Real Test is Still to Come

Bearish sentiment about the

Chinese economy has surged in recent months， owing largely to three conjectures. First， China’s housing market is on the brink of collapse. Second， China’s fiscal pbet h r eo ne cs am icut o s ieloenl a ntop fd ws ee m i b loatl f s. wsuiAvon end r sdel o er， g cntar ho l r uaigrnpoddiv， d-ly goveLroncmael credit networks in cities such as Wenzhou， Zhejiang province， will lead to a broad financial crisis across the country.

In fact， despite its problems， China’s economy remains on course and it is not yet anyway near to hitting the rocks.

In the last decade， skyrocketing house prices， except for a short respite during the global financial crisis， have caused serious social discontent in China. But after years of effort， the central government has finally clamped down on housing speculation. As a result， prices fell in October 2011 for the first time this year， while real-estate investment growth fell as well.

The fall in house prices is unlikely to turn into a rout， because the demand for houses will remain strong even after speculative demand is driven from the market. As soon as house prices fall to an affordable level， buyers will re-enter the market and set a floor under the decline.

Moreover， because there are no subprime mortgages in China and down payments are as high as 50-60 percent， even a significant fall in house prices will not seriously damage China’s mega-banks.

Over the past decade， real-estate investment in China has been the single most important contributor to fixed-asset investment growth and therefore， to the economy. Indeed， since the late 1990s， the real-estate investment-to-GDP ratio has been far higher than it was in countries like Japan and South Korea during their high-growth periods.

It is simply wrong for a developing country with per capita GDP of around$4，400 to concentrate its resources on producing concrete and cement. Although a significant decline in realestate investment will have a negative impact on China’s growth， as long as the fall is not too drastic， it is a welcome development.

Local government debts are a relatively new phenomenon. In 2009， local governments were encouraged to create special purpose vehicles， specifically “local finance platforms” (LFPs)， to supplement China’s 4 trillion yuan($628.7 billion) stimulus package. The LFPs would borrow from banks using future government revenue as collateral to finance packaged investment projects in Chinese localities. By 2010， some 6，576 LFPs had been created.

There is no denying that local government debt could be a ticking time bomb for the Chinese economy. According to China’s National Audit Office (NAO) ， the total borrowing of these LFPs amounts to 10.7 trillion yuan， of which 79.1 percent is bank loans. But it is equally true that China’s local government debt has so far been manageable， and there is no reason to believe that all of it is bad. In fact， for the majority of the LFPs， the cash flow generated by investment so far has been enough to meet repayment of principal and interest. According to the Industrial and Commercial Bank of China(ICBC) the largest of China’s “big four”banks 93 percent of its loans to LFPs are being repaid regularly.

Indeed， the ICBC’s non-performing loan (NPL) ratio for LFP loans is as low as 0.3 percent， while the corresponding coverage ratio the bank’s ability to absorb losses from NPLs is 1，066 percent. According to the NAO， the NPL ratio for the 10.7 trillion yuan in local government debt is roughly 2.3 percent.

In addition， given that local government debt comprised 27 percent of China’s GDP in 2010， and central government debt stands at 20 percent of GDP and policy loans at 6 percent， the total public debt-to-GDP ratio is approximately 53 percent lower than Germany’s. So， while China should not be complacent about local government debt， panic is unwarranted.

Finally， there is a long history of underground lending and borrowing in some of China’s east coast region， especially in Wenzhou. Whenever monetary tightening causes bank credit to shrink， small and medium-sized private enterprises are prepared to borrow at suicidally high interest rates from relatives or loan sharks.

In recent years， real-estate speculation has become another important source of demand for underground loans. When real asset prices fall and cause local credit networks to collapse， not only are hundreds of families left financially shattered and enterprises bankrupted， but banks suffer collateral damage， as occurred recently in the Wenzhou region.

But the severity of Wenzhou’s underground credit crisis has been exaggerated. In fact， Wenzhou’s underground credit accounts for less than 20 percent of total credit in the region， while the region accounts for less than 1 percent of China’s GDP. The total volume of affected bank credit in the crisis was just more than 3 billion yuan， roughly 0.5 percent of bank loans in the Wenzhou region. So， the damage that the breakdown of Wenzhou’s underground credit networks has inflicted on the regional banking system is limited， with scant national impact.

Thus， despite the high likelihood that China’s economic growth will slow significantly in 2012， a hard landing is unlikely. Nevertheless， while there is no need to be overly bearish about China’s short-term economic prospects， because of the slow progress in fundamental adjustment and further reform， China’s growth is ultimately unsustainable. So the real test is yet to come.