A $1.2 trillion timebomb ticks in China

Venkatesan Vembu / DNA
Saturday, March 27, 2010 2:53

Hong Kong: A major fiscal shock looms over China, arising from local governments’ shadowy finances and banks’ reckless lending to them as part of the frantic rush to boost GDP growth in China following the global economic slowdown in 2008.

The fiscal crisis represents “the biggest risk to China’s economic and financial stability over the next two years” and has the potential to more than completely wipe out Chinese banks’ equity base, and trigger an equity market panic when it bursts, says Credit Suisse chief regional economist Dong Tao.

At the heart of the crisis are about 8,800 investment vehicles set up at the local government level to take up massive infrastructure projects to prop up GDP growth to make up for the export slowdown owing to the global economic recession.

These vehicles —- called urban development investment corporations (UDICs) —- were set up “in part to circumvent rules prohibiting local governments from borrowing,” notes Louis Kuijs, senior economist in the World Bank’s China office. Local governments injected land and cash into these UDICs as equity, and the land was used as collateral to get bank loans for infrastructure projects.

“UDICs share many common characteristics with the investment vehicles that caused the financial crisis in the US,” adds Tao. “They lack transparency, are high on leverage, rely on short-term funding and land-based valuation, and their assets are illiquid.”

And although it’s very hard to determine how much bank lending has been channelled to the UDICs, Tao estimates outstanding loans to be about 8 trillion yuan (about $1.2 trillion), which is about 24% of China’s GDP, 83% of overall new lending in 2009, and a whopping 180% of the equity base of all Chinese banks.

Estimates by other economists paint a grimmer picture.

Victor Shih of Northwestern University, who has studied local governments’ debt, estimates total bank lending to UDICs (including further lendings) to balloon to 24.2 trillion yuan ($3.5 trillion).

“If large portions of the debt end up being taken over by the central government, that will add significantly to the official government debt,” says Kuijs. In Tao’s estimation, if the central government absorbed 8 trillion yuan of UDICs’ liabilities, China’s debt-to-GDP ratio would explode from an estimated 19.1 in 2010 to an estimated 50.3 in 2010.

The key problem with the UDIC financing model is its use of land as collateral, points out Tao. “If there is a change in the assessment of the value of the land that UDICs pledge to banks as collateral, we may have a serious problem.”

In particular, when property prices in China fall —- as Tao expects them to in the second half of this year, owing to an oversupply of finished apartments and expected interest rate hikes to fight inflation —- “banks will review the value of the land they have as collateral, become risk-averse, and initiate a loan call-back.”
If even one or two UDICs fail as a result, Tao reckons, “it will trigger a wider loan call-back and trigger an equity market panic.”

Flagging the risk of policy errors, he adds that Beijing is “too complacent about how a property market correction could aggravate the UDIC problem.”

Zhu Min, deputy governor of China’s central bank, the People’s Bank of China, however, dismisses concerns about the stability of Chinese banks arising from local governments’ debt as exaggerated. Greater economic activity from China’s enhanced infrastructure would offer sufficient payback on loans for these projects, he observed in a speech at the 13th Credit Suisse Investment Conference in Hong Kong on Thursday. “In 1998, following the Asian financial crisis, China unveiled a 400 billion yuan stimulus package, almost all of which went into building highways,” he recalled.

And although the highways remained empty for a while, the roads catalysed economic activity, and today they are packed, he added. “So long as China keeps growing and these loans have gone into real infrastructure projects, things will be okay.”

The problem with UDICs can be solved right away if the central government cracks the whip and asks the central finance ministry, the local governments and the banks to absorb the losses, Tao believes. But Beijing perhaps lacks a sense of urgency, and it may be difficult for the three parties to agree on who should bear how much of the losses.

The UDICs’ financial problems would affect future local government investment spending and could lead to a rise in banks’ non-performing loans, points out Kuijs. “Problems would emerge if the infrastructure projects do not generate enough growth and revenues to pay the operating and interest costs and repay the loans.”

The time duration of the crisis, when it blows up, could determine the severity of the crisis, reasons Tao. “If the crisis lasts just two weeks, there will only be short-lived market panic. If it lasts two months, fixed asset investments could be affected. And if it lasts two years, China may go down the path of Japan in the 1990s —- but without a property safety net.” However, he expects any crisis to be an “abrupt but short one” —- for three reasons.

In China, the government owns all banks, “and once Beijing realises the magnitude of the risks, it will order banks to keep lending.” Of course, banks’ shareholders would lose out.

Secondly, although local governments are low on cash, the central government is cash-rich, and “we could see another 4 trillion yuan or even 8 trillion yuan fiscal spending program to boost growth and stabilise the banking sector.” And thirdly, China is, in the global context, “too big to fail” —- and in any case it has a roadmap in the form of the US bailout of banks.

“You have a Western recipe —- and you have lots of fresh materials (in the form of China’s fiscal strengths)... Even a mediocre chef can cook a reasonably good meal,” says Tao.
But even as he sounds the alarm over local governments’ debt, Tao puts it in perspective. “What’s happening in China is not very different from what’s happening elsewhere: the government leveraging up during a global financial crisis to stimulate the economy.” The critical difference is that China’s starts with a low debt-to-GDP ratio, about 19% currently.

“It’s a hiccup, and a big hiccup at that,” he acknowledges. “But nevertheless, this is not something that will derail my fundamental view of China over the next decade... We remain bullish on China’s long-term outlook.”


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