Fraser Howie Explains China’s Debt Crisis
Epoch Times: Mr. Howie, please tell us a bit of background about your book “Red Capitalism.”
Fraser Howie: Myself and Carl Walter [co-author], we had worked together 15 years ago at China International Capital Corporation Ltd. and we actually started writing then. We did a couple of books on the stock markets, which came out in 2003.
But we knew there was a bigger story to tell about the Chinese banks. In the year 2000 the Chinese banking system was bankrupt, nonperforming loans of 30, 40, 50 percent—huge numbers. And yet by the end of the decade, you had pretty much all the big banks listed … doing some of the world’s biggest IPOs. This seemed to be a great success.
In the book [“Red Capitalism,” 2011] we wanted to address the question “How did that happen?” and then also tell a broader story: The numbers look very impressive, but a Chinese bank is not what we understand in the Western sense or in developed markets.
The book goes into detail how the banks restructured, how much of the restructuring was an accounting trick. A lot of it was accounting: reshuffling assets, moving things off balance sheet, taking them out of the public eye.
And yet after reshuffling these assets and putting them into this good-bank-bad-bank model, the actual good banks were still on the hook for some of the exposure. China was talked about as a miracle economy and the Chinese seemed to be able to walk on water when it came to economics and we wanted to show that this was not the case.
There were some good things done and there were some bad things done. You could only look at China if you fully understood how this thing had been restructured.
Epoch Times: Please explain the debt problem the Chinese are facing now.
Mr. Howie: If you start adding up all the liabilities of the government, the level of government debt is much higher than what people commonly accept it to be. Because it’s hidden by using off-balance sheet and nonstandard ways of issuing debt or using non-Ministry of Finance issuing vehicles. We looked more broadly at the level of debt in the economy and how the Chinese deal with the debt. They basically never write it down; they just push it back to a later day.
This is a problem we see in the West as well. There were no miracles in China; this was a China which was much more understandable because there is no miracle. They have taken shortcuts here, they’ve done a trick here, they have done some fancy accounting here, and then you can see that there are no miracles here and in fact there are many problems in the system.
At the time of writing in 2010 and 2011 those ideas were not understood, were not accepted—the problems of the past had long been forgotten about. We basically raised this issue and highlighted the discussion and made people aware of the stresses and limitations within the financial system.
Now, fast-forward a few years, you now see an economy which is struggling with a large amount of debt.
Epoch Times: What happened after the 2008 crisis?
Mr. Howie: The collapse of Lehman was a seminal moment for China as much as it was for America. In the Chinese context, to have a Lehman fail, to have such a large bank fail in such a public manner, to have something like that happen in China would effectively mean the collapse of the Communist Party. Those types of entities are seen to be completely backed by the government.
How the Chinese [regime] responded to it was to splurge credit and use the state banking system, which it previously tried to reform. People had understood they needed to build a proper commercially driven banking system. But China responded to the great financial crisis by turning on the credit tabs in the beginning of 2009 and pumping a vast amount of credit into the economy to keep growth going.
This was hailed at the time as China as the savior of the world economy, boosting world growth, kicking off a huge investment boom in China, and that was all seen as a great thing. What we of course pointed out was that a lot of that credit was going to just about any company out there and there was no focus on returns.
The reforms that have been pushed in the banking system in the past decade have basically been thrown out and the central planning model very much asserted itself to push credit through the system.
This led to a huge buildup of credit in 2009 and you saw that continue in 2010. Credit did come off to some extent in the last couple of years, but credit is still at a very high level compared to what it was historically.
Epoch Times: Why is this problematic?
Mr. Howie: You not only have credit at a high level historically, but you also now have growth at one of the lowest levels it has been for the last 20 years. So you’ve had this double effect of more credit, less growth, and more misallocated capital.
Now what you have is a very nasty situation in China. By obsessing about growth remaining high, they became more and more dependent on debt because you are investing in projects that were not providing a return—certainly not in the short term and probably not in the long term—to pay back that debt. So to avoid bad debt and defaults you were dependent on more and more loans being rolled over and further credit being extended, which basically leads to this vicious cycle.
Credit becomes tighter for real businesses because there is less fresh credit available as all the loans are being rolled over. This is the position that China finds itself in now.
Epoch Times: What will happen now?
Mr. Howie: I don’t think that there is going to be a collapse, but there is clearly tremendous stress on the Chinese economy. I think this should remind us of a number of things. One is that the idea that the Chinese leadership is a great long-term manager of the economy, I think it’s false. This is a problem that largely didn’t exist five years ago and has now taken on very large proportions. It’s also a problem that China has a debt crisis without any of the entitlements that for example southern Europe has.
China has created a debt crisis for itself within five years, whereas the Europeans took at least a decade if not longer to find themselves in this position through over-entitlements. China finds itself in a much weakened position because of this obsession within GDP growth.
That has long-term consequences because the economy is slowing and you have bad demographics going forward and you have margins being squeezed. Prices for goods and services are going up. The minimum wage is now mandated to go up 15 percent per year. A lot of the costs were suppressed through the post WTO boom and are now being fed back into the Chinese economy. So China is becoming less competitive.
It doesn’t mean collapse but it certainly means there is a cost to work itself through this, a cost that is going to come through a mixture of things, certainly slower growth as companies are finding it tougher to operate. It will come through higher inflation because it’s always easy for the government to inflate away the debt, ultimately just print more money to pay the debt.
The final cost is: China has overextended itself and has wasted and misallocated this capital. This means it’s not in a position to allocate it somewhere else.
Therefore, China’s capacity to fund social security and drive urbanization, or to build more health care and fund more schools, is going to be impacted as well, because it simply no longer has the resources as it has misallocated them elsewhere.
This is Part 1 of a two-part series. Read about the details of the coming Chinese bailout in Part 2.
Fraser Howie is the co-author of three books on the Chinese financial system, including “Red Capitalism,” named a Book of the Year 2011 by The Economist magazine. For 20 years, he has been trading, analyzing, and writing about Asian markets. During that time he has worked in Hong Kong, Beijing, and Singapore for companies like Bankers Trust, Morgan Stanley, CICC, and CLSA.
The interview has been edited for brevity and clarity.