(Bloomberg Businessweek) -- Take a spin around Tianjin’s Binhai New Area, a massive development project about an hour from Beijing, and you’ll see one partially finished building after another—and empty storefronts with black crosses painted on glass doors. Conceived as a futuristic financial hub and business center on par with Shanghai’s Pudong district or New York City, Binhai hasn’t yet lived up to the hype. “Only about one-third of the apartments here are occupied,” estimates Liu Yulan, 75, who moved to the area to be closer to her daughter-in-law. “I don’t see Binhai becoming a boom town.”
In January, Binhai government officials made a startling admission. The region was revising down its 2016 gross domestic product—by about 30 percent, to 665.4 billion yuan ($104.9 billion). That news followed revelations of creative accounting by two northern provincial governments: Liaoning and Inner Mongolia, both of which have been hit hard by recent downturns in steel, oil, and coal prices.
President Xi Jinping is far less tolerant of such profligate spending and fudged data than his predecessors, and he’s in the midst of an historic three-year battle against the systemic financial risks threatening to hinder the economy. So far the focus has been on excessive lending by shadow banks and acquisitive private conglomerates such as the Dalian Wanda Group, whose founder, Wang Jianlin, is China’s fourth-richest executive, and Anbang Insurance Group Co., owner of the Waldorf Astoria New York. Amid pressure from bank regulators, these companies are selling assets at a furious pace. A once-voracious aviation and shipping giant, HNA Group Co., plans to jettison $4 billion in commercial properties in Chicago, Minneapolis, New York, and San Francisco.
Yet that’s just an overture to a far bigger drama that will play out for years: Xi’s quest to restrain borrowing by local governments and the nation’s behemoth state-owned enterprises. Last year he called curbing SOE leverage “the priority of priorities” and warned local officials they’d be held accountable “for a lifetime” for building up regional debt.
China’s debt of $30 trillion, roughly 259 percent of GDP, has been powered primarily by massive borrowing by state companies. That credit buildup, on track to hit 327 percent of GDP by 2022, estimates Bloomberg Economics, is in turn fueled by local government leaders, whose advancement has traditionally been tied to hitting economic targets. State companies feed off the infrastructure projects approved by career Communist officials at the local level.
“The root cause is the top-down, command-based economy,” says Junheng Li, the founder of JL Warren Capital LLC, a China-focused research company in New York. “Local governments in each province are given targets by the central government and each province then gives targets to counties, counties to municipalities, municipalities to strategic state-owned enterprises.”
Reining in the money flows between state-owned enterprises and local governments is the third rail of Chinese politics because so much of the power of the Communist Party is tied to controlling key levers of the economy. China Mobile, Dongfang Electric, Industrial and Commercial Bank of China, and China National Petroleum are some of the world’s biggest and most powerful companies—and are all state-owned. The combined profits of the SOE sector reached $460 billion in 2017, according to the Ministry of Finance. State companies command about 40 percent of China’s industrial assets and create almost 20 percent of urban employment. The party, not the markets or independent boards of directors, decides who runs these corporate giants.
Although it’s unlikely China will ever privatize these companies, economists do expect Xi’s government to consider more consolidation. Last year, Beijing signed off on the merger of Shenhua Group, the top coal miner, with the power company China Guodian Corp. That created the world’s biggest power company by installed capacity, according to Bloomberg New Energy Finance.
The tougher challenge is how to overhaul weaker state-owned players, possibly via debt-for-equity swaps by lenders or even the outright collapse of “zombie” SOEs that are basically on life support. “I hope China will take the first step to crack down on SOE debt soon, which is allowing some zombie companies to go bankrupt,” says Larry Hu, chief China economist at Macquarie Securities Ltd. in Hong Kong. “The cost will be that a lot of SOE employees could lose their jobs, but this step has to be taken.”
Then there’s cleaning up local government data to get an accurate read on debt burdens. During China’s run of breakneck growth from 1980 to 2012, some local governments played fast and loose with data to attain ambitious growth targets. Economists have long noted that the sum of provincial GDP has exceeded the national total—calculated separately—by more than 10 percent in some years. The National Bureau of Statistics is taking over the calculation of provincial data and says it will almost eliminate this discrepancy by 2019.
Shanghai-based analysts Meng Xiangjuan and Li Tong at SWS Research Co. recently did some back-testing of data after tax reform legislation in 2016 made the double-booking of local government fiscal revenue much harder. By comparing reports from before and after the tax change, SWS developed a quality ranking for local fiscal revenue and debt burden data. Western megacity Chongqing was at the bottom of the list, but Tianjin and even Beijing weren’t far behind.
Tom Orlik and Qian Wan at Bloomberg Economics use electricity consumption as a proxy for real output and find that Qinghai, Yunnan, Guizhou, and Shaanxi provinces and Chongqing have questionable growth statistics and high debt levels—a double vulnerability. Another worry: Government data don’t take into account so-called local government financial vehicles (LGFVs) set up to skirt lending restrictions. Their outstanding liabilities are estimated at about 6.2 trillion yuan.
Xi’s economic team views defusing the debt bomb as a priority for two reasons. First, debt-fueled growth no longer delivers the same oomph it did during the 1980s and 1990s. Even before the previous government run by Hu Jintao unleashed a record borrowing binge during the global crisis a decade ago, China’s incremental capital-output ratio—which measures how much extra output is yielded from additional investment—was worse than that of other Asian economies during their rapid-development phases. Before 2008, China generated 1 yuan of extra output for each 4.4 yuan invested; more recently, it takes more than 6 yuan of investment to generate 1 yuan of output, according to data cited by the International Monetary Fund.
Few think China faces a near-term crisis from its debt. The economy is growing at a robust 6.9 percent, and domestic deposits of $27 trillion almost equal outstanding debt. If China were to simply continue the rapid credit growth and wasteful investment of the past, a sharp and wrenching downturn would likely result. At some point the country’s ability to roll over existing debt and fund new projects will wane.
Xi and his economic planners appear to understand such risks and are taking steps to get debt under control. China’s clampdown on excess spending has already resulted in the shutdown of subway projects in Inner Mongolia. And the country could see the first default on a bond issued by an LGFV this year, according to a recent report by credit rating company S&P Global Inc.
Make no mistake: China’s great deleveraging will be a multiyear undertaking, and the country is just getting started. There also may well be instances of backsliding. Yet China’s debt dynamics are now so pressing that there’s probably no turning back. —With Tian Chen and Kevin Hamlin
To contact the author of this story: Brian Bremner in Tokyo at bbremner@bloomberg.net.
To contact the editor responsible for this story: Howard Chua-Eoan at hchuaeoan@bloomberg.net, Jeff Black
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