Beijing’s Bad Debt Bailout: Problem Solved?

On Tuesday, Reuters reported that China’s central government will take responsibility for RMB 2-3 trillion (US$ 308-463 billion) in at-risk loans extended by Chinese banks to so-called Local Government Financing Vehicles (LGFVs) to fund the construction of infrastructure and other projects as part of its economic stimulus.   The news was interpreted as a big shot in the arm for Chinese banks, which despite record earnings, have been laboring under a cloud of concern over potential losses down the road:

“There has been concern over asset quality risk, especially (to the financing vehicles),” said Victor Wang, an analyst with Macquarie Securities. “I think it’s the right move — it removes uncertainty, and helps the banks operate on a more clear and sustainable basis.”

“We believe this would be a general positive for the Chinese banks as we consider their local government financing vehicles’ exposures to be the greatest risk to the banks’ credit quality,” Bernstein Research Analyst Mike Werner wrote in a research note.

Two months ago, I wrote a post questioning the profit figures reported by Chinese banks — using ICBC as an example — by calculating their loss exposure to LGFV loans.  So now that the government says it’s going to be picking up the tab, are the banks off the hook?  Should we all breathe a big sigh of relief for China’s banking system and economy?

Here are a couple reasons I think it’s premature to declare this problem “solved”:

First, this is the tip of the iceberg.  As I pointed out in my earlier post on “Chinese Banks’ Illusory Earnings,” LGFV loans are only one category of risky loans we should be worried about.  In fact, when China’s lending boom was first blossoming, in early 2009, LGFV loans were the ones China’s banking regulators were least worried about, on the assumption that the government would step in and back them if necessary.  They only began attracting attention after Northwestern professor Victor Shih tallied up the potential exposure to this one type of loan, arguing that China’s official figures for public debt understated the government’s real obligations.  The banking sector’s exposure to other types of risky loans — mortgages, real estate development loans, emergency working capital loans to keep failing exporters from going under, business loans diverted to stock and real estate speculation, business loans collateralized by land at inflated valuations, bonds issued to finance China’s ambitious high-speed rail build-out — is far more extensive, and not so easy to rationalize as a public obligation.

Even within the LGFV category, RMB 2-3 trillion is only a fraction of the potential losses China’s banks may end up facing.  As David Cui of Bank of America-Merrill Lynch Global Research writes:

LGFV loans are at Rmb10tr by the government’s estimate; the ones with no cashflow support, i.e. those public service projects mostly, amount to Rmb2-3tr; given the initial estimate tends to under-estimate the scale of most problems, e.g. subprime & PIGS debt to just name a few, we suspect the above numbers are a best-case scenario rather than a worst-case scenario.

Based on the numbers I’ve seen, the RMB 2-3 trillion corresponds (roughly) to the 23% of LGFV loans regulators believe are beyond all hope of repayment.  However, only 28% of LGFV loans can be reliably repaid through cash flow.  That may leave 50% (roughly RMB 5 trillion) in problematic LGFV loans that remain to be worked out. 

Second, the devil is in the details.  If you read the fine print of the government’s plan, it looks like, rather than simply paying back the failed LGFV loans out of taxpayer funds, regulators will oversee the refinancing of these loans in the form of local, provincial, or central government bonds.  If China’s last bank bailout is any signpost, that most likely will involve a significant portion of the bad debts being buried deep off balance sheet, represented at face value by unbacked securities that will be indefinitely rolled over, with the buried losses never being recognized either by the lenders or the government.  Or as David Cui puts it:

We suspect that, initially, most of the bad loans will be shifted off balance sheet via AMC bonds/MoF IOUs, similar to what happened in 1998-2005. When the day of reckoning arrives, i.e. the eventual write-off, via MoF bonds or PBoC printing money. At the beginning and at a minimum, it seems to us that the banks will be stuck with some “perpetual” low yield assets (AMC bonds/MoF IOUs) on their balance sheet.

At best, China is repackaging the debt and kicking the can down the road.  At worst, it will be temporarily lightening the loan on local governments and giving them the freedom and means to take on even more debt.

Third, generous bailouts undermine banking reform.  I’ve always argued, beginning with my initial article in the Wall Street Journal, that the real damage to China’s banks from their latest lending binge was not the impact on their balance sheets, but on their corporate culture.  For the past decade, Chinese banks have been striving — with varying degrees of success — to turn themselves into viable commercial entities, which lent on the basis of earning a return.  Sadly, with the stimulus, they reverted to being slush funds for government largesse.  Going forward, China desperately needs to develop a banking system that allocates capital efficiently, making positive returns on investment.  This will become all the more important as rising wages — due both to demographic shifts and to growing prosperity — reduce China’s traditional source of competitive advantage.  I can understand wanting to avert a banking crisis, but allowing Chinese banks to declare record profits while shifting their problem loans onto the public is an entirely different matter.  What kind of message does it send to Chinese banks?  Lend as the government directs and you will not be held accountable.  That may solve the immediate problem, but it will create a host of problems later.  The banks should be forced to take some sort of haircut on these loans, for their own good — otherwise, they and their investors are merely profiting at the public’s expense.

Fourth, bailouts add up.  The all-purpose excuse these days, whatever the problem, is that it doesn’t matter because the Chinese government has the resources to foot the bill.  Or as Tom Friedman succinctly put it, “Never short a country that has $2 trillion [now $3 trillion] in foreign currency reserves” — an argument that, as Michael Pettis notes, completely misunderstands the nature of China’s forex reserves and their relatively uselessness for plugging gaps in China’s domestic economy. 

Some people argue that China’s lending boom, these past two years, was just fiscal spending in disguise — that the banks merely fronted the money, and when the loans (inevitably) cannot be repaid, the government will step in and foot the bill.  In the end, they argue, it’s the same as though the government had simply spent the money itself.  I’ve already noted how this ignores the harmful impact of using the banking system as a conduit.  Another problem is lack of transparency.

When a government goes out and spends money, on the level, at least we know the size and scope of the problem.  We know, for instance, that Japan has a public debt more than double its GDP, and it probably better start taking steps to get its fiscal house in order.  But when a country backs into debt, like China is doing, by assuming commercial losses in the form undisclosed, uncalculated contingent liabilities, it’s harder to gauge when to become alarmed.  I’m sure we’ve all had the experience where a whole bunch of small credit card charges — any one of which was easily affordable on its own — added up to a total that came as a rude surprise.  The Chinese government probably has the means to bail out the LGFVs.  It can bail out the Railroad Ministry.  It can bail out the SOEs that have speculated in real estate, or the banks that lent them money.  It can subsidize loss-making loans to build “affordable housing.”  It can subsidize the cost of food, or fuel, or other products hit by rising prices, in order to mask inflation.  But whether it can do all these things — and much, much more — at the same time, I’m not so sure.

Fifth, inflation.  Let’s assume the lending boom was disguised fiscal spending, and the government can and will pick up the tab.  When most governments borrow and spend money, in order to stimulate the economy, the worry is that they will eventually be tempted to “monetize” that debt — essentially, finance the spending by printing money and expanding the money supply, which can fuel inflation (this is why Arthur Burns, the former Fed Chairman, identified government deficits as the main cause of inflation).  The problem in China, though, is that its latest burst of stimulus “spending” — even if it is ultimately funded by the government — was monetized right off the bat, because it took the form of a commercial lending boom that grew the money supply by more than 50% over the past two years.  We don’t have to wonder whether China will monetize its public spending — it already has, and we are seeing the effect (in order of intensity) in rising asset prices, wages, and food prices.

To summarize, as I see it, the LGFV bailout announcement may solve one short-term problem, but only in part, and it may contribute to bigger problems down the road.  Of course, the government may have no other choice, given the actions that have already taken place.  The point is, I see the announcement as more of a beginning than an end.  I certainly don’t think anyone should be unfurling any “Mission Accomplished” banners, as far as the health of China’s banking system is concerned.  It’s more a sign that the first of many chickens has, inevitably, come home to roost.