China’s Achilles’ heel

China’s economy is a major constituent of global growth, making its economic model not only important to the future of 1.35 billion people in China but to the world as a whole. Popular media remains fascinated by China’s economic heft but less attention is paid to the fundamentals of its economy.

The larger problems with China’s economy are structural, the result of unconventional policies and instruments used by the government.

Chinese economic strategy is based on aggressive expansion; the state is quick to provide loans that finance domestic and international business, and returns are often forgone in the quest to acquire market share.

Until now this has worked for China. But the time has come to recognize that these policies will likely have adverse implications in the long term. The signs are visible in the country’s slowing growth. China’s GDP for the second quarter of 2012 fell to 7.6%, the lowest in three years, and the growth rate for 2012-13 is on its way to being the lowest since 1999 if things do not improve in the coming two quarters.

To get a ringside view of this slowdown, follow China’s banking sector. It underpins the country’s economy and growth and is a key structural problem that challenges future prospects. The big threat: Non-Performing Assets (NPAs) or, loans for which interest payments are overdue.

This threat dates back to 1999 when Chinese banks were in dire need of liquidity. As a response, the Chinese government transferred 1.4 trillion Yuan ($223 billion) of non-performing assets from the four major national banks, Bank of China, the China Construction Bank, the Industrial and Commercial Bank of China and the Agricultural Bank of China, to an equal number of newly-created special financial vehicles called Asset Management Companies (AMCs). This amounted to 50% of the total NPAs held by the four big banks at the time. A second round of similar transfers was made in 2004, totalling 1.6 trillion Yuan ($255 billion). The expectation with both transfers was that the AMCs could recoup about 30-50% of the assets through re-use or divestment of the asset. But as the China Banking Regulatory Commission admits, the actual recovery for the total was closer to 20-25% or $100 billion, below the minimum target of $143 billion.

The global recession of 2008 resulted in China’s annual export demand dipping by 16% and worsened the NPA problem. The losses exposed China’s dependence on exports to fuel growth. Domestic consumption is still low in China at 35% of GDP, compared with India, Brazil or the U.S.’s 54%, 61% and 74% respectively. Beijing could also not find solace in its domestic debt market which remains underdeveloped for local governments due to central government restrictions. In the absence of these tools, Beijing had little option but to use creative economic instruments such as the ‘local government funding platforms’ to boost the economy.

Under this, local governments borrowed 2.8 trillion Yuan ($440 billion) from public sector banks and 1.2 trillion Yuan from the central government for infrastructure projects. Local governments used their own land as collateral for borrowing. Then, rich with cash, they spent it on more land to build infrastructure projects. By 2009-10, these purchases had caused property prices to rise by as much as 16% in 70 cities across China, and up to 21% in Beijing. The high real estate prices in turn enabled local governments to borrow more, and so it went, initiating a vicious cycle. Since land sales form 70% of total revenue for local governments, they had a vested interest in seeing land prices escalate.

Unfortunately, they used the borrowed money for misdirected investments. Kangbashi or the “Ghost Town” of Northern China is a case in point. It has 30,000 residents against the capacity of the 1 million the government thought it would attract by 2010; now there are a massive number of empty houses and unused public utilities. The Xianyang International Airport in Shaanxi is another example. It opened a third terminal and runway on May 3 this year with a passenger capacity as much as New York’s busy John F. Kennedy, but daily traffic has only reached one-third of that.

As the number of misdirected investments grew, so did the NPAs, with the likelihood of local governments’ ability to pay back the loans, diminishing. According to China’s National Audit Office, local government debt alone at the end of 2010 exceeded 10.7 trillion Yuan ($1.7 trillion). This may be as high as 14.2 trillion Yuan ($2.2 trillion), or a third of China’s economy, according to estimates by Moody’s, the UK credit rating agency. By the end of this year, i.e. 2012, as much as 1.84 trillion Yuan ($290 billion) of total local government debt will come due. In June 2011, Fitch Ratings claimed that the NPA rate in certain cases in China could rise from 3% to 5% or even as high as 15% if GDP growth slows down to 5-6%, depending on how well the government responds to the problem.

If the situation is so dire, why are the banks continuing to lend?

Not dissimilar to India, the Chinese government controls the big four banks through a majority shareholding of up to 70% with management control of appointments, promotion and perks. It can influence lending to local governments and overlook the issue of local governments paying back the loans.

Now, the cases of default have started to show. For instance, 85% of the loans held by local governments in Liaoning province missed debt service payments to the banks in 2010. Others such as those in Yunnan and Shanghai unsuccessfully attempted to default in 2011 by refusing to pay the principal. The central government quietly stepped in to cover the payments in order to keep the local debt problem quiet.

There are ways to make up the losses. Beijing can allow local governments to issue municipal bonds. But it will require modifying the existing legislation, political will, and eager buyers – not easy in this difficult investing environment.

Or Beijing can continue to be the knight in shining armour for defaulting local governments – possible but not sustainable.

Or China can use its reserves to pay down the debt. That will require China’s economy to continue to grow, so the central government can pay off the local government debt of $1.7 trillion by using several hundred billion dollars of its foreign reserves. Adding the $400 billion of reserves to the AMCs will bring the total local government debt closer to $2.1 trillion – almost 70% of China’s total foreign reserves of $3 trillion.

But even if the Chinese government could pay, international rating agencies like Standard & Poor’s will surely downgrade China’s credit rating from its current AA-. A downgrade could send tremors across world markets and create bearish sentiments about China, affecting capital inflow.

If growth starts to slow down – which is evidently becoming the case – it poses an even bigger threat. In June 2012, manufacturing growth in China fell to its lowest level in seven months and import growth fell by 50% from the previous month’s level. The central government will surely find it difficult to use its foreign reserves for these bad assets.

Until now, Beijing has been able to sustain growth with its unconventional approach of having a lower regard for returns. But with the continuing global economic slowdown, China will surely be impacted, and the anticipated ‘soft landing’ could become unbearably hard. China’s banking sector, it seems, is its Achilles’ heel.

Mukul Raheja is a Research Intern at Gateway House: Indian Council on Global Relations and a Graduate Research Student at the Jindal School of International Affairs.

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