Is China heading towards a financial crisis?

Category: Asia, China, Global, U.S.A.
By Larry Cao*

The dangers of irresponsible borrowing and lending

Uncontrolled subprime lending made it possible for millions of ill-qualified borrowers in the United States to live beyond their means and buy houses that they would not otherwise be able to afford. As the system got stretched, the housing bubble eventually burst, triggering the most severe global financial crisis since the Great Depression.

Many people are now starting to find parallels in today’s China. The booming real estate market has finally given way to more tempered growth initially and countrywide price declines, according to most recent reports. Shadow banking (i.e. financial intermediaries that help banks get some of their liabilities off balance sheet much like the famed special purpose entities in the 2008 crisis) seems to have started showing signs of cracks in the system, with a number of institutions and debt issuers either bankrupt or reaching the brink of bankruptcy earlier this year. Will the cooling real estate market pose a threat to the shadow banking industry and, further, to the overall financial system? And what’s the implication for economic growth?

At the recent CFA Institute China Investment Conference, a group of experts, including economists and investment practitioners, shared their expertise and knowledge on some of the most important questions about China today. The following is an excerpt from the event:

Can the real estate market in China continue to drive growth?

Investors are painfully aware of the global wreckage caused by the bursting of the US real estate bubble. Reports that the Chinese real estate markets are similarly over-extended are coming in at an increasing rate. Ghost cities apparently exist that have no residents. The question on everyone’s mind is, will we see a rerun of the 2008 drama on this side of the Pacific? Dr. Ha Jiming, vice chairman and chief investment strategist of the investment strategy group at Goldman Sachs China, sees three troubling signs on the horizon for the real estate market in China:

  1. Poor demographics: Demographic shifts mean the demand for housing will peak soon as more of the “Chinese boomers” start to retire. A shrinking working-age population simply demands less housing.
  2. High real estate prices: Many real estate markets across China have outpaced household income in recent years, making it a severe stretch on an average family’s budget to support a mortgage. For housing affordability in top cities to come down to reasonable levels, prices have to come down by one-third to one half.
  3. High real estate inventory: Developers have gotten too aggressive on building activities. The ratio of floor space under construction to floor space sold reached new highs in the last two years, forcing developers in second- and third-tier cities to unload their inventory at drastic discounts.

Real estate investments in China drive economic activity elsewhere, such as in building materials, steel, and furniture. Hong Kong’s Monetary Authority estimates that the overall impact of the real estate complex on China’s GDP is 32%. So, a correction in the real estate market will clearly further slow down economic growth.

Does shadow banking pose a serious threat to the Chinese financial system?

There was good news from the panel on shadow banking discussion that I moderated, where we considered the question of whether falling real estate prices are the likely catalyst for a Chinese version of the subprime crisis. The expert panellists did not think so. Sitao Xu, China representative of The Economist Group, expressed concerns about the moral hazard issues prevalent in shadow banking. “Earlier this year, [some financial institutions in the shadow banking business] came close to bankruptcy, but eventually got rescued by third parties,” he said.

The moral hazard issue is indeed very similar to what happened in the US subprime crisis. Financial institutions lent freely and irresponsibly to borrowers without proper due diligence. The situation is exacerbated in China by the expectation that the government will always step in to save the borrowers from default.

Fan Huang, head of wealth management at Deutsche Bank (China), agreed. He suggested, however, that the problem is not with shadow banking, but with the entities that are borrowing irresponsibly, such as local governments that are more concerned about creating GDP growth than with the economic viability of the projects.

When asked whether shadow banking poses a serious threat to the financial system, neither Xu nor Huang thought so, citing the limited scale of shadowing banking compared to the size of the banking sector’s balance sheet.

Simon Gleave, regional head of financial services at KPMG, agreed. “In the upcoming semi-annual reporting season for the major banks, we expect to see some write-offs. Non-performing loans will be on the rise. But it is nothing the banks cannot handle,” he said.

Can the Chinese economy continue to grow at its current rate?

Based on economists’ accounts, China contributed to over a third of the world’s economic growth in recent years. With its GDP growth slowing to 7.4% in the first quarter this year, will China continue to be the world’s growth engine?

Dr. Ha looked back at the past drivers of China’s economic growth and asked whether they would continue to work. Chinese economic growth averaged 10% per annum over the last three decades. In his opinion, the key reasons were favourable demographics and economic reforms. Birth rates were high in the post-war periods until the one-child policy was implemented in the late 1970s. As a result, China has since then enjoyed the benefits of more workers feeding fewer dependents. Unfortunately, Dr. Ha thinks this trend is likely to reverse itself in 2015, similar to what Japan experienced over 20 years ago.

Additionally, major reform policies implemented since the mid-1980s – including joining the WTO – and reformation of both the state-owned enterprises and the banking system propelled GDP growth to its pre–financial crisis peak. But China can only join the WTO once, and the question economic authorities face is, what’s next?

What will be the main drivers of economic growth going forward?

It is clear that the investment-led growth model has outlived its usefulness in China. In recent months, Dr. Ha observed, the government dialled up fiscal expenditures by 25% only to see GDP growth increase by just 7 – 8%. This type of growth in government spending is clearly not sustainable. Exports cannot be counted on to the extent before either given the uncertain economic recovery in Europe and the United States.

If not investments and exports, then what? The only place left to turn is domestic consumption. This was the same prescription many experts wrote for Japan when it came off its growth peak in the 1980s. But challenges remain there as well. Major consumption spending, such as electronics and furniture, are closely tied to the housing industry as people purchase new appliances, furniture and TV sets for their new condos. Making things worse, when real estate prices fall, consumers feel not as wealthy and tend to spend less.

At the conference, Nobel Laureate Myron Scholes pointed to the promise of the small and medium enterprises. They tend to be the most vibrant economic force if provided with the right set of set-up, such as funding. This is where peer-to-peer financing can play a major role and why it has been such a rage in China over the last year. The world may depend on it.

The picture is not all that rosy for the Chinese economy, but these experts are confident that we are not heading towards any kind of a major crisis like 2008.   

* Larry Cao, CFA, is director of content, Asia Pacific at CFA Institute. Follow Larry on Twitter @LarryCaoCFA