Mortgaging the Future?
by Tom Orlik
A massive expansion in bank lending has propelled China through the economic crisis, its growth trajectory unbroken. The current leadership will see only the benefits of this lending bonanza. The long-term costs will be faced by the next generation of leaders – their inheritance a bloated banking system and an unbalanced growth model.
In the first three quarters of 2009, China’s banks issued more than RMB 8.6 trillion in new loans (USD 1.26 trillion), an impressive figure. To put it in perspective, it is more than double total new lending in 2008, more than a quarter of China’s GDP, and almost as much as the entire GDP of India. Very high levels of lending, combined with a smaller but still sizeable fiscal stimulus, have enabled China to tough out the global economic crisis.
It is bank loans that have fuelled China’s investment engine, providing the capital needed to keep the economy moving. Across the country, new roads, railways, airports, an improved electrical grid, irrigation for farmland, and an upgraded industrial base are all testament to the success of China’s credit driven stimulus. At a macroeconomic level, the results are equally apparent. France and Germany are creeping out of recession and the US can look forward to negative growth for the year. For the Chinese economy, in contrast, the government’s eight per cent growth target for 2009 is well within reach, and the outlook for 2010 is even better.
The first impact of China’s massive expansion in new lending has undoubtedly been positive. Economic growth has been secured and, with it, employment and social stability. But an expansion in new lending of the magnitude seen so far this year also has other, more negative consequences. With just a few years left in office, China’s President Hu Jintao and Premier Wen Jiabao will probably see only the benefits of the stimulus. For their successors, and perhaps even in the twilight of the current administration, the after effects of this year’s massive expansion in lending will be less unequivocally positive. Asset bubbles and inflation, the return of non-performing loans to China’s banking system, and an increasingly imbalanced economic model depressing prospects for future development are the long-term costs of China’s short-term boost to growth.
From the Bank and into the Bourse
The evidence that a portion of loans issued so far this year is being used to fund speculation on the stock market now appears conclusive. Early in the year, the announcement by the banking regulator that they were sending a team to Shanghai to check up on the illegal use of loans for speculation caused a sharp fall in the market as borrowers scrambled to get their books in order. At the end of July, a researcher in a leading government think tank calculated that nearly RMB 1.2 trillion of this year’s new lending had been illegally invested in shares.
It was new lending, rather than rising corporate profits, that pushed the Shanghai Composite Index up more than 80 per cent from the start of the year to the beginning of August. Fears that the flow of liquidity will dry up, rather than falling corporate profits, have triggered the volatility in the market since then.
China’s equity market is relatively small and its rises and falls have little significance for the macroeconomy. The concern for the government is that inflated asset prices may trigger inflationary expectations and herald a more widespread increase in prices. Industrial overcapacity will keep a lid on price rises, but the massive increase in new lending has created the right conditions for inflation to return to the Chinese economy.
Driven by the expansion in new lending, money supply has grown at a record pace. Increases in the cost of imported commodities, or in the cost of domestic inputs to China’s production process, would now feed through rapidly into higher prices for the goods in China’s consumer price index (CPI) basket.
Bad Loans Horror Show
For the banks, the lending free-for-all of the past nine months will also have consequences closer to home – in the adequacy of their capital base and the quality of their assets. To guarantee their solvency, banks are required to hold capital equivalent to a certain percentage of their assets. As banks’ loan books have expanded, so too the capital requirement has increased.
For some banks, the rapid expansion in lending has pushed them close to the regulatory limit. At least one bank is close to the eight per cent minimum. Other banks, including the big four – Industrial and Commercial Bank of China (ICBC), China Construction Bank (CCB), Bank of China (BoC), and Agricultural Bank of China (ABC) – are slightly better off, but for many the capital adequacy ratio has deteriorated from the position at the start of the year.
With the margin as narrow as it is, in September the banking regulator was forced to back off from plans to tighten up capital requirements. If the regulator had pushed ahead with their proposal to exclude certain risky categories of capital from the calculation of banks’ capital base, it would have drawn a line under the nine-month long lending bonanza. With the recovery still on shaky ground, that possibility rang alarm bells at the highest levels of government and the banking regulator was forced to beat a hasty retreat. The regulator might have backed off, but the to-and-fro on the question of capital adequacy makes clear that the super-rapid expansion in lending has come at a cost in terms of the quality of the banks’ capital base.
Not only have the banks’ capital base taken a hit, the risks to which they are exposed have also increased. At the end of the 1990s, after years of state directed lending, and in the shadow of the Asian financial crisis, the banks were plagued by non-performing loans (NPLs). Estimates at the time placed total NPLs in the banking system at about 42 per cent of total loans. Over the past ten years, those bad debts have been moved off the banks’ balance sheets and asset management companies have been given the job of collecting what they can. At the beginning of the year, the regulator was pleased to report bad loans accounted for fewer than 2.5 per cent of the total.
Although the banks went into the crisis looking much healthier than before, the unprecedented growth in new lending comes at a price. The banks might insist that strict credit controls have been maintained, but with lending in such large amounts, it is clear that some fairly dubious projects have received funding. Political influence on lending decisions means substantial funds have been directed to local government investment projects with limited repayment ability. Overcapacity in the economy, to which new lending has contributed, will also mean lower corporate profits and a higher number of bankruptcies.
Like the villain in a horror movie that you thought was dead, NPLs are set to lumber back to life, and hack a bloody path through the banks’ balance sheets. With the banks’ capital bases also less solid than they were, “NPLs: the Sequel” may be just as gory as the original.
Scalpel or Axe?
Finally, the decision to fund China’s stimulus mainly through bank lending, and only secondarily through a fiscal stimulus, has important consequences for China’s economy. China’s fiscal stimulus is RMB 4 trillion over two years. New lending so far this year is already twice that. A fiscal stimulus in the form of higher public spending is to an ailing economy like a scalpel to a patient in need of surgery – painstaking work that allows for precision cuts. A monetary stimulus on the other hand is like an axe – more effective in the first instance but with a higher propensity to leave the patient a little scarred.
A stronger fiscal stimulus might have taken longer to get to work, but the government could have directed resources at areas that boosted growth at the same time as addressing some of the deep imbalances in the economic model. Investment in health and education systems and strengthened support for pensioners would have bolstered growth. At the same time it would have addressed a major structural challenge – freeing up households’ resources for higher levels of consumption.
A stimulus channelled through the banking system, in contrast, has resulted in a massive increase in infrastructure investment and industrial capacity. This is not money wasted, and the impact on short-term growth is clear. But neither is it doing anything to boost household consumption, and steer the economy away from its reliance on foreign demand and very high levels of investment as the main drivers of growth.
The great economist John Maynard Keynes is said to have once remarked that “in the long-term we will all be dead.” Hu Jintao and Wen Jiabao, closing in on the end of their time in office, might well add “or someone else will be in charge.” The global economic crisis presented China’s leaders with a pressing short-term challenge – the collapse in the foreign demand that has driven China’s export boom, and supported high levels of employment and social stability. A massive expansion in bank lending funded an investment led recovery and solved that short-term problem.
But stopgap solutions will only go so far. For 2009 and 2010, the stimulus will ensure rapid growth. Asset bubbles and inflation, bad loans in the banking system, and imbalanced growth are problems for the long-term and, more importantly, the next guys to solve.
