Can China handle another debt Crisis? We still remember the last one.

According to the most recent audit of China’s local government debt by the China Banking Regulatory Commission, municipal authorities owed lenders somewhere in the region of 9.7 trillion Yuan, or USD 1.6 trillion. The audit, the results of which were timed to coincide with the start of the Third Plenum highlights just how much of an issue local borrowing has become in China and just how seriously it is viewed by the central government.

Despite the woolly, vague and wooden language of the policy announcements which followed the plenum, it’s probably safe to say that tackling the nation’s hidden debt bomb was probably fairly high on the agenda. A point highlighted by the timing of the audit, the third such survey requested by Beijing in as many years. But the big question for many is just how did China’s local governments get themselves into such a mess, how can they get themselves out?

To understand this it’s important to understand the way in which this debt is structured. After local governments were forbidden from borrowing directly in 1994, there emerged a proliferation of local ‘holding companies’ – or local government financing vehicles (LGFV) – ostensibly owned by or on behalf of local governments.   According to the most recent audit, these holding firms are responsible for 45 percent of the debt payment of local governments.

These holding companies were ostensibly responsible for undertaking local infrastructure investment. This investment was seen as essential by many local authorities for meeting growth targets – the primary yardstick political performance for government functionaries in China. This process then accelerated exponentially in the wake of the financial crisis as exporters saw foreign markets dry up.

The main problem for local governments is that in terms of generating economic growth, construction is really the only game in town. Or at least the only game that generates returns quick enough to reap the political benefits. The situation was made worse by a culture of corruption and blurred lines of ownership which disproportionately rewarded government officials that green-lighted infrastructure and construction projects. Land could be appropriated from rural owners at massively below the market price and sold on to holding firms for development financed by cheap loans from local banks. Land laws which prevent local peasants any meaningful property rights over the land they work exacerbated this problem and local officials were further incentivised to make risky investments safe in the knowledge that if they paid off in the short term, they would have moved on to greener pastures once the bills come due.

This over-investment in construction projects led the housing market to saturation point in some regions of China as ‘ghost towns’ like Ordos in Inner Mongolia testify to. As meaningful infrastructure projects became harder to find increasingly grandiose white elephant projects were financed to keep the economic growth train rumbling along.

One story in the China Daily which outraged Chinese netizens across online micro blogging platforms illustrates the lengths to which local governments will go – an USD 11m, 2,300 ton, 295 foot-long puffer-fish. The gaudy, almost surreal scene is billed as the world’s largest metal construction, at roughly the same length as the height Statue of Liberty. The 15 story viewing platform was erected by local officials from the town of Yangzhou to celebrate the opening of a local agricultural exposition but in many ways is symbolic of waste and folly that lurk behind some of China’s impressive economic statistics.

Recent attempts however to curtail profligate lending and temper China’s housing market restricted credit lines and demand for housing already in the pipeline, forcing the LGFV to turn to other sources of financing to keep their projects solvent in some cases and to continue serving debt repayments in others. To find the money, local governments turned to brokerage houses which securitized the debt as bods and resold it through high street banks to high street savers as wealth management vehicles – ostensibly risky, high interest savings accounts. This proliferation of debt through the banking the system is sometimes referred to as the shadow banking sector.

It is important to note here, however, this is not the first time China’s local governments have got themselves into hot water running up bills that can’t be paid. And the central government has already been forced to clean up the mess once, no doubt making them loath to pick up the pieces again. The last time was after the last borrowing frenzy in the 1990s, after which the government simply bought all the debt off the books of the ‘Big Four’ State banks and consolidated it in what were euphemistically called Asset Management Companies, where it has languished, essentially untouched for nearly 15 years.

In recent months there has been a lot of speculation as to just how Beijing intends to deal with this build up – particular as many now believe that interest payments are rapidly approaching unserviceable levels in many regions. One solution suggested by a Beijing think tank is to simply allow local government holding companies to default on their bond repayments. A fairly harsh medicine intended to puncture the confidence of investors and cut off funds to local governments. Such a radical approach is however very unlikely as it would hit middle class savers hardest – the one core demographic the government is terrified of upsetting.

In another attempt to resolve the web of debt, Beijing has rolled out a Municipal Bond trial program across two Provinces and recently extended it to a third.  The program is intended to allow local governments to finance their debt directly by issuing bonds. Such a move would make local government debt more transparent but it’s unlikely it would go very far toward resolving the issue with additional borrowing disappearing into the money hole servicing existing debt.

In fact, groping for substance in the woolly language of the Third Plenum, it is possible that the government will first reform land laws making it more difficult for local governments to use poor property rights as an easy source of political and financial capital, effectively trying to stem the bleeding before mopping up the mess.

Shadow Banking

Last week, the Shanghai interbank offered rate (Shibor), China’s once-anonymous version of London’s LIBOR, made news around the world when it suddenly spiked at all time high. Expected to lower this rate by injecting cash into struggling Chinese banks, the People’s Bank of China (the country’s equivalent of the Fed) instead did nothing, leading to speculation that China’s leaders were finally prepared to tackle the economy’s overheating problem. In the process, the media appears to have finally taken notice of the potential dangers that lurk within the byzantine industry that is Chinese finance. Reviewing the headlines, a series of arcane, sinister terms leap out: off-balance sheet lending, inter-corporate finance and shadow banking.  

Such terms, nebulous as they may be, are keeping Chinese policy makers up at night: According to Fitch, China’s shadow banking sector may be hiding as much as $2 trillion worth of risky assets in off-balance sheet lending. But what does that really mean? And, more importantly, how did China find itself in this situation? Before we can answer these questions, it’s worth going back and having a look at what shadow banking really is, and how it presents a risk to China  — and the world economy as a whole.

Firstly, the concept of shadow banking has an unfortunate reputation and is in dire need of rebranding. Despite the macabre connotations its name conjures, it’s not inherently a bad thing. Generally, shadow banking simply refers to the lending and borrowing –- basic financial activities — that occur outside the traditional deposit and loan model; that is, anything other than putting money in the bank and occasionally borrowing for things like buying a house. In Western nations such as the U.S, hedge funds, venture capital firms and private equity – all forms of shadow banking — form a major part of economic life. In China, however, the structure of shadow banking is very different.

Until around 2007-8, conventional banks, in the form of loans, undertook the vast bulk of all lending in China, and because the Communist Party controls the vast majority of banks, this structure allowed the government to retain a handle over the economy at large. However, in the aftermath of the financial crisis, as export-oriented businesses — the companies that form a major pillar of the Chinese economy — saw markets shrink, two important things happened.

First, in response to the global financial crisis in 2008, the Chinese government enacted a stimulus package worth $586 million, more than half of which was financed through new bank lending. This package won praise around the world for its speed and decisiveness and kept the country on track in the short term, in noted contrast to a similar plan implemented by the United States.  But the stimulus also flooded the economy with cheap credit, thereby fuelling a speculative housing bubble, propping up inefficient state-owned enterprises (SOEs), and undoing years of work spent trying to instil China’s banks with financial discipline.

In the two decades leading up to the financial crisis, a lot of hard and sincere work was done to try to teach profligate SOEs, local governments, and banks to live and work within their means, but that doesn’t mean these institutions suddenly forgot how to take advantage of a free lunch. In fact, it probably heightened their appetite for it. As a result, much of the money was sunk — almost literally — into local government financing vehicles (LGFVs), which are municipal government-owned companies often responsible for infrastructure investment.  These companies, for the most part, exist to keep local government debt off the books — since local governments have a very limited capacity to borrow money directly — by allowing them to borrow indirectly and finance construction projects through companies they own, built on land often acquired and sold below market price by them.

Surprisingly, this system constituted a huge source of revenue for cash-strapped local governments, which have few real sources of tax revenue. Less surprisingly, it is also an endemic, institutionalized form of corruption. A recent OECD report estimated that total public debt reached 57 percent of GDP by the end of 2010, with LGFVs accounting for about three quarters of this figure. Given that some people familiar with LGFVs see them as little more than holes in the ground into which seemingly endless amounts of perfectly good money are poured, it is likely this borrowing generated a wave of future defaults.

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How, and why, was the money spent this way? To answer this question, it’s important to understand the love affair between the Chinese government and infrastructure projects. Over the past two decades, Beijing has relied on building roads, power grids, and other fixed assets in order to facilitate the rapid expansion of the economy, but this method of growth inevitably leads to declining returns over time. As a result, Chinese policy makers understand that to decrease the economy’s dependence on investment and export markets (which depend too much on the whims of the global economy) domestic consumption needs to pick up the slack. Unfortunately, however, this “rebalancing” is tricky.

One problem is this: Contrary to popular belief, China’s manipulation of the yuan isn’t the golden goose Western critics make it out to be. Even if the currency were allowed to float freely, Chinese labor would still cost a fraction of what it does in the U.S. This discrepancy is mainly achieved through the hukou, a household registration system that prevents workers from becoming fully entitled residents in the regions to which they have migrated to work, as well as restricting the rights of children born in these regions to services like education and health care.

In short, the hukou ensures that workers remain in the shadows — and wages remain low — by constantly recycling labor out of factories and back to the place of registration. Factors like this have made it increasingly difficult to rebalance the economy and have contributed to the yawning wealth gap in Chinese society. Though Chinese leaders have hinted at reforming the hukou, they nonetheless face a vexing dilemma: How do they increase domestic demand without significantly upsetting a social order upon which the economy depends for its competitive advantage?

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Historically, the answer to this question was infrastructure development, and for good reason: Infrastructure is politically neutral, theoretically benefits the whole of society, is generally dominated by massive State and quasi-State owned enterprises, and in the past generated massive returns. However, over the last four years, the GDP growth generated by each yuan of additional loan has fallen from 0.85 to 0.15, an indicator that the limits of debt-fuelled growth are being reached. In effect, the very engine that caused China’s growth ––fixed asset investment fuelled by local debt — wasn’t sustainable, and the government began to worry about the negative consequences of an overheating economy: inflation, real estate bubbles, and overcapacity.

So in 2009 they slammed on the breaks. An economy that was addicted to credit needed to go somewhere else to get its fix.  This was where shadow banking came in.

Desperate for credit, banks began working closely with trust companies and other entities to refinance bad loans by bundling them up and repackaging them as “wealth management vehicles”, or WMVs. These vehicles, which require a tenure ranging from a year to a few days, offered a higher rate of return than conventional bank deposits. They also allowed banks to keep their lending off their balance sheets and were sold through their branches or online, effectively turning banks into middle men between recipients and investors. In theory, this should have solved the problem of obtaining local financing. But the problems have only begun.

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As more and more of these loans turned bad they were simply recycled into high yield WMVs, a fact that China’s policy makers have acknowledged. In an uncharacteristically stark warning aired in a China Daily op-ed, Xiao Gang, the former head of the Bank of China, said that there are more than 20,000 WMPs in circulation — compared with “a few hundred” five years ago. Worse, many of these WMPs lack transparency or are linked to empty real estate, long term infrastructure projects or collections of assets which have no sure fire way of generating the revenue needed to repay them at the given time, creating the real possibility of a liquidity crisis.

Has this crisis already begun? There’s evidence that banks and trusts have colluded to circumvent a shortage of liquidity by issuing ever greater numbers of WMVs — with still higher rates of return to attract the cash necessary to finance the short fall. But if the music stops and investors pull their money or stop purchasing new issuances, then the rollover for the bank to pick up could potentially be huge. The consulting firm KPMG estimates that shadow banking and WMVs overtook insurance to become China’s second largest financial sector in 2012 and represent assets roughly equivalent to 15 percent of total commercial bank deposits.

This situation has arisen in a country whose people, facing restrictions on investing abroad and nervous about China’s volatile stock market, have so few other investment options. In addition, most simply don’t believe banks will let them lose their money and will support their investments, no matter how risky they are: the basic ingredients of a Ponzi scheme. The Shibor rate hike and the government’s refusal to step in with additional funds, then, is a not-so-subtle statement that the party’s over and that it’s time to solve debt addiction the old fashioned way — cold turkey. The question, then, is this: how bad was the addiction, and how big will the comedown be?

The Changing Structure of SOEs

Since the turn of the 21st Century, China’s State Owned Enterprises (SOEs) have undergone a dramatic transformation that is widely misunderstood. Since China joined the World Trade Organization (WTO), its trade surplus has ballooned and SOE share of total exports as dropped relative to private enterprise to become relatively small. To many, this shift is correlated with moves in the late 1990s to ‘reign in’ SOEs and restructure the economy along market lines. However, the real picture is more complicated and far more interesting than this common-sense conclusion. In fact, almost all of the 57 Chinese firms on the Fortune Global 500 list are SOEs.

This phenomenon is puzzling to those who would naturally assume that relatively inefficient SOEs should be out-competed by more efficient private enterprises in a market environment. To understand this paradox, it is important to understand the nature of the shift that occurred at the end of the 1990s.

At the time, Western government’s around the world assumed that Zhu Rongji’s efforts to reform the SOE sector was akin to Gorbachev’s Perestroika program. When in reality the goal was to move toward a much more sophisticated model.

While thousands of workers were let go and vast sprawling heavy industry plants cut loose, something else was also happening. SOE enterprises were quietly repositioning themselves away from highly competitive, export-oriented, downstream industries and consolidating their grasp over lower competition, highly monopolistic up-stream industries – for example, telecommunications, information transfer, storage, banking, energy, transport and post.

At the same time, this freed privately owned, competitive enterprises to concentrate on lower value, more volatile, export-orient industries. This restructuring also drastically increased demand for the intermediate goods, services and factors SOEs provide allowing them to charge monopoly prices consolidating the party’s control over the economy at large.

With SOE enterprises ostensibly under government control, instead of freeing the economy from SOEs, this upstream/down-stream restructuring created a hyper-profitable SOE sector capable of subordinating the private economy into lower value markets, consolidating State control over the economy at large.