Revaluing the RMB Part 1

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.


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?


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.


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?

Understanding Wage Data in China

For the last 30 years, one of China’s primary economic advantages has been the product of a demographic dividend brought about by high birth rates 1960’s and 1970’s. This birth rate ensured that as China embarked on its program of economic reform at a time that was demographically very favorable. In 1980 the average age was 20 years old and average wages remain pennies on the dollar compared to equivalent US wages until well into the 21st Century and a fraction of many other competitors. For the most part China has managed to maintain these low wage levels through a number of institutional measures.

One such factor is way in which the bargaining power of labor is restricted by the State. The State affiliated All China Federation of Trade Unions is a largely ineffectual body, which often sides with employers. Added to this the household registration system, or Hukou, restricts the rights of migrant workers by denying them social service provision in the cities in which they work. This ensures, to a large degree, that migrant workers remain migrant workers and are usually recycled back to their place of residence.

Despite this lack of recourse to bargaining rights, industrial disputes have broken out in recent years leading to pay rises in numerous sectors. As China population ages, a consequence of the one-child policy, pressure on employers is likely to raise eroding China’s competitive edge.

For many years, the way in which China calculated its wage data was a legacy of the Communist-era command economy and represented only a small, disproportionate portion of the workforce at large. Under the old system where most workers were State sector, a system based on survey SOEs and local government offices made sense. But as China modernized the system became laughably antiquated – reporting major pay rises in the wake of the financial crisis as millions were laid off or faced salary cuts.

By discounting the wages of migrant workers and failing to account for the non-salary benefits of SOE jobs, like grossly expansive expanse accounts and kickbacks, hopelessly skewed the wage data. This massively understated white-collar salaries and overstated blue-collar jobs.

In order to redress this imbalance, the NBS has extended their survey to include wages for urban private enterprises, but still fails to account for migrant workers that make up around 275 million workers. However independent estimates of migrant worker wages put the figure somewhere around 1500 USD a year, as of 2013. This relative stagnation is confirmed by the China Academy of Social Sciences that outlined in a recent report that wages as a percentage of GDP have fallen almost consistently for the last 25 years.

Despite the fact the data displays a woefully inadequate picture of the Chinese economy at large, it does present data for comparison by region and the disparity between urban and rural incomes.

A true assessment of China’s wages would illustrate how difficult the task rebalancing the Chinese economy through boosting domestic consumption will really be.

The Paradox of China’s Economic History

If we examine the structure of the Chinese economy on the eve of reform, we can see that at the same time it is both ‘over-industrialized’ and ‘under-urbanized’ compared to economies with similar levels of income. When Deng Xiaoping first unleashed the dynamic forces that would transform China into a major economic power in 1979, China’s per capita GDP, as estimated by the World Bank, was roughly equivalent to 675 USD (measured in constant year 2000 ppp US-dollar equivalents.) Which was a relatively unremarkable figure for a low-income developing nation at that time.

 However, according to price data from the time, some 44 percent of China’s GDP was accounted for by industrial production, a figure far higher than comparable low-income countries. Moreover, China’s energy consumption per dollar of GDP was several times that of equivalent low-income countries leading to the conclusion that China was ‘over-industrialized’ for a nation with such a low level of GDP.

However, paradoxically, at the same time, China’s urbanization rate was only 18 percent. Far lower than comparable nations leading to the conclusion that China was ‘under-urbanized’ for its GDP level. Additionally, literacy and life expectancy far outstripped other developing nations at the time.

It is possible to square some of these data, like life expectancy and energy consumption, by adjusting GDP upward by assuming the Yuan was undervalued at the time, but this only serves to make the urbanization rate even more anomalous. Added to this, China actually began devaluing the Yuan as it entered its period of reform and opening up. To which one can only conclude that China was an economic paradox, before it was an economic power house.

Revaluing the RMB Part 2

Revaluing the RMB – Part 1

There has been a lot of posturing of late in regard to China’s undervalued currency. However, despite the repeated calls from officials within the US government, there is very little talk about the potential implications of such a move and the whether or not it would address all, or indeed any, of the issues perceived as a consequence of an undervalued Yuan.

In this post, I’d like to look at some of the likely ramifications of any potential revaluation of the Chinese currency. For the first part, would a revaluation really do much to address Europe and the US’ trade deficit with China?

In many respects, the simple answer is no. The reason for this – as I touched on the last post – is that the price competitiveness of China’s exports are only partially explained by an undervalued currency. What in fact continues to fuel China competitiveness in global trade terms is the continued supply of cheap labour into the industrial sector. As I mentioned last week, this flow of rural labour has depressed industrial wages for the last twenty years as pointed out in a recent article in the China Daily, illustrating the fact that China’s proportion of GDP spent on wages over the past 22 years has constantly declined, year-on-year.

In these terms, it might be worth recalling the example of Japan and their ill-fated revaluation in the mid-80s. Despite a de-facto doubling of the Yen in value against the USD during the period – again under pressure from Washington to reduce the trade deficit – Japan continued to maintain a 50-70bn USD trade surplus with its trading partner almost constantly since the revaluation largely because its competitive advantage was not primarily based on an undervalued currency. But instead on technological advantage. Likewise, China’s undervalued currency represents only a small part of its competitive advantage with low cost labour constituting the lion’s share. (As I pointed out in my last post, even accounting for a revalued Yuan, Chinese labour costs are still vastly more competitive than those of many other countries)

This aside, there are yet more compelling reasons to suggest that a rapid revaluation of the Yuan might be counter-productive as a measure for reducing the EU and the US’ trade deficit. One of the most compelling of which is the way in which trade figures are calculated.

The problem is, that base line trade figures are calculated exclusively from customs statistics – figures that greatly over simplify the realities of global trade, and more specifically the nature of Asian production cycles. This oversimplification occurs because customs figures are a simple summation of the overall value of all products leaving China for destinations such as the US and the EU. What this figure fails to take into account, given that production cycles in the Asia region have become increasingly geographically diversified over the past 20 years, is the true value added in the China stretch of the production cycle.

Given that many ‘China exports’, as calculated by customs statistics, are in fact composed of components manufactured in Japan, Korea and Taiwan – whose implicit value is not calculated in RMB, but in the currencies of the respective countries – the real level of added value created by the production process which occurs in China is often as little as 50 percent of the total book value of the finished good.

Added to this, it remains likely that Chinese manufacturers would be forced to further cut margins in an effort to remain competitive in global terms. Failing this, there is good evidence to suggest that consumers in the EU/US trading blocks would simply switch their purchasing habits to goods manufactured in other low cost emerging economies to supplement their addiction to low cost Asian import goods as Chinese export prices rose in relative terms.

What this implies, in real terms, is that a revaluation of the RMB, even one as large as 20-25 percent of the current value as defined against the USD, given the relative weighting of China imports in the US trade deficit calculation, might impact global trade deficits by as little as 5 percent. Given the these factors it seems extremely unlikely that a revaluation would have any significant effect in alleviating the real gripe of those who complain loudest against China’s currency policy; namely, the creation of jobs and the promotion of the domestic manufacturing sector.

Indeed, on the contrary, there is good evidence to suggest that such a revaluation might in fact have a far reaching negative impact on the regions that currently argue so fervently in favour of it.

One the one hand, substantial increases in the price of Chinese imports to the EU/US region would almost certainly help to fuel inflationary pressures in those regions; at the same time such a revaluation would most likely trigger an interest rate rise, especially in the US, as a shrinking of China’s trade surplus inhibited its ability to continue its investment in US financial assets, most notably US Treasury Bonds – of which it is currently estimated to hold somewhere in the vicinity of 1.2 trillion dollars worth.

In the second part of this post, I will attempt to look at some of the possible domestic ramifications of a significant revaluation of the RMB.

Revaluing the RMB – Part 2

In the last post in this series, I looked at whether a revaluation of the RMB would actively address the trade imbalances and job destruction highlighted by the most vocal of its proponents.

In this post I would like to address some of the likely domestic implications of a valuation.

In these terms, a substantive revaluation would clearly hold numerous, and obvious, benefits for China.

Firstly, unpegging the RMB from the US Dollar would greatly increase China’s autonomy in terms of monetary policy as well as give Beijing more tools with which to control inflationary pressures. Added to this, the relative cost of imported products, and much more importantly raw materials, would fall. An important consideration for a nation that is now a net importer of energy in every category; not to mention a huge consumer of iron ore.

Furthermore, easing restrictions of capital flows by moving toward a more marketised exchange rate would allow Beijing to strangle illegal capital flows fuelling speculative real estate investment as well as go a considerable way to making the RMB a global currency greatly enhancing China’s presence and prestige on the global financial stage.

However, the inherent dangers of any rapid, substantial revaluation may well undermine all of these potential benefits. Potentially creating a disruption within the Chinese economy that could lead to a contagion that might, given world’s current dependence on China as an engine of growth, filter back through the global financial network to create unexpected and unwanted feedback across the world’s developed economies.

Firstly, the Chinese industrial landscape is fundamentally different from its US and EU counterparts. Many, many enterprises in China operate on profit margins that would be deemed incremental elsewhere in the world. For this reason, a rapid revaluation, and hence loss of competitiveness in foreign markets, could well have a knock on effect throughout the economy as the shaky financial structures of domestic sub-contractors begin to feel the squeeze. That said, whilst this, in and of itself, might in the longer term actually help Beijing in its stated aims of consolidating many of the disparate industrial sectors that contribute to inefficiencies within industrial production in China, a clumsy, heavy handed approach to this would no doubt further fuel fears of social dislocation and industrial unrest.

A rapid revaluation could also be disastrous for the agricultural sector. As mentioned in another recent post on this site, real incomes in the Chinese countryside have never punctured the 40 percent of urban incomes ceiling. Indeed, for almost half of the last fifteen years real incomes in the Chinese countryside have in fact fallen. This is at least in part due to the relative lack of competitiveness by global standard. The ensuing benefit gained by international producers by a higher value Yuan would almost certainly spark social unrest in the agricultural sector as impoverished rural workers see the fabled lifestyles of the city dwellers slip ever further from their grasp. A very serious worry for a government that has already staked its credibility on being able to close, or at least mitigate, the rural/urban divide.

Added to these potentially disastrous outcomes, the Chinese financial sector remains in its infancy in terms of its overall market sophistication – even in spite of huge bank recapitalisations in recent years. Perhaps the biggest problems arise from China’s relative lack of experience in handling floating exchange rates with many in the sector lacking fundamental knowledge in risk management and hedging instruments designed to protect  against the risks involved in managing a floating rate system.

Last, but by no means least, a steep, rapid revaluation would mean huge losses for China, with more than 70 percent of its foreign reserves invested in US dollar denominated assets. In short, such a revaluation, as called for by many foreign commentators, some arguably courting domestic audiences, would be unlikely to address the global trade imbalances affecting economies around the world – but could instead have wide reaching negative implications for China, and hence the globalised world.

Instead, perhaps those seeking to redress trade imbalances might take another lesson from the Japanese experience. A nation that has managed to maintain a trade surplus with China despite China’s huge advantage in cost competitiveness.

In the next post in this series, I’ll look at how Japan has managed to do this.

Low Wages

Is the undervalued Yuan really a red herring? Is China’s economic miracle dependant upon artificially low wages?

As an article in the China Daily recently points out, the proportion of China’s GDP that goes to wages has been steadily declining for 22 years. This revelation is in stark contrast to China’s neighbours who also followed export driven models. So the question is, is China’s continued competitiveness really due to a forced, and prolonged, stagnation of industrial wages?

China’s pre-eminent success at implementing an extreme mode of the East-Asian export driven economic miracle has been dependant upon a number of critical factors; both domestic and international. On one hand, China’s emergence onto the global stage coincided with the an unprecedented explosion in international trade that saw the traditional industrial workhorses of the world embark on a program of de-industrialisation the likes of which had never been seen before, beginning in the 1980s. This explosion was driven primarily by two factors – a dismantling of capital restrictions around the world and the ubiquitous adoption of containerisation.

As China adopted the model already proven by economies such as Japan, Korea, Hong Kong and Taiwan, the world was teetering on the edge of the single greatest shift in manufacturing patterns since the dawn of the industrial revolution. And as the western world’s appetite for cheaply produced foreign imports grew, China was set to take full advantage of its enormous levels of cost competitiveness locked within its massed pools of cheap labour. But that doesn’t explain why China was able to remain so competitive long after other countries following similar models found their competitive edge dulled. Taking a closer look at the other nations that have followed similar export driven models, it looks possible that urban biased policies and neglect of rural development may have forced industrial sector wages to stagnate – keeping China cheaper, longer.

Arguing against this point, many international observers contend that China’s competitiveness is due to fixed exchange rate system that many contend pitches the Yuan at an artificially low level against major currencies – most notably the dollar. However, even if the Yuan were to appreciate by as much as many of the fiercest critics in the US administration currently demand, 20-30 percent, that would still not make Chinese industrial wages anything close to that of its most comparable neighbouring economies – for the sake of argument say, Korea or Taiwan.

Another school of thought contends that China’s continued tapping of vast rural inland labour pools has created the illusion of unlimited supplies of cheap labour – appearing to go on long after many comparable countries ran dry at equivalent levels of development. But a closer look at the underlying economics paints a slightly less obvious picture.

In many ways, this illusion of bottomless pools of low cost labour can be seen not, in fact, as a function of population structure – but as a consequence of economic policies that, intentionally or not, slant the balance of economic development in favour of coastal populations at the expense of rural populations creating an almost unending exodus from the land.

The impact of China’s imbalanced development can be seen by comparing the country’s development with that Japan, Korea and Taiwan – societies composed of similar demographics in terms of rural and industrial composition during similar stages in their development.

In the case of all three of these economies, the rural/urban income divide never reached the polarised levels currently seen in China largely due to wealth redistribution programs and fiscal measures such as infrastructure spending, agricultural development loans and grants, tax relief, import tariffs, education spending and farm subsidies. This ensured agricultural workers remained on their land. Improved infrastructure meant factories could be built closer to rural populations, allowing the local populace to supplement their incomes without abandoning their ancestral homes to become full fledged migrant workers. These policies had two main consequences; the first saw rural incomes rise to between 60 and 95 percent of urban levels across the economies; the second was cut off the flow of cheap labour into the cities and industrial hubs, forcing urban wages up in return.

Although the overall effect of these policies across the three economies was largely similar – effectively removing the rural/urban wage divide – the motivations for implementing them varied. In the case of Japan, the ruling Liberal Democratic Party depended on the rural demographic to maintain it democratic mandate; in the case of Taiwan and Korea, in the context of the Cold War, it was to maintain food security and pre-empt any leftist sympathy emerging from the rural classes as a result of the social dislocation traditionally caused by rapid economic development.

This urban bias and the resulting redistribution of resources from country to town has created numerous negative effects within the Chinese economy.

One such negative effect of this agrarian crisis on the Chinese economy has been the creation of over-dependence on continued cheap labour. As comparable economies developed and industrial wages rose, this drove a corresponding development in overall economic efficiency within industrial production cycles as the relative cost of research and development fell in relation to wage costs. This would certain seem to be the case in China where energy input per unit of GDP has actually seen a net increase since the end of the Mao era.

Another negative effect has been to contribute to the excessively high savings rate across the economy. As I pointed out in a previous post addressing overcapacity, the savings rate is something of a misnomer in that it doesn’t necessarily mean that people are directly saving – instead it implies a more general disparity between production and consumption which can ultimately be fuelled by stagnating wages within a growing economy. This excessively high savings rate undoubtedly contributes to China’s over-dependence on the global economy and its inability to stimulate domestic demand in times of economic uncertainty.

But perhaps the most serious, given the government’s current fear of social turmoil is the simple desperation and hopelessness caused by the economic situation of those caught in the rural poverty trap.

In the next post in this series I will look at the reasons how this imbalance was created and way in which it can be addressed.

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.