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Ponzi in Peking
By Gady Epstein
China's economy is humming along in high gear, thanks to a fast-growing pile of
dicey debt. Such booms tend to end badly.
As developed nations struggle to eke out a bit of growth and to get unemployment
rates out of double digits, Chinese output gallops ahead at an 8% annual rate.
This $4.7 trillion economy, it seems, is the world's dynamo and the prototype
for the future.
Take a close look, however, and you may come away thinking China resembles
nothing so much as Japan shortly before its stock and property markets melted
down two decades ago. A speculative frenzy of borrowing and bidding-up is at
work. If and when prices crash, there will be hell to pay.
Signs of the times: government bureaucracies funding themselves by foisting debt
on state-owned business enterprises; local governments raising capital by
selling land at sky-high prices to corporations they own; and the People's Bank
of China lavishing liquidity on the entire system in a way that makes Federal
Reserve Chairman Ben S. Bernanke look downright stingy.
"It's a Ponzi scheme whose head is the central bank, and it can print money,"
says Victor Shih, a China expert at Northwestern University outside Chicago.
The U.S. government's $7.6 trillion in debt at the end of September represented
more than half of gross domestic product. The Chinese government's officially
disclosed $840 billion in public debt represents less than 20% of GDP. But the
People's Bank of China and China's treasury are also on the hook for potentially
$1.5 trillion in off-balance-sheet debt owed by cities, provinces and entities
they control. They're also implicitly obliged to backstop $1 trillion, both in
loans that "policy banks" were directed to issue, even when they made no
economic sense, and in nonperforming loans that the government removed from the
books of state-owned commercial banks over the past decade.
Add it up and the national government is responsible for debt equal to over 70%
of 2009 GDP. That doesn't count any loans generated this year that might go sour
amid a 30% increase in debt balances nationwide. (The U.S. government, in
addition to its direct debt equal to 50% of GDP, is responsible for cosigning
mortgage borrowers' obligations equal to another18% of GDP.)
Like the U.S. housing industry a few years ago China's big developers are highly
leveraged and dependent on low interest rates and rising prices. Municipal
governments are knee-deep in this asset swamp. They use land sales as a means of
funding themselves.
As fast as China is growing and urbanizing, its cities are churning out more
office towers and luxury malls than can be leased for years to come. Tianjin, a
gritty metropolis not far from Beijing, will soon have more prime office space
than will be filled in a quarter-century at the current absorption rate. Shunyi
County, in the capital's suburbs, sold a residential plot last month for $400
per square foot, a new national record. The bidders were mostly state-owned
companies and the winner none other than a developer owned by Shunyi County.
Where the developer came up with the money for the purchase is unclear, but the
county will nevertheless book $740 million as revenue from the sale.
China's mercantilist trade policy is another contributor to its asset bubble. By
artificially depressing the value of its currency and making it difficult for
locals to invest abroad, China has forced an artificially large amount of
capital to chase after domestic investments, inflating property and stock
prices. It's the same scenario China pursued in late 2007 before its stock
market lost two-thirds of its value, but compared with today that era was
characterized by monetary restraint.
"It's a pure debt game," says Andy Xie, an ex-Morgan Stanley ( MS - news -
people ) economist who advises private investors and sees the current bubble as
"much worse than previous ones."
In late November China's ruling politburo declared that the nation's monetary
and fiscal promiscuity will continue in 2010. The markets, predictably, were
overjoyed. Economists who see parallels to the Russian and Brazilian financial
crises of a dozen years ago are less sanguine.
"The more debt that's on the balance sheets, whether you see it or not, the more
vulnerable borrowing entities become to shocks," warns Michael Pettis, a finance
professor at Peking University and an expert on China's economy and sovereign
debt.
China naysayers have been wrong before. Gordon Chang, author of the 2001 book
The Coming Collapse of China, has warned--wrongly, so far--that doom lies around
the corner. Cushioning China's economy is its high growth rate, an estimated
$260 billion (but declining) annual current account surplus and, at $2.3
trillion, the world's biggest foreign exchange reserve.
Bubbles, it bears noting, tend to surprise many observers with their longevity.
(A FORBES cover story warned six years too early that the U.S. housing bubble
threatened to tank the economy.) But when bubbles do eventually burst, it's
usually with a bang.
In the first nine years of this decade China added an average of $1.50 in new
credit to the economy to produce each incremental dollar of output. With so much
money chasing domestic investments, that ratio has jumped to $7 of fresh credit
for each additional dollar of GDP this year, estimates Pivot Capital Management,
a Monaco hedge fund.
Assuming China's reckoning does arrive someday, it's impossible to say whether
it might presage Japan-style deflation or Russian-style hyperinflation, both
products of the 1990s, or American-style stagnation.
For now, private, semiprivate and state-owned enterprises are getting creative
to keep the boom alive. Some cash-starved local governments were said to be
asking companies to prepay 2010 corporate taxes to meet 2009 budgets. It's the
kind of monkeyshines you might expect in New Jersey or California, not in
supposedly cash-rich China.
Related-party transactions are another popular funding source. Hainan Expressway
Co. in southern China is a government-owned outfit deep in hock. In the last
year it has lent some $40 million to its founding shareholder, the Hainan
Department of Transportation, and booked the loan due as an asset on its balance
sheet. This classification provides the Hainan Expressway with additional
collateral to borrow even more in new construction loans from state-owned
financial institutions and increases the risk that it will eventually default,
according to Northwestern's Shih.
Western and Hong Kong investors are in on the frenzy, too. Evergrande Real
Estate Group, a Guangzhou developer, staved off a default on short-term debt in
the fall by raising $800 million in a Hong Kong initial offering, which bestowed
it with a $14 billion market cap. But who is it kidding? Sixty percent of its
"profit" this year is expected to come from increasing the reported value of its
properties, a ploy that is a common source of earnings for Chinese real estate
developers.
As is typical in the later stages of property booms, many investors in China
appear to have discarded rental yields as a measure of how much a building is
worth in favor of greater-fool pricing. In downtown Beijing office towers sold
this year for $400 per square foot, despite the fact that many were unleased and
many more are under construction. The leading buyers: state-owned enterprises,
including banks and insurers.
Asset-flipping can go on only so long. At some point you need paying tenants.
Warning Signs
Asset bubbles can go on surprisingly long but eventually do burst--often after a
speculative frenzy like China's.
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