The Taiwan Banker

Bubbles have long been a concern when it comes to China’s growth model. During a 1988 visit to Shanghai’s Pudong District – whose financial district was then full of empty buildings – the economist Milton Friedman declared it “a statist monument for a dead pharaoh on the level of the pyramids.” Yet the China bears have been proven wrong time and time again. The latest potential bubble in China to receive widespread attention is local government debt – a multi-faceted problem involving almost all aspects of China’s economic model. In response to the 2008 financial crisis, China’s central government directed entities at all levels to take on unprecedented levels of debt. As a result, China almost entirely avoided the ravages of the crisis, from which developed countries are only now fully recovering. Meanwhile, because the governments could not borrow money directly, entities termed Local Government Financing Vehicles (LGFV) were set up to accommodate the credit. As the name might suggest, LGFVs are a catch-all category which could include any manner of assets, such as PPP projects, local state-owned enterprises, poverty alleviation projects, pensions, or other loans. It has often been unclear who is ultimately responsible for the debt and investors have failed to fully price the risk of default into either the vehicle itself or the local government guaranteeing it.Comprehensive data can be difficult to come by, due to both restrictions on information in China (such instruments are often not publicly traded), and also the difficulty in defining the problem. A 2013 government audit, the best official source of information, found RMB 17.9 trillion of debts (including contingent liabilities), or 30% of the GDP that year. Meanwhile, a recent Standard & Poor’s report estimated only the off balance-sheet portion at RMB 30-40 trillion, with government debt totaling 60% of GDP. Because of the complexity of the situation, LGFVs have been identified as a source of systemic risk to the Chinese economy. Local debt is only the tip of the iceberg. It makes sense that problems would arise in this form, given the lack of distinction made in China between public and private, and the strong distinction made between different levels of the governance hierarchy. The most notable features of this phenomenon, however, involve its connections (both practical and logical) to China’s overall debt situation. Total debt to the non-financial sector reached 256% of GDP in 2017, up from 141% in 2008. GDP growth slowed from 9.6% to 6.9% during the same time, so debt productivity decreased. The economy won’t crater tomorrow, but it is becoming clear that systemic financial risk is rising. Several perspectives on LGFVs can help clarify the drivers of these trends. Neither public nor privatePerhaps the most straightforward way to view the problem would be through the lens of the government sector (i.e. regarding local government debt, both on and off the books, as a substitute for central sovereign debt.) China’s local government officials are appointed almost solely on the basis of economic growth, and their relatively short terms means that they themselves don’t have to bear the consequences of overleveraging. Following fiscal reforms in 1994, local governments have broad mandates, but few financial resources. They have frequently turned to land sales to make up the difference. Efforts have been made to rectify all of these problems and normalize the status of local governments, but the debt overhang remains. China’s government debt remains manageable by international standards, but with around 60% of debt being originated at the local level, China is an outlier in terms of its decentralization.Part of the problem with local governments is that is it unclear exactly which levels of government are too big to fail. Some municipalities could potentially be allowed to default without catastrophic results, but it seems likely that a whole province would be too big. The multitude of levels at which a given project might be guaranteed adds an additional level of complexity to the situation.Despite the association with local governments, going by the numbers, the substance of the problem involves the private sector. China’s total non-financial private sector credit reached almost 165% of GDP in early 2018 (a figure which may include some of the aforementioned local debt), compared with about 105% for emerging market economies as a whole. China’s official non-performing loan (NPL) ratios consistently hover between 1-2%, but few outsiders trust these numbers. In 2016, the IMF noted that 15.5% of commercial loans had EBITDA coverage ratios of less than 1, signifying insufficient profits to service the company’s debt, at least in the long term. Real estate is where these microeconomic and macroeconomic perspectives come together. China’s broad money supply was 203% of real GDP in 2017, the highest ratio in the world. Since inflation in commodities has generally been kept under control, it is logical to conclude that the country’s booming real estate sector has absorbed much of this liquidity. Land also plays an outsize role in the real Chinese economy, taking an important place on balance sheets. Banks, protected from competition, also prefer to base their lending decisions on collateral rather than projections of future cash flow.China’s housing price-to-income ratios show it takes 30 years of a typical income to buy a house in lower-tier cities, and even 50 in first-tier cities. That is to say, the market for housing is non-functional. Traditionally, market mechanisms would not be used to acquire housing, as parents would buy apartments for their children (or, during the command economy days, people would simply be granted housing.) Growing personal debt, particularly mortgages, however, shows the enduring relevance of the market. While personal debt is a small part of China’s overall debt picture, it may prove to be an especially critical one, hampering consumption – which is supposed to form the backing for all of these other types of debt.Failing gracefullyThe trigger for a systemic risk event would probably be an uncontrolled bout of RMB depreciation. The main risk factors in that case are the loss of foreign exchange reserves, and the loss of market confidence. Both elements have been occurring for some time, but the ongoing trade war is exacerbating the situation. On the surface, China’s foreign exchange reserves are sufficient (though somewhat off their peak of US$ 4 trillion in 2014). The foreign exchange for these reserves is earned through China's trade surplus. Even though the trade balance has defined the course of the trade dispute thus far, widespread media attention has not yet been reflected in more balanced trade. This divergence from expectations may in part reflect exporters front-running the tariffs, and the 25% tariffs planned for possible implementation next year could change the situation. Controlled depreciation would however somewhat offset their impact (although supply shortages in imported items like oil, microchips, and grain could be painful in the medium term).Market confidence, meanwhile, seems to be a key element in US strategy. Its opening move against ZTE appeared tailored to pierce through some incorrect public perceptions of China’s technical dominance. Most recently, the US has revived efforts to directly audit Chinese companies listed in the US, which had previously been stymied by the bureaucracy. This dispute originally arose because a number of companies were found by short sellers to be engaged in fraudulent behavior. As of writing, the Shanghai Stock Exchange Composite Index is down about 25% on the year. Prior to 2018, markets in China largely underestimated the depth of US frustration with China, so the trade war came as unexpected. In fact, in addition to its economic connotations, the notion of Chinese collapse has strong political resonance in the US. The Soviet Union is an example of a country that turned out to be "too big to fail" non-catastrophically – a lesson the US remembers well. Nassim Nicholas Taleb coined the term “antifragile” to describe a system in which small failures can be isolated before they turn into big ones. The Chinese system, which sees the business cycle as a matter of national security, is the antithesis of this design philosophy.This is not to say that there are no failures in the Chinese system: the recent failure of P2P lenders makes that point clear. Rather than learning from that episode, and allowing for an alternate financial system to develop outside of the state banks, however, the government seems set on stamping out alternative financing as a whole. This approach ensures that risk remains concentrated in the state sector. The fear is that state lenders have conflicts of interests and “soft budget constraints” which prevent state-sponsored projects from failing properly. Corporate defaults have increased – potentially a sign of a healthy system – but they are still not routine. (One LGFV missed a payment deadline in August, the first technical LGTV default in recent years.)It is fair to say that Chinese markets and regulators, having lived through 40 years of continuous growth, lack proper experience handling a bear market. China’s growth was certain to slow in any case at this stage in its development, but the lack of development in the financial sector overall risks the creation of a long-term “middle income trap” as good money chases bad.