For years, China has been viewed as a place flush with money, erecting gleaming airports, highways and entire cities seemingly overnight. But experts say that much of that building — and impressive economic growth — was fueled by debt that local governments are now struggling to repay, especially as the economy slows down.
“You’re dependent on creating new debt every day,” said Anne Stevenson-Yang, co-founder of J Capital Research, a Beijing-based analysis firm.
On top of that, the old method of taking on more debt to drive growth may be losing its potency.
“It takes a lot more credit to produce the same unit of output than it did five years ago,” said Nicholas Lardy, an expert on China’s economy at the Peterson Institute for International Economics.
Analysts say China risks entering a vicious cycle. The slower the economy grows, the harder it becomes to pay back loans. The more defaults there are, the more banks pull back credit that could be supporting economic growth.
The unfolding events in China, the world’s second-largest economy, are being closely watched by U.S. economists and investors because of the close ties between the countries. This week, the rate spike and manufacturing slowdown contributed to volatility in U.S. stock markets. Rates in China eased off their record Friday.
China’s leaders have acknowledged problems with its financial system, and President Xi Jinping has vowed to reform the country’s economy in sweeping ways that rebalance China’s sources of growth, from an economy dependent on speculative investment and real estate to one that relies more heavily on consumption.
“We believe the new leaders are fully aware of the financial risks in the economy,” wrote Zhiwei Zhang and Wendy Chen, economists at Nomura, the investment bank. “As their tenure will last for 10 years, they are willing to tolerate some short-term pain in order to achieve long-term policy objectives — preventing financial crisis and delivering sustainable growth.”
But there’s some disagreement on how much China’s leaders are actually in control of the situation, and how well they can manage the political perils if people are out of work or see their wealth stop growing.
Stevenson-Yang said that soon, even China’s famously large U.S. dollar reserves will start dwindling when the government has to step in and shore up its financial system.
“It’s like going down a tunnel where the walls get closer and closer,” she said. “This is not a liquidity crisis. This is a debt crisis, which is way more systemic and difficult.”
Part of the issue is that China’s financial system is still relatively immature, at least compared with developed economies. The banking sector is awash with so-called wealth management products that form the backbone of a largely unregulated shadow banking industry. These short-term products offer high returns, but they are often invested in risky assets such as real estate.
The growth in shadow banking has been astronomical as banks have pulled back on traditional lending. In 2008, there was an estimated 1 trillion renminbi (or about $163 billion) worth of outstanding bank-issued wealth-management products, according to Nicholas Borst in a recent paper with the Peterson Institute for International Economics. By the end of last year, that amount had grown to more than 7.1 trillion renminbi, or about $1.16 trillion.
Interest rates with traditional savings deposits are so low that many ordinary Chinese have begun purchasing these often riskier products in the hopes of getting higher returns on their money. The products are so ubiquitous that they’re regularly advertised on people’s mobile phones.
The situation is potentially so dire that Xiao Gang, the chairman of the board of Bank of China, wrote an op-ed earlier this year saying the products amounted to essentially “a Ponzi scheme.”
Still, some have faith that the Chinese government will step in before things go haywire.
“Unlike the banking system in other countries, most of the Chinese banks are state-owned. . . . The resources which the central government can offer are abundant,” said Chen Gong, founder and chief researcher at Beijing-based Anbound Consulting. The banks “might be on the edge of collapse, but they will never collapse.”
Liu Liu contributed to this report from Beijing.