The Chinese timebomb

By John Burton

The North Korea nuclear issue dominated the headlines when South Korean President Park Geun-hye met Chinese President Xi Jinping in Beijing last week. But perhaps they should have spent more time discussing the perilous state of the Chinese financial system, which poses a more immediate threat to the well-being of both countries.

With Korean exports slowing to Europe and the U.S. and the country's export competitiveness being undercut further by a weakening Japanese yen, China is more important than ever to South Korea's economic health. The scores of South Korean businessmen who accompanied President Park on her visit underscored the fact that China is South Korea's leading trade partner. China now buys more products from Korea than Japan and Seoul wants to increase bilateral trade to $300 billion by 2015 from $256 billion in 2012.

So it might have been of concern to President Park that just days before her arrival in Beijing the Chinese banking system suffered a sudden credit crunch, a symptom of the country's flawed growth model.

China's economic expansion, particularly since the global financial crisis in 2008, has rested on an unsustainable amount of debt. Wasteful investment in construction and industry, fueled by a binge of bank lending over the last five years, is creating inflationary pressure and threatens social stability. The credit splurge benefited the business elite, but has been a source of growing concern to the government worried about the consequences to social stability.

China's central bank has been tightening liquidity to the official banking system since 2010 in an attempt to regain control over credit growth. As a result, overstretched and desperate borrowers, including local governments, have turned to the "shadow" banking system, which offers high-interest, short-term loans. The loans are made by largely unregulated financial institutions, which attract funds from savers looking to earn high interest rates not available from regular banks.

Demand for these so-called "trust loans" grew by nearly 700 percent last year and any curtailment in the liquidity provided by them could result in a major solvency crisis as businesses and local governments would be unable to repay their debts.

Such a situation would seem familiar to any Korean who lived through the 1980s and 1990s when an extensive network of non-bank financial institutions helped fuel excessive corporate debt levels that set the stage for the 1997 financial crisis.

China's central bank, the People's Bank of China (PBOC), is clearly aware that it needs to curb aggressive lending to prevent the already large debt levels from growing bigger. As a warning shot, it engineered the credit crunch in mid-June by temporarily refusing to inject more liquidity into the capital markets. The result was that the interest rates that banks charge each other for loans spiked sharply, which particularly affected the shadow banks.

The PBOC has since eased the liquidity crunch, but its recent action has signaled its determination to gradually curb credit growth by shadow banks in an orderly manner. But such a policy will not come without costs.

The biggest blow will be directed against property developers who have often financed their projects with the help of local governments. But as many as half of these so-called local government financing vehicles (LGFVs) are unable to pay back their debts, according to regulators. The assumption is that the central government will eventually bail out the LGFVs, but that may not turn out to be case given the staggering amounts of money involved.

The situation of the LGFVs underscores the dilemma that China faces.

The country embarked on a massive wave of construction and infrastructure investment after 2008 in an effort to maintain economic growth. But it is now faced with an excess supply of offices and housing projects, known as China's "empty cities," mired in debt.

A lot of those projects are likely to remain empty because potential residents or businesses cannot afford to buy them because they are already too deep in debt. The end of China's credit boom will force some hard choices on what to do with the wasteful and unprofitable projects and the result will likely lead to lower economic growth as the banking system is restructured.

The slowdown of the Chinese economy will have a profound impact on Korea when it already wrestles the consequences of its own debt bubble that began bursting 15 years ago.

The parallels between Korea and China are striking. Both engaged in a binge of borrowing to finance housing and construction that left their populations with huge debts, with Korean households among the most indebted in the developed world. The construction boom in both countries has ended with public savings wasted on boondoggles and a recovery in property prices is unlikely as China and Korea follow Japan into an aging demographic cycle.

John Burton, a former Korea correspondent for the Financial Times, is now a Seoul-based independent journalist and media consultant. He can be reached at john.burton@insightcomms.com.

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