Source: Financial Times
Bad Loans Could Take Their Toll on China’s GrowthWill China have a banking crisis? Beijing’s massive credit stimulus will almost certainly lead to a future surge in bad loans, but so what? As the more optimistic of China analysts have pointed out many times, the last jump in non-performing loans a decade ago was also widely cited as a sign of impending doom, and yet nothing happened. China grew its way out of the loan mess at little apparent cost.
But did it? The optimists have almost certainly failed to understand how Beijing paid for its earlier banking crises. In fact, the cost of resolving the previous surges in non-performing loans exacerbated China’s domestic imbalances. The current build-up of bad debt may very well do the same.
Beijing used three main tools to manage previous increases in bad loans, all of which passed costs on to bank depositors. First, the central bank slowed the accumulation of non-performing loans by keeping lending rates low. Low borrowing costs made it easier for struggling businesses to roll over the debt as the economy grew and reduced the real value of debt payments.
Second, policymakers infused the banks with additional equity, partly directly and partly by purchasing bad loans at above their liquidation value. They financed these capital infusions by borrowing, which at artificially low rates has the effect of passing the repayment burden on to lenders. Finally and most importantly, the central bank mandated a wide spread between the bank lending and the deposit rate, which increased the profitability of banks substantially and so helped to recapitalise them.
Beijing’s strategy was very successful and certainly prevented a banking crisis, but there was nonetheless a cost. The bail-out implicitly required that bank depositors subsidise the cleaning up of the banking industry. This in effect represented a large transfer of income from the household sector to the banks, to government and to businesses. It is perhaps not surprising, then, that during the period of the bail-out household income, already a relatively low share of gross domestic product, declined to alarming levels.
This is the real risk of rising non-performing loans in China. It is not that China’s banks are likely to collapse. Debt levels are certainly high and highly pro-cyclical – normally a toxic combination – but Beijing largely controls domestic funding and can protect itself from the bank runs that plagued the US and Europe. Like Tokyo in the 1990s, Beijing is in a strong position to continue to fund its rising bank-related liabilities and will not have a debt problem any time soon.
The danger is that the cost of cleaning up the banking system will fall, as in the past, on the household sector. China must reduce its excessive reliance on exports and investment to fuel its continued growth, and the only way that can happen is if household consumption rises as a share of GDP. But since growth in household consumption has always been constrained by growth in household income, it may be unreasonable to expect a surge in consumption when households are also required to clean up a sharp increase in bad loans.
Over the next few years, as trade tensions increase and the world finds it increasingly difficult to absorb China’s rising capacity, the country’s growth will rely more than ever on the growth of household consumption. If the worriers are right and non-performing loans surge, China can nonetheless easily avoid a banking collapse. But that does not mean the cost of cleaning up the banks will be negligible. On the contrary, it will put even more pressure on low-consuming Chinese households and will make the inevitable rebalancing of China’s economy much more difficult than many expect.
Japan showed how difficult. Since 1990 Japanese consumption growth has limped along at between 1 and 2 per cent annually as households have been forced indirectly to clean up their own bad loans. The economy grew much more slowly. Just as Japan slowly rebalanced its economy towards consumption, so must China.
If future Chinese consumption growth also slows because households are forced to foot the new bad-debt bill, we may see the real cost of the current explosion in bad loans – several years of sub-par growth.