Eight years ago, accounting company Ernst & Young landed in trouble with Chinese authorities for estimating the bad debts in the Chinese banking system at $911 billion (R10 trillion). Since then, China’s bad loan problem has been swept under the rug.
But it may now be back with a vengeance. That has serious implications, both for China’s past – which the world has unquestioningly admired – and the future we can expect.
Since the Chinese government started tightening up on the banking system at the end of 2009, China’s shadow banking sector has grown exponentially. It has provided more than 30 trillion yuan (R51.5 trillion) of loans since 2007.
Together with the formal banking system, loans have expanded by 87 percent of gross domestic product (GDP) since 2006, according to a recent Financial Times report. That is more than double the expansion in US credit from 2002 to 2007, and indicates the potential for a severe crisis.
More than 10 000 so-called local government financing vehicles have been set up to circumvent borrowing limits on local governments. By the end of last year, they held more than 31 percent of GDP in off-budget financing for local governments.
Total debt in the Chinese economy as a proportion of GDP has risen from 130 percent in 2008 to 220 percent last year, with assets in the formal and informal banking sector increasing from $10 trillion (R106 trillion) to $25 trillion.
That is the killer statistic. For the rise in Chinese debt from 130 percent of GDP to 220 percent in only five years shows that debt has risen by 18 percent of GDP a year, over and beyond the increase in GDP during that period.
However, Chinese GDP growth has averaged only 8.9 percent in those five years. It therefore follows that growth in debt during the period was double the growth in real GDP. In other words, net of the increase in debt, China’s GDP shrank substantially from 2008 to 2013.
Of course, some of that debt may be backed by real assets, and hence may represent a real increase in GDP. Indeed, if all the debt were solid, Chinese GDP would indeed have grown at 8.9 percent a year, as officially stated.
However, we know from the anecdotal evidence of empty office buildings and unused super-highways that a very substantial percentage of that new debt is bad.
If one assumes that China’s bad debt losses will prove to be about three-eighths of the new loans put on since 2006, that would make China’s true annual growth in the last five years 2.2 percent.
It would also imply that the net bad debt loss to the Chinese banking and secondary banking systems will be about a third of last year’s reported GDP, or $3.5 trillion.
Presumably, the majority of the funding to fill this hole in the financial system will come from the state, which can afford it since China’s debt is still relatively low. However, running an extra public sector deficit of 7 percent of GDP for five years would destabilise China’s public finances.
In principle it would be possible to raise taxes or cut other government spending to fill the gap, but doing so within what is likely to be an unpleasant recession would be very unpopular. This suggests the government will do as so many Western counterparts have done since 2008: it will print money and increase government debt to solve the problems of the financial system.
Filling in the hole will cause a substantial recession, for two reasons. First, since China’s true growth rate over the past five years has been only 2.2 percent, any substantial slowdown will push the economy into recession. Second, much of the bad debt will be located in the consumer sector.
In addition, wages have been rising rapidly in real terms in recent years. Some of these rises will prove to have been built on sand, as companies can no longer afford to manufacture in China given the higher costs. That suggests that there will be both unemployment and draconian wage cuts. The unrest caused by such a growth hiatus will be considerable.
The outlook for China is thus exceptionally clouded. If all goes well, the country will suffer a substantial recession and return by about 2024 to the level of living standards it thought it had achieved last year. However, the probability of a worse outcome is substantial indeed.