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China could face a Japan-style debt crisis

China could be ripe for a crisis of its own that might resemble the collapse of Japan’s “Bubble Economy” in the early 1990s — and have enormous global impact, analysts warn.
China property
A man stands on a pedestrian bridge overlooking a half-demolished old neighborhood and nearby newly built apartments in Shanghai, China. Rapidly-growing China could be ripe for a crisis that might resemble the collapse of Japan’s ‘Bubble Economy’ in the 1990s.Qilai Shen / EPA
/ Source: The Associated Press

When financial crisis devastated its Asian neighbors a decade ago, China sat safely on the sidelines, its own markets and banks largely closed off from the world and insulated from the upheavals wracking more open economies.

But today, China could be ripe for a crisis of its own that might resemble the collapse of Japan’s “Bubble Economy” in the early 1990s — and have enormous global impact, analysts warn.

Just as in Japan at that time, stock and property prices here are soaring. Banks have lent billions to build malls, office towers and apartment buildings — although many remain unfilled.

Authorities warn the economy may be overheating and are taking steps to cool investment and lending, but to little avail. An attempt in late May to rein in surging stock prices sent shares tumbling for a couple of days before they resumed their climb.

The likely trigger of a crisis, should it erupt, would be a pile-up of bad loans in a weak banking system, analysts say.

“The banking system is still based on collateral and the collateral is all overvalued,” says Andy Xie, an independent economist based in Shanghai and Hong Kong.

“If the bubble bursts, then you will have a banking crisis like Japan in 1990,” he says. “The question is how China can manage after the bubble.”

Given China’s growing role in global manufacturing, financial markets and commodities, the repercussions of such a collapse would be far-reaching.

While there are differences between Japan’s asset price bubble and China’s situation today, the similarities are instructive.

Easy money from Japan’s banks led to an estimated $3 trillion in investment in new plants, hotels and a glut of golf courses. Real estate prices soared.

Domestic investors piled into stocks, seeking higher returns than the paltry interest paid on savings accounts. The value of the Tokyo stocks soared from $2.6 trillion in late 1987 to $4.5 trillion at the market’s peak in late 1989.

When the orgy of speculative trading collapsed after the Bank of Japan tightened monetary policy, a decade-long slowdown ensued.

In China today, many of the same factors are also at work — low returns on bank savings, cheap capital, soaring stock prices and relentlessly surging property prices. In just two years, the value of shares traded in Shanghai and Shenzhen has skyrocketed to about $2.2 trillion from $393 billion.

So far, there are no obvious signs of a crisis. Exports keep growing and average incomes are rising. But under the edifice of robust growth lie serious strains.

“Right now, we’re in a sweet spot. Everything is as good as it can get,” says Michael Pettis, a professor at Peking University’s Guanghua School of Management and author of a book on financial crises in emerging economies. But he adds, “Nobody should assume it’s going to stay like this. No country in history went through such a rapid period of growth without periodic crises.”

China’s banks are actually in better shape today than they have been ever been — at least by official figures. They show nonperforming loans at about 7 percent of total lending in the first quarter of 2007, down from estimates of 40-50 percent a few years ago.

But some of the decline in bad loans reflects the surge in overall lending. And the figures exclude so-called “special mention loans” on the verge of going bad. Including those, plus bad loans already written off, the total amount of problem loans may be triple the figure for the narrower category of nonperforming loans, according to some estimates.

“The risk is still there. We walk around. We see so many empty buildings in Beijing. We know that there’s something going on that may not just be being recorded,” said Charlene Chu, a Fitch Ratings analyst in Beijing.

New bank loans totaled a staggering $275 billion in January-May, already two-thirds of the total issued in all of 2006. In mid-May, the government tightened bank credit and raised interest rates for the fourth time in a year after reporting that investment in construction and factories was still growing by double digits.

As in late 1980s Japan, bank loans, often made with scant regard for risk, are often guaranteed by collateral whose value is exaggerated by surging real estate prices, Xie says.

Today’s go-go China is something of an economic Never-Never Land. Reliable data on credit risk and bankruptcies are virtually nonexistent, making it hard to know when a crisis might strike.

However, unlike Thailand, South Korea and Indonesia, which were left owing billions of dollars in foreign debts when their currencies collapsed in 1997, China has kept strict controls on its capital markets — insulating them from most external shocks.

Moreover, thanks largely to its soaring trade surplus and booming economy, China is awash in cash. Its foreign currency reserves, at $1.2 trillion, are the world’s biggest. Beijing could easily dip into those to pre-empt a brewing crisis.

But Chinese authorities face a precarious balancing act in shepherding the world’s fourth-largest economy, which grew a sizzling 11.1 percent in the first quarter. Beijing needs strong growth to lift millions out of poverty.

“China is like a giant elephant riding a bicycle — it has to maintain a fast speed, otherwise it will crash,” economist Zhang Chunyue quipped in a recent commentary in the state-run newspaper China Daily.

Despite warnings to banks to tighten credit, tax penalties on speculative property dealings and interest rate hikes, real estate prices in major cities are still rising at an average annual rate of 8 percent to 11 percent.

Meanwhile, inflation is creeping up, rising to a two-year high of 3.4 percent in May.

The stock market suffered only a brief setback last month when authorities tripled a trading tax. The Shanghai index is still up 54 percent this year while the Shenzhen Composite Index, for China’s smaller, second market, is up 120 percent.

“It’s still a bull market,” says Chen Huiqin, an analyst from Nanjing-based Huatai Securities Co.

There’s little risk that a big stock correction alone would trigger a financial crisis, given the limited proportion of shares in household wealth and corporate fund raising, although a crash could provoke an angry backlash from middle-class investors.

But that doesn’t mean China is immune from potential shocks. As its markets open ever wider to foreign trade and investment, the economy grows increasingly vulnerable to global trends, such as a downturn in exports due to slower growth elsewhere.

“In the case of China you can make a very plausible case that we have all the conditions for a serious crisis when there’s an adverse shock,” Pettis says. “There’s a lot more debt out there than we think.”