The new east railway station in Chengdu is like an entire city in itself, with its six floors, 26 platforms and brand new surrounding infrastructure, including two new underground lines and freshly built streets. And it all popped up within just two years. It is China's largest train station and it cost around one billion euros to build. Most of it was financed on credit. During the financial crisis, Beijing gave all local governments a free hand to spend money in order to keep the economy going. As a result, there were countless new infrastructure projects. Within a short time, the provinces and municipalities accumulated a debt of over one trillion euros – around 60 percent of Germany's national debt.

Duncan Innes-Ker of the Economist Intelligence Unit in Beijing believes the newly accumulated debt is dangerously high. He says the local governments only have a limited ability to repay the growing debt. "But also there's also the question of transparency – what type of debt exists? Is it good debt or bad debt or are banks just rolling over loans that in other systems would be considered bad debt?" Innes-Ker points out a further aspect: the so-called gray financial system. "There is a growing amount of lending that's happening outside of the official data set. And that gray financial system is really a concern because we don't know what's going on in it – it's not subject to the normal financial regulations. It does increase the risk of there being a volatile outcome in the economy in the months ahead."

Non-payment

No one knows exactly how much debt local governments and provinces have piled up thus far. But it is clear already that some municipalities are having problems making payments. In the end, Beijing might have to foot most of the bill, which, at the moment, the Chinese government would be able to shoulder. But there are further risks involved. China's "underground" or gray banking infrastructure, which has been growing over the years, is surely one of them. Entrepreneurs and investors who cannot get credit at normal banks go underground and get loans that they have to pay back at much higher rates.

One businessman from the eastern Chinese city of Wenzhou has experience with this kind of banking. He says the so-called banks are really just groups of people who lend money – their own or money lent from a bank – usually to relatives or friends. "They get the loans at three or four percent but they charge more than that. It is risky business, but highly profitable."

Underground banking

Credit Suisse estimates the sum of all such dubious underground banking activity to be at somewhere around 400 billion euros. And here, too, more and more people are unable to pay their bills. This trend might possibly hit the real banking world, as much of the underground money has gone into real estate speculation. Housing prices have started to fall. Credit is going bad. And, as was to be expected, nobody knows exactly how high the pile of debt is going to be.

Innes-Ker believes this is where the greatest threat is lurking. "We all see people borrowing more for their houses. We are seeing property developers as a quite important section of the borrowing market." He says the banking sector is very exposed to the economic cycle risks that come along with investment in the housing sector. "And there is no doubt at all that if we did see a genuine slowdown in the property sector, it would drag down much of the rest of the economy," as the banks are particularly exposed to the rest of the economy. The worst case scenario, according to Innes-Ker, would be a big rise in non-performing loans, "if we did see a sudden drop-off in the property sector."

And that could have an impact on local governments, whose main source of income comes from the real estate industry.

Author: Markus Rimmele / sb
Editor: Grahame Lucas