Local Debt Puts China Boom on Hold

Inventories of raw materials sit idle as production slows

By Dr. Mark A. DeWeaver

Dr. DeWeaver manages the emerging markets fund Quantrarian Asia Hedge and is the author of Animal Spirits with Chinese Characteristics: Booms and Busts in the World’s Emerging Economic Giant (Palgrave/Macmillian)

Earlier this year, Chinese steel producers were ramping up for a boom in local-government infrastructure spending.  The emphasis on ‘urbanization’ at last November’s National Party Congress was expected to have set the stage for large numbers of new projects to be launched throughout the country.  Over the next ten years, some four trillion yuan (645 billion US dollars) is supposed to be invested in the expansion of China’s cities and towns.

So far, however, things have gotten off to a surprisingly slow start.  Inventories of steel, iron ore, and coking coal are piling up.  Steel prices are down about 7 percent since late February, after rising by some 15 percent during the preceding five months. Producers have started cutting production and extending maintenance periods.

Where did the steel makers go wrong?

Chinese animal spirits

To understand their mistake, we have to begin by taking a look at the forces that drive Chinese investment cycles.  While generating booms and busts in investment that look a lot like those in capitalist economies, China’s ‘animal spirits’ are a product of state-sector decision making rather than private-sector manias and panics.  They are the result of political rather than economic factors.
In China the means of production continue to be monopolized by the state.  Entities that are at least partially state-owned account for the lion’s share of investment.  Land is almost entirely state or collectively owned.  The so-called ‘commanding heights’—key sectors such as banking, telecommunications, and oil and gas production—are all occupied by state-owned enterprises.
State ownership does not imply central-government control, however.  Most of the economy is in the hands of local governments.  These control all but about 100 of China’s approximately 100,000 state-owned enterprises and almost all of the country’s developable land.  They are also responsible for enforcing most of the central-government’s laws and regulations.
The economic dominance of local governments leads to overinvestment because local officials’ promotion prospects depend more on GDP growth within their jurisdictions than on any other single factor. They also generally do not face real bankruptcy risks.  Their incentives thus favor quantity rather than quality.

‘Investment enthusiasm’ (as the Chinese call it) tends to be strongest immediately after local officials take office.  Generally they want to launch projects right away, in order to ensure that as much of the resulting GDP growth as possible will occur during their tenures.

As a result, investment booms tend to follow National Party Congresses, most officials being assigned to new posts around the times of these meetings.  All six of the investment cycle tops that have occurred since 1977 happened within the first two years following a congress.  And every congress except the 1997 15th Congress has been followed by a top within the ensuing two years.  (Congresses are held every five years.)

Given that a congress was held last November, it’s easy to see why the steel makers should have increased production.  Why should this time be different?

The local debt hangover

Local officials are certainly not short on investment enthusiasm.  But the localities are now facing a fiscal hangover from the last investment boom in 2009.  Total local government debt is estimated to be anywhere from 10 to 20 trillion yuan (1.6 to 3.2 trillion US dollars)—20-40 percent of Chinese GDP.  Much of this consists of non-performing loans, which the state-owned banks have been forced to ‘evergreen’ or have shifted into off-balance sheet ‘wealth management products’.
This debt crisis had its origins in Beijing’s response to the 2008 global financial meltdown.  In order to keep Chinese GDP from falling below 8 percent, the central government allowed the localities to borrow heavily from the state-owned banks to finance investment projects.  Most of this borrowing was done through entities known as ‘local government investment platforms’ (LGIPs), which local governments set up to finance investment within their jurisdictions.

LGIPs were backed primarily by the localities’ expected revenues from future land sales rather than by cash flow from investments. Many of these reportedly consisted of redundant infrastructure projects or were in sectors with excess capacity. By the end of 2009, some 8,221 LGIPs were reported to have borrowed the equivalent of 240 percent of total nationwide local government annual revenue. Seventy percent of their projects were said to be unprofitable.

A 2011 LGIP audit uncovered serious problems with collateral and capital adequacy as well.  In some cases the same plot of land was pledged for multiple loans. In others, incorrect valuation was an issue. One locality was reported to have taken out a10-million yuan loan using land with a market value of only 3 million yuan. As Chinese banks generally only lend 60-80 percent of the value of collateral, this particular site must have been overvalued by at least 300 percent.

Sometimes the registration status of the land was also in doubt.  Some local government entities pledged city parks, land under administrative offices and stadiums, farmland illegally converted to other uses, or sites to which they did not even own the land-use rights.

The auditor also found that about one in every seven local platforms was not properly capitalized.  There were cases in which the capital had not actually been contributed, was illegally contributed by local governments or entities they controlled, or was subsequently withdrawn.

Beijing’s response to the 2008 global financial crisis thus sowed the seeds for a new crisis by allowing the state-owned banks to lower their lending standards.  While this strategy worked well in the short term, the severe strain it put on local-government finances has now become a threat to China’s long-term growth prospects.

Beijing’s dilemma

At this point, Beijing has no good options.  Allowing the banks to finance another investment boom will put the banks at risk.  But with export growth falling, investment is now more essential than ever for GDP growth.

The leadership claims that it can resolve this dilemma by engineering a transition to consumption-led growth.  This would require a redistribution of Chinese national income from the state to the household sector.  The necessary reforms will inevitably be blocked by the powerful interest groups that benefit from the status quo.  State-owned enterprises are not about to give up the massive subsidies they currently enjoy.  Nor can they be expected to start paying out more in dividends.

Indeed this is not the first time Beijing has attempted to ‘rebalance’ the Chinese economy.  Transitioning to a more efficient ‘mode of growth’ has been a central part of every five-year plan since 1982.  Yet China’s economic imbalances have only worsened.  Investment as a share of GDP is still rising at the expense of household consumption, following a trend that dates back to 1962.  Excess capacity continues to grow.  Air pollution indexes in some cities are off the charts.  The gap between rich and poor is steadily widening.

Beijing’s attempts at economic restructuring have always failed because the fundamental problem is political rather than economic.  As long as China remains a Leninist one-party state, its only real options will be investment-led growth and stagnation.  Transitioning to a different economic model will not be a real possibility as long as the ‘leadership of the Party’ goes unchallenged.

The outlook for steel is thus not quite as bad as it seems.  When faced with a choice between growth and stagnation, the central government has invariably chosen to allow investment to grow at the expense of the banking sector.  While the next boom may have been put on hold, sooner or later credit will once again start flowing to the local governments and the investment cycle will begin again.

China’s animal spirits may be dormant for now but they are far from extinct.