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Awash in Debt: Chinese State Liabilities and Monetary and Welfare Implications
In recent years, Boston University’s Center for the Study of Asia has hosted a number of conversations with renowned political economists. Joining them, on Tuesday, December 6, was Victor Shih, Associate Professor of Political Science at Northwestern University and author of Factions and Finance in China: Elite Conflict and Inflation, the first book to inquire about the linkages between elite politics and banking policies in China. Shih is a frequent adviser to the financial community on the banking industry in China.
In his talk at BU, Shih focussed on Chinese state liabilities, a weak spot in China’s “miracle economy” with its 3 trillion USD foreign exchange reserve. What people don’t realize, Shih explained, is that the amount in reserve is balanced by another 3 trillion in state issued liabilities. In fact, if one were to add the combined debt of state owned enterprises in China to that of the central and local governments, it would comprise some 150 percent of Chinese GDP. And the central government is on the hook for all of it!
Over the past decade, in response, the government has set up a number of special purpose vehicles to recapitalize the state banks, the result being huge increases in current assets and ever tightening cash flows. The situation, Shih stated, is not urgent: the loans are balanced against assets in foreign exchange reserve, the Chinese banking system has the world’s highest reserve requirements, and, since all the money is owed to domestic creditors, there is little risk of a European style financial crisis.
Nevertheless, Shih argued, there are some disturbing implications in China’s economic picture, one being inflation. The government, as the largest debtor in the financial system, has been reluctant to raise interest rates in order to combat inflation.
One reason the government is so “addicted to liquidity,” as Shih put it, is that capital is being used inefficiently. The projects being financed are not generating sufficient cash flows to keep up with interest payments. So, to stem the pile up of distressed debt, a lot of loans are being rolled over into medium and long term debt. As the average maturity of debt lengthens over time, partly due to new mortgages, but mostly due to roll over of non-performign loans, the central bank must allow the money supply to increase robustly year after year.
This is why, Shih explained, massive foreign exchange inflows are not a problem for the Chinese government. As long as the foreign exchange reserve was growing, it allowed the central bank to increase the money supply without needing to print new money. As the trade surplus declines, he argued, the government will have to resume re-lending.
Another problem that Shih touched on is the enormous amount of debt being financed by Chinese households. Chinese households are net lenders in the Chinese banking system: deposit transfers to the state corporate sector amount to some 50% of GDP while borrowing hovers at 20% of GDP. According to Shih, if consumption is ever to become a driver of growth in China, as it has been in the US, the political economy of China will need to change drastically.
The current situation (high inflation, low interest rates), he argued, is unsustainable. Chinese households are earning negative real interest on their deposits, and this motivates them to look outside the formal banking system for investment opportunities. For the time being, they are buying real estate. But if anything were to happen to the real estate market, the risk of capital flight is very real.