Default threat: Bubble behind the Chinese Wall

The real Chinese debt-GDP ratio is a staggering 230%, which has spiralled in the last five years.

ISLAMABAD: In China, a bubble is about to burst.

In early January, China Credit Trust, a major non-banking financial institution, warned its investors that it may not be able to repay when one of its wealth management products worth $469 million was about to mature.

Days before its maturity, Industrial and Commercial Bank of China (ICBC) – the largest Chinese lender – rescued the trust by announcing that the bank would be able to recoup the money investor had put in by selling to “unidentified buyers”.

This transaction might have rescued few investors at the cost of a more vibrant financial industry, which rewards good performance and penalises poor results with equal force. But this bailout is just a tip of the iceberg.

The Chinese banking system is dominated by state-owned commercial banks including Bank of China – which specialises in foreign exchange transaction and trade finance – China Construction Bank – which focuses on medium to long-term credit for long-term projects – the Agricultural Bank of China – which provides financing facilities to the agriculture sector and the ICBC.

Of these, the ICBC is the largest bank by assets, employees and customers and is the second in foreign exchange business.

The ‘Big Four’ were transformed from specialised banks into commercial entities during the 1994 banking reforms and were liberalised to the extent of floating shares on Hong Kong and Shanghai Stock Exchanges. But the state still maintained majority stakes in these banks.

Due to state control, the Big Four are a source of subsidising loans to state-owned enterprises (SOEs) and other arms of the government. For the past few years, stagnation of SOEs produced negative real returns on the capital employed, increasing non-performing loans (NPLs) for these banks. It is noteworthy that hundreds, if not thousands of SOEs, have already gone bankrupt.

Crisis triggers shadow banking

Shadow banking sector has been on the rise, particularly investment in ‘wealth-management products’ because of the official ceiling on deposit rates where savers make little return on their bank deposits.

In a recent column in The Times of India, William Pesek equates Chinese shadow banking system with Enron whose real business was not energy or commodities, but book-cooking.

The rise in shadow banking was triggered after the 2008 financial crisis when Chinese government allowed banks and other lending institutions to extend credit lines. Private domestic credit has increased from $9 trillion to $23 trillion, an increase of 2.5 times in five years.

The concern here is that credit has reached a point where it is no longer generating economic returns and the government is not allowing market forces to take their toll on poorly performed credit products. In freely functioning financial markets, the poorly performing assets should be allowed to be written off instead of being bailed out.

According to Professor Feng Xingyuan of Unirule Institute of Economics, the credit policies are decided by the National Development and Reform Commission of the State Council, together with the central bank and the China Banking Regulatory Commission, instead of commercial banks.

This has led to a significant distortion in credit market leading to reflective investors like George Soros to possibly go short on yuan. For Soros, who has amassed billions by correctly predicting various financial crises at least three times, the main risk facing the world isn’t the euro, the US Congress or a Japanese asset bubble, but a Chinese debt disaster that’s unfolding in plain sight.

Debt-GDP ratio spirals

So is the Chinese debt-to-GDP ratio going out of hands? It depends on how you define debt, as the central government is comfortable at 21.3% debt-GDP ratio as per the IMF in 2013. However, when one adds debt from local governments, SOEs and government-run banks into that mix, the situation becomes suddenly bleak.

The real Chinese debt-GDP ratio is a staggering 230%, which has spiralled in the last five years. If history is any guide, Chinese trade surplus and its forex reserves may not prove reliable defence.

Thus, the Chinese financial system faces a triple challenge: decreasing return on capital due to bloated credit distribution, swapping of commercial bank deposits with investment in shadow banks and an exponential growth in cheap private credit.

Investment flow to Pakistan

As a long-standing friend of Pakistan, Chinese investment in our country offers opportunities – but mainly for China itself. As the rate of return on credit-run capital on investment made for ghost cities and empty bridges in China dwindles, it can find greener pastures in infrastructure-hungry Pakistan, on the back of a rising middle class and its ever increasing geostrategic importance.

And to those who claim for Chinese banks that there has never been a default, the answer is “there is always a first time”.

The writers work at Policy Research Institute of Market Economy (PRIME), a public policy think tank based in Islamabad