China’s Burgeoning Local Debt Means Debt, Banking System Risk Understated

Victor Shih has done some serious analytical work to try to get a handle on the magnitude of China’s local debt. His post, which included extracts from his op-ed in the Asian Wall Street Journal, shows that some of the narratives about China are woefully incomplete. The whole post is very much worth reading, but here are his main conclusions (hat tip Michael Panzner via Jim Chanos):

Did China accomplish the impossible? Did it generate almost 9% growth and maintain low debt to GDP ratio even as its export plummeted by 20%? What about claims that the torrent of investment in China has come without too much leveraging? After spending half a year looking into the debt level of local government investment entities– some 8000 of them– my conclusion is no. As in the past, the Chinese government just ordered banks to lend to investment companies set up by both central and local governments. Local governments have fully taken advantage of the green light in late 2008 and borrowed an enormous sums from banks and bond investors starting in late 2008 (well, a large amount even before that)….

So basically, in addition to the 20% of official debt-to-GDP ratio, one has to add an additional 30%. We also have to add other debt that the central government guarantees, such as the nearly 1 trillion RMB in Ministry of Railway bonds and bonds issued by the asset management companies. All of this gives China a high debt to GDP ratio. Also, there are some disturbing implications of this high debt. For one, local governments would have to sell lots and lots of land every year for many years to come to pay interest payment on this debt. Thus, to the extent that there is a real estate bubble today, it must continue for local governments to remain solvent. Regardless of what you believe about Chinese real estate, you have to think that this growth in real estate and land prices must slow or reverse at some point.

Yves here. This is consistent with what I heard at a lunch with Josh Rosner and Chris Whalen yesterday, who went on at some length about how awful the Chinese banks were, as in stuffed to the gills with bad loans. They think the idea that China is so well off by virtue of its massive FX reserves is oversold, given the black hole in its banking system.

Shih thinks the central government needs to stop leveraging by local investment companies, take over their debt, securitize it, and peddle it to local and foreign investors. Shih argues that foreign investors will take up this paper as a renminbi revaluation play.

I’m skeptical for several reasons. The act of selling this paper itself would push the RMB up. The early buyers can rely on momentum, but what about the later sales? Moreover, what will be the reporting on the performance on this debt? The US has had more than two decades to create the legal mechanisms and related reporting for securitization of debt to work (and it still wound up with considerable abuse and mispricing). Is anyone going to find the initial and ongoing reporting the underlying assets in this sort of program adequate? Highly doubtful, which means it would need a government guarantee.

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  1. Andy

    meh, I don’t see it.

    China is at the beginning of urbanization, demand for housing is still big. And everybody hold cash. If somebody can’t afford paying his house, there is always somebody coming in wanting to pay that property. Big personal debt at US level does not exist. The market is still primitive that way.

    Instead of bad debt, maybe it’s more a case of slightly over valued real estate. But the chinese public still has gigantic appetite for real estate ownership

    1. MyLessThanPrimeBeef

      Really, everyone holds cash there?

      Duly impressed by their Chinese Exceptionalism, I was hoping to apply for a Chinese Express card. They say, in China, no tycoon would leave his mansion without it.

      1. andy

        with average income of less than $3000/yr, credit card doesn’t mean jack. Like I say, China’s credit market is nowhere near as sophisticated as US.

        The US style debt only exist in urban/wealthy part. Which is a tiny part of china’s economy.

        This is same conversation as “china will collapse” without US consumer market bblaa blaaa blaaa..(and yet there they are clearly saying. 16% export based on US consumer market is dead. time to move on and find new market. 1-2% dip on GDP, big deal. And next year they are projecting 9%)

        and rest assure everybody will say, inflation, over heating, deflation, bla bla blaaa, as anybody has chinese market data instead of winging/extrapolating from US data and lifestyle.

        1. reprobate

          Did any of you actually read the post? Clearly not, lotsa knee jerk reactions.

          This isn’t household debt, folks. That’s America’s story. Did you see any mention of that? Nah. This is lending to businesses, often in real estate, and the loans are clearly bad.

          And we did see that movie, high household savings rate, out of control real estate and corporate debt and big trade surplus. It was called Japan. That movie can most assuredly end badly.

          1. andy

            All large chinese banks are government owned one way or another. And they got $2.4T cash. And their dollar intake is $500B/year.

            They can bail out all their banks ten times over and has pretty dimes to spend, then they can lower the Yuan for even harder trade war.

            So..whatever ..

            I can’t wait until some clever ass hedge fund tries to test the peg (like they test Hong-Kong peg and get burns) Not only China is covered by Chiang mai agreement, $120B, they can crash any hedge fund without feeling a thing. That’ll be some battle to watch.

            I wonder if they have anything to say about dumping their holding and crashing dow 1000 pts. last week because they don’t like that weapon sale.

          2. Yves Smith Post author


            That’s not the view of Rosner and Whalen, who are bank experts. They think the banking black hole will consume a significant portion of the FX reserves.

          3. john c. halasz

            PBoC’s $ for-ex reserves can’t be used directly to bailout China’s banks. From a comment on Michael pettis’ blog, here’s the explanation:

            “Pettis has answered this question so many times that he probably won’t again, but let me try. Reserves are not wealth. They represent assets on one side of the central bank balance sheet.

            On the other side is matching debt. If the central bank were going to donate reserves to the banks to recapitalize them, it would create a hole in the balance sheet, and the net result would be an increase in the net indebtedness of the central bank. Since the central bank is part of the government balance sheet, this increase in net indebtedness would be exactly the same as if the Ministry of Finance borrowed money and gave it to the banks.

            I have left out the fact that these dollar reserves cannot be converted into yuan by the banks without giving them right back to the central bank. The result would be no change in the central bank reserves, higher government debt levels, and recapitalized banks. You would get exactly the same result if the government borrowed money and gave it to the banks. So its the same.”

    2. Costard

      Are you serious? The “beginning” of urbanization? Are you aware that over half a billion people live in Chinese cities? The rest of what you say I can chalk up to hopeful thinking. But this urbanization comment is just grossly ignorant. Calling them barefooted peasants will not endear you to any Chinese.

      As for the rest… good luck. China is a dictatorial, mercantilist economy. You’d have to live in a closet not to know about the currency situation. If you go to bed with thieves, don’t be surprised when you wake up with no shirt.

      1. andy

        Hello, At the end of 2008, China’s total population was 1.33 billion, with 723 million (54%) and 607 million (46%) residing in the rural and urban areas respectively (not including Hongkong, Macau, Taiwan).[1] The rural population fraction was 64% in 2001 and 74% in 1990. The annual population growth rate was estimated at 0.59% (2006 estimate).

        1. Yves Smith Post author

          We’ve discussed this in other posts. China uses an unusually high population density threshold for its urban designation. Under its classification. ALL of Houston and Brisbane would be rural. From an earlier post:

          Back in China, a lot of the so-called “villages” and “townships” are in fact highly industrialised. Qiaotou, home to 64,000 people, produces 60% of the world’s buttons and 70% of its zippers. Songxia with 110,000 people is the umbrella capital of the world: it produces 500mn umbrellas per year. Bordering on the edge of surreal is the story3 in the Wall Street Journal about the “village” of Shaliuhe at the outskirts of the city of Tangshan where a month before the Olympic Games, in order to reduce pollution, 26 inefficient cement factories were dynamited. Workers at the local Dafeng Steel Mill had to take an early vacation.

          1. andy

            It is not the urban size that matter but the movement/potential movement. How many people are there to buy those houses? Which relates to ability of market to keep absorbing those inflated real estate. As the number suggest, people still coming into city and all those people ultimately gonna need to own a place. Since we know wage isn’t collapsing, growth is back and the migration pattern continues, all those houses will get sold. Their money is much more liquid. Most hold cash or cash equivalent. (unlike US, loan, or various market sensitive investment asset.)

            Can’t extrapolate US consumer behavior to understand chinese data.

            re.banking. same thing. The politics and ownership structure, hence capital flows are entirely different than US. Replace invisible hand of market mumbo jumbo with murky political connection, then you get the main pattern differences.

            Like i say, I can’t wait until some hedge fund attacking yuan peg under the usual market assumption. (those model assumption of market behavior doesn’t quite translate.)

            There is money to be made there.

  2. Independent Accountant

    The Chinese banking system is another disaster waiting to happen. In my experience, lax lending standards by Chinese banks is permitting many Chinese companies to stay afloat which should long ago have failed.
    I am with Chanos on China. It’s an economic disaster waiting to happen.

    1. psychohistorian

      I chuckled a bit as I read the comment, replaced China with US and instead of waiting for disaster to happen we are in the ugly beginning of a catastrophic meltdown.

      Otherwise I expect it is an apt comment.

      1. andy

        with high trade surplus, low debt and gdp growth back?

        And china is the one about to implode? whew, didn’t they say that about japanese economy for the past 2 decades. And china’s real estate bubble is much smaller than japan’s in the 80;s.

        1. Yves Smith Post author

          China does not have low debt. Shih debunks that in his article, and we discussed that in and older post:

          For instance, the notion that China has a low government debt to GDP ratio is a canard once you factor in liabilities of local governments. bonds guaranteed by the Ministry of Finance and the central bank as part of the 2003 bank bailout, explicit guarantees of the debt of the three “policy banks” and other off balance sheet liabilities. Adding them yields a public debt to GDP ratio of 62%, comparable to most Western European nations.

          And you are wrong about the comparison to Japan. The relevant time frame would be pre the bubble implosion, in the 1980s. Go read the press about Japan then. Businessmen saw it as an unbeatable force. Books like Japan as Number One were best sellers. And you heard almost nothing in the way of countervailing views.

          1. andy

            that’s what I just said.

            1. compared to japanese bubble, the chinese bubble is tiny. and the chinese has much bigger surplus and deeper potential growth. This on top of murky transparency.

            2. Japan survive one of the biggest bubble collapse, because they have gigantic trade surplus and strange government controlled pension system. Which means they can go into deep debt without even defaulting as long as the people doesn’t revolt. The japanese has almost zero non yen debt. Basically, they live within their mean albeit strangely allocated. Greece, Iceland, etc owes boatload of external money and they don’t produce anything. It’s pure ponzi scheme.

            US? screwed, It’s industrialized nation in decline, but keep spending like it’s the halcyon day of postwar baby boomer.

          2. Yves Smith Post author


            Did anyone here talk about China defaulting? Shih says the local government vehicles will default, but no one was talking about China defaulting. Please read more carefully.

            Chinese residential real estate and urban center real estate is overvalued, and its stock market arguably is, and it has a considerable amount of over-investment in manufacturing capacity. The argument here was never that China faced a real estate bubble, but China’s banks were in trouble in 2003, and the Shih analysis says that we have another wave of big bad loans and no clear rescue path.

          3. andy

            Chinese residential real estate and urban center real estate is overvalued,”

            Is there any city on the planet in a country that experience high growth that doesn’t have overvalued real estate? San Francisco is perpetually over valued. half of manhattan are over valued crap. (now it’s just crap nobody wants to buy)

            Want over valued? how about Hong Kong or Moscow real estate, you don’t hear bankers on TV ever talk about that on TV, despite having much worst effect when it burst. Nobody can afford Hong Kong real estate unless you are a russian oil mob tycoon. (hint: there is a big media war against china right now. Related to Iran sanction. Bad mouthing china’s economy is the fashionable thing to do. About as interesting as “china decide to ban eating dog meat” news.)

            “and its stock market arguably is, and it has a considerable amount of over-investment in manufacturing capacity. The argument here was never that China faced a real estate bubble, but China’s banks were in trouble in 2003, and the Shih analysis says that we have another wave of big bad loans and no clear rescue path.”

            capacity schmapacity. All they have to do is quit making walmart junk, pay their own worker better wage and make junk that their own people want to buy.

            You are not talking about subsaharan nomad here. but a civilization that sit at the other end of silk road. You don’t want to ask if asian can consume or not. Or if there is enough capacity of anything to satisfy those consumption. Ostentatious consumption is what Chinese empire was about. They’ve been consuming luxurious goods for 3000 years. They know more about fine craftmanship than anybody. (That’s the reason 17th century european trade begun, remember?)

            Manhattan will be a semi barbarian peasant village after the chinese done with their “consuming”. Stop worrying about asian not consuming, and start worrying if the planet can survive asia consumers.

        2. Yves Smith Post author


          Rosner and Whalen never said the FX reserves would be used directly to deal with the banking system problems, but most observers use the FX reserves to argue that China is robust fiscally (which reflects an imperfect understanding) when a look at the banking system gives quite another picture.

  3. Daniel

    Chinese communist assignats would come up under some kind of securization à la Wall Street :)

    What a joke and a good one. The sad thing is that someone smart and credible would put out this kind of nonsensical proposal. We have not being spared these recent years as “investors”…

    Successful investment in the coming years will strictly be regressive in its format. No way that you can trust anything out of sheer direct ownership, possibly full or at least majority-stake.

    Of course, this looks plain right. China is not on the perfect track. It is leaky in terms of finance. A lot of money will lost. And we’d be quite lucky if the tensions that will arise are resolved pacifically.


    This isn’t new, there have always been a lot of bad loans which have been paid off more or less through the recycling of massive trade surpluses. Except their surplus is narrowing. What’s that black swan ? China devalues in 2010 to support exports.

    Their hysteria over long planned sales to Taiwan should give pause as to China’s true internal political situation.

  5. Glen

    I’d like to know how the Chinese can pump more liquidity into their system in January (ie lend) alone than the entire previous quarter and yet have an inflation rate of 1.5%. It’s all a lie.

  6. NotTimothyGeithner

    The real danger is whether the Han regime lashes out in the face of economic collapse and rebellion by the non-Han. Its happened before.

  7. KFritz

    China is a de facto fascist state, with a leftover Marxist-Leninist ideological overlay, and an underlayment of Confucian psychology. It’s a hybrid-command, quasi-commmand, soft-command economy. In the event of a financial implosion, this will color its oligarchy’s response. The response can’t be adequately discussed without reference to a range of responses not available to the representative governments of the world’s other large economies.
    I’m interested to read responses from anyone who understands this idea and who has an economics background and insight regarding China. Thanks for any responses.

    1. plschwartz

      China is not any of these Western descriptions of statedom.
      China is China and has (as Hill Gate 1996 has shown) has had the same basic feudal structure since the Song Dynastic about a millennium ago. Those in power still use whatever means possible to enrich themselves. There are numerous stories of local governments simply taking land build say a cement plant.
      The funds for that cement plant was supplied by the central government for whatever reason and simply appropriated by the local authorities. There is no real law that functions against any level of government.
      Occasionally some of this may reach the central government and a high Manderin is set out to investigate. A few people are hung and life goes on.
      I hate to say it but Shih seems naive. The paper he talks of has no value and never did.

      For our own mythology we believe that Cultures are fragile and new ones can easily be imposed from above. Cheney believed in that myth.
      Mao will all his power could not in the end budge China.
      In final desperation he devised the Cultural Revolution
      Final score China 1 Mao 0

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