Western politicians will have been looking on with envy. Only months after the government announced its record fiscal stimulus, China’s banks reported record loan growth of Rmb7.37 trillion ($1.08 trillion) in the first six months of 2009, equal to 150% of 2008’s full year total.
That breakneck pace has slowed somewhat since, but by the end of August the figure had risen to Rmb8.19 trillion, a year-on-year increase of 164%, as the government continued to use the banking system as the main channel for its fiscal expansion.Exactly what happened to the flood of new loans, however, remains a subject for debate. Certainly the biggest recipients of long-term financing in 2009 have been government-backed infrastructure projects, a key component of the Rmb4 trillion ($585 billion) investment stimulus announced late last year, but analysts worry that the binge of state-directed lending will leave China with a big hangover in years to come.
“We cannot guarantee that bank lending will produce the most efficient allocation of resources; some loans may go to unproductive sectors,” Jong-Wha Lee, chief economist at the Asian Development Bank, tells Emerging Markets. “If everything goes smoothly and the world economy recovers, that will be no problem. But if something goes wrong, that unproductive lending will eventually become non-performing loans [NPLs], which will be a big burden to China’s under-developed banking sector.”
China bulls say the new loans were mainly channelled to projects that were already under discussion, requiring no compromise on credit quality. Standard & Poor’s analyst Liao Qiang disagrees, expecting the quality of new loans “to be on average inferior to the banks’ loan book a year ago”. Even state-sponsored projects can take longer to generate returns than initially imagined, and other dangers remain.
THE NPL RISK
“Given the speed at which loans were made, there will be instances of fraud,” says Nick Lord, a banking analyst at Macquarie Securities in Hong Kong. He acknowledges there is a risk of non-performing loans, but says “it’s not inevitable, and the first signs are probably 18 months to two years away”.
Non-performing loans booked in the construction boom of the 1980s and 1990s still haunt China’s financial system, providing a stark reminder of the problems of rapid, state-directed lending. The asset management companies set up to absorb bad loans in 1999 remain a burden on the government, which has deferred the problem without fully dealing with the losses.
China’s Ministry of Finance allowed China Cinda Asset Management, set up a decade ago, to take on China Construction Bank’s bad debts, to roll over Rmb247 billion ($36 billion) of bonds due in September for another 10 years, after it became clear Cinda could not afford to repay the full amount at the original maturity. The other asset managers also sold bonds to pay for the bad loans and are likely to face similar difficulties, having earned only minimal revenues from managing the portfolios of bad debt.
But the financial sector has come a long way since then, Andy Rothman, China macro strategist at CLSA Asia Pacific Markets, tells Emerging Markets.“Non-performing loans will go up, but not to the levels we saw before the carve-outs to the asset management companies. It’s a structurally different system to the bad old days,” says Rothman, who has spent most of the last 25 years in China.
“Back then banks were not meant to be careful; their job was not to be profitable. Now banks are being told to flood the system, but managers are being held personally liable for NPLs. That’s a big deal if you’re an employee in a country where the government controls all the banks.”
Fuelling speculation
Rapid loan growth brings with it other risks. China watchers are not convinced that the money has all been put to good use, pointing to surging stock prices and property markets as an unwanted side effect.
Ben Simpfendorfer, Royal Bank of Scotland’s chief China economist, says: “Probably only half of the lending at best went into the real economy, 30% went into just pure arbitrage of market-set and government-set rates, and another 20% into the equity and property markets.”
China’s banks opened up an arbitrage opportunity at the start of this year, when they brought down the cost of bill discounting dramatically in a move designed to ensure that corporate cashflows remained strong during the crisis.Discounted bills, which accounted for 30% of loan growth in the first half of the year, allow Chinese companies to receive immediate payment for goods or services, while banks take on that payment risk in return for a fee that in the past was very high. When banks slashed those fees, companies used the bills to boost their cash reserves, which analysts say may have been invested elsewhere.
There is anecdotal evidence that the stock price correction in the A-share market in August was triggered by a number of big companies selling shares in order to repay bills, while others believe most of the money was simply kept in deposit accounts that paid a higher rate of return.
“Bank lending [in the first half] was stronger than the real economy so it seems to us that there was some spillover into asset markets, particularly residential property in coastal China, as well as into the stock market,” says Stephen Roach, Morgan Stanley’s Asia chairman.
Shanghai’s A-share index raced 85% higher in the first seven months of the year, before shedding 23% in August. The correction came after loan growth fell sharply in July to Rmb356 billion, down from Rmb1.5 trillion the previous month as banks effectively closed bill discounting facilities, prompting analysts to point to a close correlation between new loans and equity prices.
Is new lending fuelling an asset price bubble? Roach says the turnaround of the property sector from a recession in 2008 is “certainly building the case” for one.
China’s property market, however, is not dependent on leverage. Around one-third of home purchases last year were made entirely in cash, says Rothman at CLSA, while buyers who took out mortgages borrowed on average only 46% of the purchase price – compared to an average of 76% in the US. Property sales in Shenzhen, one of the hottest markets this year, declined 29% in August from the previous month, Rothman says, a sign that the market may be stabilizing.
“Credit growth running at below Rmb500 billion a month will be enough to prevent an equity price bubble,” says Simpfendorfer at RBS. “There are risks” in the already expensive property sector, he adds.
Economic impact
The lending stimulus has doubtless had a positive impact on economic growth. Roach at Morgan Stanley says it has been “decisive” in kick-starting an economy that was “actually very weak”.
“In the first half of this year you had a huge surge in fixed investment, which by our calculations accounted for 88% of the total 7.1% GDP growth in the first half. It was all funded by this record bank lending,” he says.
Most economists are convinced China will hit its target of 8% GDP growth this year, if not exceed it. Lee at the Asian Development Bank raised his full-year growth prediction for China from 7% to 8.2% in September, citing the “highly effective” government stimulus.
But the numbers also show that China’s economic recovery is dangerously dependent on the government’s fiscal policy, raising fears that growth will stall as stimulus measures are withdrawn and lending returns to more sustainable levels. The government has done little to change China’s dependence on demand for its exports, says Roach.
“When the government put these policy actions in place last November, they weren’t counting on the Chinese consumer to take over as the stimulus wore off. They were counting, as they normally do, that external demand would pick up in the recovering global economy in a way that would restart the export machine,” he says.
“External demand is going to continue to be depressed in large part because the most dynamic piece of support to external demand growth in the developed world has long been the American consumer, and the American consumer is finished in terms of excess spending,” Roach adds.
Without a social security or state pension system, China’s household savings rate is rising – from 27.5% in 2000 to 37.5% in 2008 – but China’s private sector does offer some bright spots. Passenger car sales were up 31% in the first seven months of the year, with July’s figure coming in 71% higher than a year ago and August 90% higher, although that last number is inflated by traffic restrictions imposed last August in the run-up to the Beijing Olympics. Chinese consumers almost always pay cash for new cars, so the surge has little to do with the rampant credit growth.
Banks, too, are reporting a jump in demand from the private sector, says Lord at Macquarie. “In the first half of 2009 the only demand for new loans was from state-owned projects or for bills. There is definitely evidence of demand for lending from other parts of the economy,” he says.
Exit strategy
Record credit growth cannot be sustained in the long term without causing severe damage to the banking sector, and China’s banking regulator shows it is well aware of the risks. The China Banking Regulatory Commission (CBRC) has introduced tighter capital requirements in recent months, clamping down on lending that fuels speculative investments.
“Financial institutions should always stick to the bottom line of compliance management, in order to lay a solid foundation for risk management,” CBRC chairman Liu Mingkang said in September, calling for banks to strengthen their internal compliance measures with “professional, scientific approaches”.
Despite the slowdown in new lending, monetary conditions remain loose, and forecasters see little risk of a dramatic shift that could derail the economic recovery. Simpfendorfer at RBS expects rate hikes to come only in the second half of 2010, although he notes that a slower global recovery could delay that view.
The government’s exit strategy needs to be carefully timed. Withdrawing the stimulus too soon will kill off a recovery that depends so heavily on government investment, while continuing it for too long risks inflating asset price bubbles.
China’s focus needs to shift to economic reform, argues Simpfendorfer at RBS, who says a structural shift is required if China is to return to the growth rates of the last 10 years. “I would be happy to see growth at 6% if it was accompanied by economic reform, in particular reform that opened up new sectors to private investment,” he says.
Roach at Morgan Stanley says the lack of structural reform has been a “major disappointment”, calling for a social security system that would discourage precautionary saving and stimulate private consumption. “This crisis is a real wake-up call for China,” Roach says. “When you have an external demand-led growth strategy, you need a back-up plan.”
China’s government, however, controls the world’s most liquid financial institutions and is under no pressure to reverse its credit boom.
“China’s recovery is investment led, but there’s nothing wrong with that,” notes Rothman at CLSA, who likens the post-command economy infrastructure spending to a post-war reconstruction that “will be very productive in the long term”. He adds: “Growth doesn’t have to come from private consumption.”