China’s cooked books and bad loans scare the heck out of us

China has $400 billion in bad loans on the books of its banks (and possibly $1 trillion or more). The country’s bad loans, whatever the precise number, are equivalent to a vast amount of the country’s foreign exchange reserves. China has no idea what the true number is.

China decided to revalue its GDP upward by 17% in one fell swoop the other day. So China’s GDP is $1.65 trillion, or maybe $1.9 trillion, or maybe $8.1 trillion (PPP, via Economist). Again, it is evident that China has no idea what the true number is. (Indeed, Investors Business Daily (IBD) says that China has systematically overstated its GDP for many years.)

We saw this chart in the course of a thoughtful Stratfor piece by Peter Zeihan on China’s coming instability. The point of the chart is that Foreign Direct Investment in China by the US has been quite low, about $7 billion a year — in our mind, the purpose of the chart is to for its government to spin China as a stable economy, not terribly dependent at all on the US’s foreign investment:

These numbers do not appear to add up. Citibank alone (Economist) is investing $3.8 billion in a couple of banks in China this year, and BofA made a $3 billion investment as well. The Economist also says that by “last October, 22 foreign banks had spent $16.5 billion on stakes in 17 mainland lenders.” Intel‘s investments are in the hundreds of millions of dollars, GM and Ford have put in at least a couple of billion each, and this is the result of less than 30 seconds of research on the internet. China’s $7 billion claim is inherently implausible.

And while China is saying that investment from the US is low, it is also saying the opposite. While China is spinning these particular numbers to show that US investment is low, it is hyping its numbers to show what an attractive investment China is, touting an annualized investment rate of $60 billion a year in its official publications. The trick in the numbers is that US companies may invest in China using funds from other foreign operations that were never repatriated to the United States, or through other foreign vehicles.

A little context

Changes are coming swiftly to China. For a little context, we’ll quote a bit from the Zeihan article, about the massive problems facing the Chinese economy as it becomes subject to international banking and accounting standards:

Until very recently, China’s economic system operated in this way: State-owned banks held a monopoly on deposits in the country, allowing them to take advantage of Asians’ legendary savings rate and thus ensuring a massive pool of capital. The state banks then lent to state-owned enterprises (SOEs). This served two purposes. First, it kept the money in the family and assisted Beijing in maintaining control of the broader economic and political system. Second, because loans were disbursed frequently and at subsidized rates — and banks did not insist upon strict repayment — the state was able to guarantee ongoing employment to the Chinese masses.

This last point was — and remains — of critical importance to the Chinese Politburo: they know what can happen when the proletariat rises in anger. That is, after all, how they became the Politburo in the first place.

The cost of keeping the money circulating in this way, of course, is that China’s state firms are now so indebted as to make their balance sheets a joke, and the banks are swimming in bad debts — independent estimates peg the amount at around 35-50 percent of the country’s GDP. Yet so long as the economic system remains closed, the process can be kept up ad infinitum: After all, what does it matter if the banks are broke if they are state-backed and shielded from competition and enjoy exclusive access to all of the country’s depositors?

This system, initiated under Deng Xiaoping in 1979, served China well for years. It yielded unrestricted growth and rapid urbanization, and helped China emerge as a major economic power. And so long as China kept its financial system under wraps, it would remain invulnerable.

But the dawning problem is that China is not in its own little world: It is now a World Trade Organization member, and nearly half of its GDP is locked up in international trade. Its WTO commitments dictate that by December, Beijing must allow any interested foreign companies to compete in the Chinese banking market without restriction. But without some fairly severe adjustments, this shift would swiftly suck the capital out of the Chinese banking system. After all, if you are a Chinese depositor, who would you put your money with — a foreign bank offering 2 percent interest and a passbook that means something, or a local state bank that can (probably) be counted on to give your money back (without interest)?

Significant disruptions have come and are coming to China. Often the focus has been on the mass uprisings in the countryside, but maybe the real uprising will come from a ledger and green eyeshades.

Whatever its detractors say, accounting is not merely a matter of spin and opinion. China’s spinning its GDP, its bad debts, the troubles of its SOE’s, and its foreign direct investment levels, is a huge signal flashing a warning about the Chinese economy. We have seen such things before. From the unbilled receivables of Sterling Homex to the non-hedge hedges of Enron, from the claim that junk-bond-loaded Columbia Savings was the safest S&L to the extravagant valuations of internet companies on “projected revenue before expenses,” we have seen this play before, and it never ends well.

Accounting is where the chickens come home to roost in a capitalist economy, and China is the land of a devastating bird flu. (HT: Samuel Kennard)


We’ve written a number of pieces about the blip in growth that China is likely to experience. Most of these have not been alarmist, but — at least in our own view — along the lines of Barton Biggs’ famous and early predictions of a correction in Japan’s market and economy 15 years ago (rather than like this Samizdata piece referred to us by reader Larwyn). But these accounting issues in China raise the stakes for us. Companies and countries go through good times and bad times. But if a country, allegedly practicing capitalism, reaches the point that its accounts appeared to have been jiggered, markets can get spooked and it can take a long time for confidence to be restored. No doubt the investments by American and EU banks in Chinese financial institutions will help to identify and rectify problems in those banks. Let’s hope it can all be kept under control.


Ernst & Young estimates that the amount of bad loans at China’s banks are $1.2 trillion, not $400 billion.

4 Responses to “China’s cooked books and bad loans scare the heck out of us”

  1. 上海鲜花 Says:

    Your article makes sense extremely, I supports

  2. 深圳速达 Says:

    The first time I meet this ideal from your article, so I will try to understand your topoint for it.Sometimes new way to the truth for it. ah. isn’t it?

  3. Eric Van Buskirk Says:

    The biggest threat to me is the lack of transparency. How in the world can foreign investers put so much money into banks that are not showing their cards and are loaning to God-knows-who? It was the same in Japan.

    I can’t help but think about what happened in Japan in a similar way. Actually, strike 1/2 of what I said! As a college student during the high flying Japanese economy days, that is what let me really witness their rise and fall, and as someone now working in Asia, I can see a couple same similarities now– especially the way in which access anyone can line up for a loan.

  4. 速达软件 Says:

    Hello! Write your blog well, I come from China, I would like to exchange friendship and connect you can?

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