China must allow bad loans to fail for the good of its economy
Andy Xie says China must tackle the related problems of overcapacity and high leverage to stabilise its financial system, and this requires resolve to sort out bad loans and the property market in particular
China's structural reforms have stalled. The decision to deepen reforms, taken at the Communist Party's third plenum last autumn, has produced few tangible results so far. Worry over financial stability seems to be a major factor in blocking meaningful reforms.
The recent measures, marketed as a mini stimulus, aim to shore up financial stability. The targeted reductions in deposit reserve ratios, for example, are helping some banks that are experiencing a liquidity crunch due to mounting non-performing loans. Mini-stimulus measures, like the redevelopment of urban slums, channel loans to local governments that need new loans to service the existing ones. Such measures merely prolong the unsustainable status quo.
China has stimulated the economy with debt since 2008. Most of the current debt stock is from the period after the global financial crisis. Local governments, property companies and supporting industries, as well as property buyers, leveraged up to absorb the debt. Rising leverage and land prices - the primary collateral - formed a temporary equilibrium that channelled money into overinvested industries.
Overcapacity and high leverage pose a mortal threat to financial stability. The former destroys profitability of capital- intensive industries and their ability to pay banks. Overcapacity isn't limited to commodity industries. Residential and commercial properties have massive oversupply, as does the financial industry, pumped up by the credit bubble.
The current stabilisation measures merely keep everyone afloat. But, as long as overcapacity remains, more of these measures are needed to prolong stability, because industries with overcapacity bleed cash and always need money to stay afloat. The stabilisation measures will never lead to a solution.
China must deal with overcapacity to stabilise the financial system. Cutting some capacity will expose some bad loans, lower gross domestic product, and hurt the revenues of some local governments. But overall profitability will improve and banks will be able to function normally again. The steel industry, for example, suffers from serious overcapacity. The post-2008 stimulus artificially boosted prices. Local governments saw expanding steel mills as an easy way to increase GDP and fiscal revenue. Now the bubble is deflating. Steel prices are down 40 per cent from the peak.
Obviously, profitability has crashed. But local governments have protected their steel mills from closure by persuading banks to roll over loans and add some more. The longer the situation lasts, the more value is destroyed, and the more losses the banks will eventually suffer.