Andrew Sheng & Xiao Geng: China's subprime risks

Shallow capital markets and skewed interest rates have led to over-investment in a few sectors

It is now widely accepted that the recent global financial crisis was actually a balance-sheet crisis. Long periods of negative interest rates facilitated the unsustainable financing of asset purchases, with high-risk mortgages weakening national balance sheets. When liquidity in the key interbank markets dried up, the fragilities were exposed - with devastating consequences.

Today, the rapid expansion of Chinese financial institutions' balance sheets - which grew by 92 per cent from 2007 to 2011, alongside 78 per cent nominal gross domestic product (GDP) growth - is fuelling predictions that the country will soon experience its own subprime meltdown. Is there any merit to such forecasts?

The first step in assessing China's financial vulnerability is to distinguish a solvency crisis, which can occur when firms lack sufficient capital to withstand an asset-price meltdown, from a liquidity crisis. During the Asian financial crisis of the 1990s, some countries suffered foreign-exchange crises, in which devaluation and high real interest rates de-capitalised banks and enterprises, owing to the lack of sufficient reserves to repay foreign-exchange debts. In the case of Japan's asset-price collapse in 1989, and again in the United States in 2008, bank recapitalisation and central-bank liquidity support restored market confidence.

The recently released Chinese Academy of Social Sciences National Balance Sheet Report suggests that China is unlikely to undergo a foreign-exchange or national insolvency crisis. At the end of 2011, the central government's net assets amounted to CN¥87 trillion ($14 trillion), or 192 per cent of GDP, of which CN¥70 trillion comprised equity in state-owned enterprises (SOEs). Moreover, at the end of last year, China's net foreign-exchange position totalled $2 trillion - 21 per cent of GDP - with gross foreign-exchange reserves totalling just under $4 trillion.

The concern is China's rapidly increasing domestic debt, which currently stands at 215 per cent of GDP. Since 2008, SOEs and so-called local-government financing platforms have been using loans to fund massive fixed-asset investments, while private-sector actors have been borrowing - often from the shadow-banking sector - to finance investment in real-estate development.

This excessive dependence on credit stems from the lack of adequate funding and the relative underdevelopment of China's equity markets, with market capitalisation amounting to only 23 per cent of GDP, compared to 148 per cent of GDP in the United States. The debt held by non-financial enterprises amounts to 113 per cent of GDP in China, compared to 72 per cent in the United States and 99 per cent in Japan.

But, given that the largest enterprises are either state-owned or local-government entities, their debts are essentially domestic sovereign obligations. With China's total government debt-GDP ratio amounting to only 53 per cent - much less than the America's 80 per cent and Japan's 226 per cent - there is sufficient space to undertake debt-equity swaps to tackle the internal-debt problem.

Of course, China's leaders will also need to pursue major fiscal reforms, including improved revenue-sharing between central and local governments. In the longer term, the authorities must put in place stricter regulations to ensure that local-government infrastructure investments are sustainable and do not depend excessively on revenue from land sales.

In the interim, the burden of adjustment will fall largely on monetary policy, which will be particularly challenging given the structural "tightness" in liquidity in the more productive sectors. From 2007 to 2011, China's money supply increased by 116 per cent, whereas its foreign-exchange reserves grew by 180 per cent. The excess was mopped up through statutory reserve requirements amounting to as much as 20 per cent of bank deposits.

With the official banking system thus constrained, it allocated the remaining credit to large enterprises and those with sufficient collateral, resulting in an uneven distribution of loans across regions and sectors. As a result, large enterprises - mostly SOEs, which enjoy considerable financial subsidies and liquidity - accounted for 43 per cent of total bank loans in 2011; small and medium-size enterprises (SMEs), which face financial repression, including higher borrowing costs and tight liquidity, accounted for only 27 per cent.

This highlights two fundamental structural imperatives. First, large SOEs and local governments must be discouraged from over-investing, which undermines the rate of return. Second, more capital must be channelled toward the SMEs and faster-growing regions, which are more likely to generate jobs and innovation.

In other words, interest-rate reforms must be pursued alongside capital-market reforms that boost access to credit by the more productive sectors. China cannot complete its transformation from an export-led economy to one driven by domestic consumption and services unless value creation through innovation exceeds value destruction from excess capacity.

In short, despite a strong national balance sheet and ample central-bank liquidity, China is confronting a localised subprime problem, owing partly to high reserve requirements. One promising move is the central bank's recent release of CN¥1 trillion in liquidity through direct lending to the China Development Bank for the reconstruction of shanty towns, fulfilling the need for socially inclusive investment. Unlike the United States Federal Reserve, it has not purchased subprime mortgages.

The key to success will be to manage the sequence of liquidity injections and interest-rate reforms so that the effort to address local subprime debts does not trigger asset-price deflation, while reducing financial repression that cuts off funding to more productive sectors and regions. If it manages to get these structural reforms right, China - and the rest of the world - will be able to avoid the consequences of a hard economic landing.

Andrew Sheng is Distinguished Fellow of the Fung Global Institute and a member of the UNEP Advisory Council on Sustainable Finance. Xiao Geng is Director of Research at the Fung Global Institute
Copyright: Project Syndicate, 2014