How a Chinese Ponzi Scheme Distills Beijing's GDP, Debt Problem

The FT gives one example of how Chinese local government off-balance-sheet debt has been accumulated, and also serves to illustrate how, as growth slows and a surplus accumulating of whatever is being made (in this case housing), these debts will become more of an issue as they turn bad. Get the context for this in Part One of this article.

The city of Guiyang, capital of Guizhou in southwest China, encouraged (as all cities have done in China) a building frenzy over the last five years in order to generate massive financial returns for the city. They transferred land to a wholly owned financial vehicle who used the land to borrow heavily from the banks; the funds were then used to provide infrastructure to the land and to compensate farmers and land owners who had to be cleared to make it more attractive to developers.

The land was then sold to developers and the vehicle – and hence, the city – pocketed the proceeds. So far so good; following initial success, the model was run again and again in ever-larger cycles and like a Ponzi scheme, proceeds were used to fund expansion rather than maintain a healthy balance sheet.

As a glut of housing in Guiyang has left house sales stagnant, the financial vehicle is struggling to pay interest charges. Infrastructure projects are stopped because the vehicle doesn’t have the funds to pay for them, blighting the area and those that live around them.

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So where will this all end up?

Our China Economy Prediction

While some media sources headline with tales of the imminent collapse of the Chinese financial system under the weight of debts, that is unlikely to happen. Savings will not be withdrawn from the banks, savers have no other investment options.

The Chinese government, behind most of the banks, is the largest creditor and Beijing controls the currency and owns most of the wealth, including, as the FT notes, huge foreign reserves. But coping with the debt hangover will be painful and, maybe even more pressing, so will the controls applied to skew the economy away from acquiring even more debt.

Investment accounted for 42% of GDP in 2007. It was 48% in 2010 and is even more now. Maintaining growth while reducing the reliance on investment and hence debt will be a tough balancing act.

China at least has the advantage over countries like Argentina that have collapsed under debt in the past, in that the economy is centrally controlled and the levers of power are mostly in the state’s hands; but if Beijing is serious about tackling levels of debt that are getting to potentially dangerous levels, growth in the medium term will almost certainly be a casualty.

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