Minxin Pei writes: Financial collapses may have different immediate triggers, but they all originate from the same cause: an explosion of credit. This iron law of financial calamity should make us very worried about the consequences of easy credit in China in recent years. From the beginning of 2009 to the end of June this year, Chinese banks have issued roughly 35 trillion yuan ($5.4 trillion) in new loans, equal to 73 percent of China’s GDP in 2011. About two-thirds of these loans were made in 2009 and 2010, as part of Beijing’s stimulus package. Unlike deficit-financed stimulus packages in the West, China’s colossal stimulus package of 2009 was funded mainly by bank credit (at least 60 percent, to be exact), not government borrowing.

Flooding the economy with trillions of yuan in new loans did accomplish the principal objective of the Chinese government — maintaining high economic growth in the midst of a global recession. While Beijing earned plaudits around the world for its decisiveness and economic success, excessive loose credit was fueling a property bubble, funding the profligacy of state-owned enterprises, and underwriting ill-conceived infrastructure investments by local governments. The result was predictable: years of painstaking efforts to strengthen the Chinese banking system were undone by a spate of careless lending as new bad loans began to build up inside the financial sector.

When the Chinese Central Bank (the People’s Bank of China) and banking regulators sounded the alarm in late 2010, it was already too late. By that time, local governments had taken advantage of loose credit to amass a mountain of debt, most of it squandered on prestige projects or economically wasteful investments. The National Audit Office of China acknowledged in June 2011 that local government debt totaled 10.7 trillion yuan (U.S. $1.7 trillion) at the end of 2010. However, Professor Victor Shih of Northwestern University has estimated that the real amount of local government debt was between 15.4 and 20.1 trillion yuan, or between 40 and 50% of China’s GDP. Of this amount, he further estimated, the local government financing vehicles (LGFVs), which are financial entities established by local governments to invest in infrastructure and other projects, owed between 9.7 and 14.4 trillion yuan at the end of 2010.

Anybody with some knowledge of the state of health of LGFVs would shudder at these numbers. If anything, Chinese LGFVs are known mainly for their unique ability to sink perfectly good money into bottomless holes in the ground. So taking on such a huge mountain of debt can mean only one thing — a future wave of default when the projects into which LGFVs have piled funds fail to yield viable returns to service the debt. If 10 percent of these loans turn bad, a very conservative estimate, we are talking about total bad loans in the range of 1 to 1.4 trillion yuan. If the share of dud loans should reach 20 percent, a far more likely scenario, Chinese banks would have to write down 2 to 2.8 trillion yuan, a move sure to destroy their balance sheets. [Continue reading…]