Recent economic indicators out of China would suggest that the country's economy is rebounding. HSBC's flash purchasing managers' index (PMI) came in at 51.9 for January, which is above the 50-point level indicative of quickening growth.
While the markets rejoiced after the release of the PMI data, other signs suggest that the optimism may be short-lived. From a longer-term perspective, China's economy faces serious headwinds; one of the biggest is the rapid accumulation of debt among its corporations and local governments.
China's credit boom
In the five-year period from 2008-2012, China's debt-to-GDP ratio skyrocketed by around 60 percentage points. That's worse than debt growth in the U.S. prior to the global financial crisis, and also worse than Japan's credit boom in the latter half of the 1980s . We know how both of those ended -- not too well.
In a sense, China has done exactly what the western economies did prior to their respective crises. They binged on credit, and effectively borrowed from the future. Now they're struggling with finding the right balance between austerity, inflation, and growth.
While debt-financed investment isn't necessarily a bad thing, it can be, depending on how the money was invested. In China's case, mounting evidence suggests that malinvestment has been rampant. In fact, several recently-completed projects may be unable to generate sufficient cash flows to cover their costs of financing.
While there are numerous examples of indebted entities within China -- the state-owned enterprises, various solar and alternative energy companies, to name a few -- the debt problem is especially acute among local governments. Let's take a closer look.
Local government debt
Borrowing by local governments in 2009 and 2010 saw debt levels surge to roughly 10.7 trillion yuan, or $1.7 trillion. And, while local government debt issuance fell somewhat in 2011, recent data indicates that borrowing spiked yet again last year.
Unlike in the U.S., where local governments can issue municipal bonds, the authorities in Beijing allow local governments little flexibility in raising their own revenues, ostensibly so they can continue to exert influence over them.
With little recourse, many have resorted to more shady methods of financing, including platform companies known as local government funding vehicles, or LGFVs. After 2008, as infrastructure spending ballooned, these quasi-official entities took on massive volumes of debt - debt that the central government will ultimately be responsible for.
In a report published this month, the China Central Depository & Clearing Co. found that LGFV bond issuance amounted to a whopping 636.8 billion yuan, or $102 billion, last year, representing a nearly 150% increase from the year earlier. Similarly, trust loans directed toward infrastructure also rose markedly, increasing by 376 billion yuan in the first nine months of last year, as opposed to the same period in 2011, when loans from trusts actually fell by 17 billion yuan.
LGFVs also face severely high borrowing costs. For instance, a 10-year 150 million yuan bond issued by Fushun City Construction Investment Co. in March yielded 8.5% -- significantly higher than the central government's cost of borrowing. In addition to their use of LGFVs, local governments face another threat - their excessive reliance on revenues from land sales.
Local governments' dependence on real estate market
According to Christine Wong, a professor of Chinese public finance at Oxford University, land sales brought in more income than taxes in 2010, accounting for 35% of that year's fiscal revenue, as compared to 30% for tax revenues.
The fact that land sales account for such a significant share of local government revenues is disconcerting. While China's real estate market fared remarkably well last year, if it were to head south again, local governments would find themselves strapped for cash.
Moreover, there's evidence that the value of land held as collateral against these loans has been overestimated by local officials, and is often valued substantially higher than comparable properties nearby.
Consider the city of Loudi, in south-central China's Hunan Province. To fund the construction of a massive Olympic stadium and other athletic facilities, the city's local government borrowed 1.2 billion yuan in bonds. The loan was secured by land valued at roughly $1.5 million per acre. As a Bloombergarticle detailed, that's roughly the same as land values in Winnetka, Illinois, a prominent Chicago suburb, where the median household income is around $250,000.
In Loudi, by comparison, the average worker earns a little over $2,000 a year. What's more, local officials valued the tracts of land, which are used as collateral against the 1.2 billion yuan loan, at nearly four times the value of similar nearby plots sold earlier that year . Is it just me, or does something seem out of whack?
Final thoughts and ways to invest in China
While indebtedness among local governments, state-owned enterprises, and numerous Chinese companies is a major issue, it's hard to tell when the problem will actually start to impact China's economy. After all, China's economic indicators have continued to surprise to the upside over the past few months or so.
In the meantime, there may be relatively higher growth potential among U.S.-listed Chinese Internet companies. With China's number of Internet users numbering higher than 500 million, yet penetration levels at just 40%, many see tremendous opportunity. In addition to this long-term favorable trend, some suggest that Chinese Internet stocks now look more attractive from a valuation standpoint, after declining considerably last year.
For instance, Renren , commonly hailed as the Chinese Facebook, declined about 10% over the course of last year, while Baidu , China's dominant search engine, shed about 20% of its value during 2012, though shares are up 5% so far this year.
A word of caution is in order, however. Some Chinese Internet stocks may seem deceptively cheap. For instance, Dangdang , often referred to as the Chinese Amazon by the media, looks relatively cheap at a little over $4 a share, with a price to sales ratio of less than 0.5 , yet it faces a number of headwinds, including slowing revenue growth, rising expenses, and growing competition .
Regardless of your short-term view on the Chinese economy, there may be opportunity in Baidu (aka the "Chinese Google"). Our brand new premium report breaks down the dominant Chinese search provider's strengths and weaknesses. Just click here to access it now.
The article 1 Major Long-Term Threat to China's Economy originally appeared on Fool.com.
Fool contributor Arjun Sreekumar has no position in any stocks mentioned. The Motley Fool recommends Baidu. The Motley Fool owns shares of Baidu. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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