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News
Why we should worry about China's web of debt
Editorial by Jeff LoCastro, Founder of North Central China Real
Estate Association-7 Feb 2013
Around the world high and unsustainable sovereign debt is causing
problems. Hardly a week goes by in Europe without the threat of a
country defaulting on its debt repayments. In the US, the debt
ceiling keeps getting raised. China on the other hand has generated
the image of a sovereign state whose debt is minimal and whose
spending is sustainable. Scratch the surface and you see a more
troubling picture.
Most things in China operate just below the surface. Anyone who is
doing business here full-time (not the business traveler) knows this
all too well. Things are never quite what they appear. The debt that
China incurs is not central government debt, but local government
debt, and local governments are intent of building a House of Cards
whose eventual collapse seems inevitable.
The web of debt
Local governments borrow from Chinese banks who are owned and
controlled by the Beijing government to provide economic subsidies
and general growth funds to maintain the country’s economic
trajectory.
These banks are borrowing on huge scale. In 2010 local debt reached
RMB 10.7 trillion (USD 1.7 trillion). In 2011 another RMB 2.15
trillion was added.
The 2x Rule
In actuality, I would suggest that the 2011 debt level is closer to
RMB 24 trillion (USD 3.8 trillion) under the “2x Rule”, my rule of
thumb I now apply to most Chinese economic statistics. The 2x Rule
states that a statistic that is owned by the Chinese government
should be multiplied by 2 or divided by 2 (depending on which result
is the positive or the negative) in order to discern the true value.
However, even without applying the 2x Rule, in 2010 local
governments made up an astonishing 80% of all bank lending. If the
Central government is owning that figure on it’s face, the debt
situation is clearly out of control. Having local governments borrow
to drive economic growth instead of the Beijing government is akin
to hiding expenses in a shell company so that the parent appears
profitable.
Not passing the smell test
The problem is that it’s the central government that still owns the
debt and is responsible for making it good when defaults occur.
Although individually branded banks are making all the loans, the
banks are state owned enterprises and are the tools of the Beijing
government. This play is akin to Company X setting up Company Y for
the purpose of making loans to Company Z for the express benefit of
Company X. In most business quarters such an arrangement would never
pass the smell-test.
Supporting false businesses
So, where’s the money going? It is no secret that China delivers
massive subsidies to its people and industries. It’s everywhere and
in every city and most are invisibly obvious.
For example, in Changzhi City (pop. 3.5m, Shanxi Province) if one
walks down any one of the major thoroughfares you will observe row
after row of enormous 4, 5 and 6 storey “malls” each easily 400,000
to 750,000 square feet (38,000 to 70,000 m2). Each floor in each
building accommodates row after row of vendors sitting in 8′ x 8′
cubicals each selling identical items as the vendor in the next
stall. On one floor alone one may routinely find 50 – 100 vendors
selling exactly the same hair clips, pants, shirts, wallets and even
toilets at exactly the same price as the guy in the next booth.
Imagine walking into a mall in the west where each store sells
exactly the same items at exactly the same price. It wouldn’t work.
But in China they don’t care.
These businesses are not about selling anything, its about the
government giving them free rent, a cot on the basement level to
sleep, money to buy their initial inventory and an hourly stipend.
At the end of day the “hair clip” vendors, for example, settle-up
with each other, the money is pooled and split and used for that
evening’s noodle bowl. While you can buy things in these malls, but
these are false businesses meant to simply keep people busy.
False value cannot repay real debt
The problem is that it provides only Opportunity Returns and minimal
value to the economy in terms of Accountable Returns. Therefore,
there is no practical way for local governments to service the debt
without more borrowing and more deficit spending. Not withstanding
the massive subsidies provided to build the tens of thousands of new
apartment units each year (166,000 new units in Changzhi City alone
in 2011), this scenario is played out scores of times in hundreds of
cities throughout China.
It’s the local governments that have the burden of borrowing to
create and maintain perhaps millions of these false enterprises and
is encumbered with the task of sustaining growth with no realistic
method of repayment. It’s one of the biggest shell games in the
world.
What does this all mean?
It means that Chinese Government continues to keep its debt off the
books. It means that the Central Government can maintain the moral
high-ground in discussions over the international debt crisis. It
means a real threat of stagflation in China. It means that, although
China is a terrific growth market (and one in which I have staked a
personal claim), the entrepreneur must enter it with eyes wide open
and understand what is going on just below the surface.
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