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It's China's turn to wrestle with a pile of bad debt 

It  looks like it's China’s turn to face up to a giant pile of bad debt. This being China, though, the story isn’t playing out like an ordinary Western financial crisis.
Image: Pedestrians walk past the headquarters of the Bank of China in central Beijing
Pedestrians walk past the headquarters of the Bank of China in central Beijing April 28, 2011. David Gray / Reuters

The U.S. banking system was the first to get hit by the financial Panic of 2008. For the past year, European bankers have been scrambling to head off exploding debt bombs in Greece and other countries with high debt loads.

Now, it looks like it's China’s turn to face up to a giant pile of bad debt. This being China, though, the story isn’t playing out like an ordinary Western financial crisis.

The source of China's current problem dates back to the collapse of the global economy in 2008 when, like its Western counterparts, the Chinese government unleashed a flood of cash to stimulate its economy. Much of that money was loans from state-owned banks to local governments, which were supposed to spend all those yuan on new roads, railways, power plants and other projects to help China maintain its torrid pace of economic growth.

Many of those yuan didn't get where they were supposed to go. It's still not clear exactly where they all went. But this week the Chinese government announced the results of a nationwide audit of 31 provinces and hundreds of municipalities which found that those local governments are now carrying some $1.6 trillion worth of loans. And a large portion — as much as 20 percent — may have to be written off as bad debt.

Following the blueprint of economic transformation laid out in the early 1980s by Communist Party leader Deng Xiaoping, China has embarked in recent years on a massive spending spree. Beijing hopes the spending will expand the economic success of coastal cities to inland regions by stitching them together with vast networks of roads, railways and high-speed Internet. But many of those projects have become mired in debt, with modern high-speed rail lines carrying handfuls of passengers and four-lane rural highways all but empty of vehicles.

Special report: China 2.0

“Last year, 55 percent of GDP was contributed by infrastructure investment — in other words bank lending,” said Carl Waters, an American investment banker until recently based in China and co-author of "Red Capitalism." "If you keeping making bad loans that don't pay back, you’re going to run out of money sooner or later."

For now, Beijing has said it will simply shift some $463 billion of those bad debts off the books of local governments and allow them to sell bonds to raise fresh cash. China’s state-owned banks, which also need fresh cash, will likely recapitalize their books with the profits guaranteed by state-mandated interest rates that pay savers less than banks charge borrowers.

Chinese bankers are also allowed to roll over their bad debts indefinitely, writing them off a little bit at a time while they raise fresh cash by selling stock to investors. That’s how China dealt with its last debt crisis in the late 1990s.

“At face value it was successful,” said Mark Williams, senior China economist at Capital Economics. “The banks cleaned themselves up and official government debt stayed down. But it only worked because the government rigged the financial system to guarantee big bank profits.”

The problem, said Williams, is that under such a system, bankers make money even when they make bad loans. Now, with debt piling up on the books of local governments, the government and its state-owned banks have increasingly more bad debt to warehouse. Eventually, that bad debt will make it harder for China to lend more money to invest in new infrastructure projects.

“China is already rapidly becoming significantly leveraged,” said Waters. “If you look at what happened in Greece or Ireland or Portugal when a country is leveraged, it has to borrow more and more to meet its interest obligations. That makes it less and less possible to invest in projects that will grow your GDP.”

But, as politicians from Washington to Athens have discovered, cutting back on spending can be a tough sell with the voters. In China’s case, any slowdown in growth could further inflame an already restive population. Chinese leaders have recently sought to bolster popular support with higher wages. But those higher salaries have raised the cost of doing business in a country that catapulted itself to the world's second-largest economy based on its seemingly endless supply of cheap labor.

Demands for higher wages in factory towns have sent multinational manufacturers looking elsewhere for cheaper labor. Southern China, where the low-cost manufacturing revolution began two decades ago, is now suffering what the Chinese people call a “hollowing out,” according to John Rutledge, an investment manager and advisor to the Chinese government.

“The assembly jobs in Guangdong that are now going to places like Vietnam are leaving empty buildings behind,” he said. “Those buildings were filled with the migrant workers from Sichuan and Hunan who were making money to send home to their families in the poor villages in western China. So there's a serious employment issue there.”

Infrastructure development was supposed to spread the wealth created in factory cities to rural inland areas to raise the living standards of those poor villages. Now, rising levels of bad debt will make it much harder for Beijing to continue to invest in those efforts to realize Deng's vision of spreading the wealth to all of China.

Beijing's massive spending spree poses another threat to China’s long term economic stability. Pumping more money into infrastructure projects may help prop up growth. But that cash infusion raises the risk of a sustained bout of higher inflation.

“The Chinese government is facing the difficult balancing act of maintaining high levels of economic growth while containing inflation,” said Jing Ulrich, JPMorgan’s head of global markets in China. “They need to keep job creation levels high and they need to maintain a decent level of income growth. They also need to dampen the inflation of wage increases and the impact on China's global competitiveness. It is a difficult juggling act.”

Rising levels of social unrest this spring and summer have made that juggling act even more difficult. So far, those riots and demonstrations have been relatively isolated. That situation could change if inflation continues to erode the economic gains brought by rising wages.

“There a lot of dry tinder on the ground,” said James Rickards, head of market intelligence at the research firm Omnis. “What's the match? The match is inflation. The inflation rate is 5.5 percent. But food inflation is 10 percent.”