China's Systemic Risk

Borrowing by China's local governments threatens to saddle banks with nonperforming loans.

A Chinese financial newspaper last month reported a case in which a Shanghai township took two billion yuan ($293 million) in loans intended for a new railway and instead used the money to repay other debts and invest in real estate projects. While the large sum involved may be unusual, such tales of misappropriation have become more common since Beijing began encouraging bank-financed spending on infrastructure a little over a year ago. Evidence is mounting that the problem of local government debt is already extremely serious and could eventually threaten the country's financial stability.
Victor Shih, a professor at Northwestern University, wrote in these pages in February that his research put the level of borrowing by local government investment entities between 2004 and the end of 2009 at 11.4 trillion yuan ($1.7 trillion)—or about one-third of annual GDP. That figure stirred up a lot of controversy, with regulators insisting that the loans stood at six trillion yuan.
Beijing has since asked banks for an updated accounting of such debt on their books, however, and it's looking more and more like Mr. Shih was on the right track. The government has revised up its estimate to 7.8 trillion yuan, and more revisions may come as the banks continue to report. A new report from Goldman Sachs last week implicitly supports Mr. Shih's calculations.
But the total figure is only important in the context of the trend of new lending and the quality of the loans. And here things get even murkier.
So far Beijing has clamped down on lending to county-level governments, but city and provincial entities continue to have no trouble getting credit. The counties were always a small part of the total, probably less than 20%. Total new bank lending in the first quarter of this year dropped off significantly compared to the same quarter last year, but at 2.6 trillion yuan it was still pretty spectacular. So it's safe to assume that the headline number continues to grow, albeit at a slower rate.
What we're learning about those loans doesn't inspire much confidence, either. The China Banking Regulatory Commission has brought out a new requirement that loans to local government investment vehicles be better collateralized. It turns out that the banks were only demanding collateral worth 40% to 50% of the loans.
Local government loans tend to be particularly corrupt because of the collusion among local officials, bank managers and regulators. Cases abound in which the three groups all took their cut out of new lending. And even at the national level, nobody is interested in revealing the true level of the banking system's nonperforming loans, which have been officially capped. This is a rerun of Japan in the 1990s and the crisis of the jusen housing loan companies; the government is complicit in allowing the banks to "evergreen" loans by continually rolling them over.
Mr. Shih thinks about one-quarter of the local government loans could eventually go bad. China is in the process of creating a huge moral hazard problem, as all the players feel free to abuse the highly liquid banks safe in the knowledge that the central government with its massive foreign exchange reserves and capacity to borrow will bail everybody out when the bills come due. This attitude has real costs and eventually causes systemic risk.
In the late 1990s and early 2000s, paramount leader Jiang Zemin delegated Premier Zhu Rongji to be the enforcer of economic discipline, making sure that corruption, lending and investment didn't get out of hand. It's troubling that today's top leaders seem to lack their predecessors' political will.