It's China's turn to wrestle with a pile of bad debt

Topdawg13 · Jul 2, 2011

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The source of China's current problem dates back to the collapse of the global economy in 2008 when, like its Western counterparts, the Chinese government unleashed a flood of cash to stimulate its economy. Much of that money was loans from state-owned banks to local governments, which were supposed to spend all those yuan on new roads, railways, power plants and other projects to help China maintain its torrid pace of economic growth.

Many of those yuan didn't get where they were supposed to go. It's still not clear exactly where they all went. But this week the Chinese government announced the results of a nationwide audit of 31 provinces and hundreds of municipalities which found that those local governments are now carrying some $1.6 trillion worth of loans. And a large portion — as much as 20 percent — may have to be written off as bad debt.

Following the blueprint of economic transformation laid out in the early 1980s by Communist Party leader Deng Xiaoping, China has embarked in recent years on a massive spending spree. Beijing hopes the spending will expand the economic success of coastal cities to inland regions by stitching them together with vast networks of roads, railways and high-speed Internet. But many of those projects have become mired in debt, with modern high-speed rail lines carrying handfuls of passengers and four-lane rural highways all but empty of vehicles.

“Last year, 55 percent of GDP was contributed by infrastructure investment — in other words bank lending,” said Carl Waters, an American investment banker until recently based in China and co-author of "Red Capitalism." "If you keeping making bad loans that don't pay back, you’re going to run out of money sooner or later."

For now, Beijing has said it will simply shift some $463 billion of those bad debts off the books of local governments and allow them to sell bonds to raise fresh cash. China’s state-owned banks, which also need fresh cash, will likely recapitalize their books with the profits guaranteed by state-mandated interest rates that pay savers less than banks charge borrowers.

Chinese bankers are also allowed to roll over their bad debts indefinitely, writing them off a little bit at a time while they raise fresh cash by selling stock to investors. That’s how China dealt with its last debt crisis in the late 1990s.

“At face value it was successful,” said Mark Williams, senior China economist at Capital Economics. “The banks cleaned themselves up and official government debt stayed down. But it only worked because the government rigged the financial system to guarantee big bank profits.”

The problem, said Williams, is that under such a system, bankers make money even when they make bad loans. Now, with debt piling up on the books of local governments, the government and its state-owned banks have increasingly more bad debt to warehouse. Eventually, that bad debt will make it harder for China to lend more money to invest in new infrastructure projects.

“China is already rapidly becoming significantly leveraged,” said Waters. “If you look at what happened in Greece or Ireland or Portugal when a country is leveraged, it has to borrow more and more to meet its interest obligations. That makes it less and less possible to invest in projects that will grow your GDP.”
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