Is China Actually Bankrupt?

03/30/2010 9:36 am EST

Focus: MARKETS

Jim Jubak

Founder and Editor, JubakPicks.com

Jim Jubak is on vacation the week of March 29 to April 2. We will be reviewing some of his SABEW award-winning columns this week before resuming the regular posting schedule on Monday, April 5.

The nation has erected a complex system for magically making its debts disappear, but a look up China's sleeve shows that its IOUs may equal its GDP.

Is China broke?

It seems like a silly question, right? China's foreign exchange reserves stood at $2.4 trillion at the end of 2009. Yes, China announced that its proposed annual budget for 2010 would produce a record deficit, but the deficit is just $154 billion, or 2.8% of China's gross domestic product. In contrast, the Congressional Budget Office projects the US budget deficit for fiscal 2010 at $1.3 trillion. That's equal to 9.2% of GDP.

But remember the theme of my March 9 column: All governments lie about their finances. At worst, as in Greece and the United States, the lies are bold and transparent. Everybody knows the emperor has no clothes, but no one wants to say so. At best, as in Canada and China, the lies are more subtle—more like a magician's misdirection than a viking raider's ax. Look at these great numbers, the lie goes, but don't look at those up my sleeve.

There's a good argument to be made that if you look at all the numbers, instead of just the ones the budget magicians want you to see, China is indeed broke.

More Debt Than Meets the Eye

Want to see how that could be?

If you look only at the current position of China's national government, the country is in great shape. Not only is the current budget deficit at that tiny 2.8% of GDP, but the International Monetary Fund projects the country's accumulated gross debt at just 22% of 2010 GDP. US gross debt, by comparison, is projected at 94% of GDP in 2010. The lowest gross-debt-to-GDP figure for any of the Group of Seven developed economies is Canada's 79%.

But China has a history of taking debt off its books and burying it, which should prompt us to poke and prod its numbers. If we go back to the last time China cooked the national books big time, during the Asian currency crisis of 1997, we can get an idea of where its debt might be hidden now.

The currency crisis started in 1997 with the collapse of the Thai baht—and then, like dominoes, the currencies of Indonesia, South Korea, Malaysia, and the Philippines collapsed. In each case, the country had built up an export-led economy financed by foreign debt. When the hot money that had been flowing in instead flowed out, that sent currencies, stock markets, and economies into a nosedive.

China escaped the first stage of the crisis because the country's tightly controlled currency and stock markets, and its economy, had kept out hot money from overseas. China had built its export-led economy on domestic bank loans instead. The majority of bank loans, then as now, went to state-owned companies—about 70% of the total, the Congressional Research Service estimated in a 1999 examination of the period.

Those loans were all that kept the doors open at many of China's biggest state-owned companies. In its review, the Congressional Research Service estimated that about 75% of China's 100,000 largest state-owned companies lost money and needed bank loans to continue operating.

That became a problem when, in the aftermath of the currency crisis, China's exports fell. That sent revenue plunging at state-owned companies that were already losing money. Suddenly, China's banks were sitting on billions and billions of debts that anybody who'd taken Bookkeeping 1 in high school could tell were never going to be paid. This was especially a problem for China's biggest banks, all of which had ambitions to raise more capital—and their international profile—by going public in Hong Kong and New York. But no bank could go public with this much bad debt on its books.

What to do? Why not bury the bad debt?

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The Beijing government created special-purpose asset management companies for the four largest state-owned banks, the Industrial and Commercial Bank of China, the Agricultural Bank of China, the Bank of China, and China Construction Bank. These asset management companies—China Cinda, China Huarong, China Orient, and China Great Wall—would ultimately wind up buying $287 billion in bad loans from state-owned banks. The majority of those purchases were at book value.

So how did the asset management companies pay for the purchase of that $287 billion in bad loans? They certainly didn't pay cash. Instead, they issued bonds to the banks in exchange for the bad loans. The bonds, of course, were backed by the promise that the asset management companies would gradually sell off or collect on the bad loans in time to redeem the bonds. And in the meantime, they'd pay the banks interest on those bonds.

Neat, huh? In one swell foop, the state-owned banks got $287 billion in bad loans off their books and turned deadbeat loans that would never pay off into streams of income from these bonds. To read more on this neat bit of financial engineering, check out this research paper (.pdf file).

Of course, that still left the little issue of where the asset management companies were going to get the approximately $30 billion in annual interest they had promised to pay the state-owned banks. There was also the small matter of how they were going to pay off these bonds when they came due in ten years, especially since the cash recovery rate on these bad loans would run at just 20.3% in the first five years.

Fast-Forward Financing

But who really cared? The Beijing government and the state-owned banks had kicked the problem ten years down the road. (A favorite tactic of politicians, Republicans, Democrats, and Communists alike, is to punt, so that today's problem becomes somebody else's problem in the future.) The bonds issued by the asset management companies didn't have an explicit government guarantee, but everybody assumed that at some future date the government would either pay up or punt again.

The ten-year punt of 1999 came to earth in 2009, and, lo and behold, there was more magic.

In some cases—China Huarong, for example—the asset management companies simply declared that they were done disposing of bad debts, that profits were soaring, and that they were seeking strategic partners in preparation for a public offering.

In others cases, the magic was more complex. In October 2009, for example, China Cinda said it had secured government approval for a restructuring plan that would create a company to dispose of the $30 billion in bad loans still on Cinda's books. The company said it would then look for strategic partners in preparation for a public offering.

Who in their right minds would be a strategic partner and investor in one of these asset management companies? Well, how about one of the original state-owned banks, China Construction Bank, that Cinda had bought the bad loans from in the first place. "The hardest thing," China Construction Bank chairman Guo Shuqing said in this October 17, 2009, interview, "is evaluation."

Really? When the government runs the books, does all the accounting, and decides what assets to send where, I think evaluation would be very easy. Any wonder, then, that today's huge run-up in loans—and bad loans—by China's banks is making some critics nervous?

The bigger problem, though, isn't so much China's big banks, but the country's local governments.

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Thinking Globally, Hiding (Debt) Locally

By now, everyone who has a nickel in China, or a dime itching to get into China, knows that the country's banks went on a lending spree in 2009. On top of official government stimulus spending of $585 billion, banks, encouraged by the government, doubled their lending in 2009 to $1.4 trillion from the previous year.
 
(Please remember when judging these figures that China's economy was an estimated $4.8 trillion in GDP in 2009, according to the CIA World Factbook. Estimated US GDP was about three times larger, at $14.3 trillion. So China's 2009 bank lending of $1.4 trillion would be equal to lending of $4.2 trillion in the United States, and China's $585 billion government stimulus package would equal a $1.7 trillion US package, more than twice the $787 billion size of the US stimulus package of February 2009.)

China's banks hit the ground running even harder in 2010, lending out an additional $309 billion in January and February. If the banks had continued at that rate, they would have passed the official lending ceiling of $1.1 trillion by August. (See my January 14 column for more on the lending boom and its results.)

So China's banking regulators, spooked by the increase in bank lending, tightened the reins. For 2010, they set a lending target 20% lower than 2009 lending levels. They raised reserve requirements so banks would have less capital to lend. And they told banks to hit the capital markets to raise an estimated $90 billion through 2011. (See this blog post for more.)

It's not clear that those steps will be enough to balance the huge number of bad loans that China's banks made during the lending boom. But China's regulators have clearly learned a lot about how to address a bad loan problem in the banking system since the 1997 currency crisis. But as our own Federal Reserve has so amply demonstrated over the past decade, regulators tend to gear up to fight the last war. That leaves them vulnerable to the next crisis precisely to the degree by which it differs from the last one.

China's new debt problem is the thousands of investment companies set up by local governments to borrow money from banks and then lend it to local companies.
 
By law, China's local governments can't borrow directly. But the incentives for local governments to set up investment companies were huge.

By making loans to local companies, local governments could produce thousands of jobs and drive up the value of local enterprises. And by funding commercial and residential construction, they could drive up the price of land. Those results were important to local officials who often profited personally, but they were also essential to the survival of local governments. By law, those units also aren't allowed to raise their own taxes for local expenditures. To meet local demands—and to fulfill the directives issued by Beijing—local governments are dependent on frequently inadequate revenue transfers from Beijing and what they can collect from such transactions as local real estate sales.

So how much did these investment companies borrow and then lend?

Local government investment companies had a total of $1.7 trillion in outstanding debt at the end of 2009, estimates Victor Shih, an economist at Northwestern University and the author of Factions and Finance in China. That's equal to about 35% of China's GDP in 2009.

In addition, banks have agreed to an additional $1.9 trillion in credit lines for local investment companies that the companies haven't yet drawn down, Shih says.

Together, the debt plus the credit lines come to $3.8 trillion. That's roughly equal to 75% of China's GDP.

None of this, Shih points out, is included in the IMF calculation of China's gross-debt-to-GDP figure of 22%. If it were, the number would be closer to 100%.

NEXT: So Why Is This Number So Important?

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Savings Aplenty, But for Whom?

Exactly how important is this number?
 
It depends on how many of those loans at local investment companies will go bad. Shih estimates that about 25% of current outstanding loans—totaling $439 billion—will go bad. (For comparison, remember that in the aftermath of the 1997 currency crisis, the newly established asset management companies swallowed $287 billion in bad loans.)

It also depends on how much of China's huge reserves and huge base of personal savings are available to offset the debt. So far, I've been talking about gross debt. But China, like Japan, has a huge domestic pool of savings it can use to buy debt. Economists point out that Japan has carried what looks like a crippling gross-debt-to-GDP ratio for years—188% in 2007, 197% in 2008, 219% (estimated) in 2009, and 227% (projected) in 2010—without disaster, because the country funds its debt internally from savings.

China, the argument goes, could easily do the same, so what's the problem?

The problem for both China and Japan is that it's not clear exactly how much of their huge pools of domestic savings are actually available in the long run to buy debt. Japan has a woefully underfunded retirement system, and it's by no means clear how the population of the world's most rapidly aging country is going to pay for retirement.

China has, for all intents and purposes, no public retirement system. As a result of its one-child policy, the country has also begun to age quickly, and by 2030, its population will be as old as that of the United States.

In the US, the national accounts may lie about the effect of the problem by putting Social Security and Medicare off-budget on the argument that, since these programs have their own dedicated revenue streams, they don't count as part of the national debt. But that lie aside, because the benefits of these programs are defined, it is possible to put a dollar figure on the government's future liabilities in this area (with all the uncertainty that comes with forecasting inflation, of course).

China isn't hiding any future liability for pensions or retiree health care off the books. The government hasn't promised future payments. In an accounting sense, then, there is no future liability that ought to be on the nation's books.

But that doesn't mean China won't have to consume some portion of its accumulated savings to pay for its post-65 population in 2030. The country, either through the government or through private citizens, will have to cover the costs of old age, however it defines that cost. And any savings it will use to pay for those costs really aren't available now to pay current debts.

I think the Chinese leadership is profoundly aware of the need today to not waste money that the country will need tomorrow. That's one reason Beijing has taken steps recently to rein in local investment companies. On March 8, the Ministry of Finance announced plans to nullify all guarantees by local governments for loans taken out by their investment company vehicles. And the national government plans to sell $29 billion in bonds for local governments this year, giving those governments an alternative to setting up local investment companies.

But the big job—the reform of China's tax system so that local governments don't have to rely on real estate and stock market bubbles for funding—didn't make it on the to-do list announced by the National People's Congress this week and last. And I don't think it's likely to with Communist Party leaders jockeying for position to replace President Hu Jintao and Premier Wen Jiabao in 2012. (For more on the effect of politics on economics in China, see this blog post.)

By the time China's leadership team has sorted itself out in 2013, China's finances will certainly look different. There's little chance they'll look better.
 
Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.

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