The international community of China-watchers is suffering one of its periodic flaps. China’s debt levels, we are told, are spiralling out of control, and the country is speeding towards its very own version of the Lehman crisis of 2008, except on an even bigger scale.
Several things have come together to feed this latest flap. Last week, the Bank for International Settlements, often called “the central bankers’ central bank”, flashed a red light over something called China’s credit-to-GDP gap, which it said had widened to more than three times the level normally considered dangerous.
Coming on top of China’s annual health check from the International Monetary Fund, which last month emphasised the “the urgency of addressing the corporate debt problem”, the BIS warning revived fears about an impending financial crisis in the world’s second largest economy. A research report from brokerage house CLSA fed those fears further, estimating that bad debts in China’s shadow banking system now exceed 4 trillion yuan.
Then, on Wednesday, news broke that state-owned Guangxi Nonferrous Metals had become the first ever issuer in China’s interbank bond market to be forced into liquidation, after repeatedly defaulting on its debt. To confirmed China bears, this last piece of news was the most significant: proof, they argued, that China’s state-controlled banks are now so fragile that they can no longer protect their own. To them, the bankruptcy was just the tip of an iceberg, and a full-scale financial meltdown can’t be far behind.
Happily, the grizzliest of these bears are wrong. Yes, there are reasons to be worried about China’s debt build-up, but the risk of a 2008-style crisis is not one of them. It is true that at close to 250 per cent of GDP, China’s non-financial sector debt is approaching the levels at which crises struck in Japan at the end of the 1980s and in other economies since. Even more troubling is the speed at which the debt pile has accumulated, with outstanding debt currently growing at around twice the pace of nominal GDP. Such rapid growth, fret the bears, means credit standards must have been lax and much of the capital must have been allocated poorly. With economic growth now slowing, more and more borrowers will inevitably default, they argue.
To a certain extent they are right. Although the bad loan ratio in China’s banking system is low, at less than 2 per cent, factor in the number of “zombie” companies kept from default because banks would rather roll over their loans than acknowledge losses, and the true ratio is many times higher and getting worse.
But that does not mean a crisis is imminent, because in China there is no obvious trigger point. Usually a crisis strikes not because of insolvency – when liabilities exceed assets – but because of illiquidity – when an institution can no longer obtain ready funding. It was illiquidity that led to the collapse of Lehman Brothers in 2008, when other Wall Street banks declined to lend to it any more, afraid they would never be repaid. And it was illiquidity that triggered the Asian crisis of 1997, when foreign investors decided they were no longer prepared to finance Thailand’s current account deficit. But there is almost zero chance the Chinese banking system will suffer a liquidity crisis in the foreseeable future.
Unlike banks elsewhere in the world which are often dependent on volatile wholesale market funding, China’s banks finance themselves largely from a captive pool of customer deposits. The big state-owned banks typically rely on the interbank market for just 10 to 15 per cent of funding. The proportion of wholesale funding at smaller city banks is often higher at 20 to 30 per cent. But as a whole the ratio of private sector credit to deposits across the whole banking system is no higher than 100 per cent. In contrast, the ratio in the US banking system on the eve of the 2008 crisis was around 370 per cent.
In other words, China’s banks are not going to run out of cash as Lehman Brothers did. And even if one or two small local institutions run into trouble, the banking system remains state-controlled. In the event of any localised financial turbulence, either Beijing will strong-arm big banks into smoothing things over, or it will truck in as much cash as it takes to hose the problem down. In short, there will be no financial system meltdown.
Instead the danger for China is that the financial system will continue to misallocate capital to heavy industrial state sector zombies rather than productive private sector businesses. By doing so it may achieve stability – but at the expense of future economic growth.
Tom Holland is a former SCMP staffer, who has been writing about Asian affairs for more than 20 years