By He Qinglian on July 3, 2013.
Source article in Chinese: 中国近期内会不会发生金融危机？
Due to the recent “money shortage”, the question whether China is facing a financial crisis became a trending topic. Discussion on this focuses on two main themes—those inside the financial sector wonder how big this crisis actually is, how profound an impact it would have on China’s economy, and whether or not the crisis would erupt; those outside the sector are concerned if a financial crisis would lead to a political one.
This article will discuss if a financial crisis would take place in China in the near future.
Worries about a Chinese financial crisis are not groundless.
A financial crisis can be further classified as a currency crisis, a debt crisis, and a banking crisis among others. There are good reasons/sufficient grounds that people feel worried that a financial crisis would emerge in China because, compared with the United States in 2008, there are indeed quite a number of similarities—take for example the rapid surge in credit and house prices, the increase in various forms of financial derivatives (chiefly operated by shadow banking in China), and on June 20 in particular, China's short-term inter-bank lending rates soared to 25%. This shortage of funds markedly resembled the US financial crisis in 2008.
On June 24, the Industrial and Commercial Bank of China (ICBC) claimed that as a result of its operation system upgrade, the bank's ATM system was suspended. After the incident, some journalists phoned and asked me, “would a financial crisis take place in China?” My reply was: those factors that triggered the US financial crisis in 2008 can be found in China. For instance, most of the economic indicators (short-term interest rates, monetary assets, securities, real estate, land prices and so on) are not good; starting from a few years back, there have been instances of SMEs going bankrupt; and the unemployment ratio has been on the increase. Besides, there are two other factors in China that were not seen in the US (in 2008): the continuous depreciation of the RMB inside China (the currency's exchange rate to the dollar hasn't changed much, thereby creating a false sense of stability of its value among the general public in China) and the voluminous debt of the local governments.
General speaking, any country facing either a debt crisis or a currency crisis would find the problem difficult to address. At this moment, China is facing both: first there is a debt crisis of local governments and enterprises (total size of these debts is somewhere between 120 and 128 trillion yuan; in 2012, the debts of non-financial sector of China reached 2.21 times the country's GDP); and second, there is a severe excessive issuance of the currency. According to the data released by the central bank, in the last three and a half years, China's money supply rose from 60 trillion to 100 trillion, an increase of 67%, as a result China became the world's largest "money printer."
Despite the accumulation of so many risk factors, a financial crisis will not take place in China in the near future. That's because China's financial system is different from that of the United States, its operations rely not solely on commercial credit, but national credit as well.
National Credit—the ballast stone of the financial ship.
Although facing the dual pressures of debts and inflation simultaneously, China would still find the situation manageable because of some simple reasons: China's financial sector is controlled entirely by the government, the country's commercial credit and its national credit is a pair of conjoined twins, the means that Western countries could not put to use when facing financial crisis are perfectly usable for the Chinese government so long as it deems those measures are necessary.
For example, the ways China’s financial system deals with bad debts are unparalleled in the world. In the past fifteen years there were two debt crises, and China’s financial industry managed to weather both.
The first debt crisis erupted in 1998. At that time the bad debts of the country’s financial system was roughly 1.4 trillion yuan. To address this, the Chinese government came up with an ingenious solution. In 1999, four asset management companies (China Huarong, China Great Wall, China Oriental Group, ChinaCinda) were established, and respectively they took in the bad assets divested from the ICBC, the Agricultural Bank of China, the Bank of China and the Construction Bank.
After repeated government maneuvers in “trading”, “divesting” and “funds injecting”, by 1999 1.3939 trillion yuan of bad assets were divested, about 1 trillion of which were non-performing loans from four state-owned commercial banks.
In 2006, when the bad debts of China’s banking system reached as high as 3 trillion yuan, the Chinese government divested those bad debts in much the same way, and then it attracted a dozen major foreign banks including Citigroup, UBS to inject funds as “strategic investors”. Those “divested assets” were subsequently repackaged for the market. With that, a staggering amount of bad debts disappeared instantaneously.
Banks of Japan deeply felt that they were dwarfed by the debt reduction ability of the Chinese counterpart. With decades of efforts, the Japanese banks only managed to reduce bad debts by a mere one percentage point or two.
When the financial crisis broke out in the US in 2008, banks in America found themselves facing some impossible problems. Many recalled the miraculous disappearance of astronomical bad debts from the Chinese financial system and joked that if Wall Street was taken over by a branch of the CPC, the financial industry of the US would definitely be saved.
I am convinced that now a sizable amount of new bad debts has emerged in the banking system of China, and to make them go away is not something difficult. They could do so by referring to old methods and devise new techniques according to the present situation.
Only that unlike in 2006, when foreign banks would buy bad debts of Chinese banks to understand the operation of China’s financial system and to reap profit by pushing up share prices of Chinese banks, most of them being able to exit from the Chinese market without suffering losses when the contract reached maturity; this time round it would be much harder to locate new strategic investors and new methods have to be found.
Why wouldn't there a financial crisis in China in the near future?
In recent years, some historical researchers pointed out that the fall of Ming dynasty was caused by a financial crisis. Thus some envisaged that if the general public in China were called upon to initiate a bank run, the financial system would be brought down, and a political crisis would ensue. This idea is conceived due to a lack of understanding of how the CPC manages the financial system.
First of all, while there is severe excessive issuance of RMB, and the populace have high expectation of an inflation, it is not very likely that today's China would undergo a bank run akin to the one that took place after the Nationalist government issued Gold yuan as the legal tender. That this is so is because the current economic system of the CPC differs from that during the Nationalist government era. At that time, both private and foreign capitals could start a bank, which could only rely on corporate credits; in today's China, banks are backed by national credit.
It is said that the central bank has in its disposal nearly 30 trillion yuan of excess reserves, there is no need to worry about bank runs.
Even if the exact figure of the excess reserves has been exaggerated (a common practice in China), bank runs are not possible there.
In addition to the public belief that the banks are owned by the government and will not collapse, a more important factor is that local governments would in no way let a bank run happen.
As early back as in June 1998, Hainan Development Bank was already bankrupt. The lessons as concluded by the Hainan provincial government was that, a run triggered by panicked depositors led directly to the closure of Hainan Development Bank in 1999.
Since then, whenever a local financial institution becomes bankrupt, the local government responsible would, along with implementing measures to prevent a run, instruct other banks to step in. And so basically there would not be a run.
The recent incident of “money shortage” in China, based on the public statement by People’s Bank of China Governor Zhou Xiaochuan that “the market is basically correct in understanding the central bank”, is interpreted as a “live-fire drill” of the central bank in its attempt to rein in bank credits and the scale of currency. More importantly, people buy into this explanation because they still maintain a strong confidence in national credits. The panicked feeling of “the wolf is coming” has effectively been alleviated.
Secondly, although the local debt risk may appear to be the risk of local government financing vehicles (LGFVs)—a creation unique to China, it would eventually be shouldered by the central government.
Broadly speaking, the bundled-interest relations between LGFVs and local governments are manifested in three aspects.
To begin with, LGFVs are established by local governments for financing purposes. These vehicles are predominantly composed of state-owned enterprises. As the law prohibited local governments from borrowing from the market, these vehicles became vital financing agents for local governments.
Secondly, local government treasuries are in communion with the assets of LGFVs. Local governments can not only transfer to LGFVs land as collateral when they apply for loans from those vehicles, but also funnel to LGFVs revenues from land sales that serve as their expected operating income.
Local governments provide capital to LGFV through various means including injection of projected income; transfer of existing assets like roads and bridges, use rights of land, and income from bond issuance by the central government on behalf of local ones.
Thirdly, local governments provide LGFVs with explicit guarantees to enable them to get loans from other lenders. To make these guarantees legal, local governments invariably put them into local budget which would be submitted to local People’s Congress for approval.
The existence of LGFVs has eased the pressure of budget deficits of local governments, and prevented the increase in explicit liabilities of local government. Local governments, therefore, like LGFVs a lot. However, these LGFVs apply for loans using land as collateral has resulted in treasuries of local governments becoming even more closely tied to land and real estate.
Under the circumstance that the real estate bubble could burst at any time, the good fortune of LGFVs would ultimately become a dreadful problem for the central government, that is, financial risks.
But in China, letting local governments go bankrupt is out of the question. The central government would in no way allow any local governments to be bankrupt or paralyzed. It would instead find ways to address the bad debts of local governments.
For the central government, this is only a piece of cake. Most banks in China operate on state funds; and the credit of those joint-stock banks, with state-owned banks and major state-owned enterprises as shareholders, is actually national credit.
With this, local governments and banks could be likened to two brothers with the same parents (the central government) who would clean up the mess of local governments. In an orderly manner, the risks would be distributed using a number of means and the economic development could thus continue. That’s why I don’t think a massive financial crisis would take place in China in the near future.
Therefore, my conclusion is that the financial system of China would, like the political system of the country, be in a state of moribund, but not quite dead so long as the regime is in power.
(In a separate article I would discuss whether or not financial crisis and inflation would trigger a political crisis in China.)