Op-Ed Contributors

China no answer to West's credit crisis

By David Roche (China Daily)
Updated: 2010-06-29 07:53

China is set for a hard landing. We now know that much of the credit explosion in 2009 that boosted economic growth went into local government entities where it was wasted on unproductive real estate and infrastructure projects. These entities are mostly insolvent and will create huge bad debts for the banks as credit is tightened this year.

It shows that China has its own sovereign debt crisis and is part of the global leverage problem, not the solution.

China is an economy where bank credit equals 130 percent of GDP - twice the penetration of peer emerging markets and where credit grew by one-third last year, adding money to the system equal to nearly 40 percent of GDP. Worse, the productivity of such lending plummeted; it took 6 units of new credit to create 1 extra unit of GDP last year. It used to take only 1.5 units of credit back in 2000.

We at Independent Strategy Ltd narrowed China's credit bubble down to lending between the State-owned banks and the State-owned enterprises (SOEs). But now the location of potential bad debts is getting clearer, thanks to research by Victor Shih at Northwestern University in Illinois, US.

According to Shih, the rot is located in the so-called local government financing vehicles (LGFVs) belonging to one of China's many levels of local governments ranging from towns and counties to cities and provinces. LGFVs are conduits, like the special investment vehicles (SIVs) were for Western banks, used by local governments to borrow and spend on infrastructure and other projects (like real estate).

Local governments inject land banks, SOEs and cash into a LGFV to give it assets and a capital base for borrowing. Guarantees of LGFV debt by local governments are also common (as are guarantees of one LGFV's debts by another). The usefulness of the LGFV is that it allows a local government to borrow and spend way in excess of its own budget, where normally tax revenues cover only about half of the expenditure (with the rest coming from Beijing). Local governments are not allowed deficit spending.

There are more than 8,000 LGFVs in China, with only paltry information available for all but 100 of them and even for those the information is incomplete.

Local authorities have used LGFVs to divert funds borrowed for authorized projects to other ends (that is, loans for infrastructure spending channeled into real estate speculation by local officials) or to borrow and feed back the proceeds to local governments. LGFVs are predominantly unprofitable, with the debt service on existing debts being funded by further cash subsidies from local governments and additional borrowings.

And they have been financed by asset injections at inflated prices (that is, local government land banks) to dress up their balance sheets and facilitate borrowing, despite often being insolvent.

According to Shih's study, the total borrowing of LGFVs is 11 trillion yuan ($1.6 trillion), which breaks down roughly into 7 trillion yuan borrowed for infrastructure spending and 4 trillion yuan for "other" purposes. These figures match China's domestic credit growth in 2009 of about one-third of GDP and go a long way in explaining the credit bubble (we knew about the lenders, but little about the borrowers).

LGFV debt is big enough to be a potential source of major macro-economic instability. LGFV borrowing adds about another 30 percent of GDP to public sector debt; is equivalent to 25 percent of outstanding bank credit; and more than 80 percent of new bank loans during the 2009 credit bubble. This hidden debt is equivalent to 225 percent of bank equity capital, meaning that a loss-given-default ratio of 30 percent would wipe out two-thirds of existing bank equity.

This LGFV edifice will not survive credit tightening, because it is a Ponzi-type pyramid built upon borrowing more to service existing borrowings. But timing the day of reckoning is complicated by the fact that China's credit bubble is domesticated, because it is built on debts owned and borrowed at home. The LGFV scheme is credit borrowed and lent between State entities or, in the case of banks, between semi-State entities.

So the authorities can fudge and fiddle as they did when a similar, but smaller and foreign-financed, ITIC (investment trust) credit bubble burst in the mid-1990s. LGFV bad debts will be surgically removed together with collateral to the State-owned asset management corporations where they will linger unresolved for a good time (old debts are still there today).

This is a nice rosy scenario, which will undoubtedly be pedaled under the "we believe in the China story mantra" by all those institutions with an interest in doing so. And there's no doubt that ultimately the Chinese will try and navigate this course.

But we can't share such optimism about the outcome. That's because the problem is economically huge. In a nutshell, the LGFV crisis completes the picture of China's bubble, by showing who were the excessive borrowers, to match the excessive credit that the banks pumped into the system.

It confirms that the China story is a credit bubble story of its own and not the answer to the West's credit crisis or growth deficit.

The author is president and global strategist of Independent Strategy Ltd, and author of Sovereign DisCredit.

(China Daily 06/29/2010 page9)