China: Mounting Debts and Shadow Banks
China's total domestic debt hit 323% of its GDP (vs India's 184%) in Q1 of 2021! What's going on? đ§
âDear companiesâŚdo whatever you want, just keep producing so that our GDP increases and we beat the shit out of the USA.â â Chinese Government.
In its hunger to grow at a break-neck pace and emerge as a superpower, China has allowed its companies to borrow recklessly. Without remorse.
What Goes Up, Must Come Down
Troubles are mounting.Â
Chinaâs years of reliance on borrowed money has now resulted in an overwhelming debt pile-up at a time when its economy is contracting.Â
As per the Institute of International Finance, Chinaâs total domestic debt hit 323% of its GDP in the first quarter of 2021.Â
Well, the worst part is that this data under-reports the true picture of Chinaâs indebtedness.
Everything in China is controlled by the Chinese government.Â
All the banks are state-owned. Now, this means that each and every step taken by these banks is monitored by the Chinese government. Loans are made from the governmentâs money. Repayments go to the government.Â
Every single activity is monitored by the government.Â
Constant vigilance.
In short, they are following an insider system, prone to manipulations and misreporting.Â
But, letâs not get into manipulation. In fact, letâs assume thereâs no manipulation at all and China is corruption-free. After all, innocent until proven guilty.
Then how is the debt underreported?Â
Well, they use a magic wand called âShadow Banks.â
Understanding Shadow Banking
In the traditional banking system, if businesses need funds, they go to banks, get loans, use the funds to make profits, and then repay the amount back to the bank (along with some interest).Â
Lending to big and successful companies is easy because you know theyâll repay.Â
It becomes hard when it comes to lending to new companies, startups or companies with a history of defaults.Â
But, in its hunger for growth, the government turned a blind eye to the risks and lent as much as the companies wanted through the state-owned banks.Â
To âmanageâ this risk, ultra-smart bankers could actually give loans to businesses without investing anything from their pocket.Â
How?Â
The smart bankers know that many of the businesses they have given a loan to will go under. They are well aware that they have taken a higher risk while loaning the amounts to these companies. If these companies stop repaying, and in large numbers, the bank might go bankrupt. It may be unable to repay the money to its depositors, to the public.
So, how do they âde-riskâ themselves?Â
Well, the world of finance is beautiful. In our world, a loan that a company owes to the bank is the bankâs âasset.âÂ
Hmm .. now the bankers come up with an idea.Â
Why not pool all of these poorer âassetsâ together, bundle them, and sell it to someone else?
Great idea, but who would buy this? Other banks? They have problems of their own. So, no.
The government? Hah! The Chinese Government and the banks are one and the same. Just a facade. You wonât sell shit to yourself now, would you?
So, who would be so naive to buy these so-called âhigh-risk assets"? Who has the appetite for stupidity?
Yep. Us. The unsuspecting, innocent, financially illiterate public.
But, how to do this? If the banks do this themselves, it would be too obvious, no?
So, why not create a structure in between the banks and the public? Someone that will buy these businesses from the bank, and sell it to unsuspecting, small investors.Â
Someone working for the banks in the shadows.
Say a bank has given loans to 10 bad businesses worth 1,00,000 Yuans each, carrying 5% interest per annum.Â
Pool Total = 10 lakh Yuans.Â
This pool of 10 businesses is bought by the shadow bank for say 9 lakh Yuans. Now, if the businesses repay, the money will go to the shadow bank.
The risk of non-repayment of loans by businesses, therefore, shifts from banks to shadow banks.
Now, the shadow bank converts this 10 lakh Yuans worth of loans into 1,000 papers of 1,000 Yuans each and sells them to smaller investors. If the businesses repay, the money goes to the smaller investors.Â
The risk has now shifted from shadow banks to the public.
All hell breaks loose when these companies start defaulting. The bank or the shadow bank bears no risk.Â
It is the small investor who loses their hard-earned money.
This process of packaging multiple loans into a product and re-packaging becomes extremely complex sometimes. So complex that it becomes a burden to trace back these businesses.
Again, as we said earlier, more often than not, these loans were initially given to poor companies, many of which were bound to fail.Â
The problem with China is that it has given people hope that it wonât let big companies fail.
It has a history of bailing out several corporations that went bankrupt.
The shadow banking industry in China has grown to over $12.9 trillion (86% of Chinaâs GDP in 2019). Is it possible for the government to bail them out if they fail?Â
Most of the money borrowed by corporations went into making property, establishing power plants, iron and steel industries, and boosting infrastructure. But they failed to realise that if 100 companies in a country set up iron and steel plants, only 20 of them will survive.Â
80 WILL FAIL.Â
Also, the country tried to boost its infrastructure to such an extent that some of its cities have been declared âghost towns.â
No kidding.Â
These are under-occupied cities in China, waiting to be populated. The irony lies in the fact that the most populated country is waiting for people to occupy its ghost-towns.
If youâre wondering why China built these towns in the first place, let us remind you that they want everything âbigger.â
Again, in order to promote growth, they became kinda super-excited to boost their infrastructure.Â
âProperty prices can never go downâ is what they think, and thatâs exactly what the people in the US thought. Well, we know what the consequences of the 2008 financial crisis were.
Estimates suggest that more than 50 such towns in China are âGhost Townsâ. And these are fully developed corporate deserts, not just some small hub or district. Until recently, they had everything, except, well, people.Â
This is what is happening in China now. It is facing a problem of overcapacity. It has the resources but it doesnât know whom to sell to. With the coronavirus fiasco, countries like the USA, India, and Russia have gone anti-China.
And these countries used to be few of the biggest importers of Chinese goods.Â
What happens when thereâs such overcapacity?
Businesses fail. Employees who used to work for these businesses lose their jobs. Thereâs unemployment, unhappiness, and restlessness in the economy.
And well, this might just be the beginning for the failure of China. Even the biggest real estate company of China could be staring at bankruptcy (catch up here, if you haven't already!)
The big question: What will happen if China falls?
Stay tuned as we dig further!
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