More Chinese Challenges

China’s Hidden Debt Risks 2012 Crisis, Northwestern’s Shih Says

March 3 (Bloomberg) -- China’s hidden borrowing may push government debt to 96 percent of gross domestic product next year, increasing the risk of a financial crisis in the world’s third-biggest economy, Professor Victor Shih said.

“The worst case is a pretty large-scale financial crisis around 2012,” said Shih, a political economist at Northwestern University in Evanston, Illinois, who spent months researching borrowing transactions by about 8,000 local-government entities. “The slowdown would last at least two years and maybe longer,” the author of the book “Factions and Finance in China” said in a phone interview March 1.

Surging borrowing by local-government entities, uncounted in official estimates of China’s debt-to-GDP ratio, is the key reason for Shih’s concern. Harvard University Professor Kenneth Rogoff said Feb. 23 that a debt-fueled bubble in China may trigger a regional recession within a decade, while hedge-fund manager James Chanos has predicted a Chinese slump after excessive property investment.

By Shih’s count, China’s debt may reach 39.838 trillion yuan ($5.8 trillion) next year. His forecast for debt-to-GDP compares with an International Monetary Fund estimate for China of 22 percent this year, which excludes local-government liabilities. The IMF sees Spain at 69.6 percent, the U.S. at 94 percent, Greece at 115 percent and Japan at 227 percent.

Chinese officials allowed lending to explode from late 2008 to fight off the effects of the global financial crisis. In 2009, new loans rose to a record 9.59 trillion yuan ($1.4 trillion).

Asset Bubbles

Now, amid the risks of asset bubbles, soured loans and resurgent inflation, officials are reining in credit growth.

One focus of concern is lending to the investment companies set up by local governments to circumvent regulations that prevent them borrowing directly. Shih estimates that, already, borrowing by such entities may result in bad loans of up to 3 trillion yuan ($439 billion).

China’s banking regulator has ordered lenders to review loans granted to local governments’ financing vehicles by the end of June and ensure they can be repaid, a person with knowledge of the matter said in January. The China Banking Regulatory Commission is concerned that a few cities and counties may face very large repayment pressures in coming years because of debt ratios already exceeding 400 percent, the person said. The ratio is of year-end outstanding debt to annual disposable fiscal income.

‘Wave’ of Bad Loans

Local-government entities may have had a total of 11.429 trillion yuan in outstanding debt by the end of last year, according to Shih. They have agreed credit lines with banks for an additional 12.767 trillion yuan, said Shih.

A crackdown on local-government borrowing could trigger a “gigantic wave” of bad loans as projects are left without funding, while a failure to rein in lending could lead to inflation of over 15 percent by 2012, Shih said. Either situation could trigger bank runs and a crisis as people lose confidence in the financial system, he said.

China will soon face similar challenges to the US.  It has runaway property speculation thanks to an easy money policy and rising inflationary challenges.
Andy Xie has made statements similar to Professor Shih in the last few months.
The choice is clear, either more restrictive monetary policy resulting in deflation with the bad debt written off and the economy healing, or severe inflation that simply delays the ultimate collapse.