China may not be about to crash, but there's reason to be sceptical about Asia's second biggest economy's health, regardless of what Beijing says
You will not find any Enrons here in China. That recent declaration came from the very top: Premier Zhu Rongji. Yet in arguing that there are no Enron-like time bombs in Asia's second-biggest economy, Zhu may have opened a can of worms. For one cannot help but wonder if he could say the same about China's entire financial system.
Even after 50 years in government, there are certain things about which the 73-year-old does not tire of speaking. One is China's debt, or the lack thereof. During his post-National People's Congress press conference, Zhu reminded the world that debt as a proportion of gross domestic product remains within safe limits. And at 16% of GDP, who could argue? Japan's debt, after all, is approaching 140% of GDP.
Trouble is, there is a gaping hole in China's 'we have negligible debt' argument. It ignores the fact that state-owned banks, central government-run entities for which Beijing is ultimately reliant, have a whole lot of debt outstanding. Beijing's debts are believed to be at least 70% of GDP.
Worse, the banks are sitting on mountains of bad debt. Beijing contends non-performing loans account for 26.6% of lending by its top four commercial banks, but private analysts think the figure is much higher, perhaps 50%. That said, it seems appropriate to give China's economy the Enron test. Is it a gigantic debt-crisis waiting to happen? Few serious observers think China's financial system will collapse anytime soon.
Yet China boasts some Enron-esque qualities that warrant attention. Like the Houston-based energy company, China is a massive, bureaucratic operation that is big on spin and small on transparency. Its financial system has myriad problems covered up by impenetrable Communist-era accounting. It features a huge number of managers, regulators, auditors and credit raters who are either asleep at the switch or looking the other way.
How else can the nation's 'big four' banks be technically insolvent, carry such low capital-adequacy ratios and run up a massive bad-debt book without triggering loud alarms? Some have raised flags. A recent book, China's Troubled Bank Loans, by Jianbo Lou examines the 'significant and increasing problem'' of bad loans at state-owned banks.
Some household name think-tanks also have taken a crack at the issue. The Brookings Institution's Nicholas Lardy has warned that 'there is evidence that new non-performing loans continue to emerge at a prodigious rate'. For Lardy, the question is this: how will China be able to bear the fiscal cost of restoring the banks to financial health and preventing households from suffering massive losses on their accounts?
Beijing dismisses such questions. Its defense, and a powerful one at that, is that doubters are just picking on China, again. 'There is evidence that foreign investors have been overly sanguine about China plays, often to appease Beijing,'' argues Christopher Lingle, global strategist for eConoLytics.com. 'Such dishonesty does no one any good.''
China's big four ' the Industrial & Commercial Bank of China, the Bank of China, the China Construction Bank and the Agriculture Bank of China ' do not meet global standards for prudent banking. The Bank for International Settlements (BIS) recommends a capital adequacy ratio of 8%. The ratio among large Chinese banks is thought to be 6%, at best.
In 1998, China even issued Yuan 270bn ($32.6bn) worth of bonds to finance an improvement in banks' capital adequacy positions. Today, things are far worse than they were then. The nation's growing share of non-performing loans is a key reason, worsening deflation is another.
What is maddening about China's national balance sheet is that no one really knows how bad things are. For one thing, China counts bad loans differently. While most countries consider loans unpaid for three months as bad, China waits a year or more to do so. It also offers incomplete figures ' the 16% debt-to-GDP ones ' and claims that it has got plenty of room to borrow. Yet China's debt liability may be at least four times what it claims.
By letting state-owned banks do the bulk of the nation's lending, the central government figures it has a kind of statistical deniability where its debts are concerned. At the same time ' and here is where the Enron comparisons come in ' China has been farming out its non-performing loans to asset-management companies (AMCs). They take debt off the books of the big four banks.
So far, so good ' until you look at what happens to the debt after it has been ferried away. Using AMCs works as long as (a) these entities fare better than the banks in recovering loans from deadbeat borrowers, and (b) the banks being relieved of bad loans alter their ways. If they make more bad loans, what is the point?
Neither requirement is occurring to any great degree. China's socialist core, for example, means it is not keen on large-scale bankruptcies, whereby assets can be seized and auctioned. That has left AMCs to employ other, less lucrative tactics, such as engineering debt-for-equity deals. Since Chinese shares are not exactly booming, dodgy debt is being traded for wimpy stock.
True, asset-management companies have begun selling China's non-performing loans to investors. Firms such as Goldman Sachs and Morgan Stanley Dean Witter have bought some. Yet China is only beginning to come to grips with its bad-loan woes. It has a long, long way to go, and the process could restrain economic growth in years ahead.
If the Enron Corp. debacle reminded us of anything, it's that an entity that sounds too good to be true probably is. That indeed may be the case with China's economy in the short run.
The Bloomberg Beijing newsroom
Spent 56 years at Schroders
Warns on profits
Hargreave Hale seeking legal advice