Red Capitalism: The Fragile Financial Foundation of China's Extraordinary Rise
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TABLE 8.1 China public-debt obligations, 2009 and 2011
The table shows that if only the obligations of the MOF (as representative of the sovereign) are used to define central-government debt, then China’s debt ratio is less than 20 percent of GDP, well below the international standard. This is the commonly held view, but it ignores how Beijing has structured its finances over the past decade. The MOF once funded a national budget that included major investments in infrastructure and other fixed assets. Today, such projects are outside the budget and are the responsibility of the policy banks and an aggressive Ministry of Railways (MOR). The obligations of these near-sovereign (if not fully sovereign) entities should be included as part of China’s public debt: would the Party allow any of the policy banks to fail? Such sovereign entities include the MOR, the policy banks, the subordinate debt of the major state banks, as well as any known contingent obligations incurred by the MOF itself (those IOUs plus the 1998 and 2007 Special Bonds). When these obligations are included, public debt almost doubles, to 43 percent.
To this must be added the obligations of local governments, which are without doubt a part of the China sovereign. Beijing historically has been aware of this debt and that it is substantial; a quick look at the finance section of any China Statistical Yearbook illustrates this point. The Party, however, is conflicted: Does it really want to know the exact picture? Most successful Party leaders must at some point in their careers serve in the localities. Since local budgets are severely constrained, creative funding solutions—many of which would not withstand outside scrutiny—are the only choice open to the ambitious Party leader. Consequently, the best choice is not to arouse such scrutiny. Local governments comprise more than 8,000 entities at four distinct administrative levels. What is known is that the stock of local debt increased enormously after the announcement of the stimulus package in late 2008. Beijing required local governments to contribute at least two-thirds of the publicly announced total of RMB4 trillion.
This discussion is not meant to suggest that all these figures are exact and correct; it is enough to know the approximate scale of such obligations. In early 2010, Beijing publicly admitted to a figure for total local debt of RMB7.8 trillion—23 percent of GDP and likely to increase over the next few years, if only to complete projects already under way. One estimate of such additional funding needs is RMB4 trillion. There will undoubtedly be additional credit extended but, given the creative financing possibilities offered by the interaction of governments, banks, trust companies and finance companies, no one can know how much. For the purposes of this discussion, it is simply assumed that only RMB4 trillion is spent, so that by 2012, total local debt will be close to RMB12 trillion, or 28 percent of estimated GDP. While no one knows the true amount of local-government debt in China (the banking regulator most certainly does not), if the Hainan and GITIC experiences can be used as reference points, the scale of such debt is as vast as the country it finances.
Not to be forgotten in all of this are the non-performing loans, both current and those obligations yet to be written off from the 1990s. For the upcoming crop of NPLs that will derive from the stimulus-package lending of 2009 and follow-on loans of 2010, a total of about RMB20 trillion (US$2.9 trillion) is assumed.1 Of this, 20 percent is assumed to have gone to local governments, while the other 80 percent relates to typical SOE or project lending for which new NPLs are estimated, based on a 20 percent rate that begins to be seen in 2011. For the obligations left over from the earlier bank restructuring, the total of RMB3.2 billion is a hard figure derived from audited financial statements and the bank regulator. Together, these old and forecast NPL numbers yield a total of RMB6.4 trillion or over 15 percent of estimated GDP for 2011.
Adding all this up suggests that as of year-end 2009, China’s stock of public debt stood at nearly 76 percent of GDP, well above the international standard. This burden can only increase, given China’s practice of generating a significant portion of GDP growth through fixed-asset investment. Others will arrive at different estimates. The point is simply that in the past few years, China has quickly built up significant levels of public debt, and that is without taking the value of contingent liabilities, such as social security obligations, into consideration.
AN EMPIRE APART
What if this debt buildup is not just the result of a weak hand at the financial tiller? It may also be accurate to say that these increases are the result of the government deliberately leveraging China’s domestic balance sheet to achieve its policy goal of high GDP growth. The economics are simple and well understood: borrow expensive RMB now to build projects the state believes it needs, and make repayment at some point in the distant future using inevitably cheaper RMB.
Figure 8.2 shows the growth of outstanding central-government debt, here defined narrowly as that of the MOF plus the three policy banks and the Ministry of Railways only, as against the public debt of four developed economies, including the US. These developed economies have issued debt for a century; at times, as in the case of England in the late 1940s, national debt has been more than 200 percent of GDP. At times, these governments have even defaulted on their debt, as Germany did after World War II. These developed economies have extensive experience in managing public debt, both positive and negative. What is interesting about this chart is how in just a few years, China’s narrowly defined stock of debt seems to be catching up with the levels of developed countries, some with a GDP many times larger than China’s.
FIGURE 8.2 Trends in outstanding public debt: US, Europe and China, 1990–2009
Source: China Bond and International Monetary Fund
Note: China’s public debt includes only the MOF, the three policy banks, and the MOR. The Special MOF bonds of 1998 and 2007 are included.
This picture of government borrowing is also illustrated by the amount of the annual national budget financed by new debt net of that issued to repay maturing bonds (see Table 8.2). Such debt issuance represents new money and finances new budgetary spending and, of course, it will add to the stock of a country’s obligations. In 2009, for example, net new bond issues from the MOF and the policy banks supported 22 percent of national expenditures, while new CGB issues alone financed 57 percent of central-government expenditures.2 Similar to other Asian countries, China’s national budgets seem to be dependent on increasing amounts of debt.
TABLE 8.2 Net new-debt issuance as proportion of government expenditure, 1997–2009
Source: China Statistical Yearbook, China Bond; author’s calculation
Note: 2007 might be considered an anomaly given MOF’s RMB1.55 trillion Special Bond.
The budgetary dependence on debt can also be seen in the rapidly increasing amount of maturing central- and policy-bank debt. Over the period 2003–2009, the value of maturing MOF and policy-bank bonds grew at an annual compounded rate of 26.5 percent. These bonds were all refinanced; that is, rolled over into the future (see Figure 8.3). Net new debt plus debt issued to repay (and roll over) maturing debt equals the total amount of debt issued by China each year. Both add to the stock of China’s outstanding public debt.
FIGURE 8.3 Amount of MOF plus policy-bank debt rolled over, 1997–2009
Source: China Bond
Note: Retired debt is calculated as a function of year-end depository balances and annual new debt issuance.
It might be the case that this debt machine is not fully understood by China’s most senior leaders or they may be aware only of the more narrowly defined levels reported in the media. China’s public-debt figure is typically presented as only MOF obligations, its most narrow definition. It is unlikely to be a coincidence that of the total of China’s domestic debt obligations, only one percent is held directly by the end-investor: savings bonds. Aside from a minimal amount held by foreign banks and QFII funds, all else is either held or managed by state-controlled entities, from banks to fund-management companies. As the CEO of ICBC explained, China relies on “indirect” financi
ng to achieve its economic growth goals. This means that banks decide on behalf of depositors how, to whom and under what conditions to lend deposits out. In a capital-market model, there is less room for such an intermediary; the end-investor is independent of the debt or equity issuer and makes investment or divestment decisions based on considerations independent of the interests of the issuer or borrower. In China, this is not the case: the Party controls the banks and the banks lend, as directed, to state-owned entities.
This is precisely where China differs from Mexico of 1994, Argentina of 1999 and Greece and Spain today. Aside from trade finance, China does not borrow money overseas and, because of the non-convertibility of the RMB, offshore investors are overwhelmingly excluded from the domestic capital markets. Nor are foreign banks competitive in the domestic loan and bond markets, given their need to make an adequate return on capital. As a result, foreign banks rarely contribute more than two percent to total financial assets in China; after the lending binge of 2009, they now stand at 1.7 percent. The only other major entry point into the system, QFII, is a CSRC product that is directed at the stock markets rather than bond markets. In any event, the current total quota allocated is, at US$17.1 billion, a relatively small amount. Even if fully invested in bonds, this would still pale by comparison with outstanding bond obligations of US$1.87 trillion. There is simply no way that offshore speculators, investors, hedge funds or others can get at China’s domestic debt obligations and challenge the Party’s valuation of these obligations. In short, the closed nature of China’s financial markets suggests a deliberate government strategy based on a particular understanding of past international debt crises. China’s financial system is an empire set apart from the world.
CRACKS IN THE WALLS
The fact that it is well-insulated from outside markets does not mean that China’s finances are crisis-proof. The system can be disrupted by purely internal factors, as it clearly has been in the past. Take, for example, household savings, pension obligations and interest-rate exposure. Household savings are the foundation of the banks’ capacity to lend. The heroic savings capacity of the Chinese people is virtually the only source of non-state money in the game. Since 2004, China’s banks have enthusiastically expanded their consumer businesses to include mortgages, credit and debit cards and auto loans. What would happen to bank funding if the Chinese people learned how to borrow and spend with the same enthusiasm as consumers in the United States? Over the long term, this might be good for the economy and even for the banks. But in the short-to-medium term, it seems unlikely that the government will actively encourage American-style consumerism outside of the rich cities of the eastern seaboard. This, in itself, may be a source of great social instability as the more numerous relatives in the hinterlands become envious of leveraged lifestyles.
The overall demographic is pushing in the same direction. By 2050, XinhuaNews has stated, one out of four Chinese will be over the age of 65, but the actual number of retirees will be far greater (see Table 8.3). As the population ages, savings will be spent on old-age and health care. If the government continues to pursue growth through borrowing, the possibility of developing an economy based more on domestic consumption than export growth would seem low.
TABLE 8.3 China’s ageing population
Source: World Bank, Wall Street Journal Asia, June 15–17, 2001: M1
This also suggests that full funding for any national social-security program is a reform whose time is unlikely to come. Despite a strong beginning in 1997, the government continues to face difficulties in creating a standardized national program, on the one hand, and, on the other, sufficiently funding the programs it does have. Moreover, the funds it has under management lack suitable investment opportunities that can, with acceptable risk, yield returns higher than the rate of inflation. As noted earlier, at present only stocks and real estate, both highly speculative in nature, can potentially provide such a return. This harks once more back to the issue of China’s stunted capital markets. As the workforce ages, it appears likely that Beijing may have to fund any gap in such obligations largely through debt issuance.3 The Ministry of Labor and Social Security has estimated this contingent liability to be only RMB2.5 trillion, whereas in 2005, the World Bank arrived at an estimate of RMB13.6 trillion. This puts the range at somewhere between 10 to 40 percent of China’s GDP; a very large obligation.
China’s debt strategy is also vulnerable to increases in interest. At some point, a heavy interest burden arising from increasing amounts of debt will limit the government’s ability to invest in new projects and grow the economy. Very rough estimates suggest that, as of FY2009, total interest expenditure on central- and local-government debt represents 12 percent of national budget revenues and may grow over the next two years to 15 percent (see Table 8.4). Inflation also poses a threat since it would both increase these government borrowing costs and put pressure on the valuation of bonds held on the banks’ books as long-term investments; valuation provisions would have to be made. This is why the PBOC finds it so difficult to raise interest rates, thus limiting the range of tools at its disposal to deal with inflation. Raising bank lending rates affect enterprise performance and have a knock-on effect in the bond markets. It also raises expectations of currency appreciation and, therefore, can encourage inflows of hot money. The PBOC last changed lending rates (downward) in late 2008 and has since relied solely on the previously little-used deposit-reserve requirement.
TABLE 8.4 Estimated interest expense of central and local debt, 2009–2011
Note: Assumes revenues grow eight percent annually; interest rates for central-government bonds reflect data in the ICBC FY2009 performance review; local-government debt interest rate assumed four percent over one-year deposit rate. Interest rates remain unchanged through 2011.
This reserve tool was first established in 1985. Used only four times prior to 2003, it has been employed 28 times since. It limits a bank’s capacity to make loans by removing a proportion of bank deposits: no funding, no loan. Currently the reserve ratio stands at 17 percent, which is close to its historic high of 17.5 percent; that is, 17 percent of all bank deposits sit in the PBOC’s accounts. Using this policy tool and making massive sales of short-term notes into the inter-bank market are all the PBOC can do to manage China’s money supply. It is little wonder that the central bank is vulnerable to political conservatives touting the efficacy of Soviet-style administrative intervention.
None of this means that China is in danger of default or even of a slowing in economic growth. If properly managed, there is no reason why China’s use of debt can’t continue for a long time. Witness the ongoing debt crisis in Europe, which has been a decade in the making. In the case of Greece, it appears likely that its financial accounts were managed to meet the requirements of entry into European Economic Community from the start. Yet it is only today, more than a decade later, that problems have emerged in public and markets have focused on them. Greece is an open economy with a thriving democracy. Think how long things may be obscured within China’s still-opaque economic and political system.
Given China’s geographical size and huge population, it is unlikely that its economy will grind to a halt in the way that Japan’s did after its magnificent run in the 1980s. Unlike the Japanese banks then, China’s banks are not deregulated nor are they near being sufficiently international to consider “going out,” even if the Party would allow them to do so. To this can be added the very big lesson China’s government appears to have learned from Japan: keep a tight lid on currency appreciation. China knows well that when Japan freed up the yen to appreciate and deregulated its financial markets, it was entering the last stage of its wild asset bubble. The Party will perhaps allow the RMB to appreciate a little to defuse diplomatic tensions, but it will never make the currency freely convertible. All of the talk around the internationalization of the RMB has proven its weight in gold diplomatically, but it cannot be any more than that unless holders of the
RMB are able to use it freely offshore like any other currency. Until then, “internationalization” of the yuan is simply another form of barter trade.
In sum, China’s growing dependence on debt to drive GDP growth implies that there will be no meaningful reform of interest rates, exchange rates or material foreign involvement in the domestic financial markets for the foreseeable future. Nor will there be any further meaningful reform or internationalization of the major banks, although future recapitalizations will inevitably take place. The events of the fall of 2008 have put an additional seal on this outcome. “Don’t show me any failed models,” is the refrain of Chinese officials these days. But is its own financial system a model for the world to study? Can China be thought of as an economic superpower, either now or in the future, with such a system?