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.
Oversupply similarly afflicts the property market. On the residential side, more than 4 billion square metres of housing is under construction, while there may be over 40 million empty flats in the existing stock. The combined total could accommodate 300 million people. A plan is needed to deal with this inventory overhang, or the banking system will face deep trouble for years to come.
Some of the mini-stimulus measures sustain liquidity for local governments and the banks that are exposed to the troubled industries. But this is only a stalling tactic, and will work only if the tide of hot money surges again, which is unlikely. Authorities have to deal with overcapacity and the non-performing loans.
Capacity needs to be reduced for financial stability. The steel industry, for example, has to consolidate into a few large companies. Inefficient mills should close. But local government resistance and banks' unwillingness to expose their non-performing loans are in the way. Therefore, the central government needs a special task force to deal with both.
In the property market, construction should stop in cities where new property is not selling in sufficient numbers to justify extra supply. Local governments have an incentive to keep things going, for the sake of GDP growth. And banks want to sustain the perception that the underlying loans are good.
But the property industry is such a catastrophe that Beijing should set up another task force to clean it up. Vested interests are creating the perception that all is OK, hoping that speculation will revive to bail them out. Waiting will only lead to more waste.
The central government has been focusing on affordable housing and the redevelopment of slum areas. These projects need to take into account the oversupply in the commercial market. Rather than building more, the government should consider offering cash subsidies for citizens who qualify for affordable housing, so they can buy in the market. That won't solve the problem, given that such demand is small compared to the supply overhang, but it would at least cut down waste.
Non-performing loans won't sink China. The country has enough potential in productivity increases to pay off whatever the losses are from the huge policy mistake of 2008. As the bubble deflates, the economy is becoming more efficient. China should be able to handle a loss of 10 trillion yuan (HK$12.1 trillion) over five years. But we must deal with the problem now, rather than cover it up. Holding up bankrupt entities is like propping up zombies and will only increase the cost.
There is no miracle cure for China's problems. Action is needed now to recognise, then solve, the issues of overcapacity and non-performing loans.
Andy Xie is an independent economist