Will China Face a Crisis Akin to the U.S. Subprime Disaster?

The Chinese local governments’ debts have tripled since 2007. Will they be the next  U.S. ‘subprime’?

By Louisa Wah Hansen

According to a recent Financial Times article, “China’s national problems start in local government,” the Chinese local governments’ debts have tripled since 2007, and they are sucked into a vicious cycle of recurring borrowing due to a weak revenue structure. “Many wonder if Chinese local governments might be the next ‘subprime,’” writes the author George Magnus.

China Business knowledge talked to Prof. Terence Chong Tai-leung, Executive Director of the Institute of Global Economics and Finance and Associate Professor at the Department of Economics of The Chinese University of Hong Kong (CUHK) about his views and suggestions on how the Chinese government can get out of the debt spiral.

What is your view on the severity of the situation? Is it a crisis similar to the subprime crisis in America in the brewing?

I don’t think this problem is as serious as the one in the United States because most of the government debts are local debts. Currently the debts of the local governments are estimated to make up about 30 percent of the GDP, whereas the debt of the Central Government is estimated at around 10 percent of the GDP. The total debt of China is around 40 percent of the GDP. I don’t think it is a very high level compared with Japan, where the debt is around 200 percent of its GDP. In some countries it’s 100 percent. As long as the debt makes up less than 50 percent, it is manageable.

Also, it depends on whether the debts are internal or external. If they are mainly external debts, then China would be in trouble. If they are internal, then the Central Government can issue bonds or print more money to resolve the debt crisis. The reality is that most of China’s debts are bonds and borrowings from the big four banks, which are basically government institutions. So it is just like moving debts between the right hand and the left hand. If these banks have any problems, the government would intervene. The growth of China is at the expense of accumulating debts. But the debts are not a problem unless they trigger a domino effect of a bank crisis. As such, I don’t think the scenario of the subprime crisis will ever happen in China.

Even though the situation may not be as severe as the subprime crisis in the U.S., there was a report that a local government official stopped approving borrowings and made this public knowledge, because the situation was getting out of hand. What’s your take on that?

Of course local governments do realize they have a lot of debts. But you have to look at the structural reason for that. Every city or province in China aspires to increase its GDP because of the reward system in China’s politics. If the GDP of a province grows and achieves a certain target, the provincial governor will be promoted. Or if you achieve a higher percentage than the target, you can be promoted to an even higher position. So the local government officials will use every means to boost the GDP, and they do that at the expense of issuing debts to finance all kinds of projects. While they have created the debt problem, they don’t worry about it as long as they get promoted. So the debt problem will remain.

Why do the local governments have to resort to borrowing? Don’t they get taxes and other forms to revenues?

Generally, the local tax income may cover 30, 40 or 50 percent of the expenditure. The Central Government subsidizes around 20-30 percent and the rest is covered by land sales, real estate developments and so on. The local governments have to stand on their own feet and therefore they have to resort to borrowing.

Ideally, how can the local governments transform their weak revenue structure so they can operate in a more sustainable way?

The problem can easily be solved if they can sell more land and rely more on land revenues. But the Central Government has very restrictive measures on land sales.

They can also cash in on some of the infrastructure built in the past, like bridges and toll roads, so they can use the revenues to pay back bank interests and debts.

The main problem facing local governments is that they are not allowed to issue bonds as they don’t have credit ratings like the states in the United States. So one way out is for local governments to issue bonds to the Central Government, and when the Central Government buys these, they can then sell its own bonds to international buyers. If the RMB is more internationalized, Central Government bonds will have a demand in the world market.

Do you think this will happen in the next decade?

Sure, but total internationalization is difficult because it depends on two things: one is whether the capital account is totally open so people can bring money in and out freely. Currently there is strict capital control—you can only bring RMB20,000 out of the country per day.

Secondly, you have to reform the whole financial system, so that banks can operate in a free market and interest rates can be liberalized. In China, there are no market interest rates. It’s all controlled by the government. There is control over the maximum amount of deposit rate and the minimum of loan rate in order to guarantee the four big banks’ profits. Small banks cannot compete because they cannot increase their interest rates to attract deposits or lower the interest rate to attract borrowers. But financial reform would be really difficult because it may hurt the interest of those in power.

I think it may still take at least 10-15 years for RMB to be fully internationalized.

Do you see any local government wanting to make a change and get out of the debt situation?

I don’t think so. Debt is not the main concern of provincial and local governments unless the Central Government imposes the promotion criteria of lowering the debt ratio to a certain level. It all depends on the Central Government.

Do you think Premier Li Kequiang’s view of allowing China to rely more on “market mechanism” would work in this case?

China is already running on market mechanism very well in many parts of the economy. But the problem is that the major stakeholders are still the government institutions such as the big banks. The government gives every institution an official rank. This means the head of the institution is actually a government official with a rank. These officials transfer from company to company every three to six years, so their main concern is not to make profits. What they’re looking for is not to do anything wrong so they will get promoted automatically. In that case, the market mechanism can’t fully function, because market economy is based on profits.

So my suggestion is, if you want the market economy to work, you must abandon all the official ranks for the state-owned enterprises. Instead, assign business managers to run them. I also have two other suggestions: allow the interest rates to be determined by the market, and allow more foreign banks to operate in China to create a more competitive environment.

Compared with the local government debts, how serious are the risks posed by shadow banking in China? According to JPMorgan Chase, it could be as large as RMB36 trillion, or 69 percent of China’s GDP.

I don’t have the statistics of shadow banking as it is impossible to have official statistics for illegal activities. The shadow banking problem should be more serious, I believe, as you can see that if the 69 percent figure is true, it is higher than the 30 percent of GDP that local government debts make up. But the two are inter-related, as local governments also borrow from shadow banking, and some may also engage in short-term lending there. As long as there is an artificially maintained gap between the official deposit interest rate and lending rate, there will always be room for shadow banking to survive and thrive. So the solution is to remove this gap.