The unearthing of China's considerable off-balance-sheet liabilities casts a new light on the country's economic position, raising fears that its previously rapid development could stall.
China has prospered on the back of Western technology – both for manufacturing and financial markets – but it may rue the day it imported off-balance-sheet finance and shadow banking. When former premier Wen Jiabao famously said in 2007 that the Chinese economy was "increasingly unstable, unbalanced, uncoordinated and ultimately unsustainable”, he was not referring to financial engineering. And he was speaking before China unleashed its massive fiscal stimulus in response to the international financial crisis.
Since then, two broad trends have occurred that are a worry to China watchers and may hinder the country’s ability to transition smoothly from an export and investment-led economy to a model based on greater equality and more domestic consumption.
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One is the growth in the off-balance-sheet liabilities of local government which, when added to central government debt, bring the total to 45% of gross domestic product (still modest compared to Japan, most of western Europe and the US, but considerably more than the official 26% figure).
The other trend has been the expansion of shadow banking with investors’ desire for higher returns met by the creation of so-called wealth management products (WMP) backed by bank loans. Fitch’s Charlene Chu, the doyen of China bank watchers, estimates that three-quarters of this Rmb14000bn ($2333bn) market has the direct or indirect involvement of banks. In other words, similar to Western subprime, it is only nominally off balance sheet and has the capacity to find its way back.
The latest body to warn about the risks to China’s economy of off-balance-sheet liabilities is none other than the International Monetary Fund (IMF), master of the technically construed reality check.
Recent news headlines have been dominated by the likely impact of the US Federal Reserve’s unwinding of its quantitative easing programme and how that could disrupt financial markets. Far less has been written about China’s unwinding of the massive fiscal stimulus that was used to keep the economy growing through 2009 and onwards. Most of this was channelled through the banking system with bank assets leaping by as much as 30% annually. Where did all this credit end up? The answer is that a lot of it was used by municipalities for property ventures.
Local governments in China are generally prohibited from borrowing and yet face revenue shortages in pursuing education, health and welfare spending. The solution has been to finance this through land sales and borrowing by way of off-balance-sheet local government finance vehicles (LGFVs). Recall, if you will, the Chinese proverb “Heaven is high and the emperor is far away”, to see how this might come about.
Inconveniently, the IMF, in its staff report for the 2013 Article IV consultation, began adding these borrowings up and produced the 45% debt-to-GDP figure mentioned earlier. “Based on these augmented government estimates, fiscal space is considerably more limited than headline data suggests,” says the IMF. “The large augmented fiscal deficits [10% of GDP compared to an official figure of just a couple of per cent] also raise questions about local governments’ ability to continue financing the current level of spending and service their debts, which has implications for financial system asset quality and the potential need for central government support.”
Fortunately, Chinese banks are well capitalised. According to The Banker Database the top 100 Chinese banks grew their Tier 1 by 19% from 2011 to 2012, while assets only grew by 17%. This gives this group of banks a capital-to-asset ratio of 5.8% and a BIS ratio of 11.29%. Even so, some banks could be challenged if the LGFV problem hits in tandem with a WMP problem and an economic slowdown.
What the IMF has done for government debt-to-GDP numbers, Fitch’s Ms Chu has done for total credit to GDP, helpfully adding in some of the things the official estimates leave out. These are the credit extended by non-bank financial institutions as well as the informal securitisations of bank assets into WMP. Adding these in sends total credit to GDP north of 200%.
A key issue will be whether shadow banks and WMPs will be allowed to fail if they get into trouble or picked up for confidence reasons with all the moral hazard issues that would involve. To give it its dues, the Chinese government has taken precautionary measures in recent months, tightening up the rules on WMPs and requesting banks to watch closely their lending to LGFVs and property developers.
On August 16, the Financial Times (FT) reported that two of China's four asset management companies were being readied for initial public offerings with talks reported to have taken place with Goldman Sachs, Deutsche Bank and Morgan Stanley about acquiring stakes. The asset management companies were set up in 1998 to take on bad loans from China's four largest banks during a previous crisis. The FT concluded that if international investment banks were involved, it meant China was looking at a partially private sector solution to any future debt workouts.
The Chinese government clearly has considerable resources should any financial support to the banking sector be necessary. But what has changed since 1998 is the scale. According to Fitch, the Chinese banking system's assets increased $14,000bn in the five years since 2008, an uplift equivalent to the total assets of the US banking system. Chinese banks have $3000bn locked up with the central bank as reserves which could mitigate the impact of any problems. But as we saw during the financial crisis, complex financial instruments have a tendency to unravel at great speed. Their demise could test even the best laid plans of Chinese technocrats.
Brian Caplen is editor of The Banker.
