WHO PAYS FOR CHINA´S BAD LOANS ? / THE WALL STREET JOURNAL ( VERY HIGHLY RECOMMENDED READING )

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JUNE 22, 2011, 12:45 P.M. ET.

Who Pays For China's Bad Loans?

By TOM ORLIK

There is no such thing as a free stimulus.

At first sight, China's response to the financial crisis looked cheap. A fiscal deficit totaling 3.1% of gross domestic product in 2009 and 2.6% in 2010 compares with 12.7% and 10.6% in the U.S. The reality is that it was considerably more expensive than that.


China's response to the crisis came primarily from bank loans rather than central government debt. With many of those loans now threatening to turn bad, the cost may still end up on the government's balance sheet.


The heart of the problem is debt taken on by local government financing vehicles in the course of two years of huge infrastructure investment. These are entities created and backed by local governments to get around legal constraints on their borrowing. No one knows how much debt they have.


A survey by the National Audit Office, with the findings set to be reported to the State Council and published next week, is expected to answer the question. Until then, the best numbers come from the China Banking Regulatory Commission, which puts total borrowing at $1.4 trillion at the end of 2010, and the People's Bank of China, which has hinted the figure could be as high as $2.2 trillion.


Those numbers are big, but not that big. First up, not all of the loans will go bad. According to a separate CBRC study in summer 2010, 26% of loans to local government vehicles have serious deficiencies. Putting that together with the PBOC's higher figure for the loans outstanding suggests $572 billion as a back-of-the-envelope estimate of bad debts.


Using the aggressive assumption that nothing is recovered on those bad loans, $572 billion is equal to 9.7% of 2010 GDP. That is still low versus the huge debts the U.S. racked up in the course of the crisis. In the context of China's low central government debt (17.7% of GDP at the end of 2010), a high rate of growth and substantial assets on the other side of the balance sheet, the cost looks manageable.


With the chances of a debt crisis small, the real question is who will pick up the tab. The first option is for a local government to step in as guarantor to protect the banks. With local budgets already strained, town halls that face higher costs for servicing debt will need to squeeze spending on public services.


The second option is for the banks to take the hit. Fear about that possibility has contributed to a sharp fall in bank stocks since the start of the month, with Industrial & Commercial Bank of China down 11%. But the government won't leave the banks, which it controls, to swing in the wind. A continued wide spread between government-set interest rates for deposits and lending should provide them with enough of a cushion to muddle through. That means bad news for households—which do most of the saving in China, with no end in sight to the implicit tax on their deposits from negative real interest rates.


So while the real cost of the stimulus isn't yet clear, there is little doubt that China's long-suffering households will pick up most of the bill in some form. That is another impediment to rebalancing the economy toward domestic consumption. After all, households can hardly be expected to hit the shops at the same time as they are squeezed by the government and the banks.

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