An AFP headline caught my attention the other day, "Some debt defaults 'healthy' for China market: central bank." This is interesting to me because I am currently using Michael Pettis' (2013) analysis of China's economy as my working hypothesis or analytic framework for sifting through information about China's economy (there are others in my head, but this one has been getting a lot of play). According to this view, China's adherence to what Pettis calls the Asian Growth Model has overstimulated investment in China leading to many investments that will never never pay off. In short, without major reforms, the loans associated with these investments will eventually go into default leading to a credit or banking crisis.
One of the things that has been fueling the supposed over-investment is the high level of government spending (both at the central and local levels) on investments. Loans associated with government projects are implicitly guaranteed by the government, which makes them seem like good bets for banks even if the prospects of the investment actually paying off are dubious. Therefore, banks will loan more money to more of these projects than they would to private investors. Also, when you have government banks lending money for government projects, there is always the suspicion that these loans are not being scrutinized enough by the banks.
Therefore, it is interesting to see People's Bank of China (PBC) deputy governor Pan Gongsheng acknowledge the problem by saying "Guaranteed repayment... although it will ensure short-term stability, won’t help the market to effectively differentiate risks and will eventually lead to accumulated risks." Even more interesting is his suggestion that allowing defaults on some of these loan might help the banking system do a better job of managing risk by injecting some risk into the system. Presumably doing so would force banks to be more selective in evaluating and approving loans.
However, there is the danger that doing this now amounts to closing the barn door after the horse got out. This would be the case if Chinese banks had already issued lots of bad loans, or what would be bad loans if they were not based on the belief that payments would be guaranteed by the government. Weakening the payment guarantees on these loans now cannot effect decisions that have already been made.
The question then is whether China already has a dangerous amount of these loans on the books. I have previously discussed the possibility that China's large investments in High Speed Rail might turn out to be wealth destroying in nature.
But, perhaps a better example of over investment may lie in the so-called Ghost Cities of China. These are massive urban development projects that have remained largely uninhabited. Adrian Brown reported on several such examples in a 2011 SBS Dateline Report. The report notes that China was building 10 new cities a year, but found several of the cities remain empty several years after being built. Against a back drop of modern high rises under construction, a Hong Kong analyst likens the urban construction to Pyramid building in that it contributes to measured GDP growth while doing nothing for the quality of the population's life. The report notes that the apartments being constructed are priced way above the ability of most Chinese to afford. So, while there is a huge demand for better housing, these cities remain mostly vacant. The report suggests that China may creating a massive real estate bubble.
About a year later, Yale economist Stephen Roach made the counter argument that China needed to build these cities in anticipation of a massive migration of the population from rural to urban areas. With 15 to 20 million people moving from rural to urban areas each year, Roach argues that China cannot wait to build infrastructure and housing to accommodate them. He points to the city of Shanghai Pudong as an urban project that was empty when it was built in the 1990s, but had grown to a population of 5.5 million by 2013.
However, last September, Brown revisited a city in his earlier report for another Dateline report, and found that little had changed over the previous 2 years except that the government did not want him there. He also found new cities under construction.
Also, this week the Sydney Morning Herald reports that at least one of these cities are now on the brink of financial collapse. The city of Ningbo has $570 million in debt, mostly to banks, and is one the verge of collapse. The report estimates that there are 10 other cities that y find themselves in a similar situation. As for the migrations of people from rural areas, the report noted that China's workforce has decreased in the last two years and the flow of rural workers to urban areas halved since 2010, from 12.3 million to 6.3 million per year.
If, as PBC's Pan Gongsheng suggests, the government lets local governments default on loans, this will not only jeopardize outstanding loans to these cities but make it much harder for them to get new loans. These cities will need new loans to roll-over current loans and to get additional funds for operating and maintaining their property. Therefore, unless delicately handled, such a change in policy might bring the situation to a head and spark a crisis in more ghost cities. In deed, it might uncover problems in cities that don't appear to be ghosts at first glance.
So, we may have a good old fashioned real estate bubble here. The government, both at the central and local levels, may have acted like a real estate developer that see a trend (i.e., the growth of urban populations and the success of cities like Shanghai Pudong) and bets heavily on it continuing unabated in the future. The trend then abates leaving the developer with a very bad investment and a bunch of bad loans.
Also, we may have something unique to China due to the planned nature of its economy. As suggested by the analyst in the 2011 Dateline report, China may have been using urban construction to meet GDP growth targets. In this scenario, the central government set growth quotas for regional governments to meet. This created an incentive to not only engage in urban construction, but also to focus on constructing high value property like luxury high rises and shopping malls. Doing so inflates the paper value of the property constructed and justifies higher costs of construction which adds to the short term stimulative effect of the project.
The downside of doing this is that, years later, the actual value of the real estate may fall short of the property's paper value and the inflated cost of constructing it. At that point, the value of the property will have to be written down and the loans allowed to default with a negative impact on GDP. Pettis (2013) argues that because of this much of China's recent growth in GDP may turn out to be illusory and show up as future decreases in GDP if/when the loans go into default.
While you might think that this would discourage such short sighted decision making, the incentive structure of local and regional bureaucrats might encourage it. From the bureaucrat's point of view, meeting the growth target is the key to keeping his/her job and exceeding the target is the key to being promoted. Once promoted, the bureaucrat's responsibilities will shift and the project will become somebody else's problem by the time it collapses. Therefore, the bureaucrat has an incentive to focus on the short term effects of the policy and place minimal emphasis on its long term effects. Pettis (2013) notes that this is a recognized problem with government planning known as the Commonwealth Effect.
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