China must allow bad loans to fail for the good of its economy
SCMP reported that China's structural reforms have stalled. The decision to deepen reforms, taken at the Communist Party's third plenum last autumn has produced few tangible results so far. Worry over financial stability seems to be a major factor in blocking meaningful reforms.
The recent measures, marketed as a mini stimulus aim to shore up financial stability. The targeted reductions in deposit reserve ratios, for example, are helping some banks that are experiencing a liquidity crunch due to mounting non performing loans. Mini-stimulus measures, like the redevelopment of urban slums, channel loans to local governments that need new loans to service the existing ones. Such measures merely prolong the unsustainable status quo.
China has stimulated the economy with debt since 2008. Most of the current debt stock is from the period after the global financial crisis. Local governments, property companies and supporting industries, as well as property buyers, leveraged up to absorb the debt. Rising leverage and land prices the primary collateral formed a temporary equilibrium that channelled money into overinvested industries.
Overcapacity and high leverage pose a mortal threat to financial stability. The former destroys profitability of capital intensive industries and their ability to pay banks. Overcapacity isn't limited to commodity industries. Residential and commercial properties have massive oversupply, as does the financial industry, pumped up by the credit bubble.
The current stabilization measures merely keep everyone afloat. But, as long as overcapacity remains, more of these measures are needed to prolong stability, because industries with overcapacity bleed cash and always need money to stay afloat. The stabilization measures will never lead to a solution.
China must deal with overcapacity to stabilize the financial system. Cutting some capacity will expose some bad loans, lower gross domestic product, and hurt the revenues of some local governments. But overall profitability will improve and banks will be able to function normally again. The steel industry, for example, suffers from serious overcapacity.
The post 2008 stimulus artificially boosted prices. Local governments saw expanding steel mills as an easy way to increase GDP and fiscal revenue. Now the bubble is deflating. Steel prices are down 40% from the peak.
Obviously, profitability has crashed. But local governments have protected their steel mills from closure by persuading banks to roll over loans and add some more. The longer the situation lasts, the more value is destroyed, and the more losses the banks will eventually suffer.
Oversupply similarly afflicts the property market. On the residential side, more than 4 billion square meters of housing is under construction, while there may be over 40 million empty flats in the existing stock. The combined total could accommodate 300 million people. A plan is needed to deal with this inventory overhang, or the banking system will face deep trouble for years to come.
Some of the mini stimulus measures sustain liquidity for local governments and the banks that are exposed to the troubled industries. But this is only a stalling tactic and will work only if the tide of hot money surges again, which is unlikely. Authorities have to deal with overcapacity and the non performing loans.
The central government has been focusing on affordable housing and the redevelopment of slum areas. These projects need to take into account the oversupply in the commercial market. Rather than building more, the government should consider offering cash subsidies for citizens who qualify for affordable housing, so they can buy in the market. That won't solve the problem, given that such demand is small compared to the supply overhang, but it would at least cut down waste.
Source - SCMP