While the world is increasingly dazzled by the Chinese government’s financial might, we often neglect the fact that the ammunition of its vast state-owned banks derive from the savings of its (emerging) middle class. Because China’s financial sector remains nascent and dominated by the state, the general public has little choice but to deposit their hard-earned money into state banks. This virtual monopoly allows the state to impose low interest rates that provide the government with low borrowing costs subsidized by the public. This lopsided arrangement is a significant source of public dissatisfaction, particularly when the government uses depositors’ money to bail out mismanaged state run banks.
Financial gymnastics by local governments
Under the current regulation, local governments are not allowed to issue bonds. As a work around, local governments establish investment companies that then borrow money from state-owned banks to support essentially off-book investment projects. At the national level, a similar process has taken hold: in the 80’s, the central government transferred responsibility for financing much of the state’s investments to state-owned and -controlled banks with the goal of improving the position of the central budget. Victor Shih from Northwestern University extensively documents these developments in his book, “Factions and Finance in China.”
The risks associated with these off-the-books transactions—hidden on the balance sheets of banks rather than the public budget—have long been conveniently ignored by government officials, who are rather more concerned with short-term achievements and growth targets that will advance their careers. But a number of reformers and civil society advocates have begun to warn the government of the poor state of the investment companies, many of which do not appear to have the ability to repay their debts in the long-run. Reformers therefore call for a dramatic overhaul of China’s financial system to ensure long-term sustainability.
Local government investment companies have concentrated their loans on the property market and on infrastructure, particularly railroads, highways, and airports (the so called “iron rooster” trio). With most such investments, profitability and market demand take a backseat to the financing of public officials’ pet projects that help showcase their achievements and provide a stepping stone for promotion. In this way, depositors’ money is squandered at the will of powerful politicians.
Unsurprisingly, these projects have relatively low returns. As a result, the investment companies typically have low liquidity, and loans are repaid slowly. To get these long-term, unappealing loans off their balance sheets, banks repackage the loans into “trusts”—not unlike the structured investment vehicles that produced the American Subprime Crisis—and sell them to investors. With relatively high returns and tacit endorsement of the local government, these trusts are highly popular with investors, who—unwisely—do not ask too many questions.
Professor Shih’s estimates of China’s hidden local government debt are staggering. Based on his research (“China’s 8,000 Credit Risks”), local investment companies’ total borrowing amounted to $1.6 trillion between 2004 and 2009—and Shih suspects that the problem is actually worse because he could not track lending from low-level governments. If accurate, this level of borrowing is equivalent to a massive one-third of China’s 2009 GDP and 70% of its foreign-exchange reserves. Some in-depth reports from local sources in China point in the same direction. A Chinese financial newspaper with a circulation of over half a million, the 21 Century Business Herald, estimates that the local governments’ debt exceeds $1.2 trillion (8 trillion RMB). Even the Central Bank (PBOC) admits that local governments’ loans totaled more than $757 billion (5 trillion RMB) in May 2009.
The Financial Times expects only about 80 percent of this debt to be recoverable (resulting in losses easily exceeding $200 billion). Yet this number may well be optimistic. Local governments typically use land as collateral to obtain loans. Should the price of land collapse, many local governments will find themselves unable to pay their debts. This is almost certainly why the central government has had little success in containing property prices in its attempt to appease public outcry at the ever increasing cost of housing; self-interested local governments are no doubt complicit in propping up the value of land, their primary asset (for a more detailed discussion, see my featured service article).
The public is left with the bill
Should the property bubble pop and take down the banking system with it, it will be the general public who will have to foot the bill for state bailouts. Assiduously accumulating staggering amounts of foreign reserves, China would probably have the financial might to tackle the resulting non-performing loans. But China’s depositors will be saddled with a tremendous financial burden as a result of the state’s inefficient financial sector interventions and central-planned policy.
The state’s vast financial arm mesmerizes many around the world. Even Francis Fukuyama has lauded China’s efficiency in infrastructure construction. But we should not forget: these investments (often of questionable economic rationale) come at a great cost. For one, they are at the expense of the public’s future purchasing power as they are forced to accept low interest rates to subsidize the personal ambitions of local officials. For another, the state’s exploitation of the financial sector crowds-out private enterprise and market-driven investment projects.
Lacking an independent monitoring system and ignorant of market demands, many of the state’s investment projects will undoubtedly prove wasteful. Consequently, despite their many sacrifices, the depositors who will end up holding the tab are given no say in how their government decides to spend their hard earned savings.