Talk About China's Banks, Too

Treasury Secretary Timothy Geithner hosts Chinese Vice Premier Wang Qishan in Washington today, and banking reform is certain to be a key topic. The Chinese side will want to focus on US banking problems. Equal attention should be directed at China's banking system.

With the United States and the world in recession, China has emerged as a potential savior for the global economy, posting 7.1 percent GDP growth for the first half of 2009. Meanwhile, the Shanghai Stock Exchange is up 70 percent this year. On the surface, China's four trillion yuan ($586 billion) fiscal stimulus seems to have done the trick.

Yet the real reason for this success is an aggressive, behind-the-scenes bank lending binge to the tune of some 7.4 trillion yuan and counting. China's loose credit strategy delivers immediate growth, but medium- and long-term results are seriously at risk. If all goes according to Beijing's plan, China will eventually lead the world economy with a stronger, more consumer-driven economy. But if not, the world is in for a deeper recession as this white knight trips on a banking crisis of its own.

Premier Wen Jiabao describes China's monetary policy as "moderately relaxed," but this is a great understatement. The 7.4 trillion yuan of new lending pumped through the banks in the first half of 2009 equals more than three times the amount in the same period last year and 50 percent more than all of 2008.

The breakdown of China's GDP growth figures sheds some light on where this money went. According to China's statistical bureau 88 percent of its 7.1 percent GDP growth was achieved with investment growth in government projects and official guarantees for loans to all manner of public and private projects. Fixed-asset investment increased by 34 percent year-on-year: Railway investment rose 127 percent, roadway investment rose 55 percent, and investment for irrigation and public works projects was up 55 percent. The return on these and other less productive investments remains to be seen.

China's state-owned banks have never been the best allocators of credit. As an extension of the state, these banks favor loans for state-owned enterprises (SOEs) over small and medium enterprises (SMEs). Large firms are overwhelmingly state-owned. According to a McKinsey report, large firms employ 25 percent of the labor force and contribute 45 percent of GDP, but use 84 percent of total bank loans to do so. Moreover, much of that lending is not repaid. Between 1999 and 2004, over two trillion yuan of nonperforming loans were restructured to clean up bank balance sheets. Since then, China's state-owned banks have kept their nonperforming loan ratio under 5 percent, but the consequences of the recent credit binge have yet to be reflected. Beijing's claim that nonperforming loans have fallen significantly to just 1.8 percent of all loans in 2009 is hard to believe: One can only assume that new lending is being used to pay off delinquent old loans. If that is not throwing good money after bad, it is hard to know what is; it's certainly not the kind of "investment" that is going to pay a return.

China can get better and more sustainable growth and increased employment if it is able to reallocate credit from SOEs to SMEs. But China's SMEs are so short of credit that they pay 10 times the legal lending rate for underground loans. As a result, the government is experimenting with new financial institutions including village banks, guarantee companies, and small loan companies to meet SME credit demand. While village banks have attracted major players, including HSBC and Standard Chartered, their regulation is too stringent for most investors. Guarantee companies and small loan companies, which are loan-only companies and cannot legally take deposits, have been more explosive. By the end of 2007 there were over 3,700 guarantee companies according to an industry report from consultancy Research and Markets. Today, less than one year after formal rules for small loan companies were issued, over 580 small loan companies are disbursing loans and another 573 are in registration. Yet, the fruits of these strategies are uncertain.

Taken together these facts should tell Secretary Geithner a few important things about the heroic Chinese economy. First, China remains overwhelmingly investment-driven, not consumer-driven, and that will take a long time to change. This raises questions of financial and environmental sustainability. Second, the rapid increase in investment is driven by aggressive credit policies, not healthy risk-taking appetite. Credit is not necessarily bad, as long as it is channeled toward investments with sustainable positive returns; but there is reason to doubt that is happening. Third, there is huge demand for credit in China's best growth engine-its small and medium-sized sectors-but formal credit is not reaching them fast enough.

All of this points to weaknesses in a Chinese economy built on a fragile banking system. In the end, it is not just how much you stimulate: What you stimulate matters too. If China and the United States are going to have a dialogue about their economies that is truly strategic, then there is more than enough leverage on both sides to ask tough questions of one another.