Chinese debt concerns are complicated by two structural issues – the rise in borrowing by local governments and the increase in the role of the shadow banking system. Both sectors are testament to Chinese entrepreneurial spirit, but also point to deep problems in the financial system.
Outside of security matters or foreign affairs, China’s provinces, regions and centrally controlled municipalities enjoy a degree of autonomy. After the global financial crisis in 2007/2008, the aggressive stimulus measures to boost economic activity required the central government to relax controls on local government spending programmes.
According to the World Bank, China’s local governments have responsibility for 80 per cent of total spending but receive only about 40 per cent of tax revenue. As local governments are not legally allowed to borrow, they created LGFV (local government financing vehicles), also known as UDICs (urban development and investment companies). These special purpose arm’s-length vehicles, which are separate from but owned or controlled by the local government, can borrow.
The LGFVs generally borrow funds predominantly from banks (as much as 80 per cent or more), with the remainder raised by issuing bonds or other equity-like instruments. In recent times, with pressure on banks to curtail loans, LGFVs have borrowed from the shadow banking system. There are now more than 10,000 LGFVs in China, whose exact level of borrowings remains in dispute.
There is concern about the quality of the underlying projects financed, which are sometimes expensive, politically motivated trophy ones. Many of the LGFVs do not have sufficient cash flow to service debt, being reliant on land sales and high property prices to meet obligations. Probably more than 50 per cent of LGFVs have unsustainable debt levels.
In recent years, China has evolved its own substantial shadow banking system. There is the informal sector that encompasses direct lending between individuals and underground lending, often by illegal loan sharks that provide high interest loans to small businesses.
The larger sector consists of a range on non-banking institutions, which are subject to various degrees of oversight. It involves direct loans of surplus funds by companies to other borrowers or trade credit (often for extended terms). It involves non-bank institutions such as finance companies, leasing companies or financial guarantors. There are also more than 3,000 private equity funds, funded in part by foreign investors. An unknown number of micro-credit providers, consumer credit institutions and pawn shops provide personal credit. The largest portion of the non-banking institution sector is trust companies and wealth management products (WMPs).
Trust companies that control more than $1.8 trillion (£1 trn) – 20 per cent of GDP – finance riskier borrowers and transactions that banks cannot undertake due to regulations. Trust companies raise money from large investors and companies. The major attraction for investors is the high returns: about 9 to 12 per cent a year compared with bank deposits rates in low single digits. After adjusting for the trust company’s fee of 1 to 2 per cent of loan value, the ultimate borrower must pay about 10 to 15 per cent a year for the funds, well above the 7 to 8 per cent charged by banks.
The funds primarily finance local government infrastructure projects (via LGFVs), real estate and industrial and commercial enterprises. The high interest rates mean that the borrowers are riskier. Problems with assets supporting trust loans are well documented, most notably the “Purple Palace”, a half-built and abandoned luxury development in Ordos.
WMPs are higher-yielding deposit or investment products, with a variety of seductive monikers – Easy Heaven Investments, Quick Profits and Treasure Beautiful Gold Credit. They are sold through banks or securities brokers to a broader investor base than trust company investments.
WMPs invest in a variety of assets, ranging from low-risk inter-bank loans, deposits and discounted bills to higher-risk trust loans, corporate securities and securitised debt.
A central feature of China’s shadow banking sector is its complex structure. Banks may arrange and act as an agent in a loan from one non-financial company to another (known as entrusted loans). Banks can sell assets to trust companies or create WMPs to channel client funds to them. Banks transfer assets to the shadow banking sector. Corporate bonds may be bought by trusts, which are then repackaged into WMP products for bank depositors. The growth of the shadow banking sector is driven by the structure and regulation of China’s financial system.
The credit markets are dominated by the four major state-controlled banks (Bank of China; China Construction Bank; Industrial and Commercial Bank of China; and Agricultural Bank of China) that focus on lending to state-owned enterprises, firms associated with the government and officially sanctioned projects. Other businesses have more limited access to bank credit. The shadow banking sector fills this gap.
For much of recent history, bank deposit rates have been below inflation. Negative returns and have led savers to seek higher rates in the shadow banking systems.
Beijing’s attempts to rein in runaway credit expansion by reducing loan quotas, limiting lending to specific sectors such as local government and property and restricting riskier transactions, has also perversely encouraged growth of the sector. The shadow banking system exemplifies a popular Chinese saying – shang you zhengce, xia you duice – “policies come from above; countermeasures from below”.
Satyajit Das is a former banker and author of ‘Extreme Money’ and ‘Traders, Guns & Money’