Preface

It's been a decade since I sat in Beijing spending a couple of summers thinking and writing about China's financial system. In those days Fraser Howie (my co-author on other Wiley books), who had started working at real jobs in Singapore, and I would laugh when we dug up bits and pieces of the story that were new to us. But access to a good library was one thing I lacked in Beijing and I was interested in understanding how the country's fiscal system interacts with its banks. A stint at Stanford in 2013 solved that problem. What I found changed my thinking about China and led eventually to the writing of this book during another stint at Stanford in 2021. So here goes another attempt to influence the way we look at China's history with the emphasis on financial history.

My reading in 2013 led to the conclusion that the basic source of extreme leverage in China's banks, enterprises, and the state itself is found in the fiscal arrangements of its self-reliant local governments. Self-reliance and inadequate budgetary income have driven inefficient capital investment especially in an overgrown real estate sector and its millions of empty and unfinished apartments. There is a shadow fiscal system at the local levels that is so deeply imbedded in how the party operates locally that even the most determined fiscal reforms have ultimately been rejected by its "immune" system. In short, local debt, the obverse side of which is bank and enterprise lending, cannot be explained only by reference to the last decade of overflowing liquidity or poor management or the party's interference; it has always been a major feature of China's fiscal system.

The second observation is that the party, which can do whatever it wants, has failed to adjust its aspirations to the level of fiscal revenues that the official system can generate. The party recognizes no constraints; the pull of the China Dream may be too strong. But there are constraints in the real world. Each year the party presents a new central and local budget for the coming year to the National People's Congress. But after approval, there is no one who holds the party at any level accountable for borrowing excessively outside of this budget not simply to meet a budget gap, but to build unplanned infrastructure and buildings. Who said every provincial capital could have a 100-story building or two? And who is going to fund such lending or live in the buildings and use the infrastructure when the population in 2100 is the same as it was in 1976?

Looking into the fiscal system reminded me that China, as a modern country, is at best 20 years old. It has come a very long way in two decades, but it remains an unfinished project much influenced by history. It would be fair to say that in 1979 China had no fiscal system. During the Republican Era in the 1930s work had begun to establish one but was interrupted by events. In any event, Nanking's reach did not extend far beyond the city's walls. After the revolution Soviet advisors gave it a try as part of their effort to establish a planned economy. That didn't work for reasons that are well documented. From 1957 to the start of the reform era at best Beijing depended on negotiations with provincial governments and state enterprises for whatever fiscal revenues it could generate. Any semblance of a technical fiscal system was purely propaganda for outsiders.

Looking at this brief history, what stands out is the self-reliance of local governments at all levels. Prior to the revolution it was said that regional governments were run by warlords, so it is not surprising that a look at China's fiscal system today reveals the existence of a shadow fiscal system. Local governments and their party secretaries then, as now, are responsible for what happens in their jurisdictions. With little in the way of revenue trickling down from higher administrative levels, they must fend for themselves. And it has always been this way.

This is where banks come in. During the 1980s local officials generated what Beijing called "extrabudgetary" or "extrasystem" revenues by pilfering bank branches and state enterprises, all of which were "owned" locally. The scale of such income in some years exceeded official revenues, sometimes by a multiple. In 1994 Beijing was able to pass a Budget Law that for the first time specified types of taxes and what government level collected which tax. In the face of opposition by the richer provinces, Beijing committed the "original sin," promising the majority poor provinces central government fiscal transfers to make up for shortfalls and, as a result, prohibited them from fiscal borrowing; there would be no need. Ever since, and especially in recent years, Beijing has had to borrow to make good on this promise, and the banks bought the government bonds.

The Budget Law also walled off state enterprises, at least directly, from local raids on their bank accounts. At the same time, two important things happened as part of the economic reform effort. First, Beijing devolved capital investment in new enterprises and infrastructure out of the national budget and into the hands of state enterprises and local governments. This offered locals a new way to access banks since the bulk of such investment was officially designated as "self-raised" funds. The second event was the privatization from 1997 of people's homes and the development of a huge new industry-real estate-that now generates nearly one-third of the country's GDP. Developers cannot build new homes without land and land was something local governments had in spades. Experimentation created a process allowing the sale, not of land itself-that belongs to the Emperor-but of "land use rights," a new and huge source of revenue for those localities with the best locations.

But with these new revenues also came the obligation to prepare the land for development. If the land was in the city center, then the local government had to resettle residents; remove buildings; and install power, water and sewers. If it was agricultural land, it was the same story, perhaps even more expensive. Over the first few years of this activity, arable land in China was reduced nearly 6 percent. All this cost significant amounts of money, more than offsetting revenues from sales of land rights. It was raised by securitizing bank loans into long maturity trust plans, then selling the plans to banks and rich individuals.

On an ongoing basis, the land business was a money loser; expenses have always exceeded revenues. As a result local governments got caught up in a constant fundraising process that can only be partially offset by sales. They must sell more land to meet earlier debt obligations. Real estate became a Ponzi scheme and this explains why there are 64 million unoccupied apartments, ghost towns and, not to forget, the bullet train network. Looking only at self-raised funds for capital investment prior to the post-2008 decade suggests that local debt equals somewhere around 25-40 percent of total banking loans or 40-60 percent of the all important bank funding source, corporate and household deposits.

This leads to the conclusion that the fundamental reason for China's excessive leverage in its banks and enterprises today is found in the decentralized fiscal arrangements of self-reliant local governments. The second point is that the party has failed to adjust its aspirations to the level of fiscal revenues the official system can generate or hold its local party officials to their official budgets. With this background it is not surprising that China's state banks have grown like ". trees reaching for Heaven." Today the four largest are Globally Systemically Important Banks (GSIB) whose health impacts the world economy. The system's total assets are 3.5 times the country's GDP. They have grown to this scale organically and not through acquisitions and mergers as has JPMorgan Chase, their only rival in size. Their funding and scale of lending has been the result of China's policy of "opening up." The country's entry to the World Trade Organization (WTO) in 2001 resulted in the creation of a middle class to rival that of the United States. And, as the world knows, Chinese, faced with few investment alternatives or a sound social security system, save their money in banks, state banks. This is the party's deliberate policy.

Chinese state banks have grown at a compound rate of 17 percent a year since 2008, yet they maintain strong performance metrics, including sustained low non-performing asset levels. The answer to such success is found in the shadow banking system that has grown up along with them. Products include wealth management, trust plans, asset-based securities, debt-equity swaps and more, all designed to enable the state banks to sculpt their balance sheets. Flexible accounting also adds its own support. How can these four banks create such huge piles of financial assets at such a rate in an economy that in 2008 totaled US$4.4 trillion as against that of the US at US$15 trillion? They lent to local governments, real estate, the railways and to the public, the only sectors that have true scale. And they lent with long maturities; the loans stacked up.

If one existed, an official consolidated balance sheet for the Chinese government sector would show the impact of the party's economic and financial decisions. Fortunately a rough, but instructive one can be developed from official sources and compared with work done earlier by Chinese...