Wages of Neoliberalism

Part III: China’s Internal Debt Problem

By
Henry C.K. Liu

Part I: Core Contradcitions
Part II: The US-China Trade Imbalance

This article appeared in AToL on May 27, 2006

In 2005 the Standing Committee of China’s National People’s Congress (NPC), the legislative body, ratified a resolution on the implementation of a new national debt management system. From 2006 on, the NPC will examine for approval the aggregate national debt balance, rather than just the annual amount of new national debt to be issued. Statistics released by the Budgetary Work Committee of the NPC Standing Committee showed that by the end of 2004, China’s national debt balance reached 2.96 trillion yuan ($370 billion), including 2.88 trillion yuan ($360 billion) of domestic debt and 82.8 billion yuan ($10 billion) of foreign debt. China’s 2004 national debt burden rate was 21.6% of GDP, far lower than the EU-designated warning level of 60% for its members, a generally accepted international standard.

The Chinese Ministry of Finance reported that aggregate national debt balance rose to 3.26 trillion yuan ($407.5 billion) in 2005, but it fell to only 18% of 2005 GDP of 18.23 trillion yuan ($2.28 trillion). This reflects the effect on economic policy analysis with dynamic scoring in which the growth impact of the national debt on the economy can outstrip its nominal rise. By comparison, the US national debt stood at $8.4 trillion as of April 13, 2006, or 65% of forecasted GDP. About $4.9 trillion of the US national debt is held by the public and $3.5 trillion is held intra-governmentally. US national debt is about 20 times more than China’s on a nominal basis, 5 times on a purchasing power parity basis, almost 4 times on a debt/GDP basis and 100 times on a per capita basis. US per capita income is about 35 times that of China in 2005, which means each US citizen is carrying almost three times the national debt/income ratio than his/her Chinese counterpart. On average, US wages are about 50 times those of China due to higher income disparity in China.

The National Debt

The national debt is a financing bridge over the gap between a nation’s fiscal policy and its monetary policy. Fiscal policy determines government revenue and expenditures while monetary policy determines money supply and short-term interest rates. A prudent fiscal policy can moderate the need for national debt by either cutting expenditures or raising taxes or both. Monetary policy ease can also reduce the need for national debt by the issuance of more fiat money which is an instrument of sovereign credit backed by government’s authority to collect taxes payable in fiat currency. A rise in the money supply lowers interest rates in the short term but the resultant rise in inflation may cause interest rate to rise in the long term. A tax increase takes money from the private sector into the public sector and unless the government spends all the tax increases back into the economy, it essentially reduces the amount of sovereign credit in the economy. Unless there are excessive inflationary trends going forward, a government who desires an expansionary economy has no business running a fiscal surplus, particularly if the economy is plagued with overcapacity. The controversy is how the surplus revenue should be spent to yield the most beneficial and equitable effects for the economy. The national debt serves other important financial purposes for the economy. A government securities market allows the central bank to carry out open market operations to meet short-term interest rate targets and to provide a credit rating anchor for the nation’s debt market.

Dollar Hegemony Eliminates Default Risk for US Government Securities

Because of dollar hegemony, a peculiar phenomenon of the dollar, a fiat currency, assuming the role of a key reserve currency for international trade and finance, US government securities do not carry default risks, as the US can print dollars at will with little short-term penalty. The only risk US government securities carry is inflation, a prospect that the Federal Reserve, its central bank, can control through interest rate policy. High Fed Funds rates can reduce dollar inflation under normal circumstances, unless the economy is plagued by a debt bubble, in which case high Fed Funds rates can actually add to inflation.

Government securities of other nations denominated in dollars carry default risks as these governments cannot print dollars. Even government securities denominated in local currencies that are freely convertible carry default risks because the foreign exchange market limits the ability of these governments to print their own local currencies relative to the size of their foreign exchange holdings. In that sense, dollar hegemony has reduced all freely convertible and free-floating currencies to the status of derivatives of the dollar. The governments of such currencies have forfeited their monetary sovereignty with which to manage their economies. The currencies of these nations no longer derive their value only from the strength of their economies, but also from the value of the dollar, rising or falling against the dollar as a bench mark. The Federal Reserves of the US has become a super-national monetary authority through dollar hegemony, framing policies that prioritize the needs of the US from which the prosperity of the rest of the world must derive. This is why after the abandonment of the Bretton Woods fixed exchange rates regime based on a gold-backed dollar, the US has been pushing a global floating exchange rates regime based on a fiat dollar in order to impose dollar hegemony on world finance.

Interest Rate Stability or Money Supply Stability

Monetary policy authorities have a choice between interest rate stability and money supply stability, but no monetary system that operates on fiat money can have both options. The national debt is the lowest cost a nation can borrow. Sovereign debt interest rates act as a bench mark for other debts because sovereign credit is superior to private sector credit under normal conditions. When the money supply is tight, interest rates on government bonds rise. This causes interest rates on all private debts to rise with them. High domestic interest rates usually exert upward pressure on the exchange rates of freely convertible currencies.

Best Use for a Fiscal Surplus

During the years of fiscal surplus in Clinton’s second term, a policy debate surfaced on whether to pay down the national debt or to cut taxes. The economic logic tilts in favor of tax cuts because the national debt needs a future tax to repay it. Paying down the national debt would lower the future tax rate so it is merely a way to defer the tax cut to the future. Thus financially speaking, a fiscal surplus can be more effectively used to finance an immediate tax cut to stimulate an overcapacity economy rather than to pay down the national debt to reduce the tax burden in the future. For example, the US national debt was paying around 6% interest while personal credit card interest hovered around 18% in the Clinton years. But the national debt actually paid less than 6% because the recipients of the interest payments must pay income tax up to 40%, reducing the real national debt cost to the US government to around 3.5%. The degree of progressive distribution of the tax cut has more impact on the economy. Long-term interest rates are determined by supply and demand in the credit market as well as the market’s judgment of the credit worthiness of the debt issuer and the future health of the economy as affect by fiscal and monetary policies. Thus the immediate strengthening of the economy can also have positive effects on long-term interest rates.

China's Shift from Proactive to Prudent Fiscal Policy

In 2006, China’s fiscal policy begins a gradual shifted from “proactive” to “prudent”. In the past seven years, a proactive fiscal policy added 2 percentage points to economic growth rate every year. China now urgently needs to deal with a series of pressing economic and social problems that have been created by its transition from a socialist planned economy to a “socialist” market economy. And all solutions point to the need for a sustainable high economic growth rate for decades to come. If the steps of “prudent” fiscal adjustment are taken too abruptly, it would lead to a slowdown in growth rate with serious adverse impacts on national economic performance. China does not need to slow down its overall growth rate as much as it needs to redress the imbalances in its transitional economy caused by overheated sectors caused by market failure. It does need to reconsider fixation on the conventional measure of growth in narrow GDP terms and begin to aim for balance growth with renewed focus on domestic social development and environmental preservation as the real engines of growth, away from over-reliance on export and dysfunctional domestic market forces driven by speculation. The exchange deficit between environmental deterioration and single-minded industrialization is a formula for negative growth. The same is true for the mindless privatization of public goods. The shift of emphasis towards balanced development does not necessarily mean a slower growth rate. In fact, it needs an acceleration of the growth rate measured by a more meaningful standard.

The Chinese Bond Market

In China, government bonds used to be allocated by the issuing central government to state-owned banks as captured buyers, with funds from depositors who had few if any alternative investment options. With the Finance Ministry scheduled to pay back the eighteenth issuance of national debts due in 2005, China has entered a five-year peak debt repayment period. Between 2005 and 2009 the Finance Ministry’s annual debt repayment will amount to around 400 billion yuan ($50 billion). While China can easily meet this repayment schedule, its impact on the nation’s money supply will be significant unless new national debt is issued.

In addition, as part of the shift from a national banking regime to a central banking regime, China is reforming its four major state banks to become commercial banks, looking to list them in overseas equity markets as commercial enterprises to meet WTO requirements of liberalizing its banking sector by the end of 2006. To do so, substantial funds need to be injected into these banks to reduce their residual bad debt ratio by the issuance of corporate bonds and government bonds. The funds these banks need to cure their systemic non-performing loan (NPL) problems left by the era of national banking are so huge that a considerable amount of the bonds will have to be borne by the Finance Ministry. The resolution of systemic NPLs will have a contracting effect in the nation’s money supply, as the extinguishment of debt removes money from the economy. Under these circumstances, China has decided to speed up the opening of its embryonic bond market to foreign capital.

Similar to post-WWII Germany, China has a historical phobia about the political impact of hyperinflation, a condition that played a major role in the fall of the previous Nationalist government in 1949. Unlike the German Third Reich which was deprived of foreign credit and had to rely on sovereign credit to revive the collapsed German economy after WWI, China in the last two decades has been lured by the availability of easy foreign credit. This is a mixed blessing. Finance globalization is an illegitimate child of dollar hegemony which forces all nations that accept foreign credit to emphasize low-wage export to earn dollars to repay dollar denominated loans. Under such circumstances, export keeps domestic wages low while it ships real wealth overseas in exchange of dollars that cannot be used in the domestic economy.

In the early 1990s, China experienced high inflation due to disproportionate credit expansion that came with a “proactive” fiscal policy under the premiership of Zhu Rongji who was nicknamed the “debt premier” by his critics. The problem was not the expansion of credit, but that such credit was used mostly for speculative purposes. Corrective policies were subsequently introduced to deal with debt-driven inflation and imbalances. Central regulatory controls and new regulations over the Shanghai and Shenzhen stock exchanges were imposed to rein in run-away speculative debt expansion. But these tightening measures were accompanied by financial market liberalization and bank reform measures that had countering effects on the government’s effort to deflate the speculative debt bubble. The public soon discovered that other higher-yielding investment options, such as the stock market and real estate, were open to them beside bank saving accounts, without any awareness that the improved returns were paid for with cuts in social welfare benefits and employment security until it was too late. As US workers saw their jobs shipped overseas to low-waged locations to provide higher returns on their pension funds, Chinese workers saw the profits from their low wages and meager benefits shipped back to the US in the form of Chinese foreign exchange holdings in US Treasuries.

Similar to the situation in Japan or perhaps even inspired by it, Chinese corporations began to borrow low-interest loans from banks to speculate in the equity and real property markets to make easy profit rather than to invest in the plant modernization or expansion, which was left mostly to costly foreign direct investment. Experienced overseas speculators moved in to manipulate the small and under-regulated Chinese equity and real property markets at the expense of inexperienced and naïve local investors.

China's Move from National Banking to Central Banking

Until the mid-1990s, China’s state-owned banks acted mainly as funding agents of the state in a national banking regime to fund government economic policies. Bank profitability was not the controlling factor in loan decisions. The Central Bank Law and the Commercial Bank Law were adopted in 1995 at the same time when a series of financial sector reforms was introduced, including exchange rate unification, formal establishment and regulation of the inter-bank market (IBM) for short term loans, the creation of an inter-bank foreign exchange market (IBFEM), the start of open market operation (OMO) by the People’s Bank of China (PBoC), the new central bank, and other market reform measures. Together, these reform measures of 1994-95 contributed to the development of an embryonic domestic market for government bonds (GBs) in China.

Bond markets are organized into two categories: government bonds (GB) and corporate bonds (CB), the credit worthiness of both is rated by independent credit rating agencies according to well-established standards, albeit not always neutral or free of political bias. GBs are sovereign debt instruments, guaranteed by the full faith and credit of a sovereign nation, CBs are backed by the assets of the issuing corporation. Interest rates on all bonds are affected by their credit ratings. Aside from the banking sector, CBs are widely used in the Chinese telecommunication sector. It can be expected hat as the Chinese bond market develops, the CB market will become much larger than the GB market.

The PBoC, the central bank, formulates and implements monetary policy. The PBOC maintains the banking sector’s payment, clearing and settlement systems, and manages official foreign exchange and gold reserves. It oversees the State Administration of Foreign Exchange (SAFE) for setting foreign-exchange policies. The 1995 Central Bank law gives PBoC full autonomy in applying monetary instruments, including setting interest rate for commercial banks and trading in government bonds. The State Council maintains oversight of PBoC policies. China Banking Regulatory Commission (CBRC) was officially launched on April 28, 2003, to take over the supervisory role of the PBoC. The goal of the landmark reform is to improve the efficiency of bank supervision and to allow the PBoC to further focus on macro economic and currency policies.

New Commercial Banks

The CBRC is responsible for “the regulation and supervision of banks, asset management companies, trust and investment companies as well as other deposit-taking financial institutions. Its mission is to maintain a safe and sound banking system in China.” As part of the 1994 monetary reform measures, commercial lending and policy lending in the state banking sector were separated. The four specialized banks under the aegis of the People’s Bank of China: namely, the Bank of China (BOC), Industry and Commerce Bank of China (ICBC), China Construction Bank (CCB), and the Agriculture Bank of China (ABC), were transformed into independent commercial banks to be operated for profit for the benefit of shareholders rather than to support national development aims for the benefit of the nation, while at the same time assuming full market and credit risks as stand-alone profit-driven commercial institutions. There are also second-tier commercial banks and trust and investment companies. However, the government continues to be the major shareholder in these banks and trust companies. These new commercial banks put their funds to work in the market where return is highest but not necessarily in the best national interest in terms of where investment is needed most.

Policy Banks

Three policy lending banks - the Long-Term Development and Credit Bank (DCB), the Import-Export Bank (EXIMB) and the Agricultural Development Bank (ADB) - were also set up, separate from the commercial banks. The function of policy banks is to grant policy loans in accordance with state industrial policy and national plans. The capital sources of these policy banks will be mainly government budgetary funds, social insurance, postal and investment funds from a shrinking public sector, central bank credit and a developing GB market.

Interest Rate Liberalization

The central government has recently allowed several small banks to raise capital through bonds or stock issues. The reform of the banking system has been accompanied by the central bank’s aim to gradually decontrol interest rates. Market-based interest rate reform is intended to establish in an orderly manner an effective pricing mechanism of bank deposit and lending rates based on supply and demand. PBoC, the central bank, will continue to adjust and guide interest rate liberalization to allow the market mechanism to play an increasingly more dominant role in financial resource allocation. The sequence of the reform is to liberalize the interest rate on foreign currency before that on domestic currency; lending before deposit; large amount and long term before small amount and short term. As a first step, the PBoC liberalized the interest rates for foreign currency loans and large deposits ($3 million and over) in September 2000. Interest rate of deposits below US$3 million remains subject to PBoC control. In March 2002, the PBoC unified foreign currency interest rate policies for domestic and foreign financial institutions in China. Small foreign exchange deposits of Chinese residents with foreign banks in China were included in the PBoC interest rate administration of small foreign exchange deposits, so that domestic and foreign financial institutions are treated equally with regard to the interest rate policy of foreign exchange deposits.

As interest rate liberalization progressed, the PBoC liberalized, simplified or eliminated 114 categories of interest rates initially under control since 1996. At present, 34 categories of interest rates remain subject to PBoC control. The full liberalization of interest rates on other deposit accounts, including checking and saving accounts, is expected to take much longer. On the lending side, market-determined interest rates on loans will first be introduced in rural areas and then followed by rate liberalization in cities. This decision, while intended to attract more lending funds to the rural areas, appears to be out of sync with the policy to subsidize rural development as it makes rural borrowing more costly. China surprised global markets on April 27, 2006 by raising interest rates for the first time in 18 months to slow a debt-driven boom that risks destabilizing the world's fastest-growing major economy. The central bank raised its benchmark one-year lending rate to 5.85% from 5.58% but kept its deposit rate unchanged at 2.25%, widening the profit margin for banks which badly needs better profits. The move was billed as a measure “to further consolidate macro-control effects, maintain a sound trend in the sustained, fast, coordinated, and healthy development of the national economy and continue to let economic means play a role in resources allocation and macro-control.” But as experienced has shown in other economies, higher interest rates do not always reduce borrowing. Often it only shifts credit allocation to distressed borrowers who are desperate for funds even at higher cost.

Debate on Sovereign Credit

After the 1997 Asian Fiancial Crisis, China adopted a “proactive” fiscal policy, raising large amounts of debt for public investments to drive impressive economic growth. Ministry of Finance data showed that cumulative long-term construction debt rose from 100 billion yuan ($12.2 billion) in 1998 to 990 billion yuan ($123.6 billion) by 2005, a ten-fold increase in 7 years.

This policy has generated heated debate among economists. Support for sovereign debt financing is based on three arguments. Firstly, with a ratio of 1:4 between national debt and bank loans, any rise in national debt will result in a four-fold increase in bank loans, easing critical capital shortage in national construction. Secondly, since the funds raised through national debt are used to finance public infrastructure that contributes to economic growth as measured by GDP, rising national debt has played a significant role in China’s economic growth without changing the national debt to GDP ratio which has remained substantially below world standards. Since 1998, projects funded by national debt have added about 2 percentage points per year to China’s GDP. And thirdly, the European Union limit on debt burden for its members is 60% of GDP, and China is far below that level at only 22%. Therefore China can safely assume a still higher national debt level to accelerate the pace of balanced national development, particularly in social development to boost domestic demand.

Many planners believe that sovereign debt financing is an important tool in macro management of the economy, provided that the national debt/GDP ratio remains below the 60% danger level and that the loan proceeds are spent wisely. China had earlier estimated that its debt balance in 2005 would reach 2.2 trillion yuan ($270 billion), or 16.8% of its estimated GDP. Actual data from the Ministry of Finance showed the debt balance to be 3.26 trillion yuan ($408 billion) in 2005, nearly 18% of 2005 GDP of 18.23 trillion yuan ($2.28 trillion). By 2010, the debt balance is expected to be 4.1 trillion yuan ($510 billion), or 22.4% of its GDP; and by 2020 it will top 15.2 trillion yuan ($2000 billion), or 40% of its GDP. Past experience suggests that these estimates are likely to be too conservative although the debt/GDP ratio estimates may hold or even decline if the economy grows faster than the national debt.

Other planners point out that high national debt is not a free lunch. Questions have been raised on the appropriate use of the national debt. To date, not much of it has been used to support social development and environmental preservation, contributing to serious imbalances. Much of the national debt has been used to finance local infrastructure and real estate development projects and redundant industrial and commercial ventures that did not fit into a coordinated national plan. Thus the high GDP growth rate has become a problem in itself, rather than an index that reflects balance national growth. Furthermore, the national debt to GDP ratio does not include potential financial burdens such as contingent or implicit liabilities, e.g., the national debt that the central government loans to municipal governments for infrastructure construction; special national debt used for systemic bank reform with losses from the state-owned banks’ massive non-performing loan portfolios in their transition to commercial banks; about $60 billion borrowed from the World Bank, Asian Development Bank, and from foreign governments in the name of the nation but not included in the government budget; debt due to wage payment arrears by local government and state-owned enterprises; government grain price support loss, and a serious funding shortage in the social security and health care obligations.

Further, most of the national debt proceeds have been used to finance local physical infrastructure while the social infrastructure has been largely and critically neglected in the reform process towards market economy during the past two decades. China today exhibits all the symptoms of a 19th century boom economy in the age of industrial revolution as described by Charles Dickens, with urban slums, migrant workers, working poor and sweatshops at the foot of shiny new skyscrapers. Income and wealth disparity is rampant while most of the social welfare network built through the early decades of the socialist revolution lies in ruins. If all the government’s residual implicit and indirect social liabilities are included, the official Chinese government total fiscal debt is around 55% of GDP. According to one estimate by The World Bank, Chinese government total liability has already reached 100% of GDP. For China to reach the level of a modern socialist society, the nation’s social liability would be more than ten folds current levels.

For a sizable portion of the population, China’s market reform and open to the outside policies of the past two decades have only meant systemic exposure to unemployment, loss of health care, social security, unequaled education opportunity for the young, below-standard housing, wages falling behind inflation and loss of social benefits due to privatization. For everyone, rich and poor alike, a deteriorating environment from short-sighted frenzy rate of industrialization will take enormous sums of money and decades to restore. Economic loss from environmental degradation and industrial pollution and accidents is reaching crisis levels.

New Socialist Countryside Program

At long last, Chinese leaders are taking concrete steps to reorient policy priority toward people-based social development and environmental restoration. The focus now is to build a New Socialist Countryside (NSC), a program launched on March 14, 2006 in the Fourth Session of the Tenth National People’s Congress, stressing economic efficiency and social equity by narrowing the gap between rich and poor, putting more emphasis on democratic and scientific policy making and balanced development to ensure that reforms benefit the majority, if not all, of the population. This paradigm shift is clear if the 11th Five-Year Plan Guidelines are compared with the 10th. The latest version contains fewer new plans for multi-billion-dollar construction projects, aside from critically-needed investment to divert needed water from the country's wet south to the dry north, or a gas pipeline from western frontiers to the coastal east. Instead, more government funds will be used to improve standards of living for the country's 900 million rural residents, and boost sci-tech research and development. The aim is to transform the country from a low-wage workshop of exports into a powerhouse manufacturer of homegrown quality global brands anchored by strong domestic demand. Infrastructure investment will be shifted from the urban areas to the countryside, with a focus on farmland, roads, safe drinking water, methane facilities, power-grids and telecommunications networks. Premier Wen Jaibao pledged that rural children will receive free nine-year compulsory education of national standard, a correct decision to break away from the market fundamentalist policy on privatizing education in the reform era.

China's External Debt

The three main indicators for external debts for China in 2005 are all well below the internationally-accepted line of alarm reference: 20-30% for debt repayment, debt service ration 20-30% of fiscal revenue and external debt ratio to foreign exchange income of 100-165%. Debt Service Ratio (DSR) refers to the ratio of debt repayments to the fiscal income of the same year, an indication of the government’s debt repayment capability. China’s debt service ratio was 3.07% of fiscal revenue, below the 8% for international standards. The ratio of external debt to GDP was 12.63%, and the ratio of external debt to foreign exchange income was 33.59%. The Ministry of Finance reported that debt balance was 3.26 trillion yuan ($407.5 billion) in 2005, nearly 18% of 2005 GDP of 18.23 trillion yuan ($2.28 trillion). China's outstanding foreign debts (excluding those of Hong Kong and Macao) stood at $281 billion at the end of 2005, an increase of about $33.6 billion over the figure at the end of the previous year, according to statistics released by the State Administration of Foreign Exchange on March 31, 2006.

China’s government fiscal income to GDP ratio had been erratic, being either too high or too low from year to year. In 1978, central government revenue was 31% of GDP but only 15% of total national revenue. In 1995 it fell to 11% of GDP and 55% of national total. But in 2004, central government fiscal revenue rose to a slightly less than 20% of GDP and about 56% of total national fiscal revenue. The US had federal revenue of $1.8 trillion in 2004, about 15.8% of GDP, with a $412 billion deficit at 33% of GDP. In 1997, the Central Government incurred a 56 billion yuan fiscal deficit at only 0.8% of GDP. By 2003-4, the fiscal deficit increased to 320 billion yuan at 2.5% of GDP, according to Ministry of Finance data. However, Asia Development Bank reports that China’s fiscal revenues expanded considerably in 2004-5, rising by 21.4%, driven by high levels of economic and trade activity and strengthened tax collection. Fiscal expenditures rose by only 15.1%.

SOE Earnings

China’s fiscal revenue grew by 14.6% year-on-year during the first half of 2005, to 1.64 trillion yuan ($202 billion). China’s state-owned enterprises (SOEs), turning around from its loss-making inefficient past, had a combined profit of 628 billion yuan ($78 billion) in 2005, more than the US General Electric Company total earnings for the past five years at an annual average of $15 billion. While GE shareholders received about $40 billion in dividend, at a 57% payout ratio, the Chinese government did not get a fair share dividend from these profitable SOEs. Government administrative measures on bank lending to overheated sector are neutralized by SOE managers who chose to finance plant expansion with internal accruals rather than bank loans. The state as the major shareholder of these SOEs should be paid dividends of 50% of SOE earnings or $40 billion in 2005. The World Banks estimates the Chinese SOE profits represented 3.3% of China’s GDP. This would be 20% of the government’s fiscal revenue in 2005 that the government failed to collect.

Strong Fiscal Revenue

China’s fiscal revenue reached 2.64 trillion yuan ($320.7 billion) in 2004, a yearly increase of 21.6% over that in 2003, and fulfilled 112% of the budget. The fiscal revenue for central budget hit 1.51 trillion yuan ($182.7 billion), increasing by 16.9% over the previous year. Fiscal revenue was 109.3% of the budget. China reported a fiscal deficit of 319.177 billion yuan ($38.6 billion) in 2004. The deficit was 653 million yuan ($79 million), less than the 319.83 billion yuan approved by the National People's Congress. Budget spending at central and local levels totaled 1.24 trillion yuan ($153 billion) during the period, up 15%. Central fiscal spending was up 1.5%, but central fiscal revenue rose 10.1%, while fiscal spending by local governments jumped by 20.9% and local fiscal revenue grew by 21%. But the Central Government paid 150.3 billion yuan ($18.5 billion) in export tax rebates during the first six months of 2005, 104.4 billion yuan ($12.7 billion) more than the same period in 2004. National fiscal revenue would have jumped 21.9% if central government had not paid the increased export tax rebates, and central fiscal revenue would have been increased 19.4%. Central government, through provincial governments, delivered 9.53 billion yuan ($1.17 billion) in direct grain production subsidies to farmers across the country during the first half of 2005, 77% of the 13.2 billion yuan ($1.62 billion) planned for the whole year. China began to offer subsidies directly to grain growers in 2004 in a bid to encourage farmers to grow more grain for domestic consumption. China’s GDP reached 18.23 trillion yuan in 2005, an increase of 9.9% over the previous year. Fiscal revenue exceeded 3 trillion yuan in 2005, 523.2 billion yuan more than the previous year.

Shift in Public Spending Priorities

Priorities in public spending shifted in 2005 from physical infrastructure in urban areas to rural development, agriculture, social security, health care and education as part of government efforts to rebalance economic growth and social development. The 2004-5 fiscal deficit narrowed to 1.5% of GDP from 2.5% in 2003-4. However, if off-budget obligations, including the implicit pension debt and costs related to curing nonperforming loans (NPLs) in the banking sector were considered, the fiscal shortfall would be much higher.

The usage efficiency of the funds raised by national debt has been a subject of debate. Since 2000, transportation and communication infrastructure have taken up to 40% of the total. Second are municipal infrastructure and urban reconstruction. The last are environmental and social welfare programs. But the national debt yield from national construction projects has been much lower than average market return. Yet this is to be expected as market-driven private investment tends to externalize the social and environmental costs from their project accounting. Low internal rates of return in national construction projects are acceptable if they contribute to national economic growth. But the National Audit Office annual audit reported in 2002, after auditing 37 environmental projects funded by national debt in 9 provinces to the amount of 2 billion yuan, only 9 projects finished according to plan and met the quality requirement. A study by Professor Song Yongming at the People’s University of China reported that “after the economic reform, national debts were mostly used by corrupt officials in conspicuous consumption, and not in construction expenditure as most people expected.” There were frequent reports of corrupt officials converting projects funded by national debt into extensive illegal bribery networks and fraud schemes. Such corruption is rooted in the absence of separate independent supervisory and auditing authority in project management. Yet the focus should be on rooting out corruption rather than reducing sovereign credit for financing national construction. Unregulated market economies have an equal if not higher penchant for fraud and corruption as planned economies. For all governments, regardless of ideology and economic system, anticorruption is a basic responsibility.

Monetary and Obligatory Debts

Debt comes in two forms. This is true for both private and public debts. One is money borrowed or monetary debt which is expected to be repaid with money. Monetary debt requires periodic interest payments for three reasons. The first is rent for the use of the loan proceed; the second is to preserve the purchasing power equivalence of the principal in anticipation of future inflation and the third to compensate for risk of default. Thus interest rate calculations are affected by these three factors. The second kind of debt is obligatory debt which is caused by obligations yet unmet, such as payouts on health insurance claims, social security entitlements and pension obligations. Obligatory debt is different than monetary debt because it generally does not require periodic interest payments but needs to be paid with equivalent purchasing power at time of payment instead of face value at time of commitment. Thus obligatory debt, being usually indexed against inflation, cannot be cured by inflation the way monetary debt can.

For governments everywhere, health care, social security and pension under-funding in both the private and public sectors are macro material debt time bombs that have serious monetary and economic consequences. When universal health insurance or social security/pension is privatized, any potential of privatized insolvency adds to the public material debt. Sovereign governments seldom default on either monetary or material debt denominated in its own fiat currency, as they can usually issue more fiat money to meet such debt obligations, provided they are prepared to accept the monetary and economic consequences. Such consequences take the form of domestic inflation and a fall in credit ratings of sovereign debts, both of which cause interest rates to rise. Holders of sovereign debt denominated in domestic currencies seldom face default risks, only inflation risks. The real systemic danger is of course hyperinflation which can take on a destructive path of its own. Hyperinflation can occur when governments issue debt in excess of economic expansion, causing the credit rating of government debt to fall substantially below those of other borrowers. A healthy debt market is one in which government debt is at the top of the credit rating structure. Material debt, unlike monetary debt, can accumulate at a scale and speed that render normal monetary structure inoperative. Government default on material debt has direct and immediate economic consequences the can spill over to the political arena.

The Risk of Foreign Currency Debts

When sovereign governments take on debts denominated in foreign currencies, the risk of default becomes material, as no government can issue foreign currency and must earn it through taxes on export to repay foreign currency loans. When a sovereign government buys foreign currency with its domestic currency in the exchange market, it is essentially selling claims on its future exports. In a global economy of overcapacity, for an economy that incurs recurring trade deficits, the foreign currency debt can only be paid with domestic austerity, causing a downward economic spiral. Such disasters have been commonplace all through the developing world in the past two decades and are continuing today. When governments adopt freely convertible currency regimes, the exchange rates of their currencies are subject to market forces which can often be manipulated by speculators such as hedge funds which seek to squeeze profit from discrepancies between current exchange rates and the fundamental economic value of currencies. With an exchange rate regime exposed to market forces, sovereign debt denominated in domestic fiat currencies will be subject to speculative forces beyond the control of the issuing government. This leads directly to a loss of sovereign authority on monetary and fiscal policies and places restriction on the option to use sovereign credit for domestic development. The sovereign government that faces foreign currency debt default will be put under financial house arrest in a debt prison in its own country by “conditionalities” imposed by the International Monetary Fund which operates as a vicious loan shark against the indebted government.

The Mundell-Fleming thesis, for which Robert Mundell won the 1999 Nobel Prize, states that in international finance, a government has the choice among (1) stable exchange rates, (2) international capital mobility and (3) domestic policy autonomy (full employment, interest rate policies, counter-cyclical fiscal spending, etc). With unregulated global financial markets, a government can have only two of the three options. When spending for domestic development is financed by not by sovereign credit denominated in local currencies, but by sovereign debt denominated in foreign currencies, a government faces risk of loss of financial and monetary sovereignty. Even if sovereign debts are issued only in domestic currencies, cross-border capital mobility will expose domestic currencies to speculative attacks. It is becoming increasingly obvious that restriction on international capital mobility is the least costly of the three options. Through dollar hegemony, the United States is the only country that can defy the Mundell-Fleming thesis, because the dollar, a reserve currency for international trade and finance, can be printed at will by the US central bank without penalty.

The Non-Bond Debt Market

Monetary debts are generally tradable, intermediated through debt markets which consist of bond and non-bond markets. The non-bond market is relatively new and fall generally within the field of structured finance – the securitization of debt through which packaged debts are unbundled into tranches of varying risk to be marketed at varying rates of return to investors with varying appetite for risk. Along with debt securitization grew a market for financial derivatives, initially developed as a hedging venue against risk, but soon developed into a profit center that exploits the ballooning of risk. This market is not well understood by either market participants or regulators and data on it are imperfect. (See: Dangers of Derivatives)

Timothy F. Geithner, President and CEO of the NY Federal Reserve Bank, warned in a speech: Risk Management Challenges in the U.S. Financial System, before the Global Association of Risk Professionals (GARP) 7th Annual Risk Management Convention & Exhibition in New York City on February 28, 2006 that the scale of the over-the-counter derivatives markets is dangerously large. “Although the notional total value of these contracts, now approaching $300 trillion, is not a particularly useful measure of the underlying economic exposure at stake, the size of gross exposures and the extraordinarily large number of contracts suggest the scale of the unwinding challenge the market would confront in the event of the exit of a major counterparty. The process of closing out those positions and replacing them could add stress to markets and possibly intensify the direct damage caused by exposure to the exiting institution.”

Geithner observed that credit derivatives, where the gaps in the infrastructure and risk management systems are most conspicuous, are less than 10% of the total OTC derivatives universe, but are growing rapidly. Large notional values are written on a much smaller base of underlying debt issuance. The same names show up in multiple types of positions—singles-name, index and structured products. These create the potential for squeezes in cash markets and greater volatility across instruments in the event of a default, magnifying the risk of adverse market dynamics.

The net credit exposures in OTC derivatives, after accounting for collateral, are a small fraction of the gross notional values. The ten largest U.S. bank holding companies, for example, report about $600 billion of potential credit exposure from their entire derivatives positions, the total gross notional values of which are about $95 trillion. That leaves more than $200 trillion of notional value to be reckon with outside the banking sector. This $600 billion “credit equivalent amount” exposure faced by banks is approximately 175% of tier-one capital, about 15% higher relative to capital than five years ago. This measure of the underlying credit exposure in OTC derivatives positions is roughly a fifth of the aggregate total credit exposure of the largest bank holding companies. This is a relatively conservative measure of the credit risk in total derivatives positions, but, for credit derivatives and some other instruments, it still may not adequately capture the scale of losses in the event of default in the underlying credits or the consequences of a prolonged disruption to market liquidity. The complexity of many new instruments and the relative immaturity of the various approaches used to measure the risks in those exposures magnify the uncertainty involved.

Geithner allowed that internal risk management systems have improved substantially since the mid-1990s, but most firms still face considerable challenges in aggregating exposures across the firm, capturing concentrations in exposures to credit and other risks, and producing stress testing and scenario analysis on a fully integrated picture of exposures generated across their increasingly diverse array of activities. The greater diversity of institutions that now provide demand for credit risk, or are willing to hold credit risk, should make credit markets more liquid and resilient than would be the case if credit risk was still held predominantly by banks or by a smaller number of more uniform institutions, with less capacity to hedge those exposures. However, the financial system still faces considerable uncertainty about how market liquidity will behave in the context of a major deterioration in credit conditions or a sharp increase in volatility in equity and credit spreads, and this uncertainty is hard to quantify and therefore hard to integrate into the risk management process.

The apparent increase in the scale of demand for exposure to credit risk relative to the growth in supply of credit has contributed to a substantial reduction in credit spreads and to some erosion in credit terms. Banks and dealers have reported pressure to reduce initial margin levels. The scale of leverage in some transactions is reported to have risen. The spread of portfolio-based margining creates the potential for greater overall leverage in the financial system, and the substantial variance in margin required by different dealers for similar portfolios suggests a wide diversity of views on how to measure the economic exposure.

Although US banks hold a substantially smaller share of the overall credit risk in the system than they did twenty years ago, this shift understates the importance of the role they play in the underwriting, distribution, trading and market making of credit related assets, and it understates the importance of earnings derived from these activities to overall profitability. Major banks and dealers at the core of these markets generate both short- and longer-term credit and market risk exposures from a number of sources and activities, including trading positions, loan commitments that support securities issuance, and warehousing positions in advance of packaging and distributing them. Retained interests associated with securitization transactions are substantial relative to capital of the largest firms. And the importance of securitization for the firms—both from a funding and revenue generation standpoint—provides an incentive for them to support investors in these products in ways that may go beyond contractual obligations.

The post-trade processing and settlement infrastructure, particularly in credit derivatives, is still quite weak relative to the significance of these markets, although the major dealers and buy-side investors are making a substantial effort to address these problems. The total stock of unconfirmed trades is large and until recently was growing considerably faster than the total volume of new trades. The time between trade and confirmation is still quite long for a large share of the transactions. The share of trades done on the available automated platforms is still substantially short of what is possible. Until the adoption of a new protocol last fall, firms were typically assigning trades without the knowledge or consent of the original counterparties. Nostro breaks, which are errors in payments discovered by counterparties at the time of the quarterly flows, rose to a significant share of total trades. Efforts to standardize documentation and provide automated confirmation services have lagged behind product development and growth in volume. Although the risk controls seem to have done a pretty good job of capturing the economic terms of the trades, the assignment problems create uncertainty about the actual size of exposures to individual counterparties that could exacerbate market liquidity problems in the event of stress.

Chinese commercial banks, in joining the game of international competition under WTO rules, will be forced to participate in the credit derivatives market which are time bombs of massive systemic financial destruction.

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