Last month, China witnessed an historic moment — but not one that’s an obvious cause for celebration. When it failed to meet interest payments on its bonds, Shanghai Chaori Solar Energy became China’s first domestic corporate bond default. Soon after, Shanxi Haixin Iron and Steel Group Co., Ltd., defaulted on bank loans. The defaults should not have come as a surprise, since both companies operate in industries suffering from overcapacity. But in a country where the government often steps in to keep economic enterprises in key sectors afloat, the defaults signaled a change in direction. Premier Li Keqiang said during a March press conference that other defaults are “unavoidable.”
Amid predictions that China’s GDP growth rate will slow to 7.5% this year (also the government’s official target rate), Morgan Stanley suggests in a recent report that China will soon be meeting its “Minsky Moment,” or a “disorderly unwind” of private sector and local government debt. High rates of investment, fueled by borrowing, stand now at more than 45% of GDP and contributed 80% of China’s growth over the last 10 years, according to the World Bank. But as those investments grow, the return on them is declining — taking four renminbi of investment to produce 1 RMB of GDP today, compared to a 1:1 ratio in the early 2000s, according to Morgan Stanley. As it becomes harder for borrowers to make money to pay back their loans, Morgan Stanley predicts that China’s GDP growth could slow to 4% in two years, dampening global economic growth enough “to cause a global earnings recession.”
By the Minsky Moment, Morgan Stanley refers to economist Hyman Minsky’s framework identifying three scenarios for an economy: Hedge finance, where borrowers have enough cash flow to pay both interest and principal on their debt; speculative finance, where borrowers have the cash flow to pay only interest and must rollover their debt; and Ponzi finance, where borrowers can’t pay interest or principal and must borrow more or sell assets just to pay interest. The Minsky Moment comes when borrowers can no longer roll over their loans or borrow to pay their interest — often occurring at the same time as the central bank is tightening credit to combat inflationary pressures.
Morgan Stanley sees China at the Ponzi stage moving towards the Minsky brink, noting that China’s private sector and government borrowers are increasingly having trouble paying back loans — while the People’s Bank of China (PBOC) has been gradually tightening credit over the last year. Morgan Stanley’s report cites a litany of woes: Private sector debt, for instance, had risen to 193% of GDP at the end of 2013, up from 115% of GDP in 2007. Meanwhile, local government debt totals $3 trillion, according to China’s National Audit Office. Shadow lending outside the official banking sector now totals 40% of GDP, compared to 12% just five years ago. Now, a third of all new borrowings are used to roll over existing debt, and interest payments on debt represent nearly 17% of Chinese GDP. And more than half of Local Government Finance Vehicles (LGFV), set up for local governments to invest in infrastructure, real estate and other projects, do not have the cash flow to pay interest or principal, according to Japan’s Nomura Holdings.
“At some point, the music has got to stop…. We can only hope it will be gradual, so that not just China, but also the whole world, can adjust to it.” –Marshall Meyer
Experts from Wharton and elsewhere regard China’s debt build-up with varying degrees of alarm. Overall, most do not think China will plunge into a Minsky-like maelstrom and that a controlled unwinding is more likely than a dangerous death spiral. Many analysts still project a 7% to 7.5% GDP growth rate this year for the country, and first quarter GDP came in at 7.4% (annualized) on April 15. Yet, “at some point, the music has got to stop,” says Wharton management professor Marshall Meyer. “[Whether it will] stop gradually or abruptly, nobody knows. We can only hope it will be gradual, so that not just China, but also the whole world, can adjust to it.
“The worry is that local government investments could create difficulties depending on the capacity of the central government to bail them out,” Meyer adds. “In addition, the more state-owned enterprises borrow, the less they are able to pay back, as returns on capital decline. The question is whether the large enterprises will ever be able to repay their borrowings.”
Anxiety about rising defaults in China is running high, says William Adams, senior international economist at the PNC Financial Services Group in Pittsburgh, Pa. “It will be a tricky and messy year as China executes its exit from credit growth,” he notes. What’s more, there is no precedent in China for this exit when there are so many more quasi-private actors, such as local government financing vehicles, in the economy. “Even if there are laws on the books on how to deal with bankruptcy and bad debt, it’s very new territory for those laws to be used broadly,” says Adams. “The anxiety [over China] is anxiety over the unknown.”
A Key Question
According to Pieter Bottelier, a senior adjunct professor at Johns Hopkins University’s School of Advanced International Studies in Washington, D.C.: “The gap between the bears and bulls regarding China has never been wider than at the present time.” He thinks collapse is unlikely. “While China clearly has a debt problem, a controlled deleveraging process is more likely than a meltdown [in which] events take over.”
Indeed, if China can manage to deleverage its economy in a relatively controlled process and introduce reforms to put its economy on a consumption-driven, rather than investment-driven, growth path, the country ironically could end up in a stronger position than before, say experts. But can it get from here to there? “The key question is: ‘Are they hitting their GDP growth target with significant rebalancing, so that investment and credit growth are coming down and containing the risk, or is it the same old growth model with debt building up?,’” says David Dollar, a senior fellow at the Brookings Institution think tank in Washington, D.C. “I am not in the alarmist camp on an economic downturn this year, but the risks are building up, and they should get moving with all these reforms to manage the risks.”
Bottelier believes the biggest risk in the system is private sector borrowing. “Corporate debt is the time bomb,” he says. China’s corporate debt as a percentage of GDP is high by international standards, he notes, adding that most of the borrowers are non-state enterprises that don’t enjoy political protection, and many are invested in the property sector. “If there’s a collapse in the real estate market, events could start to take over,” he says. In particular, “if the property sector goes south in Tier One cities with a serious price collapse of 30% for an extended period, that could bring down the house.”
But the more likely scenario, Bottelier predicts, is “controlled deleveraging,” where the Chinese government decides, case by case, whether to bail out a borrower. Beijing will decide on a selective basis whether “the risk of moral hazard is greater than the risk of default. You’re going to see more of this kind of deliberate, discriminate decision-making based on the nature of the creditor, the debtor and the consequences.”
Fiscal Fitness
In contrast, some experts believe local government debt is less a concern. Together, local and central government debt totals about 50% of GDP. About 30% is local government debt and 20% is central government debt, notes Wharton finance professor Franklin Allen. Those levels are relatively modest by international standards, according to the World Bank. “With $3.8 trillion in reserves, or about 50% of GDP, the central government can take care of all these problems,” Allen says.
“The anxiety [over China] is anxiety over the unknown.” –William Adams
Rather, “the major reform they need is a funding mechanism for local governments,” Allen adds. Local governments shoulder 80% of the expenditures necessary to perform local services, such as health, education, pensions, housing and infrastructure, but receive only 40% to 50% of this amount from the central government, according to the World Bank. Without taxing power, local governments turn to land sales and often speculative activities to raise revenues. After the global financial crisis, local governments, flush with money from the central government’s stimulus program, set up LGFVs to invest in infrastructure, real estate and other projects that could fall short in generating the revenue needed to pay off debt.
Chinese President Xi Jinping’s sweeping economic reform plan, presented in November, proposes the introduction of local property taxes as a steady revenue source for local governments — a move that can help deter them from engaging in speculative investments. But current property tax pilot projects in Shanghai and Chongqing have not been deemed successful, says Wei Shen, a law professor at KoGuan Law School at Shanghai Jiao Tong University.
An even more fundamental change is needed to rein in local officials’ appetite for potentially risky investments, he adds. “Unlike in the U.S., lower-level government officials can be promoted only by higher-level government officials rather than by the general public. Local officials focus on pleasing higher level officials rather than the general public. Since the government always looks at large infrastructure projects to boost economic growth, local governments spend money on infrastructure [instead of] on public services. A lot of infrastructure projects funded by local governments are redundant, so they are not able to produce any sensible or sizeable revenues to cover the debt.”
As local government debt troubles come to a head, Beijing has yet to come up with a prototype solution, says PNC’s Adams. In January, a local Shanxi coal mining company was about to default on a China Credit Trust loan when an anonymous party — possibly the local government or the Trust’s parent company, Ping An Insurance Co. — stepped in to make investors whole on the principal. Improvised solutions like these will likely continue, says Adams. “There is a complex negotiation under way between central and local governments, local government-supported state-owned enterprises, and bank and trust lenders. That’s a lot of seats at the table, and that’s why it’s not a quick issue to resolve.”
Credit Cure
Even if Beijing can backstop local government debt, it must still contend with the burgeoning shadow banking system, driving much of today’s risky local government and private sector borrowing. Shadow banks lend to borrowers at high rates for credit the borrowers otherwise could not get from official banks, and they get their funds from investors seeking higher rates of return than the regulated 3% rate on ordinary bank deposits. Shadow banks’ high rates are a “symptom that the financial system is not doing its job” and that reform is needed, says Wharton’s Allen.
Shadow banking’s rise was the unintentional consequence of the central government’s $4 trillion global recession-era stimulus in November 2008, Bottelier points out. “In 2009 and 2010, the amount of credit unleashed into the economy grew two to three times as fast as GDP,” he notes. “Most of that money ended up with corporate borrowers, including state-owned enterprises, which began to lend at a much higher price to other corporations with less access to the official financial system. When the commercial banks saw non-bank financial intermediaries making lots of money at liberalized interest rates, they began offering wealth management products,” fueling an explosion of high-interest shadow banking lending after 2009.
Shadow banks’ high rates are a “symptom that the financial system is not doing its job….” –Franklin Allen
Bottelier believes that if Beijing liberalizes interest rates over the next two years, as promised, it will gain control over shadow lending. In particular, raising deposit rates will “take the wind out of the shadow banking system,” and PBOC governor Zhou Xiaochuan has already promised to institute deposit insurance by 2015, he notes. Yet, Beijing cannot remove controls on deposit rates overnight because it has to protect the margins of state-owned banks, he adds. Beijing will also lose its ability to fund state-owned enterprises in key industries inexpensively.
Acceptable Price?
However, according to Adams, “if the tricky path of constrained credit growth and the resolution of bad debt can be negotiated this year, that’s an acceptable price to pay for a more sophisticated financial system that can allocate capital more efficiently and sustain growth over the long run.”
Brookings’ Dollar agrees: “When the authorities let some private sector companies go bankrupt and associated shadow banking products go bust, it sends a healthy signal to households that it’s risky to invest in corporate bonds or wealth management products compared to low-return bank deposits.”
What lies ahead? In the optimistic case, say experts, China is likely to experience slower growth. But with a tighter labor market and rising wages, perhaps a stronger consumer market will emerge. “There are good fundamentals that could support a soft landing and provide a new source of demand for the Chinese economy as credit growth slows,” says Adams.
And, with an $8 trillion GDP, “the government has tremendous fiscal capacity,” Allen points out. “It will be a while before debt problems become serious.”
