The global financial crisis of 2007 induced recessions in many countries, but China managed to retain its robust growth levels despite dampened western demand. What is most surprising is that, how did an export-led economy like China manage to keep its finances intact in the midst of the turmoil? The answer lies in the “benevolence” of the government in launching a huge fiscal stimulus package amounting to $600 billion (about 20% of the country’s GDP), which was successful in boosting domestic demand and this is the start of a story which can have pretty much the same repercussions on the global economy as the 2007 crisis had.
Rebalancing the Chinese economy away from exports required pumping large amounts of money into construction activities. This stimulus was largely funded through loans by the state banking system, which gradually gave rise to increasing levels of debt in the country. The total debt to GDP ratio is a massive 303% in the first quarter of 2019, and China’s total credit growth averages at 20% per year since 2009. These figures are indeed frightening because they pinpoint a fundamental problem in the Chinese economy: its unsustainable debt levels and about-to-burst asset market bubbles which remind us of a pre-2007 situation in the US.
It is enlightening to know that in the socialist regime of China, the government plays a huge role in ownership; banks, pension funds, mining companies, construction companies among others, are owned by the state. In the context of the debt crisis, this translates to the government acting as both borrower and lender, since it loans money to state-owned enterprises (SOEs) to build factories and houses and bridges, despite there being a limited market incentive. There are two major drawbacks associated with this system: first, it becomes difficult to measure official debt, since one government authority loaning money to another does not exactly constitute debt; second, it is burdensome for the government to bail out creditors in case of defaults (creditors are the SOEs, so bailing them out essentially means financing their losses by incurring more loans).
Private property ownership was enshrined in the Chinese constitution in 2004, thus moving away from the collective ownership principle of the pre-reform socialist system. Consequently, the erstwhile premier, Wen Jiabao, was pushed for easy availability of credit for buying land. This made way for local and regional governments to sell land for development, and construction activities boomed, even before the 2007 crisis. The crisis further boosted the construction frenzy, and from being a mostly rural nation, China now has 59.4% urbanisation, with over 100 cities having a population of more than a million people.
There are two ways to look at the housing market bubble: the supply side and the demand side. From the supply side, local governments find it profitable to sell rural land for urban development to construction companies; easy credit financing in infrastructure and construction ensures an abundant supply of real estate.
The demand for buying property is at an all-time high, but the demographics of buyers is somewhat different. 250 million rural workers have migrated to urban areas since 2008, but they can barely afford to rent dungeon-like apartments on the outskirts of cities. The buyers of property are a new class of upper-middle class and upper class, who have recently come into money, and find it more lucrative to invest in property. Besides the neo-rich, young men looking for prospective brides also make up the buyer demographic, since the disproportionate sex ratio makes it very important for a man to own property in order to be considered for marriage. Most purchases of houses are therefore second-time or third-time deals for buyers.
Despite the high demand, the number of prospective buyers is merely a fraction of the number of apartments available for sale. Property prices in China are more than those in California, despite China having an average salary per person equal to 10% of that in California. Consequently, and not surprisingly, more than 50 million houses stand empty in the country. Unless prices are reduced drastically, more and more of these houses will remain empty, and eventually, the huge sums loaned to construction companies will be defaulted upon, if the latter fails to generate revenue, and the housing bubble will face an imminent burst.
The impact of the global financial crisis on China was not just restricted to an investment boom, it also led to the rise of shadow banking. Shadow Banking (SB) refers to all financial services provided by unregulated and uninsured institutions, which are under the regulatory radar of the formal banking sector. In China, however, the SB sector is more integrated into formal banking, in the sense that many regulated banks also provide SB loans without showing it in their balance sheets. In fact, SB has grown enormously in China in the recent years, owing to the reluctance of state-owned banks to provide loans to small and medium enterprises, and increasing demand for funds by local governments for infrastructure development projects.
Currently tallying at $9 trillion, shadow banking in China links finance companies with local governments, households and other investors looking to earn a slightly higher margin. Holding 23.5% of China’s total banking industry assets and 68% of its GDP, the loosely regulated, high-yield lenders have so far been catalysts in raising the level of domestic demand, but have lately come under the wrath of financial regulators.
The most disturbing aspect of shadow banking in China is that a large number of state-owned banks undertake unregulated credit financing, and the recipients are often local and regional governments looking to build a new apartment building or a bridge in order to keep their coffers filled with revenue. Shadow loans are not disclosed on balance sheets, which makes these banks look much healthier than they actually are.
After the 2007 crisis, the government encouraged banks to ease credit availability, but the demand for loans was so high that banks soon ran out of money to lend. This is when SB came into the picture, and banks started packaging these loans and selling them to investors by the name “Wealth Management Products” (WMPs) and investors started buying them under the lure of high-interest rates, without taking into consideration the risk factor. This is exactly what had happened pre-2007 when Freddie Mac and Fannie Mae repackaged home mortgage loans and sold Mortgage-backed Securities (MBS) to investors. This time too, there is a high probability of borrowers (in this case, SOEs) defaulting on their loans, and therefore, a high chance of a looming financial crisis in China.
China is in a precarious position right now, the central government knows it and is trying to regulate asset markets and shadow lending sectors. But forces in the regional governments are working against the Centre since the additional income that they get from infrastructure development makes their job of managing local expenditure much easier. With these internal conflicts in China, coupled with its trade war with the US, any ambiguity in its economic performance will lead to a significant weakening of the Renminbi. Such a depreciation will have a seismic effect on other global currencies, and plunge the world into a currency war and a currency war at a time of the inverted trend in the yield curve coupled with other economic slowdown indicators can only mean the worst for the global economy.