China’s Debt Trifecta: Property Loans, Muni Debt and Shadow Banking

REAL ESTATE AND shadow banking has driven a quadrupling of China’s debt since 2007, the year when the bursting of a global credit bubble brought the world’s financial system to its knees. Since then China’s total debt has risen to $28 trillion (as of mid-2014) from $7 trillion. As a share of GDP, it is now 282% — larger than the comparable figure for developed economies like the U.S., Canada, Australia and Germany.

One would expect China’s total debt to have increased as its economy grew. Though slowing it has still been growing at more than 7% a year since 2007 let us not forget. But the increase in the country’s debt-to-GDP ratio, from 158% in 2007, shows the country has been piling up debt far faster than its GDP growth rate alone would suggest.

Even that relatively high level of debt is still manageable, in the sense that “China’s government has the capacity to bail out the financial sector should a property-related debt crisis develop,” the McKinsey Global Institute (MGI) says in a new report on global debt and deleveraging. The report covers well-trodden ground, but it still provides a sobering reminder. Seven years of the world’s great and good espousing the virtues of austerity have resulted in a $57 trillion increase in global debt outstanding.

China has accounted for one-third of that growth, and, this Bystander notes, is bucking the trend of the debt burden moving from the private to the public sector, where is relatively less systemically risky. Non-financial corporations have been the bigger driver of this increase in China’s debt; the country now has one of the highest levels of corporate debt, at 125% of GDP (U.S. 67%; Germany 54%, by way of comparison).

MGI is relatively sanguine about the big-picture consequences, but it still sees three potentially worrisome developments, all of which will be familiar to regular readers here:

  • half of all loans (excluding financial-sector debt) are linked, directly or indirectly, to China’s cooling but still inflated real-estate market;
  • unregulated shadow banking accounts for nearly one-half of new lending and one-third of outstanding debt; and
  • the debt of many local governments is probably unsustainable; with the $1.7 trillion in outstanding loans to local governments’ off-balance-sheet special financing vehicles the particular worry.

History teaches us — repeatedly — that financial crises often follow rapid debt growth. The most plausible route to that happening in China is that overextended property market meets local government debt bomb. A wave of loan defaults is set off, particularly among the country’s many small property developers (who number into the high tens of thousands). That then ripples through the construction industry, and the city commercial banks and other small lenders that finance developers and building firms.

A government bailout would limit the damage, as it did when Beijing bailed out the big state-owned banks more than a decade ago. But the economy would likely slow dramatically with consequential social unrest and other political implications that the Party just won’t entertain. “The question today,” MGI says, “is whether China will avoid this path and reduce credit growth in time, without unduly harming economic growth.”

MGI’s prescription is conventional: more of what Beijing is already doing, but with greater urgency. That means:

  • reforming municipal finance (allowing local taxation to be raised, deepening the nascent muni-bond market);
  • improving transparency and risk management among lenders (including corporations that are making loans through the shadow banking system);
  • more robust data on real estate markets;
  • improved bankruptcy procedures; and
  • new retail savings and investment products from mainstream financial institutions that can be an alternative to those offered by real estate developers and informal lenders in the shadows and on the curb.

Will all those things happen? Eventually. Such reforms have the backing of the top leadership because the risks of not implementing them are greater than those of doing so — and the latter set are considerable to a Party trying to pull off the unprecedented feat of retaining a monopoly on political power while ceding its monopoly on economic power.

However, it is widely if, not universally accepted that present arrangements are unsustainable. Unwinding them requires time. First, to deal with vested interests that will lose out. China’s are uncommonly thorny because they mostly get their economic interests because they are politically powerful (elite families), rather than drawing their political clout from their economic success.

Second, to phase in the changes so that the cure is not worse than the disease. Just as China has learned from Japan about the importance of managing its currency, so it has learned from Russia the need to avoid a rapid grafting of free-market capitalism onto a socialist economy.

The question is not, does China have too much debt. The question is can the Party buy itself enough time to create the conditions in which the country’s debt is sustainable?

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One response to “China’s Debt Trifecta: Property Loans, Muni Debt and Shadow Banking

  1. Pingback: An Architect For A Rich China | China Bystander

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