Chinas wild, weird economy superficially
strong yet structurally brittle, propped up by cheap bank
lending and protected by relative financial isolation
anything seems possible.
Often, it is. In a
country so short on dependable data, where a secretive
governments decisions are rubber-stamped in private
before being casually issued to the world via friendly media
outlets, rumour and counter-rumour hold sway. Here, where
concealment of decisions, of opinion, even basic of
information is all, even the most speculative
scuttlebutt can feel feasible.
Take the issue of local
government financing vehicles (
LGFVs). These odd investment bodies are, or are set to
become, Chinas equivalent of mortgage-backed securities
or collateralized debt obligations.
to pump-prime its stalling economy in late 2008 resulted in
trillions of dollars being routed by state banks through
regional governments into LGFVs, which channelled that cash
into pet projects: golf courses, residential real estate, light
rail networks, freeways, shopping malls.
Too late, Beijing realized it had merely repeated its errors of
the 1980s and 1990s, when vast clods of cash were hurled at
ropey regional projects by state-run lenders, leading to the
huge bank bailouts of 1999 and 2004/05.
The 21st-century version
of these earlier financial clangers might prove no less
calamitous. Total outstanding bank lending to all LGFVs reached
$1.4 trillion by end-September, up 25% year on year, according
to the China Banking Regulatory Commission.
The banking regulator
warns that around 35% of these loans are insecure, or at high
risk of default. Most experts place the amount of LGFV loans
liable to go sour at between 30% and 40% of the total.
Early last month, Yang
Kaisheng, president of Industrial and Commercial Bank of China,
the countrys biggest lender by assets, put the local debt
figure at closer to Rmb10.75 trillion ($1.7 trillion), or just
shy of 30% of Chinese GDP. That figure boosts total government
debt at end-2011 to around $2.8 trillion, not far off the
countrys total hoard of foreign exchange reserves, at
Little wonder Beijing is
concerned, or that the authorities are weighing up every
possible solution to this growing crisis, however imaginative
or eccentric. One of the odder options floated in recent months
involves demanding that all local authorities and LGFVs provide
proof of their lending and spending since China unveiled its
$600 billion stimulus package in late 2008.
In other words
paper proof documenting every loan made, every parcel of
funding received, to determine whether money was used wisely or
poorly, and to discover how much cash slipped through the net,
winding up in the pockets of officials working with, or
connected to, LGFVs and favoured state firms.
Beijing started casting
around quietly for opinions around early December, people close
to the government say. "I sat in on a few meetings with [party]
officials where this was discussed," says a long-standing
foreign specialist who regularly advises the state council.
"There were compelling
reasons both ways. On the positive side, doing this would
create an effective financial census, giving the government a
powerful insight into how money was used and misused within the
system. On the downside, it was argued, this would prove very
hard to do. Local authorities wouldnt want their secrets
exposed. The sheer volume of paperwork would swamp
The argument went back
and forth for months, but by March it had been decided it was
best not to go ahead, the foreign specialist says, for two
reasons. "First, its a transition year, with the
leadership changing hands, and no one wants a big financial
scandal unrolling now," says the specialist. "And besides
this is China. Everyone will have taken a slice of the
action from the LGFV money, and you cant afford to make
everyone lose face."
With that unsavoury dish
now off the menu, China appears to be mulling over a hackneyed
alternative: forcing the market to pay for the states
mistakes. Or, put another way, forcing the capital markets to
again bail out the banking system.
This option, quietly
gaining momentum since February, would involve Beijing issuing
parcels of repackaged LGFV debt in the form of
municipal-commercial bonds which it would expect to get
snapped up by state-run banks, insurance companies and mutual
Around Rmb2 trillion in
LGFV debt comes due this year alone. James Kynge, author of China shakes
the world, believes that the bond markets could
"easily handle" that total, even if it included as much as
Rmb800 billion-worth of soured loans. It would also, Kynge
adds, help the government find a credible solution to its
"biggest red-button issue".
Others are not so sure.
China would need to keep repackaging its local debt each year
for at least the next five or six years, using the same old
ruse every time. The past has shown that the state is most
likely to flog its good debt first tranches containing
lower levels of likely non-performing loans to keep
institutional investors friendly.
That means if this second
course is pursued, within a couple of years the percentage of
NPLs held by LGFVs and their creditors will rise from 30% to
40%, 50% and beyond. One need only look at the failure of
Chinas four asset management companies (AMCs)
Huarong, Cinda, Great Wall and Orient to rid their books
of bad loans acquired during the bank bailout of 1999 to see
how things could play out here. The books of Chinas LGFVs
could get very toxic, very quickly.
However, Beijing needs to
do something. The LGFV problem is not going away. A pilot
scheme involving the capital markets buying specified bundles
of loans packages that would be sliced-and-diced, mixing
loans good and poor, again mirroring the wests unsavoury
experience with CDOs during the credit crunch would give
the authorities a breather, however temporary.
Beijing, in theory, can
keep rolling over LGFV loans for the medium term it
might well do so for three or four years or more but to
do so indefinitely would smack of procrastination or
Many believe that, sooner
or later, China will have to bite the bullet and write the
whole thing off. This will likely involve another grand,
sweeping gesture involving: the creation of a new AMC,
mirroring the contortions of 1999; or a bailout replicating the
events of 2004/05, when the Peoples Bank of China (PBoC)
pumped US dollars into the big four banks, boosting their
balance sheets in preparation for stock listings.
Whatever China chooses to do, the results wont be pretty.
"None but the most Pollyanna-like commentators in China believe
that the credit binge of the last few years will result in
anything other than massive loan-loss write-offs against local
government and some [state-owned enterprises] debt," says
Jim Walker, the founder and managing director of independent
Hong Kong financial consultants Asianomics.
|Jim Walker, the
founder and managing director of independent Hong Kong
financial consultants Asianomics
Walker says estimates
that only 30% of total LGFV debt will sour completely are soft.
"The PBoC may eventually be asked to help fill [a hole] in bank
balance sheets [that] ranges from around $300 billion to $470
billion," he says.
Local issues are also
symptomatic of a much wider malaise. Chinas once red-hot
economy is cooling, leading to angst-filled meetings at the
heart of government. One individual close to the government
says there is a "very real and very clear" concern that the
economy will slow markedly through 2012 and into 2013.
reputation-conscious mandarins, obsessed with maintaining the
appearance of control and keeping GDP above the sacred
annualized rate of 8%, this matters. Beneath the braggadocio
and gloating of recent years, while the west stumbled and China
sailed serenely on, there has always been a lingering fear here
that the financial crisis would inch its way east.
Some believe it now has.
In January, the former CBRC chief Liu Mingkang was quoted by Caixin
magazine restating his belief that the economic
crisis would "spread from the US to Europe and finally land in
Asia. Now we can see it has already begun influencing Asia."
Lius comments in the article also make clear that by Asia
he mostly means China.
Others say the crisis,
like a dormant cold, never fully left Asia, or China. "I always
thought that China would be the last major economy to emerge
from the crisis," says Michael Pettis, professor of finance at
Peking Universitys Guanghua School of Management. "Why?
Because the huge increase in investment it engineered to
postpone the domestic impact of the global crisis exacerbated
the imbalances within the economy and increased its
already-excessive reliance on debt and investment to generate
Throughout early 2012,
predicting Chinas slowdown became almost a blood
sport. On March 14, Adrian Mowat, JPMorgan Chases chief
Asia and emerging-market strategist, warned that the economy
had hit the buffers. "China is in a hard landing," Mowat said
at a conference in Singapore. "Car sales are down, cement
production is down, steel production is down, construction
stocks are down. Its not a debate anymore, its a
Few would seek to debate
these views. The Shanghai Composite, Chinas benchmark
stock market, is down 17.4% in the year to March 18. On March
15, it tumbled 2.6%, its biggest single-day fall in nearly four
months, after gloomy comments from premier Wen Jiabao on the
property sector. Figures from the China Association of
Automobile Manufacturers show deliveries of passenger cars and
light-goods vans falling 3% year on year in the first two
months of the year.
Most worrying, perhaps,
are the data behind coal and power production key
drivers of Chinas vast industrial economy. Energy
production is tipped to slow to 7.5% this year, down from 10%
in 2011 and 15% in 2010, due to slowing demand from thousands
of mainland power stations, according to a March work report by
the National Development and Reform Commission (NDRC). Raw coal
output will slow as a result, the NDRC forecasts, rising just
3.7% this year, from 8.7% in 2011.
How worried should China
be? That depends who you speak to. Carl Walter, a former banker
who spent nearly two decades on the mainland most
recently at JPMorgan Chase before retiring in 2011,
believes that Beijing, having skirted the worst of the credit
crunch, now faces a crisis of its own. "The next five years
will be some of the most difficult since 1978," he says.
Fraser Howie, who co-authored Red China: The
fragile financial foundation of Chinas extraordinary
rise with Walter, adds: "You look at almost any
economic measure, and things are tougher now than they have
been for a long time. For [small and medium-sized enterprises]
and the private sector, there is no doubt that the hard landing
started some time ago."
Things look just as bad
on the long-range forecast. Dong Tao, chief Asia ex-Japan
economist for Credit Suisse, tips the economy to grow at 8% in
2012 the absolute minimum needed to maintain reasonably
full employment and keep the lid on rising social
The government feels even
less optimistic. On March 17, Ma Jiantang, head of the National
Bureau of Statistics, warned that an ageing population and a
deteriorating natural environment would cut economic growth to
a seven-year low of 7.5%.
And in February, the IMF
gave the starkest warning yet: if eurozone concerns persist,
and worsen, Chinese growth could sink to 4.5%. It is worth
bearing in mind that Beijing deems 5% to be the line separating
its own economy between economic growth and recession.
In truth, though, any
attempt to build a genuinely coherent picture of Chinas
economy using central government data cross-referenced
against the quasi-state bodies, local authorities, banks and
the capital markets is doomed to failure. Trying to
navigate the minefields of data here is a gruelling and
Even the LGFV industry is
full of smoke and mirrors. As no one regulates the industry,
there is no way of assessing how many local financing vehicles
exist. One Chinese expert says 6,000. A distressed debt
specialist reckons up to 10,000. Even the NDRC, which is
supposed to keep track of what local authorities are up to,
professes not to know.
Most central data are
unreliable, having been collected from townships and provinces
run by officials seeking advancement by posting growth figures
in line with government expectations. So if Beijing predicts 8%
growth, local authorities post growth figures to match that
total, irrespective of whether the real number is higher or
lower. China has long had this problem, yet it is still a
surprise to find that in 2012 reliable data in the worlds
second largest economy remain so elusive.
"No one trusts any
information here," says one distressed-debt specialist. "So
foreigners have to infer, extrapolate, or assume stats.
Its a race for reality. A few years ago, official GDP was
10%, but everyone knew it was really around 14%. Is it 6% now?
Who knows? Its such a secretive country, well
probably never get a real, full picture of the situation."
Much now will depend on
what economic course the new leadership of Xi Jinping and Li
Keqiang, set to succeed president Hu Jintao and premier Wen
Jiabao respectively at the National Peoples Congress in
March 2013, intend to chart.
"The future of the Chinese economy will be determined by
whether the new leadership resumes the economic reform process
that was abandoned by Hu and Wen," says Nicholas Lardy, senior
fellow at the Peterson Institute for International Economics
(PIIE) in Washington. "[The new leaders] should start with
market-oriented interest rates. Without that, there will be no
successful transition to consumption-driven growth."
senior fellow at the Peterson Institute for International
Economics in Washington
Most experts believe the
Hu-Wen years will be seen as a missed opportunity, a decade
when budget surpluses and soaring foreign reserves handed China
a golden opportunity to steer its economy toward a
That chance was spurned,
as was a second. Even hawks in Beijing agree that the 2008/10
stimulus spree was merely a short-term patch, plugging holes in
a system overly dependent on exports and the funding of
bloated, inefficient state firms.
"There is almost a
consensus in Beijing now that the massive stimulus in 2009 has
done more harm than good to the long-term sustainability of
growth," notes Credit Suisses Dong.
So all eyes are on Xi and
Li. Do they believe China must reshape its economy or die, or
will they persist with the status quo, hoping that everything
will just sort itself out? Many are quietly hopeful for this
new generation, in a way they never were over the timid,
intellectually brittle outgoing leadership. Xi is western in
outlook with several children ensconced in US schools and
colleges. Li is intelligent, an economist able to take the long
view, yet lacking the worldliness of, say, a Zhu Rongji or a
This is where Wang Qishan
comes in. A vice-premier and member of the 23-strong Politburo,
Wang is on track for promotion to the nine-man standing
committee this autumn, the highest authority in the land. Wang,
a protégé of Zhu Chinas great
industrial modernizer is widely expected to have a role
mentoring the callow Li.
"If he is given the
chance to shadow Li, and to make decisions that Zhu would have
made, tackling the financial crisis that might be looming on
the horizon, then China has a reasonably good chance of
transitioning to a fuller, broader, fairer economy," says the
foreign-born government adviser. "If he cant do [it], I
suspect no one can."
In the latter scenario,
the most likely outcome is a stuttering China struggling to pay
its own debts, a still largely isolated financial system, and
an economy still driven by inefficient state firms and
World Bank president Bob
Zoellick warned Chinas leaders of the dangers of inaction
in a strongly worded introduction to its China 2030 report,
issued in March. Zoellick slammed Beijing for its lack of
support for private enterprise, and warned that China needed to
redress several issues, notably an ageing country hampered by
rising inequality, a large and growing environmental deficit,
and stubborn external imbalances.
Others are sharper when
using their claws. The analyst Howie predicts that five years
from now "Chinese growth is probably at 5%, and life is a lot
tougher all round. A debt crisis could well be imminent."
Many analysts believe a
few years of slower growth, and a concomitant chance to
stress-test the system, would be in Chinas best long-term
interests. One recent post on micro-blogging site Twitter
merely read: "China needs an economic disaster: discuss."
The comment was endlessly
re-tweeted, garnering responses approving and reproachful, but
it contained a refreshing honesty often missing from economic
discourse. China has not had a real recession since the economy
opened up in 1978. A genuine financial crunch would give
Beijing the chance to hone its crisis management skills. A
recession will, after all, hit the country sooner rather than
And for China, a daunting
political year recently got harder, after the public purging in
March of Bo Xilai, the former party secretary of Chongqing. Bo
was a divisive figure, a powerful princeling seeking a place on
the nine-man standing committee, and his dismissal merely rids
China of a hardliner who pines for a return to revolution and
Yet Bos humiliation
also offers China an unusual path to financial redemption. The
purging, believes one prominent Chinese distressed-asset
specialist, will lead to all Chongqing-related LGFVs being
"hammered on the market" notably one listed subsidiary
that will get "heavily audited as part of the anti-corruption
investigation against Bo. Inevitably, they will find tons of
dirt, and there will be a cash crunch for these companies, and
default risks will also rise."
Two of the companies
mentioned are Hong Kong-listed YT Realty and Shenzhen-listed
Chongqing Yukaifa, two listed divisions of Chongqings
central financing vehicle. Both companies shares were
burned in the two days after Bos exit: YTs stock
falling 3.5% and Yukaifas tumbling 10%.
At the very least, the
inevitable investigation will allow central authorities to
understand the complex webs of LGFVs a lot better. At best, it
will help Beijing plan a route through uncharted terrain,
finding a solution to its local debt quandary.
And there remains much
navigating to do. Chinas financial landscape remains an
overwhelmingly illogical place to many, one where new debts
pile up through LGFVs while others, years and
even decades old, remain on the books of state bodies,
unresolved and gathering dust.
Take Cinda, for example,
one of the AMC class of 1999.
In March, it sold a 16.54% stake for $1.6 billion to
investors including UBS, which bought 5% of Cinda, Citic
Capital, 2%, and Standard Chartered, 1%. All investors are
locked into a minimum three-year investment, paving the way for
a Hong Kong initial public offering. Other new
shareholders include Chinas national pension fund, the
National Council for Social Security Fund, which paid $790
million for an 8% stake.
Cinda board secretary
Zhang Weidong believes Cinda will become a multi-limbed
financial institution covering fund management, insurance,
futures and trust services, thanks to its nationwide network of
branches and Rmb60 billion in equity held in more than 170
companies. Bad debt management and equity holdings accounted
for around 70% of Cindas Rmb8.2 billion in 2011 pre-tax
Yet China experts remain
dubious, despite evidence that some Chinese AMCs, notably
Huarong and Cinda, have taken on a life of their own during the
past 13 years. "I am sceptical that the AMCs have a bright
future," says PIIEs Lardy. "The plan to list Cinda
strikes me as a stretch at best. They have had no profits for
10 years and had to roll over their bonds in 2009 when they
came due and needed a second government capital injection in
As for the LGFV issue, it
shows no sign of working its way through the system. Total
local debts, at $1.7 trillion and rising according to official
data, are no closer to being capped or tackled by a government
fearful of making a fatal misstep during a tricky leadership
Even when the scale of
the problem is staring them in the face, officials appear
determined to procrastinate, or look for reasons to be
cheerful. Recent comments by Fan Jianping, chief economist at
the State Information Centre an influential, central
think tank affiliated to the NDRC show the self-denial
at work. "Five or 10 years from now, local governments will
borrow very, very little from banks," Fan said in early March.
"Their debt structure will be almost entirely held in
That is a noble aim: to
force LGFVs to borrow only in bonds rather than in the form of
bank loans. That way, one can see if and when the debt is being
paid off, and can rate the bond according to the financial
reputation of the local financing vehicle. But allowing LGFVs
to borrow via market-rated bonds will only happen if China
eliminates loss-making investment activities, prevents debt
being accumulated in an opaque fashion, and halts its addiction
to maintaining a high growth rate by misallocating capital.
The only way to resolve
local debt is either to default or to force someone else to
make up the loss. Since the first option is politically
unpalatable, the burden of payment will likely fall on the
capital markets or the central bank. Or both.
Universitys Pettis points out, there seems to be an
"almost touching faith" in assuming that bonds are the answer
to local debt woes. "If banks make foolish loans, stop calling
them loans and start calling them bonds, the problem is
immediately resolved you have no more bad loans," he
says. "True, we wont, but [instead] well have bad
bonds, probably still on the balance sheets, and well
still be left with the problem of how to pay for them."
And so we return to
Beijings latest, if not its greatest, fiscal nightmare.
LGFVs constitute yet more proof that the state is not very good
at allocating financial resources.
Not that the LGFVs are to
blame: they were merely doing their job, lending and spending
like drunken sailors when ordered to. They have done it before,
in the 1980s and 1990s, when NPLs rose to toxic levels, and
will likely do so again, unless the system holds itself to
account, or forces itself to undergo genuine internal
And that, in a one-party system allergic to criticism, will
not be an easy ask.