The Pandemic Depression
The Global Economy Will Never Be the Same
In September 2008, when Chinese President Hu Jintao got word that Lehman Brothers, then the fourth-largest U.S. investment bank, was on the verge of bankruptcy, he was traveling by van along the bumpy roads of Shaanxi Province. Surrounded by policy advisers and members of the Politburo, Hu asked them how China should respond to the inevitable spillover. According to one participant in the discussion, the group reached a clear consensus by the trip’s end: China would need to launch a massive stimulus program. And it could trust only state-owned enterprises (SOEs), rather than private firms, to carry it out.
That November, as other governments were still debating what to do next, Beijing announced that it would distribute nearly $600 billion in stimulus funds to SOEs and other institutions, principally to fund ambitious infrastructure and industrial projects. Banks began lending generously, and local governments rushed to form shell SOEs that would allow them to borrow. Over the next six years, China’s nominal GDP roughly doubled, ballooning from around $4.5 trillion in 2008 to just over $9 trillion in 2014.
China recovered from the 2008 financial crisis faster than any of its peers, and it drove unprecedented growth in the process, expanding its economy at rates its competitors had failed to match even before the financial crisis. The story was positive enough that some economists called on Western governments to adopt a similar approach, advocating increases in government spending and regulation. Yet China’s speedy response would have been impossible to replicate without the power and reach of its central government. The government owns, either directly or indirectly, almost all of China’s land and roughly two-thirds of its productive assets, enabling it to quickly allocate resources on an enormous scale.
This advantage carries a significant cost, however, and one that has already begun to surface. According to a recent report from the management consulting firm McKinsey & Company, China’s total debt in 2007, counting that of private households, independent firms, and government institutions, equaled 158 percent of the country’s GDP. In 2014, it reached 282 percent of GDP—among the world’s highest levels for a major economy. In the past, China has been able to rely on a mix of bailouts and local dealmaking to keep toxic loans from poisoning the economy. But now that growth is slowing—a trend party leaders have euphemistically dubbed the “new normal”—many more borrowers are struggling to pay. If China doesn’t get on top of its debt problem, the road ahead will be far bumpier than it was in 2008 and could even lead to a prolonged and painful crash.
LOANS AND LAND
Understanding how China accumulated so much debt across much of its economy requires understanding how growth occurs at the local level. For more than a decade, there has been no more important driver of Chinese economic success than the country’s booming real estate market. Rising property prices provided the basis for a massive expansion of credit and a steady supply of capital, which allowed local governments to invest heavily in infrastructure and labor-intensive industrial projects.
In theory, the Chinese state owns urban land, whereas peasant collectives control agricultural land. In practice, the collectives have little say at all. Only local governments can open up agricultural plots to development, giving them monopolies over the supply of land. Taxes and fees included, the proceeds from land sales have made up an increasing share of local budgets, accounting for some 46 percent of revenues in 2013. Yet most of the cash has come from loans that local governments have secured through shell companies, or so-called local government financing vehicles (LGFVs), using public land as collateral. It is such funds that have, since 1998, made possible the country’s feverish construction of highways, high-speed railways, airports, subways, steel foundries, office parks, and so on.
This reliance on land-backed debt has meant that despite the central government’s efforts to stabilize housing prices and avoid a damaging real estate bubble, local governments have had a vested interest in keeping housing (and thus land) prices high, since doing so has allowed them to secure larger loans. For this reason, localities sold land one small plot at a time, which exaggerated marginal land prices and helped inflate the value of the much larger tracts of land that remained, thereby increasing local governments’ capacity to borrow. The strategy largely worked: land values soared, and credit flowed widely.
Since Chinese law forbids local governments from borrowing directly, most transferred land titles to LGFVs, which could take out loans freely. These bodies have been so successful at circumventing Beijing’s prohibitions against local government borrowing—on paper, they look just like other SOEs—that nobody, not even the Ministry of Finance, knows how much local governments owe. This ambiguity has made it impossible to estimate China’s true government debt, although guesses range anywhere from $5 trillion to $7 trillion.
For almost two decades, observers have been predicting a Chinese banking crisis but have not seen a single one. Their reasoning was flawed in two primary ways. First, they viewed China’s commercial banks as they would private banks in true market economies. Yet all major banks in China are government-owned, and so as long as Beijing has enough capital to replenish the reserves of struggling banks, none will collapse. A second flaw was overlooking the crucial role of land in settling debts. With housing prices rising and land in high demand, local governments could always sell more land—and so few alarm bells rang.
Even when warning signs did appear, the government acted quickly enough to avert an actual crisis. Throughout the 1990s, virtually all Chinese banks lent generously at Beijing’s instruction. And not surprisingly, they racked up large numbers of nonperforming loans. By 1999, four major national banks—the Agricultural Bank of China, the Bank of China, the China Construction Bank, and the Industrial and Commercial Bank of China—were technically insolvent. But officials moved quickly to remedy the situation, forming a series of asset-management companies that took over all of the banks’ toxic loans and returned their balance sheets to good health.
In 2003, however, these same banks found themselves loaded with non-performing loans once more, and again, the government came to the rescue. As part of a larger effort to restructure Chinese financial institutions so that they could be publicly listed on the Hong Kong Stock Exchange, the central government pumped $45 billion worth of foreign exchange reserves into the Bank of China and the China Construction Bank. In 2005, it injected $15 billion into the Industrial and Commercial Bank of China. And in 2008, it put $19 billion into the Agricultural Bank of China.
There is little reason to believe that Beijing won’t continue to stand behind these major banks in the years to come, assuming the government has the funds to do so. But when it comes to local banks, the central authorities have kept their distance. Although these institutions have had just as much trouble with nonperforming loans, Beijing has left the troubleshooting mostly to regional and municipal governments. Since local governments lack Beijing’s cash reserves, they have relied on mediation, bringing together lenders, borrowers, and third-party corporations capable of funding bailouts. In exchange for a corporation’s assistance, a local government would typically provide a free or low-cost piece of developable land or some other sweetener. But using land as an instrument to resolve bad loans was only tenable so long as real estate prices remained high and such land deals remained attractive—and that is no longer appearing to be the case.
For more than a decade, there has been no more important driver of Chinese economic success than the country’s booming real estate market.
Indeed, the beginning of 2015 marked a turning point for China’s real estate market; land sales in both volume and proceeds plunged by 30 percent compared to the prior year. The reason was twofold. The first was a decline in quality: after a 15-year boom, local governments had sold off most of the country’s premium plots. The second was a drop in demand. In 2014, new property sales fell by 7.6 percent in volume and by 6.3 percent in proceeds, down from increases of 17.3 percent and 26.3 percent, respectively, in 2013. To make matters worse, the real estate market is now suffering from an excess of supply. At the end of 2014, China had around 75 billion square feet of new property space either under construction or ready to be occupied; even if demand were to remain steady, it would likely take more than five years to sell all that space. In fact, demand will probably dip.
Local governments are already struggling in the face of declining property markets, and they are increasingly using shell corporations to bid up prices and keep land valuations high. According to a recent study by Deutsche Bank’s chief China economist, Zhang Zhiwei, local-goverment-owned shell entities likely won 43 percent of land auctions in Jiangsu Province in 2014, up from negligible levels in prior years. When a local government sells land to one of its own entities, it amounts to self-dealing. The sale, in other words, is fake. That this practice has grown increasingly common suggests a sense of desperation: local officials know that if land prices drop in the absence of market demand, borrowing will become more difficult, and unpaid debts harder to settle.
In a further sign of the times, China’s State Council, the country’s top administrative body, announced this past March that it planned to provide local governments with new ways of borrowing, principally by allowing them to issue up to around $480 billion worth of long-term bonds to pay off existing debt. Swapping short-term local government debt for long-term bonds represents an important step forward, since China’s debt structure has been extremely short-term and thus unnecessarily risky. But the move also raises a major concern. Since China is not a democracy, allowing local governments to sell bonds could establish a dangerous precedent, leading them to freely issue debt without any real intention of paying it back, which is what happened in the early 1990s. Of course, Beijing could address this risk by introducing new checks on local government power. Yet such a political reform is nowhere on the party’s current agenda.
Beyond restructuring local government debt, Beijing could also raise taxes in order to help pay it off. Indeed, the State Council is considering levying a property tax, the revenue from which would flow to local governments. But at a time when real estate sales are slumping, and in a country where tax burdens are already among the highest in the world, new taxes or higher tax rates could slow the economy further. At this point, then, neither policy option—maintaining short-term growth by taking on more long-term debt or upping taxation to boost revenues—is a good strategy. Both would raise the probability of a major economic crisis.
So what should China do to avert such a worst-case scenario? The immediate response should be to force local governments to cut spending and sell off wasteful assets. Many local governments still hold large portfolios of unnecessary buildings; selling them would not just provide badly needed capital to pay off debt but also eliminate burdensome operating costs. In the past, Chinese officials have preferred to issue new debt or raise taxes instead of reducing spending or selling assets. But now China’s leaders must change course.
Unfortunately, the requisite will is notably lacking. The National People’s Congress and its local counterparts have never played much of a role in budgeting, and they are unlikely to break with tradition. Only President Xi Jinping can mandate spending cuts and asset selloffs on the scale that is needed, much the same way as he has been carrying out his anticorruption campaign—as a presidential prerogative. So far, however, there are few indications that he intends to do so.
Unless China’s leaders correct course, the mixed-ownership reform, at least in its current form, will likely create more problems than it solves.In the meantime, China is trying to improve the country’s roughly 155,000 SOEs through the “mixed ownership” reform it announced in November 2013, which aims to open SOEs up to private investment. Although the concept is a promising one in theory, the policy in its current form will make things worse. The reform essentially allows private investors to own minority equity stakes in new projects and new businesses controlled by SOEs, rather than permitting them to buy into the enterprises themselves. The effect will be to enable SOEs to raise additional funds and expand their asset bases—which will enlarge, rather than reduce, the relative share of the state sector in the Chinese economy. SOEs are well known for their inefficiencies, and their wasteful operations will prove a painful drag on China’s already slowing economy. Just keeping these enterprises running will carry a heavy cost, yet they won’t be able to rely on the levels of debt they once did. As the housing market declines, land is no longer as effective an instrument to help borrowers avert defaults.
Expanding SOEs will also stand in the way of Beijing’s effort to promote domestic consumption to offset the economy’s dependence on investment. (Today, household consumption accounts for only around 35 percent of China’s GDP; in the United States, the figure is around 70 percent.) Boosting China’s household consumption is difficult in large part because of the dominance of SOEs and other state-backed businesses, whose profits and valuation gains accrue mainly to the government rather than investors, employees, or households.
In addition, SOEs will continue to undermine the rule of law, since their government owners hold unchecked power to bend or flout the rules when convenient. Any industry with an SOE cannot provide a level playing field for everyone or foster real competition. The system is rigged in every sense: even China’s judiciary cannot act impartially when it comes to ruling on cases that pit an SOE against a private party.
Finally, because of the advantages SOEs enjoy, they will continue to suck up financial resources at the expense of private firms, both within China and abroad. Consider that from January to August 2014, nearly 1,500 Chinese nonfinancial firms offered bonds worth more than $500 billion. According to the China Business Network, 267 of these companies were private, and they raised only six percent of the total, with the rest going to SOEs. Raising that capital was also cheaper for the government-owned firms; for one-year AA-rated bonds, the yield, or cost to the borrower, was 5.9 percent for SOE issuers and 6.7 percent for private firms.
Unless China’s leaders correct course, the mixed-ownership reform, at least in its current form, will likely create more problems than it solves. Before it’s too late, then, the country must shift its focus to privatizing SOEs, divesting nonessential government assets, selling at least some portions of SOE equity to private investors, and cutting government spending. Those measures would help reduce both operating costs and debt burdens for governments at all levels. If Beijing fails to act, however, standing by as local governments and SOEs generate more losses and larger fiscal burdens, a crippling crisis will become unavoidable.