China’s Growing Credit Risk

The bubble grows as Beijing keeps pushing growth before reform.

       Photo: Getty Images

Respectable financial analysts once derided the tiny coterie of “China bears” for warning that the country could face a financial crisis. But over the last year the risk of a bad loan reckoning has become conventional wisdom. While Beijing possesses the resources to shore up the banking system, its continuing efforts to stimulate growth with more lending are complicating China’s economic and political predicament.

The latest alarm comes from the Bank for International Settlements, the clearing house of central banks in Basel. Its latest quarterly review shows that China’s credit-to-GDP gap, which measures credit growth above a country’s long-run trend, is now 30.1%. Anything above 10% is usually considered a red flag.

The idea behind the ratio is that there is no specific debt level that causes problems in all economies, but a sudden borrowing spree is a good predictor of a crisis. It suggests a mania in which loans create the illusion of high returns, which justifies more borrowing. The U.S. credit-to-GDP gap breached the 10% level in 2007 right before the housing bubble burst. As Goldman Sachs GS 0.13 % warned earlier this year, “Every major country with a rapid increase in debt has experienced either a financial crisis or a prolonged slowdown in GDP growth.”
The speed of China’s borrowing was staggering as Beijing opened the credit taps to stop the effects of the global financial crisis from reaching China. Total debt in the economy zoomed to more than 250% at the end of last year from less than 150% at the end of 2007.

This is especially worrying because the ratio continues to climb despite Beijing’s decision last year to rein in wasteful investment and undertake supply-side reforms. The government promised to stop state banks from evergreening, the practice of making new loans so troubled borrowers can repay old ones. Such zombie companies were supposed to go bankrupt. Instead China has seen few defaults.

Beijing has a good political reason for its caution. Carrying out reform promises would slow growth, and every time that happens social unrest soars. The protests this year in the town of Wukan seem to reprise the violence seen there in 2011, the last time the economy went south.

In the past few months Beijing has encouraged the three policy banks to finance new investments by state-owned enterprises. Banks have also fueled a mortgage boom that has boosted property prices. While the central bank hasn’t cut rates or reserve requirements, it has used open-market operations to give banks more liquidity.

Government statistics show that the banks’ nonperforming-loan ratio is approaching 2%, an 11-year high. But even officials acknowledge that the real number is much higher. Banking analyst Charlene Chu has predicted that it could reach 22%. That would require Beijing to recapitalize the banking system as it did in the early 2000s.

Fixing the financial system could be much messier this time, due to the advent of shadow banking. The state banks have created a complex web of “wealth management products” that attract investors with higher returns than ordinary deposits. According to Ms. Chu, WMPs grew by $1.1 trillion last year, accounting for nearly 40% of total credit growth.

These short-term liabilities fund long-term assets, a mismatch that has exacerbated crises elsewhere.

And many of the buyers are other institutions, reminiscent of the U.S. mortgage-backed securities in 2008. Savers don’t understand the risks, and banks have been forced to repay their principal when the WMPs fail. A run on these investments could cause serious unrest and erode middle-class trust in the government.

Beijing faces a daunting challenge of engineering a market-driven deleveraging of an economy that has become dependent on monetary and fiscal stimulus. Managing the inevitable political fallout could be as dangerous as the economic risks.

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