SinoInsight 1
On March 29, the General Office of the PRC State Council released a new notice regulating railway planning and construction (“Opinion on Further Doing a Good Job in Railway Planning and Construction,” or 關於進一步做好鐵路規劃建設工作的意見).
The notice pointed out that railway construction in some areas are “one-sided pursuits of high standards, high-speed/low passenger flow, heavy investments but small results, etc.” Also, railway companies are facing problems like greater operating pressures and heavy debt burdens, and the notice believes that it is necessary to “properly handle existing debt, strictly control the acquisition of new debt, and prevent and resolve debt risks.”
The notice then provides some guidelines for future railway planning and construction to prevent and defuse debt risks:
- New railway projects shall be carried out in accordance with government-approved plans. Construction standards, timetable, and function cannot be freely adjusted from the approved plan.
- No construction shall commence for railway projects that are not included in plans.
- The class of high-speed railway (250km/h, 300km/h, 350km/h) that can be constructed will be tied to passenger flow density. The 350km/h class can be used in provincial capitals or megacities that have a two-way passenger flow density of over 25 million passenger trips per year or medium-and-long distance passenger flow density of more than 70 percent. High-speed railway lines connecting large prefecture-level cities or above with two-way passenger flow density of over 20 million passenger trips per year may be allowed to run trains at 350km/h. Meanwhile, railways with annual passenger flow of 15 million passenger trips are required to run trains at 250km/h. The 200km/h or less class is to be adopted by intercity railway lines, in principle.
- Current high-speed railway capacity in China is less than 80 percent of full capacity; in principle, construction of parallel lines is prohibited under the current utilization rate.
- Relevant work units will be held accountable if they conduct data falsification in conducting demonstrations or review of technical indicators like passenger flow density.
In reporting on the State Council’s notice on high-speed railways, mainland media noted that many high-speed lines with trains running at 250km/h currently cannot meet the passenger flow density of 15 million passenger trips per year. Moreover, only select 350km/h lines, including the Beijing-Shanghai and Beijing-Guangzhou lines, currently satisfy the 25 million passenger trips per year quota. Many high-speed railway companies are also operating at a loss because of low train fares and limited passenger flow. As of the end of the third quarter in 2020, China Railway (China State Railway Group Company) had accumulated 5.57 trillion yuan (about $850 billion) in total debt and had a debt-to-asset ratio of 65.88 percent. China Railway’s extremely high debt situation has persisted for several years. Meanwhile, local governments have accrued significant debt in constructing high-speed railways, but such debt is often mixed up with other types of local government debt.
Mainland media also reported that national railway operating mileage during the 13th Five-Year Plan period (2016 – 2020) increased from 121,000km to 146,300km, while high-speed rail operating mileage increased 19,800km to 37,900km. In the past five years, China added a total of 25,300km of rail lines, of which 18,100km was high-speed rail (average of 3,620km per year). And in 2021, China Railway plans to put 1,600km of high-speed rail lines, or less than half the average level of railway increase in the past five years.
Zhao Jian, a Beijing Jiaotong University professor who published “Beware of the High-speed Rail Gray Rhino” in early 2019, told mainland media that the State Council’s high-speed railway notice is a “very big turning point” in the history of the PRC’s railway construction. “Brakes have been placed on the high-speed rail ‘Great Leap Forward,’” Zhao said.
OUR TAKE
1. It seems odd that the CCP is imposing curbs on railway construction less than two months after it rolled out an ambitious transportation network plan on Jan. 24.
On the one hand, Beijing is clearly concerned about wasteful infrastructure building and does not want to pointlessly increase debt risks. The risks of taking on excess debt in the current global inflationary environment is even greater as interest rate hikes worldwide could cause foreign capital to flow out of China at a crucial time. Beijing is likely looking to avert a situation where its ambitious infrastructure building plan becomes a huge debt bomb.
On the other hand, the fact that Beijing feels the need to apply brakes on infrastructure spending so quickly after rolling out an ambitious plan indicates that the CCP regime is not optimistic about China’s economic prospects.
2. Per the CCP’s National Comprehensive Three-dimensional Transportation Plan, China’s transport system is targeted to “achieve international and domestic interconnectedness,” “three-dimensional access to major cities nationwide,” and “effective coverage of county-level nodes” by 2035. The Plan calls for the railroads in China to reach 200,000km by 2035, of which 70,000km will be high-speed rail. With 37,900km of rail lines already constructed, the PRC has to make up the remaining 45 percent in the next 14 years.
Beijing and railroad companies have to take on another mountain of debt to achieve its 2035 objective. Twelve of the PRC’s 18 railway companies operate at a loss. And of the 37,900km of existing high-speed rail, only the Beijing-Shanghai line is profitable, with the rest remaining unprofitable due to insufficient passenger traffic. Meanwhile, China Railroad’s debt will likely double to at least 10 trillion yuan if the 70,000km target is to be reached; interest alone could be 500 billion yuan per year assuming a conservative interest rate of 5 percent. China Railroad will find paying off its debt to be nearly impossible under present circumstances, and prolonged pandemic conditions will only make things worse.
3. The CCP’s willingness to spend huge sums of money to construct unprofitable high-speed railways can be understood from its “survival-dominance” dynamic.
After the Cultural Revolution, the CCP pegged its political legitimacy to maintaining economic growth. So when trouble hit with the 2008 global financial turmoil, Beijing turned to quantitative easing, infrastructure building, and vigorous development of high-speed rail to boost the economy.
The construction of high-speed railways in China helped with employment figures, drove up the price of real estate along those lines, and increased land sale revenue for local governments. Increased passenger flow also brought economic benefits to society.
Meanwhile, the CCP effectively “defrauded” foreign companies of their high-speed rail technology and developed its own so-called “independent intellectual property right” (自主知識產權) and high-speed rail industry in China. Using the advantages of industry of scale and government subsidies, the PRC captured international high-speed rail market share at the lower price range. Today, building high-speed rails has become a flagship project in the CCP’s Belt and Road Initiative, driving its expansion overseas.
4. The CCP often touts the “strength” of its authoritarian system, but Party characteristics see to it that the high-speed rail construction project develops more problems for the regime.
First, CCP officials “prefer left rather than right” (寧左勿右) on the construction of high-speed rail to boost their political performance and capital, sometimes at the detriment of local economic capacity and circumstances. Greater government investments help officials improve than promotion odds while offering opportunities for corruption on the side. The debt “black hole” is then offloaded to future officials, who usually will not dare to offend those they are succeeding out of career security and interests. Thus, the more “politically correct” local governments will find themselves saddled with increasing amounts of debt.
Second, China’s high-speed rails will unlikely be profitable for a long time. Passenger flow density in China is among the highest in the world (2.290 billion passengers in 2019) but has one of the lowest fares (0.04 euros/km). Meanwhile, the rich-poor gap in China is widening and many people are still not making a lot. Last year, premier Li Keqiang revealed that 600 million people make less than 1,000 yuan a month; unless things turn around, these people may never get to board a high-speed train.
Third, local government corruption will inevitably prevent the central government from accomplishing its stated goals. For instance, one of the goals of the CCP’s ambitious transportation plan is the reduction of logistics costs and the promotion of economic development. However, Beijing may not be able to do much about controlling spending and debt because local governments partly fund transportation infrastructure construction, and local officials will find all sorts of ways (legal or illegal) to mark up spending and pocket the surplus.
Then there are work culture issues. Trucks in China tend to be overloaded as companies seek to reduce costs; even truck manufacturers that specialize in producing freight trucks are also into overloading. Severely overloaded trucks will damage roads, which in turn increases infrastructure maintenance costs. Meanwhile, traffic police will impose arbitrary fines on truck drivers. These various problems will combine to raise costs, creating a vicious cycle.
5. The CCP is getting concerned about capital outflows and debt defaults. On March 2, China Banking and Insurance Regulatory Commission chairman Guo Shuqing said in a press conference that proactive fiscal policies and extremely loose monetary policies being adopted in Europe, America, and in several countries due to the COVID pandemic could have an adverse effect on markets and the real economy. Given the circumstances, “we are very concerned about when the financial market, and especially foreign financial asset bubbles, will burst,” Guo said.
With global inflation and interest rates on the rise, the Chinese markets are anticipating higher odds of companies defaulting in 2021 as compared to last year. In particular, SOE defaults could intensify if hot money withdraws from China or capital flows back to the United States. Beijing has to find ways to curb debt bubble risks, and restricting investments in high-speed railways is one way of doing so.
SinoInsight 2
March 29
During a performance announcement conference, China Construction Bank disclosed that its total assets increased 10.6 percent from a year ago to 28.13 trillion yuan, while its net profit increased 1.62 percent year-on-year to 273.569 billion yuan. The bank recommended maintaining a 30 percent dividend ratio, which is subject to consideration during a shareholder meeting in June.
Other data include:
- The bank disposed of an unprecedented 190.4 billion yuan of non-performing assets in 2020, an increase of 20 percent. The balance of non-performing loans increased 48.256 billion yuan to 260.729 billion yuan.
- The bank’s non-performing loan ratio increased 0.14 percent from a year ago to 1.56 percent.
- 1.76 trillion yuan of new loans were issued, with a total balance of 16.79 trillion yuan; both reached historic highs.
- The balance of inclusive financial loans increased by more than 50 percent to 1.45 trillion yuan.
On a related note, China Banking and Insurance Regulatory Commission vice chairman Liang Tao said during a Jan. 23 State Council Information Office press conference that China’s banking industry disposed of 3.02 trillion yuan of non-performing assets in 2020. Liang added that China’s non-performing loan balance increased 281.6 billion yuan from the beginning of 2021 to 3.5 trillion yuan, while the non-performing loan ratio decreased 0.06 percent to 1.92 percent over the same period.
March 30
FTSE Russell announced that it would move ahead with plans to include PRC government sovereign debt to its World Government Bond Index (WGBI) over three years beginning in October. The London Stock Exchange Group-owned index provider first announced its plan in September 2020, but noted a phase-in period of 12 months. Previously in 2019, JPMorgan Chase and Bloomberg Barclays announced plans to include yuan-denominated notes into their indices.
HSBC said that with around $2.5 trillion tracking the WGBI, FTSE Russell’s move could see about $130 billion in inflows, given China’s eventual 5.25 percent weighting (about $3.6 billion a month).
OUR TAKE
1. FTSE Russell’s inclusion of yuan-denominated PRC sovereign debt to the WGBI is another milestone in the CCP’s RMB internationalization agenda. However, the delaying of the phase-in period from 12 months to a more conservative 36 months suggests that the index provider is wary of future financial risks in China under present financial conditions; global pandemic stimulus measures have led to raising inflation pressures, increasing U.S. Treasury yields, and narrowing U.S.-China bond spreads.
2. At a glance, China does not appear to be too adversely affected by present financial conditions. While the global bond market sell-off has narrowed the U.S.-China bond spread, hot money is still pouring into China. According to official data, foreign investors’ holdings of PRC government bonds reached a record 2.06 trillion yuan (about $318.7 billion).
However, the CCP’s recent policies indicate that financial risks are a serious concern for the regime. We already looked at the seemingly contradictory expansion and curbing of infrastructure construction in the first analysis in this newsletter. Here, we will focus on Beijing’s measures to deal with banking sector risks.
Recent data shows that the CCP still has some ways to go in curbing financial risks despite having already rolled out some strong measures. China’s banking sector dealt with 3.02 trillion yuan of non-performing assets in 2020, but it still has another 3.5 trillion yuan worth of non-performing loans to handle. While the non-performing loan ratio dropped by 0.06 percent, this is the result of new loans reaching a record high. In other words, China’s non-performing loans and assets continue to increase.
In 2020, Beijing pushed out powerful measures to force banks to service the real economy to rescue manufacturing and preserve employment. Beijing even went after financial institutions and targeted some executives to “kill the chickens to scare the monkeys” (殺雞儆猴). For instance, the anti-corruption authorities announced an investigation into former Citic Bank president Sun Deshun last March, as well as his expulsion from the CCP. One of the charges against Sun was “seriously violating the decisions and plans of the CCP Central Committee in promoting the financial sector to serve the real economy.” Also, he was accused of having “no political awareness or overall situational awareness … severely violating the Central Committee’s decision and deployment of financial services to the real economy, as well as restricting and reducing manufacturing loans.”
Under central government pressure, the balance of manufacturing loans in 2020 rose from 9.2 trillion yuan in 2019 to 11 trillion yuan. Absolute value of loans increased 19.6 percent to 1.8 trillion yuan, the largest increase in history. In comparison, the increase in manufacturing loans in 2019 was only between 3 to 7 percent. Further, the loan balance of small and micro enterprises as a proportion of total loans increased from 23.26 percent in 2019 to 23.93 percent in 2020, while the absolute value of loans increased by 5.8 trillion yuan, far exceeding the 2019 increase of between 3 to 4 trillion yuan.
Beijing’s policy of getting banks to serve the real economy is a covert way of forcing the latter to assume responsibility of relieving industries on behalf of the government. The result is an increase in the rate of bad debts in the banking industry and a significant decrease in profits. Banks, however, are finding ways to get around the conundrum. According to annual banking sector reports from the past decade, the bad debts rate of manufacturing loans issued to small and micro enterprises stayed between 5 to 7 percent. In comparison, the bad debts rate of loans to the property sector was generally lower than 1 percent. Because they are ultimately responsible for non-performing loans, banks are more willing to finance supposedly less risky real estate developments, be it directly or indirectly. For instance, banks have issued low interest loans to shell/scam small and micro enterprises, who then invest those loans in real estate. This arrangement allows banks to both fulfil Beijing’s requirements and curb its bad debts, while shell/scam enterprises earn greater profits from property investments; on the whole, this arrangement inflates China’s financial bubble and heightens risks.
The PRC, however, is sitting on a house of cards. On the current trajectory, global financial pressures will eventually result in greater capital outflows from China, and excessive outflows could trigger China’s debt bomb and other financial risks.
