China: Shadow Banks and Ghost Towns
China’s desire to grow its economy as fast as it can has made it dig its own grave. How? Read on.
“Dear companies…do whatever you want, just keep producing so that our GDP increases and we beat the shit out of the USA.” – 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.
China’s years of reliance on borrowed money has now resulted in an overwhelming debt pile-up at a time when its economy is contracting.
As per the Institute of International Finance, China’s total domestic debt hit 317% of its GDP in the first quarter of 2020. The chart below shows the percentage points increase in Debt to GDP ratios:
Now, now… These are just reported numbers.
The worst part is that this data under-reports the true picture of China’s indebtedness.
Everything in China is controlled by the Chinese government.
All the banks are state-owned. Now that means that each and every step taken by these banks are monitored by the Chinese government. Loans are made from the government’s money. Repayments go to the government.
Every single activity is monitored by the government.
Constant vigilance.
In short, they are following an insider system, prone to manipulations and misreporting.
But, let’s not get into manipulation. In fact, let’s assume there’s no manipulation at all and China is corruption-free. After all, innocent until proven guilty.
Then how is the debt underreported?
Well, they use a magic wand called “Shadow Banks.”
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).
Lending to big and successful companies is easy because you know they’ll repay.
It becomes hard when it comes to lending to new companies, startups or companies with a history of defaults.
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.
To “manage” this risk, ultra-smart bankers could actually give loans to businesses without investing anything from their pocket.
How?
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 up 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 “de-risk” themselves?
Well, the world of finance is beautiful. In our world, a loan that a company owes to the bank is the bank’s “asset.”
Hmm .. now the bankers come up with an idea. Why not pool all of these poorer “assets” 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 won’t sell shit to yourself now, would you?
So, who would be so naive to buy these so-called “high-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.
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.
Pool Total = 10L Yuans.
This pool of 10 businesses is bought by the shadow bank for say 9L 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 1000 papers of 1,000 Yuans each and sells them to smaller investors. If the businesses repay, the money goes to the smaller investors.
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.
It is the small investor who loses her 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, like we said earlier, more often than not, these loans were initially given to poor companies, many of which were bound to fail.
The problem with China is that it has given people hope that it won’t let big companies fail.
It has a history of bailing out several corporations that went bankrupt.
Today, the shadow banking industry in China has grown to over $9 trillion. Is it possible for the government to bail them out if they fail?
More than 50% of loans lent out in China are through shadow banks.
Most of the money borrowed by corporations went in 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.
80 WILL FAIL.
Also, the country tried to boost its infrastructure to such an extent that some of its cities have been declared “ghost towns.”
No kidding.
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 you’re wondering why China built these towns in the first place, let me remind you that they want everything “bigger.”
Again, in order to promote growth, they became a kind of super-excited to boost their infrastructure.
“Property prices can never go down” is what they think, and that’s exactly what the people in the US thought. We know what the consequences of the 2008 financial crisis were.
Estimates suggest that more than 50 such towns in China are “Ghost Towns”. And these are fully developed corporate deserts, not just some small hub or district. They have everything, except, well, people.
This is what is happening in China now. It is facing a problem of overcapacity. It has the resources but it doesn’t know whom to sell it 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.
What happens when there’s such overcapacity?
Businesses fail. Employees who used to work for these businesses lose their jobs. There’s unemployment, unhappiness, and restlessness in the economy.
This unemployment is the answer to China’s deflationary environment. The fastest-growing economy in the world facing deflation. Strange, isn’t it?
When people are unemployed, they have to depend on their savings. They don’t have any recurring form of income. But, they still have to pay for their children’s schooling, their EMIs, and their regular expenses. Job or no job - these expenses cannot be avoided.
At such a time if the school raises its fees, the electricity prices go up or the food you eat becomes expensive, people will become even more restless. The government can’t let this happen. It can’t let the prices increase when a lot of people in the country are unemployed.
Now, even at existing prices, these people find it difficult to afford all that they could when they were employed.
The demand for these goods falls. The seller now is ready to sell his goods at an even lower price. These forces of demand and supply cause a fall in the prices of goods and services in the entire economy.
Simply put, when a country faces unemployment, it can’t increase its prices. When people don’t have jobs, how can they afford higher-priced goods, right?
The Chinese corporations that are huge are themselves crushing smaller Chinese businesses.
Umm, yes, they’re not only fighting outside their borders but also within.
It is one of the very few countries which is facing a problem of excess supply. They have achieved growth by spending on infrastructure, exports, exports, and exports.
And unfortunately (or fortunately - depends which side of the border you are on), their export industry will be suffering. And we all know the reason.
This doesn't end here.
Earlier this year, China reported a gold scam. China’s largest private jewellery company, Kingold Jewelry Inc, headquartered in Wuhan, took a loan of more than 20 billion yuan ($2.8 billion) with pure gold as collateral.
But soon, when Kingold was not able to repay, these shadow bankers claimed the gold. To their surprise, this “pure gold”, as pledged by the company, turned out to be copper.
Sauda khara khara? Not really.
There are a lot of things hurting the Chinese economy right now. This virus has lasted long (unlike their other products, obviously) and is, therefore, hurting them even more. They claim to have overcome the abnormal effects of the virus but there are still doubts if they are hiding the actual figures.
So, at a time when a pandemic is taking its toll, tourism is on halt, factories are shut, people can’t go out to earn, and they have to be solely dependent on their savings, the country is also putting a limit to the amount that can be withdrawn by people (click here to read our coverage on this).
The Chinese economy is indeed for the government, by the government, of the government.
Will this huge economy fall? Will its banks fail?
Stay tuned, we have more in store for you!
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This piece was deeply researched and creatively written by Aditya Iyer and Anmol Jain, the dynamic duo who seem to be inseparable these days. While they keep losing at Codenames (6-2 is the current tally), they for sure win our hearts through their write up :)