Friday, March 19, 2010


This will be the fifth post in our series this week. On Monday I will post a summary and my conclusions/thoughts.

Post #1 can be read here. Post #2 here. Post #3 here. And Post #4 here.

China as Canada's economic saviour

It's stunning the number of people who believe that, regardless of the US sovereign debt position, Canada will be okay because our resource based economy will be in demand by the emerging economic behemoth of China.

It won't be.

China's foreign exchange reserves stood at the astonishing level of $2.4 trillion at the end of 2009. About $2 Trillion of that is in US Treasuries.

That's $2 Trillion dollars in IOU's from the United States. If the sovereign debt crisis leads the United States to default, just who do you think is out all of that money?

Notwithstanding this small fact, the current economic situation in China is not as rosy as you might think.

Yes, they have invested an astonishing amount of foreign reserves in American debt, but did you know that China's proposed annual budget for 2010 will produce a record deficit?

Now, granted, this deficit is just $154 billion, or 2.8% of China's gross domestic product. In contrast, the Congressional Budget Office projects the US budget deficit for fiscal 2010 at $1.3 trillion. That's equal to 9.2% of GDP.

But let's take a closer look at China's finances. The following data comes to us from Jim Jurbak's journal.

There's a good argument to be made that if you look at all the numbers, instead of just the ones the budget magicians want you to see, China has far more debt than meets the eye.

If you look only at the current position of China's national government, the country is in great shape. Not only is the current budget deficit at that tiny 2.8% of GDP, but the International Monetary Fund projects the country's accumulated gross debt at just 22% of 2010 GDP. US gross debt, by comparison, is projected at 94% of GDP in 2010. The lowest gross-debt-to-GDP figure for any of the Group of Seven developed economies is Canada's 79%.

But China has a history of taking debt off its books and burying it.

If we go back to the last time China cooked the national books big time, during the Asian currency crisis of 1997, we can get an idea of where its debt might be hidden now.

The currency crisis started in 1997 with the collapse of the Thai baht—and. Like dominoes, the currencies of Indonesia, South Korea, Malaysia, and the Philippines collapsed. In each case, the country had built up an export-led economy financed by foreign debt. When the hot money that had been flowing in reversed (and started flowing out), that sent currencies, stock markets, and economies into a nosedive.

China escaped the first stage of the crisis because the country's tightly controlled currency and stock markets, and its economy, had kept out hot money from overseas.

China had built its export-led economy on domestic bank loans instead. The majority of bank loans, then as now, went to state-owned companies — about 70% of the total.

Those loans were all that kept the doors open at many of China's biggest state-owned companies. It's estimated that about 75% of China's 100,000 largest state-owned companies lost money and needed bank loans to continue operating.

That became a problem when, in the aftermath of the currency crisis, China's exports fell. That sent revenue plunging at state-owned companies that were already losing money. Suddenly, China's banks were sitting on billions and billions of debts that anybody who'd taken Bookkeeping 1 in high school could tell were never going to be paid.

This was especially a problem for China's biggest banks, all of which had ambitions to raise more capital — and their international profile — by going public in Hong Kong and New York. But no bank could go public with this much bad debt on its books.

So what did China do? They buried the bad debt.

The Beijing government created special-purpose asset management companies for the four largest state-owned banks, the Industrial and Commercial Bank of China, the Agricultural Bank of China, the Bank of China, and China Construction Bank.

These asset management companies — China Cinda, China Huarong, China Orient, and China Great Wall — would ultimately wind up buying $287 billion in bad loans from state-owned banks. The majority of those purchases were at book value.

So how did the asset management companies pay for the purchase of that $287 billion in bad loans? They certainly didn't pay cash. Instead, they issued bonds to the banks in exchange for the bad loans. The bonds, of course, were backed by the promise that the asset management companies would gradually sell off or collect on the bad loans in time to redeem the bonds. And in the meantime, they'd pay the banks interest on those bonds.

Neat, huh? In one sweat move, the state-owned banks got $287 billion in bad loans off their books and turned deadbeat loans that would never pay off into streams of income from these bonds. To read more on this neat bit of financial engineering, check out this research paper.

Of course, that still left the little issue of where the asset management companies were going to get the approximately $30 billion in annual interest they had promised to pay the state-owned banks. There was also the small matter of how they were going to pay off these bonds when they came due in ten years, especially since the cash recovery rate on these bad loans would run at just 20.3% in the first five years.

But who really cared? The Beijing government and the state-owned banks had kicked the problem ten years down the road. (A favorite tactic of politicians, Republicans, Democrats, and Communists alike, is to punt, so that today's problem becomes somebody else's problem in the future.) The bonds issued by the asset management companies didn't have an explicit government guarantee, but everybody assumed that at some future date the government would either pay up or punt again.

The ten-year punt of 1999 came to earth in 2009, and, lo and behold, there has been some more magic.

In some cases — China Huarong, for example — the asset management companies simply declared that they were done disposing of bad debts, that profits were soaring, and that they were seeking strategic partners in preparation for a public offering.

In others cases, the magic was more complex. In October 2009, for example, China Cinda said it had secured government approval for a restructuring plan that would create a company to dispose of the $30 billion in bad loans still on Cinda's books. The company said it would then look for strategic partners in preparation for a public offering.

Who in their right minds would be a strategic partner and investor in one of these asset management companies? Well, how about one of the original state-owned banks, China Construction Bank, that Cinda had bought the bad loans from in the first place. "The hardest thing," China Construction Bank chairman Guo Shuqing said in this October 17, 2009 interview, "is evaluation."


When the government runs the books, does all the accounting, and decides what assets to send where, I think evaluation would be very easy. Any wonder, then, that today's huge run-up in loans — and bad loans — by China's banks is making some critics nervous?

The bigger problem, though, isn't so much China's big banks, but the country's local governments.

By now, everyone knows that the country's banks went on a lending spree in 2009.

On top of official government stimulus spending of $585 billion, banks, encouraged by the government, doubled their lending in 2009 to $1.4 trillion from the previous year.

(Please remember when judging these figures that China's economy was an estimated $4.8 trillion in GDP in 2009, according to the CIA World Factbook. We banter around such large numbers that it's easy to have these figures gloss our eyes over. To appreciate the size and scope of China's debt consider that estimated US GDP was about three times larger, at $14.3 trillion. So China's 2009 bank lending of $1.4 trillion would be equal to lending of $4.2 trillion in the United States, and China's $585 billion government stimulus package would equal a $1.7 trillion US package, more than twice the $787 billion size of the US stimulus package of February 2009.)

China's banks hit the ground running even harder in 2010, lending out an additional $309 billion in January and February. If the banks had continued at that rate, they would have passed the official lending ceiling of $1.1 trillion by August.

So China's banking regulators, spooked by the increase in bank lending, tightened the reins. For 2010, they set a lending target 20% lower than 2009 lending levels.

They raised reserve requirements so banks would have less capital to lend. And they told banks to hit the capital markets to raise an estimated $90 billion through 2011.

It's not clear that those steps will be enough to balance the huge number of bad loans that China's banks made during the lending boom. But China's regulators have clearly learned a lot about how to address a bad loan problem in the banking system since the 1997 currency crisis.

But as the US Federal Reserve has so amply demonstrated over the past decade, regulators tend to gear up to fight the last war. That leaves them vulnerable to the next crisis precisely to the degree by which it differs from the last one.

China's new debt problem is the thousands of investment companies set up by local governments to borrow money from banks and then lend it to local companies.

By law, China's local governments can't borrow directly. But the incentives for local governments to set up investment companies were huge.

By making loans to local companies, local governments could produce thousands of jobs and drive up the value of local enterprises. And by funding commercial and residential construction, they could drive up the price of land. Those results were important to local officials who often profited personally, but they were also essential to the survival of local governments. By law, those units also aren't allowed to raise their own taxes for local expenditures. To meet local demands—and to fulfill the directives issued by Beijing—local governments are dependent on frequently inadequate revenue transfers from Beijing and what they can collect from such transactions as local real estate sales.

So how much did these investment companies borrow and then lend?

Local government investment companies had a total of $1.7 trillion in outstanding debt at the end of 2009, estimates Victor Shih, an economist at Northwestern University and the author of Factions and Finance in China. That's equal to about 35% of China's GDP in 2009.

In addition, banks have agreed to an additional $1.9 trillion in credit lines for local investment companies that the companies haven't yet drawn down, Shih says.

Together, the debt plus the credit lines come to $3.8 trillion. That's roughly equal to 75% of China's GDP.

None of this, Shih points out, is included in the IMF calculation of China's gross-debt-to-GDP figure of 22%. If it were, the number would be closer to 100%.

It means China's actual gross debt is almost the same as the United States.

Exactly how important is this number, tho?

It depends on how many of those loans at local investment companies will go bad.

Shih estimates that about 25% of current outstanding loans — totaling $439 billion — will go bad. (For comparison, remember that in the aftermath of the 1997 currency crisis, the newly established asset management companies swallowed $287 billion in bad loans.)

It also depends on how much of China's huge reserves and huge base of personal savings are available to offset the debt.

So far, I've been talking about gross debt. But China, like Japan, has a huge domestic pool of savings it can use to buy debt. Economists point out that Japan has carried what looks like a crippling gross-debt-to-GDP ratio for years — 188% in 2007, 197% in 2008, 219% (estimated) in 2009, and 227% (projected) in 2010 — without disaster, because the country funds its debt internally from savings.

China, the argument goes, could easily do the same, so what's the problem?

The problem for both China and Japan is that it's not clear exactly how much of their huge pools of domestic savings are actually available in the long run to buy debt.

Japan has a woefully underfunded retirement system, and it's by no means clear how the population of the world's most rapidly aging country is going to pay for retirement.

China has, for all intents and purposes, no public retirement system. As a result of its one-child policy, the country has also begun to age quickly, and by 2030, its population will be as old as that of the United States.

In the US, the national accounts may lie about the effect of the problem by putting Social Security and Medicare off-budget on the argument that, since these programs have their own dedicated revenue streams, they don't count as part of the national debt.

But that lie aside, because the benefits of these programs are defined, it is possible to put a dollar figure on the government's future liabilities in this area (with all the uncertainty that comes with forecasting inflation, of course).

China isn't hiding any future liability for pensions or retiree health care off the books. The government hasn't promised future payments. In an accounting sense, then, there is no future liability that ought to be on the nation's books.

But that doesn't mean China won't have to consume some portion of its accumulated savings to pay for its post-65 population in 2030.

The country, either through the government or through private citizens, will have to cover the costs of old age, however it defines that cost.

And any savings it will use to pay for those costs really aren't available now to pay current debts.

I think the Chinese leadership is profoundly aware of the need today to not waste money that the country will need tomorrow.

That's one reason Beijing has taken steps recently to rein in local investment companies. On March 8, the Ministry of Finance announced plans to nullify all guarantees by local governments for loans taken out by their investment company vehicles. And the national government plans to sell $29 billion in bonds for local governments this year, giving those governments an alternative to setting up local investment companies.

But the big job — the reform of China's tax system so that local governments don't have to rely on real estate and stock market bubbles for funding — didn't make it on the to-do list announced by the National People's Congress this week and last.

I think you will find that as the United States founders under it's debt load, so will China. Particularly if the United States opts to default on any or all foreign treasury obligations or if the United States opts to monetize the debt.

The world is placing China, today, on the same lofty pedestal in which Japan was placed in the early 1980s.

The outcome will be the same.

To read the next part, click here.


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1 comment:

  1. Whisperer,

    Thanks as always for a great series!

    As I watch and ponder over events since 2008, I have grown more pessimistic about the overall lack of understanding of the fundamental nature of the problems and the regressive nature of the solutions proposed. Most people wish or believe the good old days will return. What they fail to realize is we are experiencing effects of a paradigm shift. While all the focus is on China and the US, changes and their impact are global. I will try to be pithy and outline a few factors that I think deserve more attention and creative solutions.

    1. Automation - The effects are twofold. Firstly, it increases productivity and thus reduces the aggregate need for labor to produce most things needed to achieve a reasonable standard of living. Secondly, it reduces the skill levels needed for production. This has a more significant impact on developed countries in general because their comparative advantage is diminished. Countries like Germany and Japan are affected as well, but due to their cultural emphasis on quality and technical training, their industrial base has not been eroded as much as in the US and Canada. Complacency and specious arguments in defense of the status quo in education in the US and Canada will further leave us behind.

    2. Inequity in income distribution - The potential demand for "stuff" and services, be they a matter of need or hedonistic, is huge when we think about the number of people who still have a low standard of living and thus could have more. The big question is: What can they produce or provide so they can exchange their efforts for things they want? This is a factor of four things that will have different effects on different cultures: (1) A pragmatic definition of what constitutes an acceptable standard of living (How much do we reasonably need? Should everyone aspire to the "Western" lifestyle or is that too extravagant?); (2) The relative values assigned to different forms of productivity (Why do we pay bankers so much more than miners? Is that discrepancy warranted?); (3) Has automation simply rendered some of us redundant? and (4) How much does a given society emphasize on self-reliance, i.e. making the most of one's potential when given a fair chance instead of relying on someone to provide for them.

    While cultures in the world encompass a wide range of common or antagonistic values, in a globalized economy, it really does boil down to who's willing to work harder and spend and save more wisely. In that regard, Canada has some serious soul searching to do.