China’s Financial Squeeze; The bill for a borrowing binge starts to come due

China’s Financial Squeeze

The bill for a borrowing binge starts to come due.

Jan. 8, 2014 12:01 p.m. ET

Recent numbers and announcements out of Beijing suggest that one of the biggest global risks for 2014 is a Chinese economic slowdown. Five years after unveiling the most massive economic stimulus program the world has ever seen, the bills are coming due. And while a crash remains unlikely, deleveraging could uncover some nasty surprises in the financial system.China’s feet of clay start with excessive infrastructure investment by counties, cities and provinces. When Northwestern University Professor Victor Shih estimated the debts of local government investment vehicles at $1.6 trillion in early 2010, he was roundly attacked as alarmist. The National Audit Office confirmed the figure by the end of 2010 and last month put the borrowing at $3 trillion (although this report added village governments for the first time).

While some of these projects boost productivity—for instance with public transport systems—many aren’t generating enough revenue to service the debts. Others are boondoggles, such as garish theme parks. Beijing now proposes bond issues to repay the loans, but those securities will still need to be held by the banks.

All this government borrowing has depleted the banking system’s capacity to lend to productive businesses, which is reflected in the purchasing managers index numbers released in the last week showing weakness in both manufacturing and services. Bad loans are officially less than 1% of bank assets, but anecdotal evidence suggests widespread evergreening of problem loans.

The Chinese Academy of Social Sciences last month put total private and government debt at 215% of GDP, a shockingly high figure for a developing economy. The ratio is all the more striking because it has almost doubled since the 2008 financial panic. Total lending grew at about 20% last year, more than double the GDP growth rate, which has dipped below 8%.

When more and more lending coincides with slower growth as in today’s China, it usually heralds the end of the boom years and the beginning of deleveraging. And right on cue, the People’s Bank of China has begun using the D word as it tries to control off-balance-sheet lending that banks are using to circumvent regulators.

However, in its zeal to mitigate the risk of a crash, the PBOC may do unnecessary damage. China’s shadow banking institutions are more responsive to market signals than are the state-owned banks. And while some institutions are fueling speculation in a real estate market that is increasingly frothy, others lend to highly productive private entrepreneurs who are otherwise shut out of the capital markets.

The central bank’s efforts to control credit growth have also created recurring liquidity squeezes in the interbank lending market. On Dec. 19, short-term interest rates spiked to more than 10%, the highest since last June. There have been smaller cash crunches and rumors of banks scrambling to meet capital requirements over the intervening months.

The shadow banking crackdown and credit crunches are the result of regulators lacking the tools needed to supervise a modern market economy. Hence the crude measures left over from a planned economy: They order bankers to stop lending and may throw a few in jail.

When the market prices capital, regulators can use a lighter touch and focus on the real bad apples. The Communist Party has endorsed liberalization of interest rates as part of a new reform program, and change may accelerate. But the transition will still take time and could be more difficult to undertake in the environment of debt workouts that will come with deleveraging. Whatever happens in 2014, it’s safe to say that the Chinese economy’s slowdown will end up being more painful as a result of the failure to undertake reforms during the fat years of the mid-2000s.