China's Black Hole Investment and What's Being Done to Fill It
Beijing has done a great job of sparking China's economy. The global financial crisis continues. But China is almost out of the woods. Except for one big problem.
Just last Thursday China announced that its exports in May surged 48.5%. Imports into China rose by nearly the same percentage, 48.3%. Stock markets around the world surged.
China has enjoyed a stunning recovery from last year. The export – import increase also shows that China is driving world recovery.
But China's recovery has always held a dark secret.
Beijing has struggled for decades to stamp out shady investments among regional governments. Success has been mixed at best.
Anti-corruption drives are a part of daily life in the regions. But misuse of state capital is another matter. It has become a serious threat to the nation's recovery.
Investments in shell companies have become a real worry thanks to China's provincial and regional governments. Many have set up shell companies to steer state funds into real estate ventures. These development companies have contributed to China's real estate bubble.
They have been a boon to shady officials at regional levels. They have also contributed to a land rush – a rush that has driven up property values too quickly.
Bubbles are popular as long as everyone is making money. But bubbles are empty shells. They always collapse. And investors riding the outer edge of an expanding bubble always suffer in the implosion.
Edicts from Beijing to clamp down on regional governments haven't worked. There's just too much money to be made from shell corporations.
It's not just real estate that's in danger. Some regional shell companies have set up manufacturing facilities. The risk is that China will suffer from manufacturing over-capacity as a result.
Shady regional officials don't care about long term problems. They make their money through the financing and building of surplus ventures. They can make short term profits through land speculation and through shell property firms.
Finally, Beijing is taking credible action.
Rather than issuing orders which local governments ignore, Beijing is trying to turn off the financing taps.
On Sunday China clamped down on financing units that have caused a dangerous surge in local-government debt. Easy money has been available to the regions since Beijing launched its stimulus program with massive bank lending in 2009.
Many local governments set up special investment vehicles that borrowed from banks to fund infrastructure projects.
But will those debts turn into a huge black hole? Will they drag down banks and the whole economy?
Massive local debts are backed only by government land assets and promises. And that won't help if the property sector implodes.
Beijing is at least trying to prevent the problem from getting worse.
New rules say local governments must clean up financing to shell companies. These shells pretend to be viable companies. But they rely on the government to repay their debts. In other words they are not real businesses.
There are countless companies of this sort in China. They have contributed to fiscal expansion numbers. But they are empty shells. They might implode in a debt crisis like the one the U.S. suffered beginning in 2007.
Beijing is cracking down at the bank level. Banks won't be allowed to lend to regional companies that don't have a steady source of cash flow to repay loans.
This is a crucial change. Regional governments can ignore Beijing. National banks cannot.
Will this squeeze cause an implosion among existing companies? If so, China's banks will come under pressure from non-performing loans. But, a crisis like the U.S. mortgage crisis seems highly unlikely.
Banks reserve ratios have been raised three times this year as a protective measure. The central bank still has the reserves to bail out any banks that do get into trouble.
The upcoming IPO of the China Agricultural Bank is an example of huge state financing bailing out an insolvent bank. Beijing is determined. It will not stand by and allow a crisis to end China's recovery.
The good news is that Beijing did not stand by blindly, as Washington did, during the creation of a debt bubble. China's State Council, or cabinet, is taking every action possible to prevent the creation of new black holes.
China's black hole investments aren't going away anytime soon. But at least new holes won't be created and existing holes won't be allowed to get any deeper.