How’s China going to pay for its bad loans?

Micheal Pettis has an interesting post on China’s expected NPLs and the related cleanup costs. In short, he expects a collapse in Chinese consumption in the future as households are being squeezed to pay for the bad loans that the over-heating economy is racking up right now. And I don’t quite agree with him.

A decade ago China had a huge surge in NPLs, the cleaning up of which was to cost China 40% of GDP and a possible banking collapse, and yet, they claim, nothing bad happened.  The doomsayers were wrong, the last banking crisis was easily managed, and Chinese growth surged.
…… In fact China paid a very high price for its banking crisis.  The cost didn’t come in the form of a banking collapse but rather in the form of a collapse in consumption growth as households were forced to pay for the enormous cleanup bill.

Pettis is giving a bit of background info here regarding the last Chinese banking crisis and its cleanup. While I agree with him that the cleanup was costly (hey, there’s no free lunch after all),  his conclusion is erroneous.

There are 2 reasons why many uninformed people thought the cleanup was painless. First was rapid economic growth during the time period reduce its proportion to GDP and made the effort more bearable. Second was the fact that recapitalization was paid with China’s reserve. One could argue that the reserve was built up by pinching from household consumption, but cleaning up bad loans certainly was not the reason why it was built up. The reserve was a RESULT of China’s economic policy of preferring investment over consumption.

Why am I nick-picking over such a technicality? Because this means there was no connection between China’s historic lean consumption and the last banking cleanup. As such, the forecast collapse in Chinese consumption to pay for this recent one isn’t likely either.

Does this mean that the upcoming cleanup would indeed by painless? Not unless you believe in alchemy. But it will come in the form of running down China’s reserve, vaporizing a substantial portion of it. One can argue that this indirectly hurts consumption as the money could have been spent on things more productive like building up China’s social security network. But I don’t think anyone has a clear vision of how the reserve will be used and factors it in when making consumption forecast. As such, I doubt running down reserve to pay for banking cleanup will have much impact on future consumption, the level of which will depend on other economic incentives. In a way one can argue that the price has already been paid. China’s consumption may or may not collapse in the future, but cleaning up loans gone sour is not the cause either way.