Fixing China's debt burden will bring pain before it brings relief
Lim Say Boon says while China's debt problems are nowhere near crisis levels, they must be tackled sooner rather than later or they will continue to sap the economy of the vitality it needs to transform
Damned if they do, damned if they don't: Chinese policymakers are in a corner over the country's debt problems. Even with local government debt in the mix, China's total government debt remains moderate and manageable. But it won't stay that way if the credit binge of the past six years continues for even a few more years.
Central government debt is, of course, modest at around 25 per cent of gross domestic product. But that figure has been kept low through Beijing "outsourcing" the financial burden of fiscal stimulus to local governments, which have ratcheted up some 17.9 trillion yuan (HK$22.6 trillion) in debt, according to official estimates. Assuming that the responsibility for local government debt eventually ends up with Beijing, the government debt-to-GDP ratio rises to about 60 per cent.
That figure is still low compared with the figure of about 80 per cent for Germany, which is generally regarded as fiscally prudent, and the figure of around 100 per cent for the US. Never mind Japan, where the ratio is over 200 per cent.
The good news is that the central government can take responsibility for local government debt without too much fuss. It can issue central government paper to take out the non-performing loans at the local government level. And that might actually help advance the renminbi's evolution towards reserve currency status. After all, one of the requirements for a reserve currency is that the government has to issue debt for other central banks to buy.
The bad news is that the Chinese government seems in no hurry to clean up local government non-performing loans.
Perhaps the problem here is not the threat of a crisis but the absence of one, which means there's no urgency to deal with the issue. The mechanisms for dealing with these non-performing loans have been established since the 1990s - from the Resolution Trust Corporation in the US, to Malaysia's Danaharta and the Indonesian Bank Restructuring Agency. But it is worth noting that all these asset management companies were established when systemic crises were clear and present.
Fortunately, a systemic crisis is unlikely in China, given that most borrowers and lenders are government-owned. The banks are state-owned. And most of their loans go to other state-owned enterprises. This is lending and borrowing within the family.
However, the absence of a crisis may encourage the Chinese government to attempt to "muddle through" rather than clean up these non-performing loans, transparently and comprehensively. As a result, the loans may end up hanging over the financial system and economy for a lot longer than might have been the case.
Then there is the overlapping issue of loose lending and dubious credit quality in the shadow banking sector. A recent conversation with a Chinese investor revealed much about Beijing's debt dilemma. It went like this: The investor asked, "Mr Lim, can I continue to put money into shadow banking trust products?" I replied that it might not be wise, given that investors in the Shanxi Zhenfu Energy trust product recently had to take a "haircut" - three interest, or coupon, payments were missed - before a mystery group of "investors" bought out the principal.
To which he replied: "But if that is all that will happen, if the coupon is high enough, it might still be worth missing a few!"
I said there was a risk the government might raise the size of the "haircuts" to frighten off investors. To which, he countered: "But if it does that, how can the shadow banks roll over the maturing trust products? Isn't the government in a corner?"
Touché! Yes, indeed. Our research estimates the shadow banking sector to be worth US$3.9 trillion. As big as that number is, we are at the lower end of the range of estimates, which go as high as US$7 trillion, according to JPMorgan Chase.
Between US$600 billion and US$800 billion of the total is estimated to be maturing this year. They need rollovers. And that's the dilemma. If the authorities clamp down on this, the funds needed for rollovers dry up. The consequence is obvious. But if they don't clamp down, the consequences in a few years should also be pretty obvious.
Apart from local governments, Chinese corporate indebtedness is very high, with estimates ranging from 110 per cent to 150 per cent of GDP. That is way above the figure for most emerging markets (80 per cent for India, 60 per cent for Russia) and 90-100 per cent for developed market economies. This is the product of the race for growth, never mind the quality.
We have seen this before in Southeast Asia, 20 years ago. Then, it was accompanied by a race for corporate expansion, never mind that the weighted average cost of capital was in many cases higher than the returns on equity. If the same has happened in China - and I think we can safely assume any difference is only a matter of extent - a rise in non-performing corporate loans is not far away.
This leads us to China's economic growth model, which the government wants to change from one led by investment to one driven by consumption. Changing consumption behaviour does not happen in a few years. It takes social safety nets, sustained real wage increases and possibly decades for consumer behaviour to evolve.
A stronger currency - which is effectively a transfer from exporters back to consumers - will also help. But that's another dilemma, given the already low manufacturing capacity utilisation.
So fixed asset investment will continue to play an important role in the Chinese economy. Yes, growth of such investment (excluding rural households) has fallen markedly from a few years ago. But, to put things in perspective, it is still running at around 20 per cent year on year. And investment is credit-driven.
China's longer-term economic potential - courtesy of its sheer scale, demographics and urbanisation - remains potent. And the market-oriented reforms announced late last year are steps in the right direction.
But even there, the move away from economic outcomes by bureaucratic fiat to market forces will be painful in its implementation, at a time when deleveraging is also needed. We should not kid ourselves that this transition will be either quick or easy.
Lim Say Boon is chief investment officer in group wealth management and private banking at DBS Bank