Source: Carnegie Endowment—
After discussing the troubled rural banks in Henan in my previous post, it is important to note that what happened in Henan was not the first adverse credit event to hit the Chinese financial system. It was just the most recent in the country’s latest string of notable financial events, which can be said to have started back in May 2019 with the intervention in Baoshang Bank. A little over a year later, Baoshang became the first Chinese bank to be shut down since Shantou Commercial Bank closed shop in 2001.
The Baoshang case was followed by interventions or investigations involving several other institutions, including banks, shadow banks, property developers, local governments, homebuyers, and other overextended borrowers. Because these events seem to be happening regularly, and with rising breadth and magnitude, it should be clear that they are not isolated events that can be blamed on the various triggers that set them off. They are far more likely to be part of a systemic problem that has been brewing in China’s economy for more than a decade.
This means, among other things, that even if the property market recovers next year as a consequence of the end of pandemic lockdowns, the recovery can only be partial and temporary. In the medium term, property prices will continue to decline, and insolvencies will keep on emerging. Until the systemic problem is addressed and resolved, there can be no permanent stabilization of China’s property market or of its economy more generally.
CHINA’S FINANCIAL DETERIORATION
At the heart of this credit-deterioration process is the way in which the form and structure of economy activity in China has evolved over the past ten to twenty years. In most countries, GDP is a measure of the output delivered by economic actors over a specified period, whereas in China GDP is an input determined politically at the beginning of a time period. Once China sets its GDP target, local governments (and, until recently, the property sector) have had the responsibility of delivering enough economic activity to bridge the gap between the GDP growth target and what Beijing usually calls “high-quality growth”—that is, the underlying growth rate delivered by the private economy, consisting mainly of consumption, exports, and business investment.
Bridging the gap between the two was not a problem for the Chinese economy during the first thirty years of the period known as reform and opening up (the late 1970s until the late 2000s), mainly because China was seriously underinvested in property, infrastructure, and manufacturing capacity, so the investment that the GDP growth target required was, for the most part, productive. It is probably not a coincidence that during these years China’s GDP growth almost always exceeded the growth target, sometimes by a few percentage points.
This began to change ten to fifteen years ago, by which time China had largely closed the gap between the investment it had and the investment that the economy could productively absorb. When that happened, China should have dramatically lowered the share of production it reinvested, but to do so without causing a sharp drop in the growth of economic activity required rebalancing the economy toward greater consumption, which in turn meant transferring income from previously successful parts of the economy to the household sector.
This has always been the hardest part of rebalancing (as I discuss here). China, like other counties that have followed this model, found itself politically and institutionally unable to manage the transfers. It did, however, keep investment growth rates high and—again, like nearly every other country that has followed this model—China began to overinvest systematically in projects that contributed less to the economy than they cost. The result was a sharp increase in the country’s debt burden: it is only when debt is used to fund nonproductive investment that debt rises faster than a country’s debt-servicing capacity, for which GDP is a proxy.
The Chinese financial system is wholly dominated by banks, and the credit allocation decisions among the banks are effectively determined administratively, largely through various forms of “window guidance” by the People’s Bank of China, the State Council, and/or local-governments. Because of that, the rise in debt was most likely to occur either on the balance sheets of the banks or on those of entities supported by the banks.
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