Shuang Ding, China senior economist
Frequent alarms have been raised recently with regard to China's local government debt and the shadow banking. Are commentators crying wolf, or the wolves are actually approaching us? A deep dive points to risks accumulating at a worrisome pace, but the problems still appear manageable.
Local government debt expanded rapidly during the global financial crisis. According to the official audit, the broadly defined debt of the local governments reached about Rmb11 trillion (US$1.78 trillion) by end-2010, or 28% of gross domestic product (GDP), relative to about 18% of GDP by end-2008.
The government started to limit the debt growth in 2011, but economic slowdown in 2012 prompted another round of government-sponsored investment. As a result, the local government debt may have arrived at Rmb12 trillion-Rmb15 trillion by end-2012, but remained below 28% of GDP.
China's shadow banking was relatively small, but has grown rapidly. According to our estimate, the size may have reached about 55% of GDP in 2012, compared with an average of 111% of GDP for major economies (based on a 2011 estimate by the Financial Stability Board). However, the stock of wealth management products grew by a stunning 47% in the first nine months of 2012.
The exposure of the banking system to the fast growing local government debt poses significant financial risks, as a large portion – 20% by some estimates – of local government debt is potentially non-performing. Major rating agencies have downgraded China’s credit outlook over lack of progress in containing local government debt and credit expansion.
The government has started to address the risks by adopting a broad surveillance system of local government debt and strengthening regulation of wealth management products. The central bank has indicated that monetary and credit policies will gradually shift from an easing bias toward a neutral position. China can still grow out of the problems if the risks are properly managed, and in a timely manner.
Dariusz Kowalczyk, senior economist/strategist Asia ex-Japan
Crédit Agricole CIB
The Chinese Politburo recently called for guarding ‘against potential risks in financial sectors’, a sign of concern over financial risks. These risks centre on local government debt and the banking system.
While not new, the risks take increased importance at a time of unexpected deceleration of the economy in the first quarter of 2013, as they are more difficult to manage amid slower growth and because stimulus in China usually involves an increase in local government debt as well as in bank lending.
We are concerned about China’s financial risks, for two reasons: magnitude and transparency. Official data on local government debt, from 2011, puts it at Rmb10.7 trillion, although there have been indications of some decline. If measures aimed at curbing house-price gains succeed, land sales revenue may well suffer, reducing the ability of local governments to service their obligations.
Banks’ off-balance sheet products are likely high in value and may well involve substantial risks. Moreover, transparency regarding the two issues is limited. A former official has recently suggested that local government obligations may be much larger than reported. It is even more difficult to quantify off-balance sheet positions of the banking sector.
Despite the concerns, we believe the above risks do not pose a major threat to the financial system or the economy. This is because of the ability of the central government to manage them given its low debt and deficit levels (14.9% of GDP and 1.6% of GDP, respectively). Beijing could bail out local governments, if needed.
It could do the same for banks, should they require more capital, using its stockpile of US$3.44 trillion in foreign exchange (FX) reserves, although the capitalisation ratio of the banking system has increased sharply over the past few years, making such a scenario less likely. Overall, we expect stability of the financial system and a solid pace of growth of its economy.
Le Xia, senior economist
The high level of local government debt and expansion of banks’ off-balance-sheet activities, or “shadow banking”, are two domestic financial fragilities (along with rising property prices) that we monitor closely, given potential risks they pose to financial system stability in China.
The buildup of local government debt is the legacy of the huge stimulus package of 2008-2010 to counter headwinds from the global financial crisis. For its part, the growth of shadow banking activity is due to banks’ efforts to evade policy tightening to prevent overheating, and more generally to circumvent financial repression.
While local government debt and shadow banking activities pose risks to financial stability over the medium term, for the time being we believe they remain manageable given early government actions to curtail them.
But they pose a number of difficulties in the near term. The high level of local government debt acts as a constraint to further policy easing at a time when the economy loses momentum.
Moreover, off-balance-sheet activities generate vulnerabilities for banks in the form of liquidity risk, maturity mismatches, and legal/reputational risks associated with the issuance of wealth management products.
The cost of dealing with the local government debt burden could be high for banks. They may ultimately be on the hook for writing off at least a share of these credits, dampening.
The cost of cleaning up the high local government debt is one of the factors underlying our projection of falling bank profits in the coming years.
Louis Kuijs, chief China economist
Leverage in China’s economy has risen strongly in the last five years with most new lending in the non-bank financial sector. At almost 50% of GDP, this includes a thriving business in wealth management products (WMPs) and trust company products. Some four-fifths of the value of WMPs has been facilitated by banks but only half has been issued by the banks themselves, with banks functioning more like agents for third parties such as asset management firms and trust companies in the other cases. Together with normal bank lending, total lending in China’s economy is worth 180% of GDP, up from 120% in mid-2008.
What are the main concerns with regard to financial risks?
In our view, the pace of increase in overall leverage has simply been too fast in recent years, especially in the non-bank sector. Moreover, there are specific risks stemming from the rapid expansion of non-bank lending. In addition to maturity mismatch, asset quality is likely to be worse than in mainstream banking.
For instance, some WMPs offloaded from banks’ balance sheets are based on lending to companies and local government investment platforms (LGIPs) that would find it hard to get access to normal bank lending, such as LGIPs with projects considered risky because of weak revenue streams. So there is a need to rein in the pace of increase in leverage and associated risks.
China’s government has recently taken steps to strengthen regulation on non-bank lending. We expect policymakers will do more in the coming months to contain its expansion. This is likely to affect economic growth, although past experience and our empirical analysis suggest that the impact on growth should be manageable if policy action is well-coordinated.
In our view, three reasons reduce the likelihood of any systemic financial crisis as a result of a too rapid rise in leverage. In the real economy, growth has been broad-based rather than dominated by real estate and construction. In the macro realm, indicators on saving, household leverage and fiscal and external sustainability are sound. With a reasonable capital-to-asset ratio and a loan-to-deposit ratio of 70%, China’s banking system is less leveraged and substantially better and easier funded than the systems in the crisis countries, making it more robust to shocks.
As a result, we are not as worried about systemic financial instability as some commentators are. However, that is no reason for the government not to take action to rein in risks and costs of an unsustainably rapid rise in leverage.