China’s Subprime Risks

HONG KONG – It is now widely accepted that the recent global financial crisis was actually a balance-sheet crisis. Long periods of negative interest rates facilitated the unsustainable financing of asset purchases, with high-risk mortgages weakening national balance sheets. When liquidity in the key interbank markets dried up, the fragilities were exposed – with devastating consequences.

Today, the rapid expansion of Chinese financial institutions’ balance sheets – which grew by 92% from 2007 to 2011, alongside 78% nominal GDP growth – is fueling predictions that the country will soon experience its own subprime meltdown. Is there any merit to such forecasts?

The first step in assessing China’s financial vulnerability is to distinguish a solvency crisis, which can occur when firms lack sufficient capital to withstand an asset-price meltdown, from a liquidity crisis. During the Asian financial crisis of the 1990s, some countries suffered foreign-exchange crises, in which devaluation and high real interest rates de-capitalized banks and enterprises, owing to the lack of sufficient reserves to repay foreign-exchange debts. In the case of Japan’s asset-price collapse in 1989, and again in the United States in 2008, bank recapitalization and central-bank liquidity support restored market confidence.

The recently released Chinese Academy of Social Sciences (CASS) suggests that China is unlikely to undergo a foreign-exchange or national insolvency crisis. At the end of 2011, the central government’s net assets amounted to CN¥87 trillion ($14 trillion), or 192% of GDP, of which CN¥70 trillion comprised equity in state-owned enterprises (SOEs). Moreover, at the end of last year, China’s net foreign-exchange position totaled $2 trillion – 21% of GDP – with gross foreign-exchange reserves totaling just under $4 trillion.

The concern is China’s rapidly increasing domestic debt, which currently stands at 215% of GDP. Since 2008, SOEs and so-called local-government financing platforms have been using loans to fund massive fixed-asset investments, while private-sector actors have been borrowing – often from the shadow-banking sector – to finance investment in real-estate development.

This excessive dependence on credit stems from the lack of adequate funding and the relative underdevelopment of China’s equity markets, with amounting to only 23% of GDP, compared to 148% of GDP in the US. The amounts to 113% of GDP in China, compared to 72% in the US and 99% in Japan.

But, given that the largest enterprises are either state-owned or local-government entities, their debts are essentially domestic sovereign obligations. With China’s total amounting to only 53% – much less than America’s 80% and Japan’s 226% – there is sufficient space to undertake debt-equity swaps to tackle the internal-debt problem.