It's even worse than we thought

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Politics blamed for China's trillion-dollar bad debts

The real source of the banks' frailty is political patronage, writes Minxin Pei

May 09, 2006

ESTIMATES of the growing pile of non-performing loans (NPLs) in China appear to have caught many by surprise, especially because Beijing's efforts to clean up its rickety state-owned banks were thought to have greatly reduced NPLs and the risk of a full-blown financial crisis.

According to Ernst & Young, the accounting firm, bad loans in the Chinese financial system have reached a staggering $US911 billion ($1.18 trillion), including $US225 billion in potential future NPLs in the four largest state-owned banks.

This equals 40 per cent of gross domestic product and China has already spent the equivalent of 25-30 per cent of GDP in previous bank bail-outs.

The revelation shows that half-hearted reforms have addressed merely the symptoms of China's financial fragility. Poor business practices are blamed for NPLs but the real source is political. As long as the communist party relies on state-controlled banks to maintain an unreformed core of a command economy, Chinese banks will make more bad loans.

Systemic economic waste, bank lending practices, political patronage and the survival of a one-party state are inseparably intertwined in China. The party can no longer secure the loyalty of its 70 million members through ideological indoctrination; instead, it uses material perks and careers in government and state-owned enterprises (SOEs). That is why, after nearly 30 years of economic reform, the state still owns 56 per cent of the fixed capital stock. The unreformed core of the economy is the base of political patronage.

Once upon a time, I was a China-basher who lamented its strong competition and "unfair currency practices," calling it an "export juggernaut." China's economy is booming, but I've since learned that it's nothing to fear, let alone envy. "The grass is always greener on the other side," until we realize our neighbor's increasing income is out of necessity, and not because he's moving up by working more efficiently and earning promotions. He's working two jobs to replace the family's squandered savings, and to sustain its continued spendthrift practices.

Two years ago, when completing my undergraduate thesis on the U.S. current account deficit, China's non-performing loans were estimated at $180 to $200 billion. The more China prospers, the more money its corrupt officials can waste.

China's own internal chaos is why it invests so much in U.S. Treasury bonds. They're an extremely desirable form of savings, making them excellent collateral for China's insolvent financial infrastructure. Stephen Roach, Morgan Stanley's chief economist, has said we ought to thank the Chinese for funding much of our recent budget deficits. He is correct to note that much of the money comes from China, but he doesn't mention that the money originated with Americans. Also, he says that China is "plugging a hole in the American economy," but he doesn't acknowledge that China helps encourage the digging.

There is a key difference between U.S. debt today and U.S. debt in the 1980s and most of the 1990s. (Here I'm including Social Security revenues, which help reduce the actual budget deficit, because we're looking purely at how much money the federal government must borrow in addition to total revenues.) Remember that money is the ultimate fungible commodity, so ultimately it doesn't matter if I, Bill Gates and Junichiro Koizumi each invest $1 into Microsoft, Google and U.S. Treasury bonds, or if we each select one company and invest $3. Whether foreigners put money into U.S. Treasury bonds or other American assets, there was enough from everybody to satisfy federal borrowing. Now, since 1997, the current account deficit has consistently exceeded the federal budget deficit. That means that any money since 1997 that foreigners invest in U.S. Treasury bonds is effectively money they earned from exporting to us. This means the Federal Reserve won't have to worry about interest rates going up because of government borrowing, and it won't have to print money specifically so it can buy Treasury bonds and thereby fund federal budget deficits (which is very inflationary). The Fed, however, will still buy bonds as necessary to influence interest rates.

There's no historical correlation between federal budget deficits and the current account deficit. It appears correlated in recent years, but in fact, the current account deficit started surging in 1998 when the federal budget deficit was decreasing. As I said, China helped encourage the digging. When it started purchasing more and more U.S. Treasury bonds, when it started competing for bonds, using dollars it earned from exports to the U.S., China helped suppress interest rates (initially for Treasury bonds, then other bonds too). This meant that Americans who'd have otherwise invested in bonds shifted to investment assets not dependent on interest rates, or they used the money for consumption spending. So the current account deficit didn't start because Americans one day decided to spend more, or even because they realized someone else will lend the money. Their decision was all based on interest rates, like Treasury bonds and savings accounts. Roach forgot that in a free market, if domestic businesses aren't getting enough domestic investment, and foreigners cannot supply the capital, then domestic businesses will offer higher and higher interest rates until they attract enough money.

Still, we should indeed thank the Chinese. They get what they need, the world's safest bond to shore up their banking system. We get to double a small portion of our national income for around 5% interest, which we likely will be able to afford to pay in the future, and by definition for less than how we benefit today.