Importance of being earnest
Japan holds an important lesson for China. Like the People’s Republic today, it battled with runaway debts in the early 1990s. The key is to tell banks whose loans are going bad: if you must, then extend – but don’t pretend.
The first part of that message is already being put into practice. Chinese regulators and the central bank recently suggested that banks should roll over credit to troubled local government financing vehicles if they can’t pay interest or principal. This is reminiscent of the Japanese experience. After the bubble in Japanese stocks and property burst, companies did shed debt. But the deleveraging dragged on. Banks kept making new loans to debt-laden borrowers so the latter could keep repaying old liabilities.
This “evergreening” of soured debt was not a bad strategy in itself. Tokyo commercial property prices in early 1993 were down 22 percent from their peak two years earlier. Like in China, land was the main collateral for loans. If banks had forced companies to repay them by selling land, about a fifth of the Japanese corporate sector’s 1990 net worth would have vanished overnight. Even that is a conservative estimate, because land prices eventually slumped by 80 percent over two decades. If the pain had to be taken all at once, the prosperity that the Japanese society has managed to preserve despite a massive loss of wealth may not have continued.
China’s situation is similar. A group of 14 Chinese banks that Fitch Ratings analyses has a combined 20 trillion yuan ($3.3 trillion) exposure to property, four times the 2008 amount. More than half of this sum is corporate credit with property as collateral. Just like in Japan in the 1990s, it’s not clear if all Chinese banks have enough loss-absorbing capital to withstand a big shock to property prices.
What proved to be really harmful in Japan was policymakers’ unwillingness to accept the reality that their banks didn’t have adequate capital even to support gentle deleveraging. The pretending was far more pernicious than extending. A 56 percent drop in the Nikkei index over three years meant that banks were sitting on huge losses on their stocks portfolio in early 1993 and clearly lacked capital. As a result, they diverted lending away from more efficient companies to keep zombies afloat.
This led to an economy-wide slide in productivity and two decades of anaemic growth. In the absence of private-sector investment, output and employment became overly dependent on public spending. Government debt ballooned. A timely injection of taxpayers’ money as capital would have prevented much of this. But Japan didn’t quite face up to the challenge for almost a decade.
China is at risk of ignoring the Japanese lesson on pretending. It stretches credulity that in a sharply slowing economy where total credit is estimated by Fitch to have ballooned to 242 percent of GDP by the end of 2014, and where interest costs this year would amount to 15 percent of GDP, only 1.4 percent of bank loans have gone bad. But then, the non-performing loan number is meaningless because 38 percent of the overall credit risk resides outside banks, in Fitch’s estimate. But just because the dodgiest loans are hiding in the shadow banking system doesn’t mean that losses on them won’t find their way back to the banks.
China’s lenders have a head start. Many have been raising capital in the market to pad out their loss-absorbing capacity. But more might be useful, so that when the heavy losses come, the more efficient borrowers aren’t forced out of the market. China might also need to revisit the law that stops banks from lending more than 75 percent of their deposit base. Allowing zombies to exist in suspended animation rather than die suddenly can help minimize mass unemployment and social unrest, but the cost mustn’t be borne by more productive sectors.
Purists would say that to extend is just as bad as to pretend, as it prevents creative destruction that could allow the economy to start afresh. But that just isn’t realistic. Policymakers in Beijing would clearly rather mimic the prolonged discomfort of 1990s Japan than the sharp shocks of 1930s America. If China is quick to own up to the fragile health of its financial system, it might even pull it off better than Japan, and avoid the latter’s two lost decades.