Could you briefly describe the growth of debt in the Chinese economy?

The biggest boost in bad debt started between 2008 and 2009. There was a global economic recession at the time, and growth rates in every country of the world slowed down dramatically, including China. The Chinese leadership, which was then under Hu Jintao and Wen Jiabao, did not want growth to fall too much, so they launched a stimulus program. The problem with the stimulus program is that it wasn’t just financed by fiscal deficit, which is what most countries would do with a fiscal stimulus. On top of the fiscal stimulus which used up probably two to three trillion Renminbi, the central government also authorized local governments to borrow a huge amount of money from banks to build infrastructure.

So local government formed thousands of financing vehicles to build development zones, highways, rail road, bridges, and lots of subways. Beijing used to have just two lines. Now it has 15. And they keep on adding to these lines. In the case of Beijing and Shanghai, such infrastructure is productive because Beijing really needed more subways and more roads given its large population. However, when it comes to third and fourth tier cities where population are shrinking, they really don’t need new infrastructure. Nevertheless, a lot of infrastructure was built in these cities with bank loans. The infrastructure did not produce any cash flows themselves. The local governments initially benefited from the stimulus, but their economies didn’t really do so well. For example, Western China, or North Central China or Inner-Mongolia and Shanxi provinceare places where young people didn’t want to live in any more. They are moving to places like Beijing and Shanghai. So infrastructural investment generated very little economic returns in some of the “abandoned” areas. As a result, the local governments began to lose their ability to repay debt, starting around 2011 and 2012.

At that point, the Chinese leader Premier Wen Jiabao could have made a decision to acknowledge the debt problem and try to write down the debt. When you write down the debt you basically say, “Fine, I admit that we don’t have the ability to repay this debt.” The central government will just have to get into a lot of deficit, issue a bond and use the bond to pay the banks back for the bad loans. That was one option they could have taken. But the Wen Jiabao administration did not do that. Instead of acknowledging the bad debt problem, the central government ordered all the banks to roll over the bad debt. 

So what happens when you roll over a bad debt? If I lend you a hundred dollars and charge you five percent interest, a year later you will have to repay me a hundred and five dollars. It’s a hundred dollars’ principal and five dollars’ interest. What if you can’t pay it back? If I roll over a debt, this is what I would do: I would lend you a new loan that is a $105 which becomes the new principal. Then you can use the $105 loan to repay the principal and interest of your existing loan. Now on my balance sheet all my loans are good because I gave you a new loan, and the old loan was repaid to me from you. This is basically what is happening to the banking system in China but on a very massive scale. But if you notice, the new principal is not a hundred dollars any more, it’s a hundred and five dollars because the interest gets capitalized into the new principal. Therefore, you can imagine if this were to happen over time, the debt, even if there is no new borrowing, will rise automatically because the interest payment gets capitalized or rolled into the balance of the original loan. And this is what’s happening in China. 

At the same time, new bad assets are being generated on a very large scale because the Chinese government wants to maintain growth every year, maybe not higher growth rates, but they want positive economic growth. In order to achieve the government’s goal, the size of investment that’s financed by debt has to grow by ten, fifteen, twenty percent every year, which means bad loans have to increase by the same percentages. Now I would estimate that the amount of total non-financial credit in China, by that I mean the total amount of money that households, firms and governments have borrowed from both the formal financial institutions and the informal credit system in China, is probably about three hundred percent of Gross Domestic Products (GDP), that is two hundred trillion RMB (roughly $30 trillion) by the end of this year, and government-related debt is roughly around eighty-three percent of GDP if you included local governmental and the central government debt. These are very large numbers actually, over sixty trillion RMB. The disappointing thing about the current administration is that there is still no willingness to confront the problem, and really the only way to confront the problem is to write down debt. That is to admit that this is bad debt and they are going to write it down or at least do something about it. No matter what, the first step is to acknowledge it. No one high up in the authorities wants to do that; instead everything the Chinese government is doing is to roll over bad debt. 

There is a new scheme now. It’s called “municipal debt,” that is basically issuing new debt that is guaranteed by the central government at a low interest rate in order to repay existing local government debt that had a higher yield. By doing that you actually lower the interest payment for local government, but the principal is still there, and the interest payment is still being capitalized. That’s not really resolving anything. That’s just what we call “kicking the can down the road,” which is to delay the problem.

In what ways will the rising tide of bad loans in the Chinese banking system affect the Chinese economy? What will be the biggest concern for international investors?

The most likely outcome is the devaluation of the RMB, because the world, and certainly China itself doesn’t want a financial crisis in China when nobody wants to buy financial assets any more. There will be rapid de-leveraging which comes about when no-one wants to buy anything. Then the financial assets that used to be worth a lot are now worth nothing because it is no longer traded by investors. It’s zero, or deeply discounted. Those who hold the financial assets will go bankrupt. But that is unlikely to happen in China because there is the People’s Bank of China. If the worst comes to worst, the People’s Bank of China can print a massive amount of money and buy up all the financial assets, or even physical assets, that people don’t want, like real estate. If there is a big crash in real estate market, I actually think it’s quite possible for the PBOC to just print money and just buy real estate directly. In fact, they are already doing that on a smaller scale. If they can do that on a small scale, they can do that on a large scale. Therefore, I think the possibility of a financial crisis is small. 

But of course when you print so much money to buy assets, your currency is going to devalue. This is why the RMB is under a lot of devaluation pressure. Within China when you read the newspaper as well, you can often read article that says, “we are under pressure because of the U.S., and the U.S. is going to hike rates.” That is one reason. But I think the more fundamental reason is because everybody in China knows that the PBOC has to print more and more money or there would be a financial crisis, and that means the currency should get cheaper and cheaper, and that is a fundamental driver. Even if the Federal Reserve never hike interest rate again, this would still be the case in China and would still make RMB weaker relative to the U.S. dollar. Because after all, the U.S. no longer does this. The U.S. did quantitative easing for a while, but it has stopped doing so. It hasn’t hiked interest rates yet, but it has stopped quantitative easing for sure, whereas everyone knows that China has to do greater and greater quantitative easing over time, and that is the foundation of a weaker RMB. At a certain point, the reserve is going to run to such a low level that the central government will have to float the currency, which means that the RMB can devalue by 20 percent, 40 percent, or even 50 percent. It’s anyone’s guess. Once you let the market determine the exchange rate, it’s hard to tell where it goes. 

If that were to happen, it would be a pretty big shock to the world. Because first of all China will have a lot less purchasing power, which will hurt China’s ability to buy raw material from around the world. If the exchange rate goes down by 50 percent, obviously fewer people will be able to come study abroad. On top of that of course, Chinese exports’ prices will get a lot cheaper. It’s going to lead to a vicious kind of competitive devaluation in the region, which will also have negative consequences to the world. The way things are going is unavoidable because China cannot stop printing so much money. It has to. The debt level is too high, and obviously they don’t want a financial crisis, so they have to print money.

What are the measures taken by the Chinese government in addressing its debt problem? With debt at such a high level, how do you think the debt problem will play out, in terms of the possible triggers of crisis, timing, and consequences?

At the very beginning of the Xi Jinping and Li Keqiang administration, around 2013 and 2014, the China Banking Regulatory Committee issued a decree to limit the increase of local governmental debt by provinces. Provinces that were highly indebted had very little leeway with which to increase their debt. Provinces that had lower debt, like Shanxi province, could get into more debt. 

But that measure, along with the anti-corruption campaign, drastically slowed down economic growth, which was unacceptable for the central government. This is a dilemma. They have tried to contain debt, but even when they did that, debt kept on going up, though at a slower pace. The Chinese government still wants to maintain a six-percent growth rate, so after a year and a half, by the time we get into 2015, the state council gave up that idea and told the local governments to keep borrowing again. Moreover, the central government gave the local government this new instrument called the municipal debit, which I mentioned earlier. The original idea about municipal debt is that every province would get a quota. For example, If Jiangxi province has a three hundred billion RMB quota, that would be all the new debt allowance for it. They very quickly deviated from that. The local government financing vehicles were issuing their own debt on top of the provincial municipal debt, on top of the new bank loans and so the local government are now firing on all engines borrowing money. As a result, local governmental debt actually grew at its fastest pace in the past year than any other time since 2009. After the enormous growth in 2009, China grew at a slower pace. But the local debt, if you include everything, actually grew very fast in the past twelve months. Because the economy was slowing down so much last year, the central government is now encouraging Chinese households to borrow more money. Chinese households now have to borrow more money to buy properties, because properties are getting very expensive, exceeding the savings of a lot of households. As a result, we have seen household debt growing very fast in China as well. It used to be at a very low level, like 20 percent of GDP. It has now surpassed 40 percent of GDP and by my calculation, within three years, is going to be over 80 percent of GDP, which is close to the level of household debt when the U.S. got into trouble back in 2008.

If Deng Xiaoping and his government were to lead China today, how would his government react to the bad loans situation China is facing now?

Actually, I think things would be different. First of all, Deng Xiaoping wanted to reform and it stalled after Deng Xiaoping got sick. He died in 1997, but he had been very sick since 1995. That was when Li Peng came back with his proposal to grasped the big State Owned Enterprises and let go with the small SOEs. From that policy, the SOEs got very strong and well-financed in China. I think if Deng Xiaoping had lived for another twenty years he would not have allowed that process to go on. He would not have allowed SOEs get so big and strong. He wouldn’t have necessarily privatized all the SOEs, but he certainly wouldn’t have allowed them to get into these multi-trillion RMB conglomerates. Maybe he would preserve a few like China Petroleum, Electric Grid and a few strategic SOEs, but I think Deng would have allowed a lot more private investments in many other sectors and foreign investments in many other sectors. 

The economy would have been a lot more liberalized today had Deng lived for another ten years and been healthy and conscious. What Li Peng did and, to some extent, Zhu Rongji did in the late 90s formed the foundation of what we see today which are these multi-trillion RMB SOEs with a lot of political clout and the ability to borrow a huge amount of money from the banks. That is all a legacy of the late 1990’s. 

We have seen a burst of small business in China recent years. How does Xi's government's encouragement on national entrepreneurship affect Chinese economy? Would you consider this as even worsening the health of the banking system?

The way that they are doing it is very counter-productive, because both the central government and local governments have government financed venture capital funds. These funds have been given like billions of RMB, and ultimately the central bank is printing the money and giving it to these funds. 

The way that the funds are being allocated is highly political. The main people who will get the money will be the children of the elite and the children of various “connected” people. Are they necessarily the most innovative and creative people in China? In some cases, yes they are, because they are very well educated. Also in a lot of cases when you set up something like that and it is run by the government, it’s going to attract a lot of opportunists -- a lot of fraud to try to grab this money. In fact, we had this guy from the National Development and Reform Commission to visit us at UCSD just few weeks ago who told us that they are detecting a lot of frauds. There may be companies saying, “we are going to get the new patent in electric cars.” Then they just took the money and lend it in the shadow banking system to arbitrage the interest rate. It’s free money, so if you lend it for ten percent, you will get ten percent free return. That is not what the money is supposed to be used for. Nonetheless when you give people free money they are going to use that to defraud the government. I think the spirit of it is very good but the way to truly encourage innovation is to deregulate. Just give people a free hand and allow foreign venture capitalists to come in and invest on a very large scale -- allow them, give them clear ways to an exit, and clear the channels for off-shore listing. On that front, China has done pretty good and a lot of people are attracted to venture capital market in China, except now you have all this bad money flooding into the market. 

Another thing is that they are over-paying a lot of mediocre opportunities. By that I mean these are not complete frauds but they are not great things that you would want to pay a lot for. Since people are getting free money, they are putting up the prices of a lot of mediocre opportunities. 

Today on the annual meeting of IMF, Vice President of People's Bank of China claimed that he has confidence in the "stabilization" of Chinese economy, and that the policy makers will make efforts in pushing the shift from investment and industrial oriented economy to a consumption and service oriented one. Is this a sign of Chinese government's plan in strengthening the control of financial market?

There is a saying about the Chinese government that they always brag about what they don’t have. He is giving his speech and that is his job. The People’s Bank of China is in charge of the stability of the RMB, so obviously he wants to project as positive of an image of the Chinese economy as possible because that makes his job easier. But the problem is that when you look at the latest statistics, the share of fixed asset investment as a share of GDP is actually rising. I do believe the PBOC would like to see this ratio drop some more, except the problem is that there is the growth target. I think the growth target is very bad for China. Why do you need to grow at 6 percent? Why not 5 percent or 4 percent? Unemployment is very low in China so it doesn’t need to grow at 6 percent. Because of the 6 percent growth rate target, the NDRC, the PBOC and the Minister of Finance, they all have to make sure that trillions of RMB in infrastructure projects are launched every year; otherwise they wouldn’t be able to reach the growth target. In order to do that, the share of investment has to be high. That crowds out private sector activity, because the banks have to lend all the money they have to these fixed asset investment projects, and then there is not as much money left over for the genuine private sector and the service sector. However, unfortunately because of the growth target, the policy makers in Beijing have come to recognize that it is a necessary cost, and they are actually squeezing the private sector in order to achieve the growth target, so the legacy of the plan economy is still very much alive in China. They don’t care about the quality of the growth. They only care about achieving the goal.

The economy will be stable, because it is under the government’s control. They don’t dare to go below 6 percent because that would be in violation of the target. They can have a little bit of flexibility and say, “Oh well, we don’t necessarily have to do 7 percent, but it can’t be below 6 percent. Somebody will get into trouble.” Everyone in China is like this quantitative metrics.