China’s Growing Debt Underscores a Need for Structural Reforms

China experienced a hair-raising credit crisis in June, jolting world markets and reviving worries over the stability of the world’s second largest economy. The liquidity shortage, one of the worst in years, was seen by some as an omen of larger problems to come. But analysts say it mostly reflects the renewed resolve of the Chinese government to clean up the country’s shadow banking industry and reduce surging levels of leverage in the economy. 

Some seasonal factors — such as a surge in demand for cash at the end of the quarter, deferred corporate tax payments and a drop in foreign exchange flows — contributed to the sudden shortage of credit in mid-June. But the main cause was the central bank’s decision to squeeze what it saw as an alarming jump in debt levels in the shadow banking industry. Chinese banks increased lending by 1 trillion yuan in the first 10 days of June, an unprecedented jump in leverage. “Chinese banks, in the eyes of the PBOC (People's Bank of China), had lent out too aggressively in the first 10 days of June. The PBOC did not want that,” says Louis Kuijs, China economist at Royal Bank of Scotland in Hong Kong. 

To counter that trend, the PBOC withheld cash from the interbank market, pushing lending rates sharply higher. Interbank lending rates soared beginning on June 13, with the closely watched seven-day repo rate hitting 12.6% around midday on June 20, up sharply from 8.22% on June 19. The seven-day repo rate averaged 3.3% in the first five months of this year. “The primary goal is to bring down the systemic risks posed by fast growing leverage among Chinese banks,” says Hu Bin, senior banking analyst at Moody’s in Hong Kong. 

Things got messy largely due to miscommunication between the banks and regulators, says Kuijs. “The banks were under the impression that the PBOC does not mind so much if they lend out quite aggressively because the economy is not doing so well and there are a lot of calls for stimulus,” he notes. “The banks miscalculated what really is the stance of the PBOC. They expected that the PBOC would be accommodative, but they were not.” 

To a certain extent, the PBOC helped precipitate the panic that swept through world markets by failing to explain its intentions. This led investors to jump to the conclusion that the shortage of credit might lead to a true financial crisis. China’s total debt relative to GDP was estimated at over 210% in 2012, up 85% from the level of 125% four years ago. Some economists view the build-up of leverage, surging property prices and slowing economy as similar to the crises in the U.S., Korea, Japan or the E.U. several years ago. They point to the rapid growth of China’s total debt, especially that held by local government financing vehicles and some industries laden with overcapacity, such as real estate and steel-making. But others say the credit crunch was a deliberate first step in a gradual effort to reduce leverage, rather than a crisis or drastic one-time reform. 

In the Shadows

At the heart of the events is the shadow banking industry, which runs parallel to, but outside of, the conventional banking system, Hu notes. According to Moody’s, such lending includes undiscounted bankers’ acceptances, entrusted loans, wealth management products, informal lending and trust loans. Moody’s estimated in June that outstanding shadow banking products totaled 29 trillion yuan, equivalent to 43% of total loans and 55% of GDP in 2012. But since shadow bank lending and wealth management products do not appear on bank balance sheets, no one really knows the exact scale of the risks, says Wharton finance professor Franklin Allen. “There is little data available for what is going on in these markets,” he adds. 

The PBOC and China Banking Regulatory Commission, or CBRC, have been tightening regulations on shadow banking since early 2013 after observing a surge in leverage among regular banks through interbank transactions, as well as in shadow banking. “That is what made the central bank worried,” Hu says. Domestic credit, also called “social financing” in China, includes bank loans, trust loans, company bonds, government bonds, shadow banking and other financing. It rose to 15.761 trillion yuan in 2012 from 12.829 trillion yuan in 2011, according to the PBOC. With the central bank’s crackdown, Wang Tao of UBS Asia Securities in Hong Kong estimates that growth in China’s total social lending will slow in the second half of 2013. 

On June 25, the central bank issued a statementclarifying its policy intentions and saying it will ensure adequate liquidity in the interbank market when necessary. A day later, the State Council, China’s cabinet, issued a statement saying the authorities must stabilize the market. As of July 1, the seven-day repo rate had fallen to 5.43%, down from 6.16% on June 28th. Analysts expect the seven-day interbank repo rate to settle between 5% and 6% in July. 

'Strong Consistency'

China often relies on central bank actions to carry out policy decided by top leaders, and this occasion is no exception, says Kuijs. He notes a “strong consistency” between the PBOC’s line and overall government policy. “If you look at what the State Council is saying or what senior leaders like Prime Minister Li Keqiang are saying, [it is]: ‘We are observing [that] growth is pretty weak, but we are not overly concerned. We also noticed that the labor market is holding nicely, and we want to work on reforms and do not want to go for stimulus.’ This general attitude is reflected in the attitude of the PBOC,” Kuijs says. 

While they are biting the bullet of squeezing out excess debt in the financial sector, China’s leaders will avoid a “shock therapy” approach and move gradually. Even the go-slow strategy is bound, however, to deter growth somewhat, says Wei Yao, China economist at Societe Generale Cross Asset Research in Hong Kong. “The credit crunch is the message that more reforms are coming. Instead of having a crisis in one year, they are trying to drag the process out to five years, dealing with the issue bit by bit,” she says. In many cases, financing has been for projects and assets that will not yield high-enough returns. “The central government realizes there is no way out, and we have to deal with it. We have to deal with non-performing assets in the system,” Yao notes. 

So, the more conciliatory approach taken in late June does not reflect a change in China’s macro and monetary policies, says Wang of UBS Securities. “Over the coming months, we expect credit growth to slow and financing costs in the economy to rise. As shadow banking activities unwind or shrink, sectors that rely more on shadow bank lending, such as local government financial vehicles and construction, will suffer more. This could lead to slower economic growth later and higher NPLs (non-performing loans) in the banking sector,” she wrote in a research report on the liquidity crunch. 

Despite some unconfirmed rumors of bank runs or defaults, so far there have been no reports of any bank failures stemming from the credit crunch. By taking action now, China is likely to manage to avert any major crisis in the future, says Wang Qinwei, China economist at Capital Economics in London. “The level of debt is not a big concern, but debt growing for several years is a big concern,” he notes. Relaxed controls in the financial system have allowed companies to borrow not only from banks but also from other channels, including shadow banking. A surge in lending to the property sector, local government investments and industries with overcapacity is a risk and cause for concern. “This year, the government has taken measures to tighten oversight of shadow banking and has started talking about controlling local government debt. The government is taking this seriously so that China can avoid a crisis,” Wang says. 

How Much Debt?

In the meantime, authorities are trying to gauge the size of the debt problem. China's National Audit Office announced in June that direct and guaranteed debts of 36 local governments and their financial vehicles had risen 13%, or by 440 billion yuan, from 2010 to 2012. “The government realized the risks in credit growth and they started doing something to avoid growing risks,” says Wang of Capital Economics. But Moody’s, in a June 13 report, offered an unenthusiastic assessment of the data, describing it as “much less comprehensive than a report the NAO published in 2011.” Both the amount of debt among the sampled local governments and the limited scope of the report are “credit negative” for China, it said. “The amount of local government debt makes it more likely its burden will eventually fall upon the central government and the limited scope of the report makes the size of that potential burden uncertain,” Moody’s said. 

Wang Tao of UBS estimates local government debt at more than 16.5 trillion yuan, or at least 32% of GDP, as of the end of 2012. “We do see the problem is growing in the local government debt situation, so the government is implementing the controlling measures for the LGFV (local government financing vehicle) borrowing,” says Hu of Moody’s in Hong Kong. Herein lies a policy dilemma, since constraints on sales of land for development — needed to curb property speculation and limit waste of valuable farmland — are limiting the revenue streams that local governments can tap for financing. “The real problem seems to be that they do not have good revenue streams,” Allen says. “They need either taxing power or they need grants from the central government. It is a government problem.”

While financial risks in China have increased, several factors suggest they are unlikely to lead to a full-blown crisis, says Kuijs. For one thing, while construction and property development are vital sources of growth and business activity, the real estate sector does not dominate financing to the extent that it did in the U.S. or Japan before their property meltdowns. “If you look at the real economy, one big problem in the U.S., Korea, Thailand and Spain was [that] the real estate sector started to dominate the economy and it was drawing an increasing portion of resources. You can see that in terms of contribution of construction and real estate to GDP, that was becoming out of kilter and it was not reasonable anymore,” Kujis says. 

Despite China’s heavy reliance on government spending and investment to fuel growth, its economy is somewhat more balanced. “In China, we also have a gradually increasing share of GDP contributed by real estate and construction, but it is quite modest and gradual,” Kuijs notes. “Many other industries are growing as well. China’s growth pattern is not one-sided.” 

Other macroeconomic indicators are weighted in China’s favor. China’s trade surpluses and its high savings rates have left it with ample resources. “If you look at Korea in 1997, it had started with current account deficits, and growth was reliant on capital from abroad. That was the case for Spain and other countries. China is not there yet. China still runs a current account surplus,” Kujis says 

China’s banks have much bigger buffers than those that existed in Japan when its asset bubble burst in the late 1980s and in Korea at the time of the Asian Financial Crisis in the late 1990s. In Korea, Japan and other countries, loan-to-deposit ratios had risen to 100% or more, leaving many banks dependent on the interbank market. China’s interbank market plays an important role, but the central bank’s requirement that every bank set aside 19.5% of their deposits as reserves leaves the average loan-to-deposit ratio at70%.“The banking sector has an easy funding model that means that more deposits are coming in than the amount of lending going out. It is not so vulnerable to shifts in availability of financing,” Kuijs says. 

Even if some local banks end up defaulting, China’s robust reserves ensure that its financial system, still buffered from outside shocks by its capital controls, can remain strong. Even when China’s biggest banks were carrying NPLs amounting to more than 30% of total lending, there was no financial crisis, notes Wang of Capital Economics. Apart from high savings rates and mostly closed capital accounts, the government owns majority shares of most creditors and most problematic debt, Tao Wang of UBS noted in her report. The government would likely lean on the big state-owned banks to support lending and bail out any smaller banks that might fail. “My personal view is that these risks are not big enough to be systemic,” says Kuijs. “I think that it is not so easy to tip China’s financial sector into crisis.”

But in the longer run, the success of China’s current financial reforms will hinge on other structural reforms of the economy, such as reducing the dominance of state-owned enterprises in many industries, says Yao. “At the moment, we have not seen much. I think they are going to announce a lot of reforms this year,” she says.

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