China's Xi Jinping made a lot of grand promises over the weekend, pledging a new order where China and Chinese-led institutions such as the new Asian Infrastructure Investment Bank would promote prosperity across the region. But he was on shaky ground -- literally. The Boao Forum where Xi spoke took place in Haikou, capital of China's island province of in Hainan, whose local government, it seems, may not be able to pay its debt this year.
Much has been written about the $50 billion AIIB, which has won support from staunch U.S. allies Australia, South Korea and the U.K., among others. Xi is clearly relishing what looks like a soft-power victory over the U.S., gleefully touting China as a one-stop shop for "markets, growth, investment and cooperation opportunities." Before he starts writing checks, though, Xi should take a closer look at China's own books. Haikou's is just one of many local governments grappling with a $4 trillion-plus debt pile. If Chinese leaders are going to achieve their growing international aspirations, they're going to have to be far more ambitious about getting their financial house in order first.
At 282 percent of GDP, according to the McKinsey Global Institute, China's total debt now exceeds America's 269 percent and Germany's 258 percent. Even more worrying: If the credit buildup continues at its current pace, that ratio will explode to 400 percent by 2018. At those levels, China would be dangerously susceptible to a surge in long-term interest rates that triggers an accelerating series of defaults in economically-vital sectors like real estate. Even if China can avoid a South Korea-like crash, the resulting slowdown could precipitate a second wave of default risks and financial chaos from which Beijing would take years to recover. China would suddenly be an exporter of deflation, not development aid.
Yes, China is still growing 7.3 percent, its potential seems boundless and it's run by smart policy makers who are aware of where the cracks in the system lie. But then, the conventional wisdom said the same of Japan 25 years ago. To gain some semblance of control, Xi's government needs to do three things immediately: cap China's credit bubble, rein in state-owned enterprises and create a mechanism to begin disposing of bad debts. Trouble is, Xi's government isn't doing enough to address any of them.
Take credit growth. For all the rhetoric about tightening the money spigot, aggregate financing continued to accelerate in February to about $216 billion. New yuan loans totaled $164 billion, while M2 money supply rose 12.5 percent. That hardly looks like evidence of a serious crackdown. On Tuesday, the government even lowered the down payment requirement for some second-home buyers, hoping to revive a slumping property sector. Meanwhile, state companies continue to receive copious financing through a shadow-banking apparatus that the People's Bank of China and government regulators pledged to curtail back in 2013.
As for bad loans, no credible estimate exists thanks to the opacity inherent to China's political system. According to the well-regarded Chinese journal Caixin, commercial-bank non-performing loans have swelled for 12 quarters now. As of the beginning of December, Caixin estimated that about $136 billion worth of loans had gone sour. That's not a huge problem for a $9.2 trillion economy, but then the number is rising even before the sharp economic slowdown many observers expect is coming. China's recent move to let local governments convert maturing high-cost debt into lower-yielding municipal notes to be repaid at a future date is a step in the right direction. But it's too small and unfocused to defuse China's debt time bomb.
In order to steer China off its current trajectory, leaders are going to have to tolerate a bigger hit to GDP. They must also quickly build a transfer mechanism to allow banks, state-run enterprises and entire municipalities to dispose of bad loans. One way would be to emulate America's deleveraging strategy following the 1980s savings-and-loan crisis, establishing a series of Resolution Trust Corp.-like entities. "Given that local governments and state-owned enterprises are responsible for the majority of China’s bad debts, write-offs, funded by central-government bonds, will probably be necessary, and soon," writes Zhang Jun of Fudan University in Shanghai in a Project Syndicate op-ed.
If Japan taught the world anything these last two decades, it's that trying to delay the pain only courts deflation -- which already poses a threat to China -- and falling living standards. Last week, Standard & Poor’s downgraded Shenzhen developer Kaisa to default after it failed to make coupon payments on two of its dollar-denominated bonds. Once the defaults begin -- and places like Haikou run out of money -- there's no telling how wobbly China may become. If he really wants to challenge America abroad, Xi would be smart to emulate some of its boldness at home first.
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