When we look back at China’s extraordinary building and spending spree over the last decade — all those skyscrapers, modern apartment blocks, new airports, the Belt and Road Initiative, the upgrade of its navy, a countrywide network of bullet trains and so on — there’s one simple but important question to ask: Where did all the money come from?

The simple answer is, the country’s banks. With local governments starved of cash and the central government keen to keep its own deficits under control, they have been the only possible source of so much money. The enormous burden taken on by the banks is, however, a major reason why the Communist Party should now be worried about the risks that have built up in China’s financial system.

Following the logic above, we should ask from where the banks got the funding they’ve needed to make their mountains of loans. The initial answer lies in Beijing’s opening up to foreign investment and rapid export growth, particularly from the late 1990s onwards. More exports ultimately translate into higher corporate and household deposits, as money floods into an economy.

Later, after the global financial crisis, the Communist Party responded by telling the banks to lend, using all those built up deposits. Liquidity poured into the Chinese economy, mostly into the government sector. All state entities, but especially local governments, worked hard to put this money to use; this was Chinese style quantitative easing. Accordingly, China’s appearance changed as its GDP kept growing. People and companies added further deposits to the banks’ pile, driving increasing lending so that the state sector’s size grew to nearly 3.5 times the country’s output by 2020. 

Against such rapid expansion, how could the banks’ performance metrics keep looking so strong? The big state banks are professionally audited and are subject to the same Basel III regulation applied to all so-called Global Systemically Important Banks. Yet most have kept on putting out results showing low levels of non-performing loans.

There can be only one answer: China’s largest banks have managed to slough off unwanted assets. Over the past decade or more, Beijing has worked closely with regulators to develop channels and entities that would take the major banks’ ‘bad’ assets away. A shadow banking system that absorbed many of these grew rapidly during the 2010s, although even the ‘bad banks’ sometimes became saturated, as the problems of China Huarong demonstrate. So China’s banks also developed clever ways to manipulate accounting principles to reduce their ‘risk-weighted assets’, making it less pressing for them to raise fresh capital — at least on the surface. 

To avoid social and even political crises the Party must throw away the fossilized thinking that has landed the country in today’s difficulties.

How did all this impact the government sector? The only way to know for sure would be if Beijing produced a consolidated balance sheet that includes the assets and liabilities of the country’s local governments, the state banks and enterprises that it owns and its lending to the private sector. Despite research by the People’s Bank of China and other Chinese analysts around 2014, the government has chosen not to publish such a balance sheet. But official data permits the creation of a rough government balance sheet for the period 1978 to 2018. Unsurprisingly, its scale after the last decade of heavy lending became huge. Indeed, the picture it paints is of the Party’s profligate use of other people’s capital to fund the state sector. 

To backstop this conclusion, comparisons were made between how China and the U.S. have managed financial crises. For the U.S., financial outcomes of the savings and loan crisis of the 1980s and the mortgage crisis from 2008 were used. From a purely cost perspective U.S. management proved quite efficient; financial costs in both cases were similar at around 4 percent of GDP. The Congressional Budget Office provided these cost figures. For China, using the same statistical techniques as for the U.S. cases and official data, the costs of the bank restructuring from 1997-2005 and the deleveraging campaign from 2016-2019 were calculated. The results for both Chinese cases were quite similar, but they were very high, over 40 percent of GDP in both cases. These numbers are huge because the financial data themselves have grown huge. This supports a conclusion of profligate capital use. 

What can China do to resolve all this financial risk? Does the Japanese experience, beginning in the early 1990s, of a banking crisis combined with the collapse of an asset bubble provide guidance? The two economies are very different, one state-owned and the other based on markets, but there are similarities. The first is that the Japanese government’s eyes were blinded by an outdated regulatory system that they believed would protect Japan’s major banks from collapse. It took eight years of increasingly large bank defaults to demolish this thinking; only then did Tokyo take effective action. The time bureaucrats and politicians spent arguing had only led to the crisis expanding. 

China, too, has had difficulties dismissing old ways of thinking. For sure, Chinese reformers in the early part of this century were able to reject old economic ideologies discredited by the Soviet Union’s collapse. They recapitalized China’s major state banks in the early 2000s, as they built out their own version of capitalist markets, enabling the Party to later respond effectively to the global financial crisis. But in late 2008, as the U.S. economy wallowed in mortgage-related disaster, the Party disavowed the work of 20 years and started returning China to a command style economy, culminating in the bombardment of the private sector over the last year or so.

Both China and Japan now also face huge challenges as their populations begin to rapidly age. The Japanese government has prepared for the costs by building adequate medical and social security funds. China has done little. Demographic projections for China suggest that by 2100 its population will be reduced by between 330 and 760 million people. Who will use the apartments and infrastructure so wastefully built? What will be the value of the related loans? 

The demographic numbers are shocking and the costs will be huge. Yet China’s government budget is already under strain as its revenues decline. The population forecasts suggest it can no longer count on its banks to lend endlessly either: their deposit base will soon be rapidly shrinking. How will the party address the medical and living needs for its aging people? Before anything else it must recognize that pay-as-you-go will not work. To avoid social and even political crises the party must throw away the fossilized thinking that has landed the country in today’s difficulties. It must find the assets that can be used in support of the people’s grandparents as they age; completely privatizing state enterprises would be a start. Can the party respond to this challenge? This picture of China’s financial and social landscape is hardly the China Dream presented to the country and the world in 2012. 

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