A China crash in the making?
G. Bin Zhao says China's current economic difficulties, including the scale of its government debt, are not as severe as many fear, and are to some extent a temporary result of reforms. Andrew Collier is less sanguine, warning of worse to come if cash-strapped local governments fail to find alternative sources of revenue, as land sales dry up
G. Bin Zhao and Andrew Collier
'Short-term problems will neither hold up nor distort China's sustainable development'
Each time China's economy faces difficulties, talk of a collapse tends to surface. Some voices are driven by concerns about their investments; some are looking for speculative opportunities; others might just be following the trend, unable to draw their own conclusions. In any case, it's always necessary to think critically and deeply when absorbing new information, regardless of how authoritative the source may be.
So, what is the true picture of China's current economic situation? Will the country's stretched bank credit lead to a financial crisis? How severe are the debts accumulated by local governments and the shadow banking sector?
As I have said before in these columns, I expect China's economy to face a rough ride in the next few years as the new leadership introduces major changes. The current policy transitions, which are the root cause of the recent pain, combined with slower growth, have exposed major problems, such as the cash crunch in banks. But these short-term problems will neither hold up nor distort China's sustainable development, because at the core of these changes are reforms which are designed to facilitate a much healthier and better economic future.
China's top leadership has decided to follow a slower path; however, local officials, and even some ministries, as well as executives of the major banks and other state-owned enterprises, have demonstrated they are not yet ready to adapt. This is the root cause of the current tensions related to bank liquidity, shadow banking and local government debt.
More specifically, gross domestic product growth averaged 10 per cent for the past three decades; now the official target is 7 per cent. A reduction of nearly one-third can mean a lot for many industries, not to mention provinces and municipalities.
As an example, during the recent bank liquidity shortage, there were many concerns raised, mostly from the international media and various foreign institutes, that this may lead to a financial crisis in China. But these doomsayers are too pessimistic.
Chinese banks might not be as efficient as their peers in the US and Europe, but, despite the slight increase in non-performing assets due to the economic decline over the past year, they are far more healthy and profitable than many would believe.
Though many banks are public companies, the state owns most of the major ones and government policy still steers their commercial activities. For instance, the senior executives of the big four are appointed by the government and they tend to bear more of the political responsibilities, while mid-level managers are more performance-driven.
Additionally, China faced a lack of liquidity in the inter-bank market, not a real credit crunch, as many said. One of the most important reasons for the crisis was that the People's Bank of China refused to provide more liquidity when the banks expected it. Bankers underestimated the determination of the top leaders to enact policy changes, which means there would be no stimulus for the real economy and the banking industry. Banks must be prepared for market adjustments.
Some argue that the surge in shadow banking in China is threatening its economy. According to estimates, the value of funding in the shadow banking sector reached approximately 20 trillion yuan in 2012 (HK$25 trillion), not inconsequential when compared to a 52 trillion yuan GDP and 130 trillion yuan in total bank assets.
Among all the banks directly engaged in the shadow banking sector (with more than 90 per cent of the shadow banking activities), wealth management products accounted for 7.5 trillion yuan, 5.7 trillion yuan were entrusted loans, and 6 trillion yuan were bank accepted bills. Due to its huge size, the shadow banking sector has indeed challenged China's financial stability and diluted the effectiveness of the central bank's monetary policies, but we cannot neglect the fact it is the result of market demand for diversified financial products. Shadow banking has generated a large amount of profit for the banks; in the meantime, it has also promoted the real economy. For instance, the majority of wealth management products are converted into loans, trust products and bonds, and flow back to businesses.
To minimise the potential hazards, Chinese regulators have strengthened the supervision and monitoring of shadow banking since the beginning of the year. As Dr Li Yang, vice-president of the Chinese Academy of Social Sciences, recently pointed out, shadow banking represents the emergence of innovation in the financial sector and will not draw China into a financial crisis; but the real challenge for regulatory authorities is how to provide effective and gentle management.
Finally, China's local government debt became a major concern after the downgrading by Fitch and Moody's. I wonder whether these rating agencies ever notice local debt risks in the US, especially since Detroit has recently filed for bankruptcy with debts of at least US$18 billion. Will these agencies downgrade the triple-A rating of US government bonds, which is much higher compared to China's? Chinese government debts, both centrally and at the local level, are much less than those in the US. Consequently, the credibility of these rating agencies must be doubted.
Nevertheless, Detroit's bankruptcy is an alarm call for all governments, including those in China. While there is no comprehensive updated official data for local government debt, according to the latest sample data collected in June by the National Audit Office, in 2012 there was a total debt of 3.85 trillion yuan owed by 15 provinces and their capitals, as well as the three municipalities of Shanghai, Tianjin and Chongqing , and three of their municipal districts.
Clearly, this figure might disappoint many analysts who believe local government debt is a major risk. Furthermore, 78 per cent of these debts are loans from the banks, and 12 per cent are bonds. So how bad can it be?
There are indeed many signs that China's economy is at a difficult point, but the country is still in much better shape than the US and Europe. The European economy is shrinking, and there are many hardships holding back the recovery in the US. Therefore, it is clear the global economy cannot afford a Chinese collapse. So, why do so many people want to see the dragon fall?
G. Bin Zhao is an economist and co-founder of Gateway International Group, a global China consulting firm, and executive editor at China's Economy & Policy
'Financial pressure on local governments is only likely to build'
President Xi Jinping has ambitious plans to reform the economy. Ending the land grab among local governments should be top of his list.
For years, escalating land sales have been a valuable source of revenue for cash-strapped local governments. Each time Wenzhou , Fuzhou or other cities agree to a licence for a new high-rise apartment block, the local government earns a hefty chunk of cash for the land that is sold to the developer.
Land sales now account for an average of 40 per cent of local government revenue, up from 10 per cent just a decade ago. In some cities, the sale of land is the main source of income. That free income is beginning to decline as governments run out of land and the property bubble runs out of steam.
There is a reason for the giant land grab: local governments are desperate for new sources of revenue to pay for local social services and to keep the engines of the economy churning at high levels.
Local governments are responsible for everything from retirement income to health care for their citizens. Since fiscal reforms in 1994, local governments' share of the tax revenue has decreased to 40 to 50 per cent but they have been responsible for 70 to 80 per cent of expenditure. Outside fees – mainly from the sale of land – account for the difference.
Take Zen township in Zhejiang, studied by Lynette Ong of the University of Toronto. During one recent fiscal year, the town gave most of its 319 million yuan (HK$400 million) in revenue back to Beijing, keeping just 15 million yuan. To pay for the lion's share of its 88 million yuan budget, which included urban and rural development, education and health care, the town earned 71 million yuan selling land.
Another big incentive for local officials to sell land is to create glamorous projects to aid their chances of promotion. According to Victor Shih from Northwestern University and researchers at Peking University, drawing in revenue from outside the province boosts an official's chances of being promoted more than increasing gross domestic product. And what better way to show off leadership qualities than a new stadium or the proverbial "bridge to nowhere"?
Now, though, many of the best pieces of land in the city centres have been sold. According to a study by the National University of Singapore, by 2007, the average tract of land sold was 50 per cent farther from the city centre than it had been just four years earlier. That trend has accelerated.
This year, according to local developers, Guangzhou is trying to double revenue from land sales to 48 billion yuan. Guangzhou is now offering three new central business districts, but they are located in less valuable areas on the outskirts of the city centre. Xi'an is asking developers to prepay tax on land the developers haven't even bid on. "The government is mortgaging against future land sales," the chief executive officer of one Xi'an developer told me in March. Also – and a bigger concern for China's economy – there are hints that the escalation of property values and thus land prices is easing. Home prices on the mainland rose for the 12th straight month in May, but the pace of growth continued to fall.
The average price of new residential properties in 100 cities rose just 0.81 per cent from April, to 10,180 yuan per square metre. That compared to a 1 per cent gain in April and March's 1.06 per cent rise.
No one can say for certain whether China is suffering from a property bubble or when it may collapse. But land is not an endless resource. That revenue must come to an end.
What can replace it? Beijing has been testing local property taxes. Apart from bringing much needed income, these taxes would impose a cost of ownership on property, crimping the use of flats as a cheap "bank account". Owners are baulking but these taxes would be a rational source of income for local governments.
More ominously, the revenue gap is increasingly being filled by China's growing shadow banking system, in which companies and individuals feed their excess savings into everything from residential buildings to white elephant projects, many backed by local governments through side companies called local government financing vehicles. While it's nice to see Chinese capital escape the claws of the state sector, the lack of regulation is a real concern.
The past decade's big land boom has been bad news for rural homeowners forcibly evicted from their ancestral villages. At a recent conference at Sun Yat-sen University, activists called for greater protection of the rights of homeowners.
"The effects of urban development, demolition and eviction on tens of millions of Chinese citizens have been profound," notes Eva Pils, a lawyer and expert on land rights at Chinese University of Hong Kong.
Until there is a new revenue system in place, the financial pressure on local governments is only likely to build. That means more dangerous financial games by local governments and more residents evicted from their homes.
Andrew Collier is the former president of the Bank of China International’s US office. He is currently an independent analyst based in Hong Kong