Most of last week’s Analysis article was dedicated to a discussion on Chinese debt, specifically on how we should think about the Chinese debt structure and on when would we know how much debt is too much debt. Every earlier example of the investment-driven growth model that China follows ran into the problem of an unsustainable increase in debt (once capital began to be misallocated) followed by a credit contraction and an economic crisis. For that reason it is important that investors, analysts and most importantly policymakers understand the way debt risks develop.
I discussed some of these issues in my July blog entry. Interestingly enough, June 1 Reuters reported what many believe is a major new initiative in addressing what has clearly become a debt problem at the local government level:
China’s regulators plan to shift 2-3 trillion yuan ($308-463 billion) of debt off local governments, sources said, reducing the risk of a wave of defaults that would threaten the stability of the world’s second-biggest economy. As part of Beijing’s overhaul of the finances of heavily-indebted local governments, the central government will pay off some of their loans and state banks including some of the “Big Four” will be forced to take some losses on the bad debt, said the sources, both of whom have direct knowledge of the plans.
Part of the debt will also be shifted to newly created companies, while private investors would be welcomed in projects previously off-limits to them, sources said. Beijing will also lift a ban on provincial and municipal governments selling bonds, a step aimed at bolstering their finances with more transparent sources of funding. Many analysts see China’s pile of local government bad debt as a major risk to the economy, especially as the economy slows, but few see widespread banking fallout as they believe cash-rich Beijing can step in to soak up losses.
I was not able to find any mention of this in the Chinese media, but I suspect we will hear more about it over the next few days. How important is this announcement? It is good that the extent of the problem is being recognized and quantified, but this announcement doesn’t do much more than that.
And I think there is a lot of confusion given what I read in Reuters, Bloomberg and other articles. First, this announcement, if it is true, doesn’t much change the risk profile of either the local governments or the banks because they were anyway implicitly or explicitly guaranteed. Second, the real issue here is not who gets to carry the liability, but rather who is going to foot the bill for the losses, and of course that hasn’t been addressed. As I see it there are only three sources of repayment.
1. The government can privatize land and assets and use the proceeds to pay for the losses. This might be very difficult politically right now, but ultimately I suspect that they are going to move in this direction.
2. The government can tax or confiscate wealth from SMEs and the wealthy. This is politically expedient since SMEs don’t seem to have much power as a bloc, but this could cripple long-term growth prospects if it causes SMEs to disinvest.
3. The long-suffering household sector can bear the losses once again, but of course this pretty much eliminates any hope of getting the consumption share of GDP to rise and become the driver of future GDP growth.
It is of course good that they are formalizing and recognizing the extent of the possible losses — everyone’s favorite solution of ignoring the problem is unlikely to have helped much. Perhaps these huge numbers, now that they are quantified and recognized, can push the debate forward, but in my opinion we still haven’t addressed the main issue: how will this debt be repaid and when will they slow down and reverse what has clearly become an unsustainable increase in debt?
China: Unsustainable Rise in Debt? by Michael Pettis
China: Will Increasing Wages Lead to Rebalancing? by Michael Pettis