able to borrow more to pay off your debts. The tide has not gone out.
What I think we’re going to see is this, and this is where the real risk comes: if the authorities are serious about really tightening down on credit, and if the recent interbank rate spike has been the first blow, then I think you’re going to see more and more of these defaults. Because credit will no longer be bountiful and when companies or products do have problems, their ability to pay will become tougher and tougher.
You’ve got this problem that so much growth has been driven by increased credit, that if you turn off those taps then growth is going to slow. You have a double whammy of growing non-performing loans and falling growth, which feeds upon itself. I’m therefore somewhat skeptical about how aggressive the authorities will be at taking on credit, because the consequences could be very severe. I think they will certainly try to slow it, but how effectively they can slow it is going to be much tougher, because there’s no clear next engine of growth. Even if you talk about reforms in China, it’s not clear to me that that’s going to kickstart the economy. I think growth is probably going to continue to fall from these levels.
Epoch Times: What can banks do when the asset invested in isn’t performing?
Mr. Howie: Either extend the loan or suck it up and take a loss from retained earnings. Remember, banks have been making substantial profits, at least on paper, for many years. The question is how much of a hit the banks are going to take.
If the hit becomes big enough, of course, then they turn to the government for a bailout. But all that’s doing is socializing the losses. The government has no money, the people have money. And so the government ultimately, if it has to bail out banks, at the end of the day will shift government spending from social welfare and a lot of other things to basically bailing out banks. There’s no free option here. If you lend money then there’s a cost to that somewhere in system, and the cost will come because either the company itself or the bank will suffer the loss, the wealth management product investor will suffer the loss, or it will ultimately be socialised by the government having to bail them out.
Epoch Times: So where do debt-capacity limits come in here?
Mr. Howie: There are only so many savings to lend out against, and the pool of money is limited. If it wasn’t then we would have hyperinflation. The pool can grow, but it has to be growing somewhat in line with the broader economy. If loans get made to companies that can’t pay them back, then how do new businesses gets loans? The answer is they don’t. New businesses or projects can’t start because the loans keep going to the same zombie companies. This can last for a long time (like in Japan) and because rates are low you can service the debt for a long time, and you think it’s OK. But what happens when rates rise? Or what if all loans were like this? How would the bank make money? They couldn’t pay interest on deposits, and the savers would take their money away. But the bank has no money left, as it all went to companies that can pay back loans. There isn’t any simple ratio or number that can tell you when the tipping point comes, but it is there. Japan’s economic performance over the years is testimony to that. Japan is also evidence that these problems can be kicked down the road for a long time.
Another point: China is the miracle economy, isn’t it? The answer is no, it’s not. So much of the recent growth has been built on debt. There is no secret formula: they borrowed excessively to get short term GDP figures.
Epoch Times: Why do the banks have to be the ones lending money? How come these trust companies or wealth management companies aren’t interfacing with the investors directly?
Mr. Howie: As Willie Sutton said, “Because that’s where the money is.” The banks, first of all, have large networks. Go to any Chinese city and you’ll see a lot of banks. They have the biggest access to funds; they have the customers coming in, and they’re someone you want to partner with.
Banks have also been looking for ways to expand their business and bring people in. They have been tying up to sell mutual funds and wealth management products. The bank provides a place to conduct business, and gets a fee in return.
Epoch Times: Do banks charge a higher rate than typical loans because of the regulations on lending and deposit rates?
Mr. Howie: Yes and no. The problem here is that there are so many permutations of what’s going on here. You have things called entrusted loans and you have trust loans. Entrusted loans are where the bank’s customers will come to the bank. You’ll have the SOE in some cases retain earnings, or borrow from bank at 6 percent, then turn to the bank and say, can I coordinate a loan through you to another company, like a property developer who needs the money. And so the bank sits in the middle of this entrusted loan.
The bank may also be able to get involved in product itself and sell at a higher rate. There really seems to be an almost unlimited number of variations in this process.
Epoch Times: Why is this problematic?
Mr. Howie: It’s not entirely clear to me that the lending is any more dangerous than regular lending, but it’s dangerous in the sense that it’s unregulated. If things go wrong, the creditor’s right to seize assets may be much weaker than a traditional loan; it’s less transparent and you’re not clear who all the players are, or exactly where the connections are.
I think one of the things that caught many off guard during the financial crisis in the United States was the interconnectivity between Lehman Brothers and all the other banks. It’s the weakest link in the chain type of problem here: you have one thing failing that has knock-on implications all along the system. That’s the real worry with shadow banking in China. In the same way that if you want to lose weight you can go to the gym, stop eating less, or cut off a leg: all of them reduce your weight but clearly they do not all have the same outcome.
Epoch Times: Who will be on the hook when or if things really go downhill?
Mr. Howie: I would look at banks being on the hook to some extent, in that the banks have been the big cash cows, they’re ultimately the biggest source of funds and deposits in the country. At some point someone’s got to take the pain here.
If defaults hit smaller banks, it wouldn’t surprise me if the bigger banks were asked to come to the rescue. We’re not at that stage yet, but there’s no way you can think of the banks as independent corporate bodies: the banks are absolutely beholden to the Party in terms of what they will do. Their management are picked by the Organization Department of the Chinese Communist Party. It’s as simple as that.
I don’t see how you have a financial crisis in China without the banks taking a hit either directly or indirectly, because that’s where the money is. They have the large branch networks, they’re the vehicle you can use to absorb these losses. I don’t think the government wants them to pay a check directly, they don’t want to issue new treasury bonds or do anything directly. They would be much happier to see banks try and soak up these problems.
Epoch Times: How about the recapitalization of the late 1990s where bad debts were shifted to Asset Management Companies? How did that work out, and could we see a repeat?
Mr. Howie: It didn’t really work well. The AMCs took on something like $370 billion of bank debts 13 years ago, they were never able to repay the terms of the loans which financed the purchase, and ultimately the debt repayment obligations were taken over by the Ministry of Finance. The AMCs kept a slew of real businesses which effectively were debt for equity swaps. i.e. The local brokerage owed money to the bank, the loan went pear-shaped, the pear-shaped loan was bought by the AMC, the local brokerage could never pay off that debt, and so the AMC agreed to take equity ownership instead of creditors rights. The result is that the AMC becomes a shareholder in a wide array of businesses. The AMC accounts ignore the original funding bond and debt obligations, they have all been pushed to the Ministry of Finance, so the AMC is the resultant equity assets of those vast non-performing loan portfolios. Of course, in some cases it has worked out well in that any property has rocketed in value, but the big AMCs are valued at perhaps $10-20 billion, nowhere near the $370 billion of loans they actually took on.
Ask yourself the very basic question: if I ignore my mortgage, am I richer? Of course not. You can’t ignore the debt side of the equation and just count the assets any more than you can just say you have a few extra million in the bank. What China has done though is not simply ignore them, but move them around from entity to entity. So they no longer exist for the bank or the AMC, but that has only moved them onto the Ministry of Finance, i.e. the state balance sheet. The state pays the debt off by issuing bonds backed by tax revenue, and taxes come from the man in the street. The bank has effectively just had its poor lending decisions socialized.
Epoch Times: How do you see all this developing?
Mr. Howie: This credit bubble in China is a chronic problem rather than an acute one. It’s going to be there for a period of years.
There is a cost and it’s going to manifest itself through, in the best scenario, substantially lower growth. In the worst case, it leads to more crisis-driven scenarios. In which case, China has so many weaknesses and so many fracture points that goodness knows how that could end up if you really start to see a systemic financial crisis. It’s simply too difficult to try to map out. You’re looking at capital flight, you’re looking at all sorts of worries about how that plays out. Again, it’s anybody’s guess.
The government touts social stability. They are right to be concerned, because they have made such a hash of so many social issues. There could be real concerns about how things could fall out.