Among
the many inadequately understood facets of China's
post-reform economy is the role of its banking system.
Before the reform, the country's banking assets were
concentrated in a few banks, especially the top four.
The system itself was a secondary instrument in macroeconomic
policy, implementing the overall cash and credit plans
of the state, besides providing working capital support
to state owned enterprises.
The consensus is that the role played by these institutions
has changed dramatically in recent years, with their
involvement in credit provision for investment purposes
having increased substantially. That transformation
came to the fore after 2008 when the Chinese government
decided to launch a huge stimulus package to address
the effects of the global crisis on the Chinese economy.
The resort to the stimulus was in itself not surprising.
Ramping up domestic spending in order to neutralise
the effects of a global slowdown on an economy that
was an export powerhouse made sense. It also served
the rest of the world well by keeping Chinese growth
going at close to 9 per cent.
There were, however, two features unusual about the
Chinese stimulus. To start with the stimulus package
was not designed to rely largely on an increase in
direct government spending financed with its own receipts.
Rather, the increase in spending was to be financed
by the banks that were encouraged to offer huge volumes
of debt to finance spending by government-sponsored,
but off-balance sheet, entities. Second, in a reflection
of the decentralisation of decision-making and implementation,
a substantial part of the additional spending was
undertaken at the provincial level by entities associated
with provincial governments.
One problem was that provincial governments in China
have not been permitted to issue bonds to borrow money
to finance expenditures. In a drastic 1994 response
to evidence that provincial governments had in a borrowing
spree accumulated debts they were finding difficult
to service, the central government imposed a ban on
local governments running budget deficits and issuing
bonds. Hence, when called upon to spend as part of
the stimulus effort, and happy to do so to launch
big, ''prestige projects'' backed by provincial leaders,
they adopted innovative schemes. Principally, these
involved the creation of financial vehicles-like the
Urban Development Investment Corporations-superficially
separated from the provincial government, which were
made to borrow from the banks to finance these projects.
The problem now is the inability of such institutions,
under the aegis of which these projects were being
implemented, to meet their loan commitments. Many
of the projects were financed with non-recourse loans
backed by collateral of uncertain or little commercial
value that could not be easily cashed in case of default.
The future cash flows associated with others such
as toll-based roads, bridges and subways are difficult
to estimate. And some are social sector projects with
an implicit guarantee of a provincial investment holding
corporation, but no explicit commitment to pay.
Though the stimulus shored up China's remarkable growth
rate even in the midst of the crisis, doubts were
soon being expressed about the way it was financed.
According to an audit conducted in the middle of last
year, in the aftermath of stimulus spending, local
government-associated debt had risen to $1.65 trillion
or around 27 per cent of Chinese GDP. In comparison,
central debt was estimated at around 20 per cent of
GDP. The audit showed that outstanding local government
debt rose by 62 per cent in 2009 alone, when Rmb 9600
billion was pumped into the system as part of the
stimulus.
The inability of provincial governments to meet their
implicit commitments seems to be dawning on the centre
with about a third of the loans set to mature by the
end of this year and around a half falling due over
the coming three years. Sensing repayment problems,
the government has reportedly initiated a huge programme
to rollover debts owed to the banks by these borrowers.
The argument seems to be that in time, these projects
would on completion yield adequate revenues, so that
an extension of maturity is the way to go.
With the economy still strong and the government in
command, there is little fear that the problem would
lead to a crisis of the kind that the over-indebtedness
of households and the high debt to GDP ratios of governments
in the West has precipitated. The centre would in
all probability recapitalize these banks as and when
required to keep them solvent. Even early critics
of the policy of restructuring debt by extending maturities,
like the China Banking Regulatory Commission, now
admit that there is no immediate option.
But the wisdom of concealing a proactive fiscal policy,
by making state-owned banks lend to state-sponsored
financing vehicles, which in turn lend to state-backed
projects is now in question. The problem is that though
these are infrastructure projects with an uncertain
future revenue stream, those revenues have to meet
the acquired interest and amortization commitments.
That is at the moment clearly not feasible, necessitating
the restructuring. If the governments had directly
financed the projects, they could, in case of a revenue
shortfall, use other receipts they are eligible to
receive or new revenue sources to cover the difference.
Thus, the experience seems to signal the need for
a change in the policy of financing the large investment
undertaken directly or indirectly by the state in
China. Over the last year, governments in a few provinces
and cities starting with Shanghai have been given
permission to issue bonds for the first time after
close to two decades. The Shanghai issue was hugely
successful reflecting the hunger for government bonds.
But that once again raises the possibility that provincial
government in pursuit of the special interests of
their leaders would resort to excessive borrowing
inadequately backed with revenue generation. The problem
is that, though constrained by the ban on borrowing
imposed by the central government, most provincial
governments in China rely on transfers from the centre
and the sale of lands they control or commandeer to
finance their expenditures. They are yet to establish
any degree of financial independence based on taxation
despite the increase in incomes and inequality in
the system.
There is cause for concern elsewhere as well. Encouraged
by easy liquidity, the credit-financed spending boom
has affected other sectors. Chinese financial institutions
have overextended themselves in the property market
in particular. The exposure of Chinese banks to the
property market is placed at more than a fifth of
their advances. Since the escalated lending has resulted
in a spiral in housing and real estate prices, fears
of a speculative bubble that can go bust have increased.
This would impact on bank balance sheets and solvency.
This problem has been exacerbated by structural changes
induced by liberalisation. Besides the state banks,
especially the top four, that dominated the financial
system as a whole in China, the Chinese financial
structure now includes a host of private banks and
a significant shadow banking system consisting of
trusts and other investment companies. In the initial
flush of the transition that saw banks becoming important
lenders, the big state controlled banks lent to state
owned enterprises and the private banks lent locally
especially to the small and medium enterprises that
have been an essential part of China's success story.
But recent developments appear to have taken the system
in three directions. First, as noted above the state-owned
banks have hugely increased their exposure to projects
launched by provincial government-sponsored entities
that have yet to show adequate returns. Second, the
private banks and trust funds have moved on from financing
small and medium enterprises to financing and fuelling
a real estate bubble. And finally, through their engagement
with the shadow banking system, the larger commercial
banks too are exposed indirectly to the property market
bubble.
These are all the result of the government choosing
to use the banking system as a development instrumentality,
even while relaxing controls on and supervision of
financial firms as part of a ''Chinese way'' of restructuring
the financial sector. In the event, while growth promoted
by the huge stimulus was a beneficial outcome, there
are a host of new problems surfacing. This would possibly
encourage the government to retrace its steps and
strike a new path. Unless membership of the WTO and
the conditions that the government accepted at the
time of entry prove to be obstacles.
*
This article was originally published in the Frontline,
Volume 29: Issue 04, Feb. 25-Mar. 09, 2012.
