Seeing red: China’s credit addiction

In June, the Chinese government made a fruitless attempt to curb the nation’s increasing dependency on credit. By August, loans from shadow banks reached an all time high. If lending continues at this rate, the Chinese economy is heading for a dip.

China responded to the economic events of 2008 with an investment-heavy stimulus programme supported by vast credit expansion. Though state investment has always been disproportionately heavy in China – rising from under 30 percent of GDP in 1980 to nearly 40 percent by 2005 – in the three years from 2008, investment grew by 12 percent. The majority of this was funded by state owned enterprises and local government, rather than the central government’s contributions, which were fairly modest. China has an autonomous system of nationality in each region, meaning local governments manage the economy of the area under their jurisdiction. This creates discrepancies in investment policy between regions.

Large-scale investment was put into a policy of heavy infrastructure regeneration in order to boost the economy. Investment in China increased 10 percent between 2001 and 2011, rising from $7bn to $74bn. The focus of these funds was in the undeveloped mid to Western China, such as the areas of Inner Mongolia, Gansu, and Shaanxi. As recently as 2012, 60 new regeneration projects, at the total cost of $150bn were commissioned.

While China no doubt needed investment for the purpose of modernisation, the rate at which this investment grew was detrimental. If one takes the example of the growth of the transport industry, within which 25 major new undertakings were funded by government investment in 2012 alone, it soon becomes clear that developers and owners will struggle to continue financing these inaugural projects.

Ghost towns
The boldest element of this intense infrastructure programme was the creation of entirely new cities. In order to maintain their export heavy economy and accommodate the resultant flow of migrant workers into cities, China needed to urbanise at an unprecedented rate. Roughly 13 million people migrate into the cities every year. According to Forbes, as many as 10 new cities are currently being built per year throughout the country, taking advantage of China’s vast and vacant land. One such city is Lanzhou New Area, where huge tower blocks were built to house mostly relocated farmers.

Empty apartment buildings stand in the ‘ghost town’ of Ordos

Lanzhou New Area is one of the success stories of this investment in infrastructure, with around one million people inhabiting the high-rise city. However, with this rapid expansion of urban environments comes the problem of a decreasing population. The new Ordos City, popularly referred to as a ‘ghost town’, has suffered this fate, with just a few families living in apartment blocks built for hundreds. It has a total population of 140,000 despite space to accommodate many millions.

On account of China’s one-child policy, the working population is falling and there are not enough people to work and live in all these newly developed residential areas. What makes matters worse is that with the competitive marriage market in China, created by huge gender imbalance, bachelors attempt to buy up as much property as possible in order to boost their marriage credentials. This leaves many properties empty, currently 64 million in total. The government has always been keen to promote the aesthetics of success, so many of these new cities are beautifully designed and opulent in appearance. In reality they house only a few thousand residents, the majority of whom are construction workers.

On account of China’s one-child policy, the working population is falling and there are not enough people to work and live in all these newly developed residential areas

It is not just housing that is struggling to attract human attention. When the New South China Mall was built, it was intended to vie for the title of largest shopping mall in the world. However, since it opened in 2005, 99 percent of the plots have been vacant and shop assistants outnumber customers.

With a shrinking workforce, expected to decrease by 67 million as soon as 2030, wages are increasing. This is unsustainable as, according to a report by the Hong Kong Monetary Authority, China’s economy is heavily dependent on exports. With economic crisis in Europe, these are no longer sufficient. Export growth is currently just 9.2 percent, compared with 30 percent between 2003 and 2007. The shrinking economy, combined with the intensive investment programme in infrastructure, has created huge debt problems for the nation.

The rate at which money is being lent in China is at an all time high. In August, annual new credit in China hit CNY21trn, up from CNY19trn the previous August. The recklessness with which these loans are being offered and the unreliability of their recipients is a great cause of concern among the Chinese government.

Shadow banks
A symptom of this credit boom is the growth of shadow banks. Although this is a phenomenon that predates the events of 2008, a desire to diversify from bank deposits and avoid regulated interest rates has led to the growth of social financing – essentially loans that are not recorded officially by the government.

Since 2008, this policy of intensive investment fuelled by credit has encouraged growth and benefited the world economy, but it is not sustainable. Debt is now over 200 percent of China’s GDP. This trend shows no sign of slowing, with net new credit exceeding a third of China’s GDP for the fifth consecutive year. It is more than likely that by 2017, credit will equal 250 percent of China’s GDP, twice the level it was prior to the global financial crisis.

Approximately 69 percent of this figure is made up of credit borrowed from shadow banks. These loans are appealing because of their wide availability and their low borrowing costs. The restrictions that apply to commercial banks are not encountered with social financing. The rise of these off-the-radar loans is a threat to China’s economy because of their lack of regulation.

What is further concerning about the growth in shadow banks is that these cheap loans are being used to roll over pre-existing debt, thus in no way creating new investment or contributing to growth. As social financing grows, it stifles wealth creation and grinds to a halt the unprecedented rate of economic growth China has been enjoying for the last decade.

The city of Wenzhou in the east of China serves as an example of the negative effects, both economic and social, that dependency on social financing can have. Wenzhou has always been rather overlooked by the government, owing to its proximity to Taiwan. Consequently, many entrepreneurs have been able to thrive. Social financing began in Wenzhou as small loans among friends and family. This developed into shadow banking when entrepreneurs hiked up interest rates and began lending to strangers. Now, 90 percent of Wenzhou’s families are in some way involved with shadow banking. A coastal city, much of Wenzhou’s income depends on exports to the EU, so as the European economy flails, so too does Wenzhou’s. The slowing of growth in this entrepreneurial city has caused widespread defaults on these off-the-record loans.

Aware of these problems, the Chinese government has attempted to legalise shadow banking, or at least bring it out of the shadows, by opening the Wenzhou Private Lending Registration Centre – where people can apply officially for these loans under tighter regulations. Unfortunately, this pilot programme has failed to attract customers. The centre will not approve a loan without a credit history, which many would-be customers lack. Instead of encouraging people away from shadow banks, this government-run centre has just served to reinforce their purpose.

With the credit bubble bursting in Wenzhou, families have defaulted on their mortgages and have been forced to abandon their properties.

Despite the real estate market flourishing elsewhere in China, property prices in Wenzhou have fallen continually since August 2011. In an attempt to stimulate growth, the government has relaxed its restrictions on the purchasing of second homes in Wenzhou, along with 46 other cities. Nonetheless, as seen by the nation’s growing number of ghost cities, the demand for property is currently limited.

Shanghai and dry
In China’s larger and popular cities, such as Beijing, land and property prices are rising rapidly. Local governments have accumulated so much debt through easy credit that they rely on revenue from the land to cover it. The average property in Shanghai now costs CNY25,000 per square metre. Rises such as these would suggest that some of China’s most important cities will soon suffer a similar fate as Wenzhou and the new ghost towns.

 As many as 80 businessmen from Wenzhou have committed suicide as a result of not being able to honour their loans and having to declare bankruptcy

The other risk associated with this credit boom and the rise of shadow banking is social unrest. As more and more people are defaulting on loans, particularly from private lenders, violence is increasing. Wenzhou residents who have refused, or been unable, to pay back their debt have been found dead. As many as 80 businessmen from Wenzhou have committed suicide as a result of not being able to honour their loans and having to declare bankruptcy.

China’s central bank has intervened in an attempt to make credit less readily available and appealing. In June, the central bank raised interbank lending rates up to 11.65 percent to tighten the supply of cash in the money market. However, this led to panic of a credit crunch and so the central bank was forced to inject CNY40bn into the economy, stalling the progress of soaring interest rates. Paradoxically, the government maintain that their monetary policy to limit the amount of available cash in the economy has not changed, despite this liquidity injection.

By August, it was apparent that the government’s efforts had not been successful and the nation’s dependency on credit was only increasing. Social financing reached a new high of CNY1.56trn, having risen from just CNY808bn in July. The impact of these high interest rates was only felt by small businesses and small-scale developers, who unlike larger companies, were unable to take advantage of overseas credit markets.

Slow growth
If one looks at historical precedence, an economy supported by credit inevitably goes bust. China’s rate of growth is slowing. In 2012, it grew only 7.8 percent. Although this may seem an impressive figure, this was the nation’s worst performance for 13 years. The World Bank recently cut growth forecast for 2013 from 8.3 percent to 7.5 percent. President Xi Jinping insists that this is all part of a strategic slowdown, created by the government’s structural reform to create an economy less dependent on investment and exports.

Chinese President Xi Jinping. He insists that his government is implementing a strategic slowdown

Despite all this, it seems unlikely that China will actually go bust. Unlike most countries that experience a massive credit creation, the Chinese population has unusually high-gross domestic savings. Since 1994, gross domestic savings have exceeded gross investment. This is serving to prop up the economy.

It remains to be seen what potential impact October’s US shutdown could have on the Chinese economy. America is China’s largest creditor and one of their most important trading partners.By failing to come to an agreement over raising the debt ceiling, the US essentially default on their financial obligations. China currently holds $1.3trn in US government bonds and $3.5trn in dollar denominated assets. If the problems associated with the shutdown persist, these could deflate in worth and exacerbate an already volatile economy.


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