Major news outlets have been covering the looming Chinese debt crisis more vigorously as of late.  The New York Times has a “Room for Debate” section last week that was pretty good, and had a number of experts weigh in on what’s going on with Chinese debt.  There’s a lot of talk in theoreticals, so I thought it might be interesting to portray this in an anecdotal fashion instead.  I would clearly prefer using a cartoon to describe this, but my artistic skills have not graduated beyond the stick-figure level.  Anyway, here’s our imaginary scenario on how infrastructure over-investment could precipitate an economic crisis.

Mr. Li is a top government official for the Ministry of Railways, in charge of planning and executing new high-speed train projects.  Mr. Wang is a high-ranking loan officer for the Bank of China.  Finally, Miss Jia is a managing director for Jiayou Railway company, a listed company in Hong Kong, with 70 percent of its shares owned by the Chinese government.  This means that Mr. Li works directly for the government, while Miss Jia and Mr. Wang or employees of nominally state-owned enterprises.

Mr. Li decides there should be a high speed rail line built between the cities of Shenzhen and Changsha.  Currently there is an overnight train that takes about 8 hours and is about 70% full during off-peak times.  High speed rail would reduce the travel time to 2.5 hours, he argues, and would promote the economy of cities along the route.  The high speed line’s tickets will be priced about 4x that of the sleeper train.  Mr. Li’s team does an engineering assessment and contracts Jiayou Railway to do construction.

Mr. Li calls Mr. Wang at Bank of China for money to pay Jiayou to get started.  Note that the base lending rate in China is currently around 6.5%, and inflation about 5.5%.  Actual consumer lending rates are higher (let’s say 8%), but because of Mr. Li’s very high ranking in the government, and the understanding that the government cannot default on debt, a loan for 100 million RMB is given at a fixed interest rate of 6%.

At best, if inflation remains consistent, the bank could make a 0.5% profit on the loan, which is absolutely terrible in any industry.  Given the fact that wages and such rise far more than 0.5% per year, the bank’s expenses will undoubtedly increase year after year.  That profit rapidly becomes a hole in the bank’s balance sheet.  No one thinks the central government won’t repay the loan, but the revenue from the loan is unlikely to match the increased maintenance expenses over time.  Mr. Wang knows this is a bad deal, but he can’t decline.  His immediate supervisor is a government appointee, and would lose face if a high official was unable to get a loan from his division.  Mr. Li could get his loan from some other bank as well, or perhaps direct unfavorable policies towards Bank of China in retaliation.  The political connections make this very much like moving money from one hand to the other.  Unfortunately, the hole in the balance sheet created by this bad deal is picked up by taxpayers and depositors, people who might not even use the new railway.

But I digress.  Miss Jia gets a down payment and starts construction.  The railway gets built, lots of news and press about it, and before you know it, people are flying back and forth between Shenzhen and Changsha at record speed.  All happy right?  Well, no.

Let’s say the price of oil or coal increases during the construction period.  Now the train costs x% more to operate.  Suddenly the 20 year plan to repay the loan becomes a 23 or 25 year plan because the railway takes on added expenses.  It could choose to continue it’s 20 year loan payment plan, but perhaps at the expense of maintenance or upgrading facilities.  If either of these decrease, it could easily cause ticket revenue to decrease.  “A bird in the hand is worth 2 in the bush,” so of course the banker will get paid “when we get around to it” instead of risking a revenue loss.

The next problem is with ridership.  Tickets are very expensive to common people.  In 20 years, the train will probably have 80% capacity because incomes will be greater.  But now, capacity is only 35%.  This makes each train more expensive to run per capita, since you’re using the same amount of electricity either way, and have the same amount of service staff on the train.  In other words, it will probably pay for itself eventually, but when is “eventually?”

Another problem down the road (or rail): stuff gets old.  Rails don’t last forever and need to be replaced.  Lets say the plan is to repay a loan over 20 years.  20 years from now, will these trains and this type of rail be efficient?  Will we be using maglev instead?  What if the railway becomes obsolete before it pays for itself?

The killer here, of course, is compound interest.  Pushing the loan out further and further away isn’t impossible (again, no one thinks the government will default), but soon all these factors collide and it becomes difficult to even meet interest payments, let alone paying off the principal.  The central government could just write the whole thing off by dipping into tax revenue, but they risk spending this money on a loan repayment, when a new high tech project might bring better returns faster.

Also, Mr. Wang’s bank gave money to the Airport Authority to construct new airports in Shenzhen and Changsha over the past 5 years.  Now that the rail is here, projected earnings from the airport will decline, along with their ability to pay back their own loans.  This goes for the newly built tollroad/highway between the two cities as well.  Mr. Wang’s neighbor, Mr. Chen, wants to take a small business loan out to start a business, but since banks have restricted lending (due to so many outstanding government loans), he cannot.  Job creation suffers, consumers have less disposable income, and private enterprise withers.

Here are the main questions to ask:

1) Is a state-owned bank capable of financially punishing a state-owned enterprise who fails to repay a loan?  If no, we must assume all state-owned banks make decisions based only on politics, and are inherently built to bleed depositor money.

2) Are mega projects like high speed rail, over a 20 year span, profitable (increased ticket revenue over time, increase in land value owned by rail company) or not (due to increase maintenance cost, technological obsolescence)?  This is key to the argument of “it will pay for itself eventually” because if it gets old and breaks before we reach that barrier, someone is going to lose a lot of money (probably bank depositors)

3) Can the maintenance cost for these loans (technology, bank employees,) be recouped through a lower-than-market-rate interest rate?  If no, the bank is in big trouble.

4) What is the benefit of building all these projects at once?  It seems more prudent to do some test cases then, after mastering the technology and reducing cost, roll it out nation wide.

5) Japan, arguably the world leader in high speed rail tech, charges about $212 for a 700km journey.  China charges about 1/4 of that.  Is this enough to keep the rail company afloat?  Meanwhile, China’s GDP per capita is about 1/10 that of Japan.  Will there be any passengers on this train?

Other nations, like Japan, have done high speed rail with great success.  However, the “it will pay for itself eventually” argument needs to die.  This is not a guarantee, especially if revenue lags for long enough that interest payments become impossible to repay, AND the project itself becomes outdated or broken beyond repair.

The key to averting the potential loan crisis is separating finance from politics, and seeking a true representation of supply and demand.  Banks must have the authority to charge logical interest rates and reject loans to projects that are not sustainable.  Similarly, building for anticipated demand 20 years from now is foolish for the reasons mentioned above.  The problem is that the Mr. Li’s of China are scarcely answerable to anyone, so long as the economic machine keeps churning, employment levels remain high, and below-market interest rates for government projects prevail.

Advertisements