Stimulus spree leaves China on the edge
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Stimulus spree leaves China on the edge

The deployment of China’s 2008/09 economic stimulus package ignored the mistakes made in the country’s previous attempts to revitalize the market. Local authorities were flooded with cash, prompting reckless investment decisions. The dimensions of the folly are as yet unclear. Elliot Wilson reports.


Related past articles
Sub-prime, China style, April 2009
China’s looming NPL crisis, April 2009

WHEN CHINA UNVEILED a $600 billion stimulus package in November 2008 it caught the world on the hop. Governments from Washington to Canberra eyed this largesse with longing, envious of Beijing’s ability to funnel vast amounts of cash into domestic industrial projects literally overnight.

For most of 2009 China was hailed as a steady hand on the wheel, steering the world through the worst of the global recession. But what few asked at the time was how Beijing was splashing the cash – and if anyone was overseeing the largest Keynesian fiscal package since the Great Depression.

A few simple but scary truths are now starting to emerge. First, the country’s leaders had neither hand on the wheel: they were driving blind and hoping no one would notice. Most of the $600 billion package – siphoned into the vast hinterland via leading state banks – wound up in the pockets of local authorities, most of which invested in pet projects designed to create short-term jobs, not long-term returns.

Such misdirected munificence will have two unintended consequences: crises lifted straight from China’s 1990s playbook. The first will be the virtual bankruptcy of dozens if not hundreds of heavily indebted municipal authorities. The second will be another banking bailout, mirroring those in 1998/99 and 2004/05, triggered by a resulting slew of new non-performing loans.

Beijing is only now coming to terms with this looming crisis. At the heart of the problem is the way the stimulus package was doled out. Fearful that slower growth would fuel social unrest, from early 2009 onward the central government authorized lenders such as Industrial and Commercial Bank of China (ICBC) and Bank of China (BOC) to flood the country’s 1,467 county-level authorities with bundles of cheap loans.

Most of that lending – around 75% of the entire stimulus package by most estimates ($450 billion) – was disbursed not to the authorities directly but to their wholly owned (and often listed) infrastructure investment vehicles, known as Udics (urban development investment corporations).

Those vehicles, suddenly flush with cash for the first time in more than a decade, in turn pumped money into projects that many had been itching to build for decades.

Some were vital additions to infrastructure, from rail projects in the south and east to apartments in the north and west. But too much was parcelled out to poorly conceived projects with little or no chance of generating a guaranteed return. Anyone who has travelled across China will have viewed with wonder the deserted five-star hotels in fifth-tier cities, or the brand-new "ghost towns", eerie and empty, that dot the landscape from Inner Mongolia in the north to Yunnan in the southwest.

In Credit Suisse’s 2010 Emerging Markets Quarterly, published on March 10, the bank’s chief regional economist for non-Japan Asia, Dong Tao, noted his alarm about the fiscal condition of local governments. "Last year saw a drastic surge in [local authority] indebtedness," he wrote, "caused by the government’s rush for infrastructure investments and aggressive bank lending."

Other analysts concur. Bill Stacey, a director at Hong Kong-based brokerage Aviate Global, and former chief Asia banking analyst at Credit Suisse, says: "Infrastructure lending to municipal platform companies was extraordinary in volume and is likely to create problems in the future."

What strikes fear into China’s leaders is how much of this lending will go sour. Opinions vary wildly. Craig Blomquist, the Guangzhou-based founder and chief executive of Fan Ya Tai, a mainland distressed debt specialist, believes that at least one-fifth of all bank loans disbursed over the past year will end up in default – and he adds that this is a "conservative estimate". He says: "The NPL build-up is going to be really bad." The amount that he estimates would generate at least $90 billion in new NPLs created by local Udics, most of which would have to be soaked up by leading banks, or one of China’s four leading asset management companies (AMCs), themselves still awash with failed loans from bailouts in the late 1990s and 2004/05.

And even this might be a low estimate. China’s leading banks disbursed a record Rmb9.7 trillion ($1.4 trillion) in new loans in 2009. A further Rmb7.6 trillion will flow out of the banks in 2010. Most has thus far ended up in the hands of local Udics and leading Chinese state-owned enterprises (SOEs) – another chunk of the Chinese economy suddenly flush with cash.

IPO net first day increase: five most recent stock offerings
Company IPO price (Rmb) First day price (Rmb) % increase
Zhejiang Wanma Cable 11.5 25.93 125
Guilin Sanjin Pharmaceutical 19.8 34.01 72
Sichuan Expressway Company 3.6 10.9 203
China State Construction Engineering 4.18 6.53 56
Your-Mart Company 19.58 37.9 94
Source: Shanghai Stock Exchange

Worse, state banks have committed themselves to lending another Rmb12.7 trillion by the end of 2011 to local municipalities – the very authorities currently squandering their ill-gotten wealth on golf courses and empty shopping malls. If just one-fifth of those new loans go sour, China’s lenders will have a further $425 billion in NPLs on their books, pushing the total well beyond $500 billion. Half a trillion dollars is more than one-eighth of China’s nominal 2009 GDP ($4.9 trillion) and roughly a fifth of China’s jealously guarded foreign reserves (currently running at $2.4 trillion). It’s also on a par with the roughly $600 billion to $700 billion in dud loans carved out of China’s three largest banks – BOC, ICBC and China Construction Bank (CCB) – in 2003 and 2004.

Other observers reckon that China’s municipal funding crisis is only just getting started, relating it to the sub-prime lending crisis that shook western nations to the core in 2008. The respected mainland newspaper Caixin said on February 5 that up to 70% of all loans parcelled out to Udics – or around $315 billion just from the basic stimulus package – could fail.

Another expert, Victor Shih, a political science professor at Northwestern University in the US, has spent the past year raking over the embers of the stimulus package. Shih believes local mainland governments might have debts of about Rmb11.4 trillion, more than a third of Chinese GDP. And even this might be an underestimate. Shih says: "There are probably a lot of loans out there that none of us – not even the Chinese government – knows about."

Tom Miller, managing editor at Dragonomics, an independent Beijing consultancy, says no one knows how much local Udics have borrowed since China rolled out the red carpet to dodgy local borrowers in late 2008. "There is currently a national audit under way, because Beijing has no clue either," he says. Other analysts put China’s NPL crisis at between $1 trillion and $1.5 trillion, or enough to virtually wipe out the vast pool of hard-earned export dollars.

As a Beijing-based distressed debt specialist notes: "It is virtually impossible to push $1.4 trillion [in new loans] out of the door in about eight months without incurring a high incidence of bad loans. A trillion dollars [in new NPLs] is not too large considering that back in 2006 many estimated ‘special mention’ loans [lending considered to have fully failed] stood at around $300 billion to $400 billion, and these loans were just magically disappeared by the banks – they went away by themselves without ever being written off by the banks, or indeed transferred anywhere."

All of this uncertainty has belatedly forced the government’s hand. On March 6, China’s central bank chief, Zhou Xiaochuan, voiced his concern about local investment vehicles that borrow heavily using land as collateral – a common practice among local government investment vehicles – particularly those in the north and west. (The concern here is that Udics place unrealistically high values on land being used as collateral, justifying the price by pointing to the current boom in Chinese property prices. That’s fine so long as property prices continue to soar. But if the real estate market deflates suddenly, as many people predict will happen, the Udics will struggle to repay the loans.)

China’s central bank chief, Zhou Xiaochuan

On March 6, China’s central bank chief, Zhou Xiaochuan, voiced his concern about local investment vehicles that borrow heavily using land as collateral – a common practice among local government investment vehicles – particularly those in the north and west

The government wasn’t finished. On March 8, Yan Qingmin, the head of the ministry of finance’s Shanghai branch, announced that the government would not honour debts incurred through loans disbursed to any Udic. You got yourself into this mess, Beijing was saying, so you can prise yourself out of it as well. For those with sufficiently long memories, Yan’s comments also brought to mind the downfall of Guangdong International Trust & Investment Corporation (Gitic), which went under in October 1998 with $3.6 billion in debts to Swiss, Japanese and US investors among others. That remains the largest bankruptcy – for now at least – of a state-run Chinese firm. Lessons that went unlearnt

Herein lies the crux of the problem. Beijing’s stimulus package was flawed from the start, in large part because it is a plan that has been tried and tested and found wanting every time. It didn’t work between 1958 and 1961, when chairman Mao Zedong’s Great Leap Forward, a plan to create a world-class domestic steel industry, resulted in a disastrous famine and up to 43 million dead.

It failed to work again in the mid-1990s, when Chinese growth stalled and banks lent profusely, creating NPLs that had to be cleared out of local lenders in 1998 and 2004. Everyone – perhaps including party leaders in Beijing – thought those days were over. And yet somehow, against all the odds, it has happened again in 2009, while everyone was looking the other way.

Again, possibly against their own wishes, Chinese banks were forced to corral the vast savings held by the country’s 1.3 billion people and channel them into the hands of local investment platforms that rely, in the absence of a proper nationwide property tax, on land sales for about 50% of annual revenues.

This pattern is well rehearsed. Local investment vehicles, used to being overlooked by central government and lacking the relevant tools to size up viable investment options, revert to type, blowing their allowances on local vanity projects. When worries leak out about probable bad debts, Beijing goes on the offensive, decrying the inability of local city-level and provincial-level authorities to lend responsibly.

It’s a carefully scripted little dance repeated whenever Chinese GDP tails off: the temporary stimulation of perceived industrial demand using internal demand, while central government waits for global export demand to pick up steam.

This stimulus package, however, is different. For a start, it has also put a rocket under property prices. Much of the fiscal package was also routed into the hands of leading Chinese SOEs, the cash pouring into their hands directly, or channelled in via local authorities and Udics (most of which own sizeable stakes in leading local and regional state firms). Much of this capital ended up being sucked into risk-stock speculation and, more notably, real estate acquisitions.

Creating a property bubble

Of the 10 most expensive land acquisitions in the year to March 17 2010, six were made by SOEs, according to figures from the Chinese ministry of land and resources. Companies such as Poly Real Estate and Chinese Overseas Land and Investment helped create a six-month property bubble that shows no sign of abating.

Craig Blomquist, Fan Ya Tai

"The NPL build-up is going to be really bad"

Craig Blomquist, Fan Ya Tai

Despite Beijing’s best efforts to curb property speculation, the price of real estate across China rose 10.7% year on year in February 2010, by 20% in Beijing and Shanghai, and by a whopping 58% in Sanya, capital of the southern island province of Hainan. Efforts by Beijing to deflate will in turn have a negative impact on local authorities, which have borrowed on the back of high land costs. As UBS China economist Tao Wang noted in a February 24 research note: "A cooling of the real estate sector and lower land revenues could cause major problems for local government financing and possibly also stimulus projects financed locally." And despite a loosely drawn central law that bans local authorities from being in the red, the ratio of year-end outstanding debt to annual disposable fiscal income at local level in China is widely held to be 400%.

It’s also worth reiterating here that the China of 2009 is vastly wealthier than its 1960s’ or 1990s’ versions. Party leaders in Beijing covet being labelled a market economy by Washington and Brussels, and China’s banks are now listed on local and foreign bourses, with all of the shareholder scrutiny that implies.

And yet, as we have again seen, during times of crisis the country’s leading lenders still show their true colours. Chinese banks – when Euromoney went to press first- and second-tier lenders were gearing up to report expected brisk fourth-quarter and full-year 2009 figures – remain slaves not to shareholders or the marketplace but to the Party.

To be fair, a few dissenting voices in the market believe talk of bankrupt municipalities and banks saddled with a welter of new loans is premature. Continued fast economic growth is more than enough, they believe, to offset rising NPLs, and losses incurred by banks and local authorities could be lower than feared. Dragonomics’ Miller believes the forecasts of Shih at Northwestern University looks "outlandish" and notes that China’s premier, Wen Jiabao, has already started to clamp down on some loans to local Udics. Anthony Lok, managing director, research, at BOC International in Hong Kong, gives doom-mongers even shorter shrift, calling Shih’s predictions of future bad loans "absolutely ridiculous".

China’s property bubble - lots for Lots
Top five winning bids at land auctions this year
Winning bidder Bid total (Rmb million) Cost per square metre (Rmb) Region where plot lies Description of bidder
Greenland Property Group 7,245 27,000 Xuhui, Shanghai State-run property firm
China Overseas Land 7,000 22,000 Putuo, Shanghai Division of China State Construction Engineering
Dalian Port Investment 4,900 4,014 Dalian Dalian city investment division
Franshion Properties 4,060 16,200 Beijing Division of Sinochem
Soho 4,000 10,197 Wangjing, Beijing Independent property developer
Source: China Index Academy

But assuming that worst-case predictions of future loan losses are realistic rather than ridiculous, China’s next big financial challenge is twofold. The first is who shoulders the responsibility of an expected sharp uptick in local authority debts. Beijing’s recent bellicose rhetoric over local government debt can be immediately discounted: the Party always bails out local authorities, and usually sooner rather than later. How will bad debts be absorbed?

The question is how rising bad debts can be safely absorbed into the system – and when new NPLs might start to bubble up. Beijing might choose to carve soured loans directly out of the system, transferring them from local authorities to one of China’s four AMCs. Alternatively the party might choose to set up an entirely new asset management firm. That’s not as unlikely as it sounds: Beijing is currently tackling the issue of failed assets on the books of leading SOEs by transferring them to a new AMC under the purview of the State-owned Assets Supervision and Administration Commission (Sasac).

Alternatively – and less likely – China might choose simply to convey new bad loans directly from local investment vehicle to the books of the state’s banks. Either way, Beijing is facing a tricky spot of juggling over the next few years as it seeks to push rising debts from one government department to another without booking a loss.

The question of when new bad loans emerge is a thornier and more political issue. As in most countries, China’s politicians choose to surreptitiously transfer their most intractable economic and social problems to the next generation of leaders. Beijing is beginning the slow process of manoeuvring a new generation of politicians into high office: the process will be completed in late 2012 and early 2013, when China is expected to welcome a new president, Xi Jinping, and a new premier, Li Keqiang.

Jack Rodman, president of Beijing-based Global Distressed Solutions

"China’s lending cycle will allow the present set of senior officials to be well retired before the bubble from this cycle is felt"

Jack Rodman, Global Distressed Solutions

Beijing takes these handovers painfully seriously: any economic weakness in the run-up to the big day (such as low economic growth or inflation) will be dealt with directly, or papered over. Rising bad loans fall into the latter category. Beijing has become a skilled juggler of NPLs: sour loans will be siphoned into new or existing special purpose vehicles, or ignored entirely – at least until the new generation of leaders have their feet under the table and the old guard is out golfing on the links of southern Hainan island. Jack Rodman, president of Beijing-based Global Distressed Solutions, says: "China’s lending cycle will allow the present leaders and bank chairmen, chief executives, and chief operating officers to be well retired before the bubble from this cycle is felt." At some point China’s leaders, whether the current ones or a future crop, will have to deal with rising bad loans at the country’s leading lenders, and the more intractable problem of bailing out hundreds of indebted local authorities. Add to that future labour shortages causing rising inflation, higher interest rates and currency appreciation, and you have a recipe for disaster.

Beijing’s stimulus package, lauded around the world in 2008 and 2009, now looks to have been a huge mistake, and one likely to tax the ruling party for years to come. For a gung-ho country that seeks to claim the 21st century as its own, the 2010s in China might come to look alarmingly like the poverty and uncertainty of the 1990s.

"The very thing that got China into trouble in 1998 and 1999 is happening all over again," says a Shanghai-based distressed debt specialist, who prefers to remain anonymous for political reasons. "They are in the position of needing to recapitalize their banks. But to most of them it doesn’t matter – they can always raise more money by going back to the well." He adds: "It doesn’t make any sense to do this. But they can’t break out of it, despite the discipline imposed on the market in recent years by foreign banks. China is always saying to itself: ‘It won’t happen again, not this time’. But it always happens. That’s the Chinese model. Go figure."

see also:

Foreign banks’ retreat prompts rethink of their China influence
Sub-prime, China style, April 2009
China’s looming NPL crisis, April 2009

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