The perpetrators of China's financial risks

Local economies stuck in an aging model of growth can be blamed for magnifying economic woes

Among the many aspects that China's new normal model of economic growth hopes to address, increased financial risk is undoubtedly one of them. It could start by working to resolve the mountain of bad loans in the banking sector.

According to the China Banking Regulatory Commission, the ratio of non-performing loans in China's commercial banks rose to 1.29 percent by Dec 31, 2014. During the third quarter of 2014, it was 1.16 percent. This single-quarter growth rate of 0.13 percent in bad loans was the highest since 2004. For the entire banking industry, the ratio of non-performing loans reached 1.64 percent last year. With approximately 86.8 trillion yuan ($14 trillion, 13 trillion euros) in outstanding loans in 2014, bad loans that year amounted to 1.4 trillion yuan.

It's worth noting that China's financial risk this year will be tied to its local economies. China's intensified local economic woes will be connected to multiple factors: the general downturn in China's economy; the stagnation or negative growth of the real estate industry, which is putting pressure on mounting local debt; a crackdown on local financing platforms, which would make it increasingly difficult for local governments to raise funds for past projects; and China's industrial restructuring that has put a few resource industries into a pickle and has dragged down local economies. Within this context, many local governments have lowered their economic growth targets.

The economic downturn at the local level has increased financial risks in various regions. Due to regional differences in the makeup of resources, the economic base, industrial structure, financial environment, business development, and exposure to financial risks vary across different regions. Often, the financial risk of local economies manifest as complicated systemic problems and cannot be resolved through improvements to a single area. Thus, it is extremely important for financial institutions to observe the financial risks of local economies from a regional perspective.

Which regions are easily prone to financial risks? Roughly speaking, the following types of local economies are financially risky.

Regions whose economic development relies heavily on scarce resource industries and cities that were once major mining powerhouses.

Luliang, a famous coal city in Shanxi province that has an abundance of coal, recently went through an economic roller coaster. In 2013, it achieved the highest economic growth in Shanxi province. Last year, its estimated GDP growth rate of minus 2 percent put it dead last in the province. From 2001 to 2011, the golden decade for the coal industry, Luliang developed by leaps and bounds through its production of high-quality coal and a double-digit GDP growth rate. But the once-prosperous coal city ran into trouble as the coal industry slumped.

While the industrial production of the county that administers Luliang accounts for 95 percent of the county's GDP, it has a poorly developed service industry and 85 percent of its industries are related to coal. Thus, its industrial growth rate last year experienced a negative growth of 24 percent. Luliang, with an industry ratio of 70 percent, is expected to experience an industrial added value decline of minus 5.6 percent, a drop in GDP of minus 2 percent and a fiscal deficit of 2.03 billion yuan.

Regions whose economy is dependent upon the real estate industry.

The economic downturn in the real estate industry has rocked many local economies. In 2013, land transfer fees surpassed 3.1 trillion yuan, which according to government statistics, accounted for 45.4 percent of the 6.89 trillion yuan in fiscal revenue from local economies in China. In 2014, when the real estate industry plunged, land transfer fees dropped 28 percent from the previous year to 2.3 trillion yuan, although land transfer fees last year still accounted for 30 percent of the fiscal revenue (7.586 trillion yuan) in China's local economies.

Keep in mind that land transfer fees are just part of planned local revenue, and if we account for the relation between local fiscal revenue and the real estate market, the latter occupies an even larger portion of local fiscal revenue. According to surveys by Anbound, a public policy think tank in China, 40 percent of the local fiscal revenue from a number of second-, third- and fourth-tier cities depend on their real estate industries. In some cities, the ratio is as high as 70 percent. Regions with fiscal revenue relying heavily on its real estate industry are easily prone to financial risks.

Cities with a heavy amount of debt. Since 2008, local economic growth has been closely tied to the expansion of government debt, with local debt reaching 17.9 trillion yuan in the first half of 2013. That is now putting enormous pressure on local governments in their settlement of debt. According to a preliminary estimate, 2.8 trillion yuan of local debt will be due this year. To make matters worse, interest payment on local debts in 2014 accounted for more than half of the increased amount of social financing. This has not only disrupted economic operations and currency economic policy, but it has created more financial risks.

In our surveys, we found that debts owed by local governments, financing platforms and real estate enterprises were alarming. Many regions are being heavily pressured to create less local fiscal revenue, spend more and pay off their debts, all of which significantly damage the local financing environment.

But the fact is that for these problematic regions, these economic, industrial and debt issues did not evolve on their own and this trifecta of problems have added to financial risks in some regions.

The author is a senior researcher with Anbound Consulting, a think tank for public policy. The views do not necessarily reflect those of China Daily.