Trade frictions with the United States have slowed China’s growth. While the economy appears to have bottomed out on support from stimulus measures, it remains burdened by a major problem reported by many in recent years: excess corporate liabilities and bad bank loans. A financial crisis in China could deal a huge blow to the global economy.
Echoes of the asset bubble in Japan
China’s exports to the United States have slowed due to growing trade fiction, and growing uncertainties have rocked private capital investment. The Chinese economy seems to be at its bottom, however, thanks to the Chinese government’s stimulus measures. Measures such as lowering the key interest rate, reducing the corporate tax by 2,000 billion yuan (about 31 trillion yen), relieving the burden of social security, promoting investments in infrastructure through increased issuance of local government bonds, subsidies for high-tech manufacturing industries and the early commercialization of 5G, the next-generation communication standard, appear to have been successful.
In addition, there are glimmers of a global recovery in IT demand, and a number of national governments have announced stimulus measures. Following these developments, the Chinese economy is showing signs of bottoming, as evidenced by the rebound in new orders for the manufacturing industry.
But we must not forget the structural problems that continue to haunt the Chinese economy. While income disparities and environmental pollution are serious issues, I pay the greatest attention to the problem of excess liabilities and bad debts. Over the past decade, liabilities have increased in China, mainly in the corporate sector. According to the Bank for International Settlements, corporate liabilities in China have quadrupled from 31 trillion yuan at the end of 2008 (about 480 trillion yen) to 136 trillion yuan (about 2.1 quadrillion yen) at the end of 2018. The ratio of business liabilities to GDP fell from 98% to 152% during the same period. As the figure shows, this rapid growth in liabilities is reminiscent of the asset bubble years in Japan.
A third of this 136 trillion yuan is made up of loans to special purpose companies, called local government finance vehicles, which local authorities use to finance investments in infrastructure and real estate development. Given that the average bank lending rate is currently 5.7% annualized in China, the annual interest charge on businesses is estimated at 7.752 billion yuan (121 trillion yen), or 8.6% of the GDP. Zombie companies with excess production capacity are mushrooming, continuing to survive without being kicked out of the market. It is worrying how long they can continue to borrow to repay their debts.
Official figures largely underestimated
In such circumstances, the risk of a financial crisis in China cannot be ruled out. The flip side of the rapid growth in business liabilities is the rapid expansion of credit. The ratio of bank loans to GDP has jumped 30% in five years. A report from the International Monetary Fund indicates that the ratio of total credit to GDP increased by 30% or more in 42 countries over a five-year period. Of these countries, 18 experienced a hard landing and financial crisis within five years. In other words, more than 40% of countries experiencing credit expansion like China have experienced a financial crisis.
To determine the risk to the Chinese financial system, it will be helpful to understand the bad debt situation. In official Chinese government statistics, the bad debt ratio of all commercial banks fell from 1.0% at the end of 2011 to 1.9% at the end of September 2019. The Chinese government explains that while there is some risk, banks have the capacity to absorb losses.
Banks, however, do not always accurately disclose their management status, and the real bad debt rate would be much higher. Using 2015 financial data for some 2,300 listed companies, I estimated the potential bad debt ratio to be five times the official figure. This would mean that the potential ratio is currently close to 10%. Although statistical differences preclude a direct comparison, China’s potential bad debt rate exceeds the record 8.4% rate recorded by major Japanese banks in the fiscal year ended March 2002. For this reason, we should consider the possibility that over the next few years the failure of small and medium-sized banks will generate mistrust among banking institutions, triggering a crisis in China.
One of the reasons for the accumulation of corporate liabilities and bad debts is believed to be the 4 trillion yuan stimulus package and aggressive monetary easing that China instituted in response to the 2008 global financial crisis. Another important reason is the number of companies and banks. make risky business decisions based on implied government guarantees or explicit loan guarantees. As the government protects public enterprises and banks from bankruptcy, these enterprises have come to assume liabilities beyond their repayment capacity. Public banks have also become lax in controlling their own management and the management of companies receiving their loans.
Much of the funds raised by state-owned enterprises have been invested in inefficient or marginally profitable infrastructure projects and in real estate development. Manufacturing industries such as steel, cement and solar panels have become burdened with overcapacity. Companies using financial engineering have left them with skewed balance sheets. Investing in risky financial assets rather than tangible investments is known as giving up reality for virtual (脱 実 向 虚, tuo shi xiang xu) in China. While speculative investments occur in the real estate and stock markets, what has become most popular are bank wealth management products and other shadow banking products that are not regulated by the government and that offer benefits. high returns.
Can a financial crisis be avoided?
If the problem of excess liabilities and bad debts triggers a financial crisis in China, its effects will instantly spread like a powerful jolt in the global economy. In 1997 and 1998, a bad debt problem led to a financial crisis in Japan. Financial difficulties have spread in a chain reaction between financial institutions, and it has become impossible for the government to protect financial institutions through a convoy system where good banks deal with troubled ones. It has also become unrealistic for financial institutions to continue to protect closely related businesses through a mainstream banking system. As a result, an economic growth rate that rebounded from 5.1% in 1996 fell to 1.6% in 1997 and turned negative from 2.5% in 1998.
If China repeats Japan’s mistake, the first to react will be the stock and currency markets. Japanese stocks will plunge and the yen will appreciate. Japan’s real economy will also be hit hard. The prices of Japanese automobiles, household electronics and industrial machinery will be withdrawn from the Chinese market, and the number of Chinese visitors to Japan will decline sharply. From large to small businesses and from manufacturing to service industries, Japanese businesses will be negatively affected.
The Chinese government has proactively dealt with the precursors of a financial crisis. In May 2019, the People’s Bank of China bought out Baoshang Bank, the first commercial bank failure in 21 years. This act prevented mistrust from growing between the banks. However, as stated in the IMF report Article IV Staff country report released in November 2019, there are many other banks similar to Baoshang Bank that are in danger of going bankrupt. Recently, bankers’ acceptances from many small institutions have been turned down and a few runs on banks have been observed.
Will China be able to continue its economic growth without encountering a financial crisis? Given the small size of its GDP per capita compared to advanced economies, China has a lot of room for growth. If such growth were to increase the size of its economy, it would lessen the perception that bad debts and liabilities of companies are excessive. In addition, China’s divergent political system could allow it to deploy public funds quickly to prevent the situation from worsening. The fact that financial intermediation is carried out mainly through public banks is an advantage that China has over other countries.
Assignment of bad debts under the Xi administration
Research by Carmen Reinhart and Kenneth Rogoff of Howard University, however, casts doubt on such optimism. In This time is different, Reinhart and Rogoff note that 268 crises occurred in 66 countries between 1800 and 2000 and that financial crises affected countries at all stages of development. China has many forms of financial institutions, such as commercial banks, the Postal Savings Bank of China, rural cooperative banks, and rural credit unions, which number about 4,000 in total. One wonders how well the Chinese government understands the bad debt situation in these banks and whether it will be able to allocate sufficient public funds in the event of a crisis.
There is no effective and easy prescription for reducing excess liabilities and bad debts. As the Chinese government seeks to strengthen the risk management of businesses, local governments and financial institutions, such efforts only treat the symptoms. They will not solve the problem in a fundamental way. What is needed is to phase out implicit government guarantees and explicit loan guarantees to banks and businesses. However, little progress has been made, as any misstep would risk successively failing public enterprises, local communities and financial institutions.
Since Xi Jinping became president of the People’s Republic of China in 2013, the government administration has become more controlling. President Xi intends to maintain an economic structure of codependency through strengthening and expansion of the public sector. The problem of excess liabilities and bad debts is expected to persist in the long term as a downside risk to the Chinese economy.
(Originally written in Japanese. Banner photo: Shanghai street view. © Pixta.)