China’s Debt Load Threatens Economic Slowdown

In order to stimulate the economy and ward off the 2008 global financial crisis, China announced a nearly $600 billion package to fund infrastructure projects that has now come under attack after local governments accumulated mountains of bad debt that now threaten to constrict economic growth.

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Local governments in China amassed 10.7 trillion yuan in debt by the end of 2010, of which the government expects 2.5 to 3 trillion yuan to sour, while Standard and Chartered says as much as 8 to 9 trillion yuan may not be repaid — that’s roughly $1.2 trillion to $1.4 trillion. The Chinese government is now working on a relief plan for local governments, which could include allowing them to tap the municipal bond market for the first time as an alternative to bank loans, which are becoming harder to get.

Meanwhile, risks of default are rising. In northeast Liaoning province, for example, nearly 85% of the local government finance vehicle (LGFV) loans missed debt service payments in 2010. However, city officials are not worried, saying they are only following Bejing’s directives to keep growth on track, and that the central government would surely step in with a bailout if necessary. After all, Bejing does hold over $3 trillion in foreign exchange reserves, more than enough to rescue them as it has done in the past. In the late 1990s, Beijing set up asset management companies to help China’s top banks clean up bad loans.

But the global downturn still threatens China’s economy, which needs every sector to be performing well in order to avoid a slump. While the infrastructure boom protected the economy from a collapse in exports in 2008, inflation is now much higher, and dumping more money into the economy would only make things worse.

Barclays Capital predicts that a global recession would cause China’s gross domestic product growth to fall below  8%, which is seen as the minimum for assuring enough job creation to keep up with urban migration. And an economic slump would depress land sales, a vital source of funding for local governments, making their debt load even more precarious.

While many businesses and local governments hope that real estate projects, to be built with borrowed money, are the solution to their funding problems, Beijing has been taking steps to halt a speculative property boom and has told state banks to cut lending. Because local governments raise money by selling or taxing property — roughly 40% of local government revenue came from land sales last year — they have a strong interest in keeping property prices high. Land is also often used as collateral backing for loans to their financing vehicles, and now Beijing is trying to push down prices.

Fortunately, the Chinese banking system had a bad loan coverage ratio of 218% at the end of 2010, keeping down the risk that defaults will destabilize major banks or crimp the government’s finances. Still, many bank executives have stopped lending to local governments entirely, unless they have some guarantee that their projects will be profitable, or that they are already too big and costly to scrap.

So now “shadow bankers” — underground lenders and trust companies that extend credit to people and companies that may not qualify for loans otherwise — are stepping in, cutting up loans into investment packages much like American banks did with sub-prime mortgages during much of the past decade. Credit Suisse last week described this growing informal lending as a “time bomb” that posed a bigger risk to the Chinese economy than the massive amounts of local government debt.

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China’s informal lending is estimated at roughly 4 trillion yuan, around 8% of above-board bank lending. Interest rates on these loans runs as high as 70%, and they are expanding at an annual rate of about 50%. Shadow bankers have lent 208 billion yuan to real estate developers in 2011, while formal bank lending has totaled 211 billion yuan this year.

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