Guest post written by Junheng Li
Junheng Li is the founder of JL Warren Capital, an equity research consulting firm based in New York. She is a Shanghai native.
Riding the high-speed rail from Shanghai to Nanjing, I couldn't help overhearing a conversation between two 40-something loan officers from the Nanjing office of the Industrial and Commercial Bank of China (ICBC), the country's largest state-owned "commercial" bank by total assets.
"Our government is running out of money, but we're still underwriting social housing projects. It's a political mandate. The private sector? No chance...No government backing and no collateral...I get fired if they go belly up."
That conversation underscores one of the biggest distortions in the Chinese economy: The country's so-called "commercial" banks are by no means commercial at all–they lend at the behest of the state and local governments, and doing so effectively gives them control over the economy's capital allocation and pricing. It also goes a long way toward explaining the effectiveness and timeliness of China's economic stimulus in 2009 to ward off the global financial crisis, especially in comparison to the U.S. Fed's lackluster "quantitative easing" policies.
In 2009, once China's central government approved the 4 trillion yuan stimulus package, banks immediately poured money into local governments to build roads, airports and rails. Infrastructure projects sprouted from busy coastal cities to less populated central areas, while capital intensive industries, like automakers and steel mills, expanded production capacity beyond their respective industry's expected demand for years to come. Although most of these crisis investments have not and will likely never generate adequate financial returns, the government frequently extols their positive social impact of boosting employment levels, no matter if those jobs are the equivalent of digging holes so they can be filled back in again later.
Local Governments Go Belly Up
When China's growth had accelerated in the past, land sales could be relied upon to enrich local governments' tax coffers, enabling them to pay off debt. However, decelerating growth and a softening real estate market has turned into a drain on local governments' revenue, while at the same time they face increasing pressure to boost investment to ward off the slowdown. As municipalities increase borrowing and spending, debt catches up with and soon exceeds their ability to service, let alone repay their debt.
ICBC, where the two aforementioned loan officers work, typifies the state-owned "commercial" banks that have had to restrict access to credit as a result of rising deficits among local governments. However, the tightening measure is biased in that they primarily target the private sector.
Wenzhou, a coastal city in Zhejiang province that was the birthplace and now serves as a hub for the country's private economy, has been suffering the most. The city has about 400,000 small- and medium-sized enterprises, or SMEs, with signature products ranging from synthetic leather, shoes and apparel, to eyeglasses and cigarette lighters. At the peak of the credit crunch last year, underground funds to SMEs in Zheijang were charging annual interest rates as high as 70%, compared with 7% of the bank lending rate. Patricia Cheng, a China analyst from CLSA Research in Hong Kong wrote during her recent visit to the city: "Prices at a luxurious residence on the riverside have dropped to 50,000 yuan ($7,860) per square meter from more than 70,000 ($11,000) a year ago. Low end, high end, all forms of consumption seems to have hit a wall. It isn't what I expected at all."
State-Owned Enterprises (SOEs) Crowd Out The Private Sector
Although the structural imbalance between investment–approximately 50% today compared to 36% a decade ago–and domestic consumption is widely recognized, government-led investment figures may be overstated due to the inclusion of a high percentage of "corruption tax" in the form of embezzlement, bribery and kickbacks paid to the ruling party, which in turn morphs into the spending at Macau's bustling casinos and black Audi A6s. However, the imbalance between SOEs and SMEs, the bedrock and engine of organic growth, represents a worse kind of imbalance.
In China, SMEs contribute more than 50% of the country's tax revenue, 60% of GDP and 80% of employment. Most of them were founded after the start of the country's market-oriented reforms in the 1980s. While China's state capitalism has largely focused on supporting state-owned enterprises to drive the economy during its early growth phase, characterized by cheap labor and heavy capital investment, the country's SMEs will need to play a vital role in rebalancing the economy into a domestic-driven and consumption-oriented market capable of optimizing technology and skilled labor.
Given the still nascent nature of the country's capital markets, 80% to 90% of its businesses are still funded with bank loans. The government favors SOEs because they give the ruling party a direct stake in the economy and its prosperity, whereas SMEs are handicapped in competing for cheap capital due to their inherent "political risks." When a loan to a SOE goes bad, the government simply rolls it over. But, when a SME loan goes bad, the bank's approval officer faces the risk of losing his job. What's more, bank lending is also collateral-based, which again gives yet another edge to the government-owned operations that dominate asset heavy industries, such as telecom and infrastructure. Private enterprises that thrive on innovation and operating efficiency tend to be in asset-light service industries. SOEs can access capital on affordable terms, while many SMEs get cut off from bank lending. As a result, many small businesses have turned to the "grey market" and borrow at interest rates as high as 20%. Since the global financial crisis in 2008, the SOEs have increased their weight in the economy largely because of this uneven playing field, biased against the private sector by the perceived need to stimulate demand at all cost, even when the composition of that demand is damaging to the economy's long term sustainable growth.
Although many view the cut to China's benchmark interest rate by the central bank on Jun. 7 as a significant step towards liberalization of the financial system, true liberalization is unlikely to happen as long as the dominant superstructure of the country's banking system does not unhinge itself from the state, and commercial banks start lending on commercial criteria.
