China’s sub­prime risks

Financial Mirror (Cyprus) - - FRONT PAGE -

It is now widely ac­cepted that the re­cent global fi­nan­cial cri­sis was ac­tu­ally a bal­ance-sheet cri­sis. Long pe­ri­ods of neg­a­tive in­ter­est rates fa­cil­i­tated the un­sus­tain­able fi­nanc­ing of as­set pur­chases, with high-risk mort­gages weak­en­ing na­tional bal­ance sheets. When liq­uid­ity in the key in­ter­bank mar­kets dried up, the fragili­ties were ex­posed – with dev­as­tat­ing con­se­quences.

To­day, the rapid ex­pan­sion of Chi­nese fi­nan­cial in­sti­tu­tions’ bal­ance sheets – which grew by 92% from 2007 to 2011, along­side 78% nom­i­nal GDP growth – is fu­el­ing pre­dic­tions that the coun­try will soon ex­pe­ri­ence its own sub­prime melt­down. Is there any merit to such fore­casts?

The first step in as­sess­ing China’s fi­nan­cial vul­ner­a­bil­ity is to dis­tin­guish a sol­vency cri­sis, which can oc­cur when firms lack suf­fi­cient cap­i­tal to with­stand an as­set-price melt­down, from a liq­uid­ity cri­sis. Dur­ing the Asian fi­nan­cial cri­sis of the 1990s, some coun­tries suf­fered for­eignex­change crises, in which de­val­u­a­tion and high real in­ter­est rates de-cap­i­talised banks and en­ter­prises, ow­ing to the lack of suf­fi­cient re­serves to re­pay for­eign-ex­change debts. In the case of Ja­pan’s as­set-price col­lapse in 1989, and again in the United States in 2008, bank re­cap­i­tal­iza­tion and cen­tral-bank liq­uid­ity sup­port re­stored mar­ket con­fi­dence.

The re­cently re­leased Chi­nese Academy of So­cial Sciences (CASS) Na­tional Bal­ance Sheet Re­port sug­gests that China is un­likely to un­dergo a for­eign-ex­change or na­tional in­sol­vency cri­sis. At the end of 2011, the cen­tral govern­ment’s net as­sets amounted to CNY87 trln ($14 trln), or 192% of GDP, of which CNY70 trln com­prised eq­uity in state-owned en­ter­prises (SOEs). More­over, at the end of last year, China’s net for­eignex­change po­si­tion to­taled $2 trln – 21% of GDP – with gross for­eign-ex­change re­serves to­tal­ing just un­der $4 trln.

The con­cern is China’s rapidly in­creas­ing do­mes­tic debt, which cur­rently stands at 215% of GDP. Since 2008, SOEs and so-called lo­cal-govern­ment fi­nanc­ing plat­forms have been us­ing loans to fund mas­sive fixed-as­set in­vest­ments, while pri­vate-sec­tor ac­tors have been bor­row­ing – of­ten from the shadow-bank­ing sec­tor – to fi­nance in­vest­ment in real-es­tate devel­op­ment.

This ex­ces­sive de­pen­dence on credit stems from the lack of ad­e­quate fund­ing and the rel­a­tive un­der­de­vel­op­ment of China’s eq­uity mar­kets, with mar­ket cap­i­tal­i­sa­tion amount­ing to only 23% of GDP, com­pared to 148% of GDP in the US. The debt held by non-fi­nan­cial en­ter­prises amounts to 113% of GDP in China, com­pared to 72% in the US and 99% in Ja­pan.

But, given that the largest en­ter­prises are ei­ther sta­te­owned or lo­cal-govern­ment en­ti­ties, their debts are es­sen­tially do­mes­tic sov­er­eign obli­ga­tions. With China’s to­tal govern­ment debt/GDP ra­tio amount­ing to only 53% – much less than Amer­ica’s 80% and Ja­pan’s 226% – there is suf­fi­cient space to un­der­take debt-eq­uity swaps to tackle the in­ter­nal-debt prob­lem.

Of course, China’s lead­ers will also need to pur­sue ma­jor fis­cal re­forms, in­clud­ing im­proved rev­enue-shar­ing be­tween cen­tral and lo­cal gov­ern­ments. In the longer term, the au­thor­i­ties must put in place stricter reg­u­la­tions to en­sure that lo­cal-govern­ment in­fra­struc­ture in­vest­ments are sus­tain­able and do not de­pend ex­ces­sively on rev­enue from land sales.

In the in­terim, the bur­den of ad­just­ment will fall largely on mone­tary pol­icy, which will be par­tic­u­larly chal­leng­ing given the struc­tural “tight­ness” in liq­uid­ity in the more pro­duc­tive sec­tors. From 2007 to 2011, China’s money sup­ply in­creased by 116%, whereas its for­eign-ex­change re­serves grew by 180%. The ex­cess was mopped up through statu­tory re­serve re­quire­ments amount­ing to as much as 20% of bank de­posits.

With the of­fi­cial bank­ing sys­tem thus con­strained, it al­lo­cated the re­main­ing credit to large en­ter­prises and those with suf­fi­cient col­lat­eral, re­sult­ing in an un­even dis­tri­bu­tion of loans across re­gions and sec­tors. As a re­sult, large en­ter­prises – mostly SOEs, which en­joy con­sid­er­able fi­nan­cial sub­si­dies and liq­uid­ity – ac­counted for 43% of to­tal bank loans in 2011; small and medium-size en­ter­prises (SMEs), which face fi­nan­cial re­pres­sion, in­clud­ing higher bor­row­ing costs and tight liq­uid­ity, ac­counted for only 27%.

This high­lights two fun­da­men­tal struc­tural im­per­a­tives. First, large SOEs and lo­cal gov­ern­ments must be dis­cour­aged from over-in­vest­ing, which un­der­mines the rate of re­turn. Sec­ond, more cap­i­tal must be chan­neled to­ward SMEs and faster-grow­ing re­gions, which are more likely to gen­er­ate jobs and in­no­va­tion.

In other words, in­ter­est-rate re­forms must be pur­sued along­side cap­i­tal-mar­ket re­forms that boost ac­cess to credit by the more pro­duc­tive sec­tors. China can­not com­plete its trans­for­ma­tion from an ex­port-led econ­omy to one driven by do­mes­tic con­sump­tion and ser­vices un­less value cre­ation through in­no­va­tion ex­ceeds value de­struc­tion from ex­cess ca­pac­ity.

In short, de­spite a strong na­tional bal­ance sheet and am­ple cen­tral-bank liq­uid­ity, China is con­fronting a lo­cal­ized sub­prime prob­lem, ow­ing partly to high re­serve re­quire­ments. One promis­ing move is the cen­tral bank’s re­cent re­lease of CNY1 trln in liq­uid­ity through di­rect lend­ing to the China Devel­op­ment Bank for the re­con­struc­tion of shanty towns, ful­fill­ing the need for so­cially in­clu­sive in­vest­ment. Un­like the US Fed­eral Re­serve, it has not pur­chased sub­prime mort­gages.

The key to suc­cess will be to man­age the se­quence of liq­uid­ity in­jec­tions and in­ter­est-rate re­forms so that the ef­fort to ad­dress lo­cal sub­prime debts does not trig­ger as­set-price de­fla­tion, while re­duc­ing fi­nan­cial re­pres­sion that cuts off fund­ing to more pro­duc­tive sec­tors and re­gions. If it man­ages to get these struc­tural re­forms right, China – and the rest of the world – will be able to avoid the con­se­quences of a hard eco­nomic land­ing.

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