Can China’s Boom Be Sustained?
Economists worry about bad loans and breakneck growth, but fundamentals remain strong.
From the fifth-story window of the executive offices of Fosun International, China’s largest privately held conglomerate, the future seems as luminous as the glittering Shanghai skyline reflected across the Huangpu River.
Peering out, Fosun’s president, Wang Qunbin, sees a forest of skyscrapers, including the new Shanghai World Financial Center, a 101-story shaft of steel and glass — the second-tallest tower in the world — looming like an enduring beacon of prosperity.
Fosun is at the forefront of China’s infrastructure boom, with more than three quarters of its 2009 revenues (35 billion yuan, or $5.2 billion) flowing from real estate construction, steel, minerals and other raw materials of construction. Not surprisingly, Wang believes China’s boom is years from sputtering.
“We are still confident China will continue its current fast pace of growth for at least a decade, if not several,” says Wang, 41, a co-founder of Fosun. “China is still urbanizing. The government is cracking down on real estate speculation, and it is good for the market. It means the strongest players will survive while the weak ones will die.”
Worried that the country will grow too fast, leaders in Beijing have imposed rules to cool the economy, especially the overheated property market. First-time home buyers, for instance, must now place a cash down payment representing at least 40 percent of their purchase; a second house requires a 50 percent down payment. Some regions have ordered banks to stop issuing new home loans to non-first-time buyers altogether.
[Video Caption: China’s Growing Prowess. The next 15 years will see China deploying its savings and cash to snap up assets, foresees Jonathan Slone, chairman & CEO at CLSA. He discusses the country’s growing prowess, with CNBC’s Bernard Lo. Airtime: Sun. Sept. 12 2010 | 9:30 PM ET]
Chinese leaders fear that their 4 trillion-yuan stimulus, launched in 2008 to offset the financial crisis, may have caused an investment bubble. Compounding fears is the fact that local governments enacted their own stimulus packages simultaneously.
China doesn’t allow local governments to issue bonds; hence local governments, which were responsible for coming up with 70 percent of the 4 trillion-yuan stimulus, had to borrow about 2.82 trillion yuan from banks.
Concerned that the Beijing-led stimulus plan wasn’t sufficient, local governments borrowed an additional 7.7 trillion yuan, about 50 percent of which was in the form of loans with a three-year maturity; the rest mature later. These were funneled into government-owned investment firms.
“This mess came as a result of panic among officials in the aftermath of the Lehman Brothers collapse,” says Beijing securities lawyer Guan Anping, a former Commerce Ministry official. “They were in a huge rush to stimulate the economy and didn’t plan it well. To date, they have refused to give too many details on where all the investments went.”
The combined spending binge, equivalent to 33 percent of real gross domestic product, spurred Chinese enterprises — many of them state-owned — to build skyscrapers, housing complexes, bridges, expressways and bullet-train networks, and helped China manage a rapid recovery in 2009 during which GDP grew by 9.1 percent.
It also coincided with property prices doubling in major cities such as Beijing and Shanghai, in which residential prices reached an average of 30,000 yuan, or more than $4,400, per square meter, far beyond the affordability of most Chinese home buyers. China’s per capita income is about $6,675 per year, 92th among major world economies, according to the World Bank.
One cautionary sign of a housing bubble: 64.5 million new apartments and houses sit empty, according to the Chinese Academy of Social Sciences think tank. Many of those units were purchased by China’s new millionaires, who were wagering on a steadily rising property market.
Another telling sign: Up to 23 percent, or 1.8 trillion yuan, of the 7.7 trillion yuan extended to local government-owned investment companies represents projects that may be unable to service loans.
Some China watchers question whether the country can sustain its stunning recovery in the longer term, especially as developed economies languish and emerging markets, increasingly dependent on Chinese investment, show signs of weakness.
“I think China will not have a financial crisis in the next 12 months, because banks are rolling over many de facto nonperforming loans,” says Victor Shih, an assistant professor of political science at Northwestern University. Shih’s landmark study on local government debt exposed the makings of a financial crisis.
“I have learned to not predict financial crises, but unless decisive steps are taken to recognize the sizable NPLs and to clean up banks, investors’ confidence in the entire financial system may begin to erode,” Shih says. “After [nonperforming loans] are recognized, the government can use market mechanisms like auctions for NPLs to digest the problem. Although painful in the short run, one must recall that China emerged from the last cleanup a much stronger economic force.”
The International Monetary Fund predicts that China’s economy will grow by 10.5 percent in 2010 and 9.6 percent in 2011. However, the Fund, in its July 9 economic report, largely concurred with Shih: “The main risks facing the Chinese economy include a renewed weakening in the global recovery, a worsening of credit quality (notably from an expansion of lending to local governments) or a misstep in the government’s response to rising property prices.”
The major concern is debt repayment.
“Some infrastructure projects with real profit potential in the long term may not generate enough cash flow in the near term to service ongoing debt commitments,” observes Hong Kong–based Qu Hongbin, who is chief China economist for HSBC Holdings. “Other projects designed more as public goods — for delivering positive social and economic development externalities — may have no profit potential at all.”
No one outside the government has a clear breakdown of how the total 11.7 trillion-yuan stimulus was spent, and Chinese officials aren’t revealing details.
However, Sun Mingchun, Hong Kong–based economist at Nomura Securities, believes the 309 public projects revealed in 2009 by the central government, although amounting to only 20 percent of the combined packages, is a representative sample. For that group, 42 percent of the money went toward building railways, 30 percent for highways, 6.6 percent for nuclear power plants and 6.5 percent for power grids, with the rest for airports, subway systems and ports.
Leaders in Beijing are considering replacing potentially nonperforming loans in the stimulus program with government-issued construction bonds, according to many economists.
Nomura’s Sun says Chinese leaders recognize the severity of the issue: If even half of the 11.7 trillion-yuan package turned nonperforming, it would spark a financial crisis. That is why government investigators are reviewing local government records, he says — to get an accurate assessment of the nonperformance overhang.
He adds that China’s central government has ample ability to manage a higher debt level. Even if the entire stimulus package became nonperforming and had to be replaced with bonds, China’s public-debt-to-GDP ratio would only rise from about 20 percent to 57 percent. “That still is well below the average of 80 percent” for members of the Organisation for Economic Co-operation and Development, he says.
Sun also believes China’s rapid fiscal revenue growth — an average 19.7 percent per year in the past decade — will help slow the expansion of public debt. Taking on substantially higher debt “should not, in our opinion, create any real concern over the fiscal sustainability of China,” he says.
Many of China’s larger banks already are planning rights issues to increase their capital base as an offset to nonperforming loans. Simon Ho, director of Asian banks research for Citi Investment Research Asia Pacific, says five Chinese banks — Bank of China, Bank of Communications, China Construction Bank, China Merchants Bank, and Industrial and Commercial Bank of China — are planning to raise a total 295 billion yuan in new capital through A- and H-share issues in the next few months.
Despite the rise in potential credit risk, Standard & Poor’s maintains a stable outlook for the Chinese banking sector. Its ratings for China’s largest banks include A– with positive outlook for ICBC; A– with stable outlook for Bank of China and China Construction Bank; and BBB+ with stable outlook for Bank of Communications.
The debt issues likely will hurt China’s regional and local banks the most. Some 20,000 local banks existed in China three years ago; there are only 4,000 today, according to S&P analysts Qiang Liao and Ryan Tsang in a note issued July 21.
To be sure, the two wrote, China’s nonperforming-loan ratio is higher than government estimates of 1.3 percent — more accurately, it is between 3 and 4 percent, a level that could double in the next two years. “But we expect the ratio to still stay below 10 percent until the end of 2012,” Liao and Tsang wrote, adding that their assumption is based on the success of big state-run banks in their rights issues and on local governments providing support to their financing companies.
S&P expects nonperforming loans will go no higher than 10 percent in part because under chairman Liu Mingkang, the China Banking Regulatory Commission has been stringent about requiring banks to keep their loan-loss ratios low.
Perversely, perhaps, a financial crisis in China’s provinces may be good for the forces of privatization, says HSBC’s Qu, who notes that the 7.7 trillion-yuan local stimulus also expanded asset portfolios at all levels of local government. Qu believes many local governments may be forced to sell assets to pay down debt. “Local governments own toll roads, ports and other commercially valuable assets,” he says. “In any case, selling these assets is a must to shift local governments away from business activities to public service,” a key objective of government reform plans.
Another positive: The new bond-for-loan swaps will boost China’s nascent bond markets. “More issuance of long-term construction bonds should be a welcome development for China’s bond market,” Qu says. China’s bond issues have a market capitalization of about 50 percent of GDP, much lower than the 170 percent limits in the U.S. and Japan. “A deepened bond market not only provides a more efficient and cheap channel for fundraising, in particular for the infrastructure projects with multiyear duration, but it also helps to reduce the risks in the banking and financial system,” Qu says.
Analysts, however, have concerns.
Charlene Chu, a Beijing-based analyst with Fitch Ratings, says Chinese banks moved an aggregate 1.3 trillion yuan of mortgage loans — out of a total outstanding loan balance of 47.4 trillion yuan as of June 30 — off their books and repackaged them as structured investment products. The loans were subsequently sold as “trust” or “wealth management” investments with a promise of 100 to 300 basis points in yields.
Unlike similar products sold in the U.S. and Europe that have third-party guarantees, those sold in China do not, Chu says. “The high concentration of loans in these products is very significant in terms of credit risks,” she says. “If a mortgage borrower defaults, there is no credit available to absorb those losses.”
On June 1 the CBRC prohibited banks from selling these structured products, but according to a senior executive at Bank of China who asked not to be identified, banks are getting around the ban by selling structured products through trust companies.
“These products are being sold to investors in many ways as a substitute for deposits,” Chu says. “Many people believe there is an implicit guarantee from the bank that they will get their money back. The banks say the risk is off their books. We believe the banks will ultimately be held liable.”
Citi’s Ho disagrees, arguing that the risks in China’s banking sector are overstated. “There are NPL issues from the rapid lending last year to local government vehicles,” he says, but “this is manageable” for the banks. “We’re not seeing the typical signs of a crisis.”
China has not experienced excessive debt across the economy, with the loans-to-GDP ratio falling from 2003 through 2008, says Ho. Government controls keep credit and interest rate spikes from damaging the economy. “Through the recapitalizations that are planned in the coming months,” he notes, “the big state-owned banks will be even better capitalized to supply credit to the economy.”
Ma Ning, head of research at Beijing-based Goldman Sachs Gao Hua Securities Co., sees little reason for concern.
“I don’t see a China financial sector shakeout coming,” says Ma, pointing out that the retail deposit base is six times the level of mortgage lending. Moreover, the government is cracking down on property speculation, so housing prices should fall even as incomes rise.
“The most important thing that will drive China’s growth for years to come is urbanization,” Ma says. “Hundreds of millions of people will move to the cities to live.” He understands the skepticism. “There was a 33 percent loan growth in 2009, and people are rightly concerned about asset quality,” he says. “Our view is, it depends on how long China can grow. Even when NPLs rise, liquidity won’t dry up as long as there’s economic growth. If growth falls, that is when liquidity may dry up.”
The key is to look at GDP growth in the next two years, Ma says. “So far, we think China will manage a soft landing. We see double-digit growth this year and next year.”
Jing Ulrich, chairwoman of JPMorgan Chase & Co.’s China equities and commodities business, thinks there’s reason for optimism. “Concerns of a double-dip recession in China are largely overblown,” she says. “While the rate of global economic recovery is slowing, it is far from the negative GDP growth developed nations experienced in 2008 and 2009.” China’s economic fundamentals remain strong, with the slowdown largely a result of planned policy tightening, Ulrich says.
She notes that the use of leverage in Chinese real estate purchases is much lower than that during the lead-up to the subprime crisis in the U.S. Even before policy tightening, the minimum down payments for first- and second-home purchases were 30 percent and 40 percent, respectively. “Chinese banks’ internal stress tests have indicated that they can withstand a 20 percent to 30 percent fall in property prices without having a significant impact on NPL ratios,” Ulrich says.
Fosun International’s Wang remains staunchly optimistic. In May he led the company to acquire a 7.1 percent stake in Club Méditerranée, the Paris-based high-end resort operator. The deal, worth just €23.4 million ($28.2 million), is part of Fosun’s strategy to expand into both foreign luxury brands and holiday travel. In 2009, Chinese travelers made 1.9 billion domestic trips and 40 million private outbound trips. “We are strong believers in China’s growth story,” he says. Wang’s logic is simple: As hundreds of millions of Chinese migrate into the cities, they will demand housing, consumer brands — and holiday resorts.
His fifth-floor office view, a landscape of soaring architecture, lends credence to his optimism.