China Must Pay the Piper
The world runs on money. From the very individual level all the way to the international, money decides everything. To this end, the modern Chinese state has sought economic growth above all else for the past thirty years. However, China’s GDP growth was -6.8% in Q1 of 2020 due to Coronavirus, the lowest in 44 years, and this could not be worse news. The economic recession brought on by Coronavirus has the capacity to bring chaos to the Chinese lending system and the country at large and it is directly related to the need for growth. For the past few decades China has experienced explosive economic growth, and has been considered by many to be the country of the future. China’s growth was impressive, with GDP growth rate rarely dipping below 10% between 1990 and 2008. However, when the largest financial crisis of the 21 century so far swept the world into economic turmoil, the expected hit to China's GDP growth was surprisingly small and short-lived. Looking at a graph of Chinese NPL ratios (non-performing loans i.e. loans that were not paid back), it is evident that they shrunk from 2.4% to 1.6% between 2008-2009 (FRED). The circumstances beg the question: how exactly did the amount of unpaid loans go down in the midst of a financial crash that crippled every other major country on the planet. It is simple, they lied.
However, before the true extent of China’s debt struggles can be explained, it has to be understood how China got to this point. The current ruling party in China is the Chinese Communist Party or CCP, which has been in control of the country since the end of the civil war in 1949. After the civil war, the Communist Party tested many different tactics in bringing China into the modern age, but none brought any large scale economic growth and some of them killed millions. So many in power thought it apt so see a change of pace so Deng Xiaoping came to power in 1974. Deng was a game-changer as he worked to integrate China into the world order that the Americans had crafted, and allowed China’s demographics and geography to monopolize global production. The ‘Made in China,’ phrase that dominated popular products of all sorts started with Deng modernizing and opening China into the global producer that it is today. The changes in global integration at first yielded many positive results. China started to see exponential GDP growth and growing living standards. But opening up came with an important caveat, as many Chinese citizens, especially those under the age of thirty, became accustomed to better living standards, and began to expect an ever increasing quality of life (Yang et. all). When this expectation was not met, they then made their discontent known. In 1989, the youth took to the streets of Tiananmen Square to express their misgivings for the government. This was in part due to the lack of jobs for newly graduated university students, but it also expressed an anger towards the lack of reform in the government (Bailey et. all). “Workers in state-owned enterprises began to resent the high incomes of many private entrepreneurs and employees of high visibility firms such as Beijing Jeep. Yet they were seldom willing to give up the job security and benefits that come with employment in the state” (Mason). So the government had workers and students who wanted economic and social change, thus the government had two options: reform the government or remove the protestors. The massacre that followed has yet to be acknowledged by the Chinese government. The events at Tiananmen Square taught the Chinese government a precious lesson: keep people occupied and wealthy. If the government fully employed everyone, then no one would have to march on the streets and they could afford a life that they would want to keep (Bailey et. all). But then the question became how to employ everyone, and they decided to offer up free money.
On a small scale in the 90’s and 00’s, the Chinese government offered zero-interest loans for factories or companies that hired that highered a certain number of people. Factories and companies no longer needed to be profitable or even able to pay back their loans so long as they could employ enough people to be an asset to the national government (Bailey et. all). This was effectively a form of stimulus to keep the GDP growth rate high and the unemployment level low. This also meant that when the international market was hungry for cheap Chinese goods, since Chinese manufacturing was the cheapest in the world, and China was building infrastructure across the third-largest country in the world, this system worked fine as shown by the number of WMP needed to keep the economy going before 2008 shown in the figures bellow. However, the system was not prepared for a massive financial crash, so when the Subprime loan crisis hit the U.S., the Chinese government found itself in a difficult situation.
At the start of the financial crash, the government used the five big state-owned banks to funnel the money from the state to the people: the Industrial and Commercial Bank of China, the China Construction Bank, the Bank of China, the Agricultural Bank of China, and the Bank of Communications. Officially, the ratio of Non-Performing Loans to Gross Loans in China in 2008 was 2.4%, and in 2009 it went down to 1.6% (FRED). And that seems highly improbable. During the largest global economic contraction for the past seventy years, the number of loans that were not paid back in China went down by .8%. Here is where Shadow Funding comes onto the scene (Xu). Shadow Funding is the term used to describe the process where state-owned banks in China hand out zero interest ‘Wealth Management Products’ that, in the simplest terms, are non-loan loans (IMF, Dec 2017). But they key is that since they are all not counted as loans they do not get factored into NPL calculations (IMF, Dec 2017). Therefore, in order to gain a full understanding of China’s lending environment, ‘WMPs’ would need to be taken into consideration. That drastically balloons every piece of financial data the Chinese government puts out. As shown in figure one, as of 2016, asset management businesses already had debt at 112.5% of GDP, and accounted for nearly a fourth of total Chinese lending (IMF, Dec 2017). The confusion that follows then concerns how these ‘non-loan loans’ got to be so prevalent in the Chinese lending ecosystem.
In the eyes of the chinese government, their most instrumental task is to keep as many people employed as possible. Before 2008, this task was simple because China was the cheapest producer that could export massive amounts to the U.S. and Europe, so filling factories with thousands of workers provided an efficient system of employment and production. However, the 2008 financial crash drastically changed China’s exporting prospects:
“As an economy that heavily relied on exports, China was severely hit by the financial crisis. Total export decreased from 136.7 billion U.S. dollars in Sept. 2008 to 64.86 billion U.S. dollars in Feb. 2009.” (Acharya et. all)
The factories were when left with millions of people should have been fired since demand plummeted, but the government instead pushed through a 4,000,000,000,000 RMB stimulus package heavily featuring WMPs and other financial products (Acharya et. all). Furthermore, while manufacturing may be the most obvious target for the stimulus, the plurality of it went to the real estate market (Maliszewski). China is one of the largest producers of steel and concrete, and when international demand falls and no one can be fired, there is little left to be done with massive surpluses of steel and concrete. Faced with this excess, it seemed that a good use for these materials would be to build massive ghost cities (Shelton Et All.). Free spending in the wake of 2008 has lead to a massive over-leveraging of the housing sector in China as more and more apartments were built that many may never be lived in, as the Chinese population is projected to start to decrease within the next two decades (Myers Et all.). If giving out large quantities of loans to people who the bank doesn’t know if they’ll be able to pay back sounds like a hellish repeat of Europe’s crash in 2008 then you would be right.
As in figure 5, China’s debt portfolio looks very similar to Europe after 2008. With the infusion of such a large amount of capital at an exceedingly high rate, it later became clear that many of the loans were not of good standing. There is some dispute on exactly what percentage of WMPs have gone bad, hence the ‘shadow’ in shadow funding, but figures 6 and 7 show an NPL ratio of at least more than 20%. For context, the U.S. had an NPL ratio of 5.1% in 2010. In the Chinese economy, many businesses became dependent on these loans, especially in the real estate market, as seen in figure 8. Since capital was so abundant in the system, growth was inevitable. Free money can do alot to ‘rev up’ economic engines, and the CCP always made sure there was money to spare. Trillions of RMB have been given out to companies over the past twelve years to artificially inflate the GDP growth rate of the CCP and maintain an ever-increasing standard of living for its citizens. Due to the frantic delivery of loans during the 2008 crisis, the entire economic system of the Chinese government now faces drastic consequences. The entire system is now rotten to its core. What this all means exactly is hard to explain and varies from industry to industry; however, the simplest summary maintains that a central pillar of the Chinese lending system is hugely over credited and is distinctly unprepared for any more major economic shocks.
As of 2020, China has very few options to deal with this crisis. The obvious solution would be to stop giving out free money (Dobbs Et All.). However, so many corporations had become reliant on WMPs that when the Chinese tried to minorly deleverage them in 2015, some debt corporations had trouble finding financing and had to default (Kang Et all.). This shows that if the government stops offering these loans, their economy would shrink, and the entire point of the WMPs would be defeated, and the attempts at financial stability over the past ten years would have amounted into nothing. The Communist government buys legitimacy from its citizens by providing them with consistent economic growth and better lives; given that the government is now stuck between a rock and a hard place with this potentially unsalvageable system, the government’s legitimacy is called into question.
Economically speaking, there are three types of people: Consumers, Investors, and Retirees. Conveniently enough, these three distinctions roughly match up with three different age groups: Consumers range from age 0-40, Investors are about 40- ~60, and Retires tend to be ~60+ (Lee). If a country has a large population under forty then it is probably classified as a consumer economy, such as Mexico, if the population is mostly over forty, then it is probably an investment-driven economy, like South Korea, and if the population is over sixty, then you have a largely retired community, like Japan. Consumers need Investors to help start their lives by getting mortgages, business loans, or student loans. Investors need Consumers to buy the products they invested in (Lee). And Retires need them both to pay taxes so they can continue retiring. It is the Investors, who are at the top of their earning potential, that the government loves to tax. So a country with a lot of fifty-year-olds but no sixty-year-olds is going to have a lot of extra tax dollars. The only issue is that fifty-year-olds tend to become sixty-year-olds, and if there is no replacement generation, a nation’s economic system can become problematic. China now has an median age of 38.4 years, and in 2040 it’s projected to be 47 years (Textor). Due to the One-Child Policy, implemented in 1980, Chinese families had one child, and Chinese demography has been in slow motion collapse ever since. Now the government is going to figure out how to afford to take care of its elderly without a large enough working population. In a few decades, the young population that fueled the economic growth of the 90’s and 00’s will be taking out their pensions and ceasing their productivity in the workforce. This demographic imbalance does not square well with the debt cycle the Chinese now find themselves in, and there is no way to find a couple of extra hundred million twenty-year-olds overnight.
It is difficult to fully understand just how much debt the Chinese are currently in because it may be simple to think that this is a bubble on its own. It is not. The fact of the matter is that the big state-owned banks are handing out these loans, and it does not matter how big any bank is, the trillions and trillions of dollars of debt simply can not be paid back. The banks may not fold, but they will certainly have to reduce operations. The Agricultural Bank of China, for example, has as many customers as the population of the United States and is primarily responsible for maintaining the liquidity of China’s farms (Forbes). What happens to food prices if this bank has to reduce operations? It is difficult to thoroughly discuss or analyze just how disastrous this could be for China in part because some of the numbers are not explicitly known, and the absolute worst-case scenario, the disintegration of the Chinese state, sounds extreme.
These dramatic circumstances become doubly worrying in the current global climate as the world braces itself against the Coronavirus, and one of the main questions for the Chinese government is, “has the Coronavirus caused enough of an economic shock to cause the WMP system to collapse in on itself ?” At this moment in time, the answer is unknowable. It’s very possible that the virus could topple the system in place, but the full economic consequences are still developing at the local level and are not expected to reach the national or international level until later down the line. If the Coronavirus is significantly economically devastating in China for the rest of this year and possibly the next as well, then the number of bad loans could be too debilitating, and the rest of the world might take notice. But at this early stage, such a statement is pure conjecture. The only thing that can be said with certainty is that the Chinese government is going to keep a very close eye on their loans and the Coronavirus. But it’s highly probable that even if the Coronavirus does not push the system over the edge, then time will. There is no policy proposal, there is no way out. The only option left is to sit and wait for the inevitable.
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Figure 1: International Monetary Fund, and Capital Markets Department. “People's Republic of China : Financial System Stability Assessment-Press Release and Statement by the Executive Director for People's Republic of China.” IMF, Dec. 2017, www.imf.org/en/Publications/CR/Issues/2017/12/07/people-republic-of-china-financial-system-stability-assessment-45445.
Figure 2: International Monetary Fund, and Capital Markets Department. “People's Republic of China : Financial System Stability Assessment-Press Release and Statement by the Executive Director for People's Republic of China.” IMF, Dec. 2017, www.imf.org/en/Publications/CR/Issues/2017/12/07/people-republic-of-china-financial-system-stability-assessment-45445.
Figure 3: Maliszewski, Wojciech, et al. Resolving China's Corporate Debt Problem. Oct. 2016, www.imf.org/external/pubs/ft/wp/2016/wp16203.pdf.
Figure 4: Acharya, Viral V., et al. In the Shadow of Banks: Wealth Management Products and Issuing Banks’ Risk in China. 5 Nov. 2016, pages.stern.nyu.edu/~sternfin/vacharya/public_html/pdfs/ShadowBank-China-AQY-20161111_all.pdf.
Figure 5: International Monetary Fund. 2019. Global Financial Stability Report: Vulnerabilities in a Maturing Credit Cycle. Washington, DC, April.
Figure 6: “IMF Global Financial Stability Report: Risk Taking, Liquidity, and Shadow Banking: Curbing Excess While Promoting Growth.” IMF, 1 Oct. 2014, www.imf.org/en/Publications/GFSR/Issues/2016/12/31/Risk-Taking-Liquidity-and-Shadow-Banking-Curbing-Excess-While-Promoting-Growth.
Figure 7: International Monetary Fund, and Capital Markets Department. “People's Republic of China : Financial System Stability Assessment-Press Release and Statement by the Executive Director for People's Republic of China.” IMF, Dec. 2017, www.imf.org/en/Publications/CR/Issues/2017/12/07/people-republic-of-china-financial-system-stability-assessment-45445.
Figure 8: “IMF Global Financial Stability Report: Risk Taking, Liquidity, and Shadow Banking: Curbing Excess While Promoting Growth.” IMF, 1 Oct. 2014, www.imf.org/en/Publications/GFSR/Issues/2016/12/31/Risk-Taking-Liquidity-and-Shadow-Banking-Curbing-Excess-While-Promoting-Growth.