How can a country that is growing at 7.5% find that its basic industries are collapsing?

Last week, I saw the most interesting statistic about China in the Chinese press. The statistic was that 20 out of the 36 largest coal mining companies were losing money. Out of the 20, nine or almost half, were on the verge of bankruptcy. If you include smaller coal companies in China, 70% are in the red. It’s not just the coal industry. According to China’s National Bureau one third of the steel, aluminium and cement makers lost money.

These numbers are truly astonishing for a country that is, at least in theory, growing at 7.5%. How can a country grow at that rate if a large part of its basic industries are either losing money or near collapse? I informed a friend of these numbers as further evidence of China’s debt fuelled economy. She brushed it all aside. “Doesn’t matter,” she said, “It’s a communist country.” In a way she was right, but these losses still matter. A lot.

But how does this happen? How can these companies keep afloat in a sea of red? The simple answer is debt. But how can these companies keep borrowing? Because the government supports them. Not the central government in Beijing, but the local governments in the cities and provinces where the factories are located.

One example is illustrated in an excellent article found in the US financial newspaper, the Wall Street Journal. They cite the cases of two steel companies, Delong Holdings Ltd and Longhai in the city of Xingtai. Xingtai is in the province of Hebei about 400 kilometers southwest of Beijing.

The problem with these two companies, like many steel and coal companies, is that they don’t make any money. Worse still, they contribute to a massive excess production problem that plagues 19 industries. On top of that, they are major polluters, which contributes to the foul air in Beijing.

In a market economy, these two companies would have gone bankrupt a long time ago. But contrary to what some some popular commentators say, China is not exactly a market economy. The central government did try to close down Longhai. They told the state owned banks to deny a loan of $177 million. For a time Longhai did close down, but this caused another problem. It threw 3,000 people out of work.

Local governments don’t like it when their local industries have to close. It creates unemployment, encourages other defaults and it also lowers the tax take. The local industrial tax is not based on profit. It only taxes industrial production, so a money losing operation doesn’t affect the local government’s income. A closed factory does.

Most people would assume that central government policies are always implemented, but it doesn’t necessarily work that way. China has 34 provincial administrations. These include 23 provinces 4 large cities (Beijing, Tianjin, Shanghai, Chongqing), 5 autonomous regions, plus Macau and Hong Kong. Each province has their own economic policy. The local branch of one of the big four state owned banks is semi-autonomous, answerable to the local government as well as to its own hierarchy and the central government.

The central government not only tried to shut down Longhai in Xingtai, but also tried to shut down other steel and cement factories in Xingtai’s province of Hebei. Hebei is home to 73 million people. Its steel mills produce 190 million tons of steel a year. This is about double the entire U.S output. It also produces massive pollution, which make Hebei home to seven of China's 10 most-polluted cities. The central government wants to cut steel production by 10%, but as the center for much of that production, the burden would fall disproportionally on Hebei. Beijing wants to cut 80 millions tons of production. If Hebei met that goal it would mean a 10% reduction in tax receipts and 200,000 unemployed. So naturally they are a bit resistant.

So it is hardly surprising that the city of Xingtai arranged a merger between Delong Holdings Ltd and Longhai. They also are trying to help find money to get them back in production as soon as possible. But there is one large question in all of this; Where is Xingtai going to get the money?

Chinese local governments are in debt to the state owned banks to the tune of $1.6 trillion. This is where my friend’s doubts came in. It is a communist system, the banks are owned by the state, so why can’t the central government just force the banks to lend more money?

In the past, that is what they did. But two years ago, the levels of lending grew too high for comfort, so, much of the lending was curtailed. However at the same time, Beijing allowed the growth of off-the-books financing, known as the shadow banking system. Lending exploded along with corporate and local government debt. There was one problem, the shadow banking system is part of the market.

Now Beijing is trying to reposition its economy. For the first half of the year, it put restrictions on lending, as a result, the economy, especially the all important real estate sector, slowed down. In April, it changed its tune and allowed total “social financing,” which includes shadow banking to the tune of 2 trillion yuan. In July it was also up to 1.97 trillion yuan, double the amount loaned in March.

So it looks like Beijing is trying to revive the economy by once again increasing the debt mountain. If you look closer at the numbers it will be clear that the growth was due to a surge in short term financing. This suggests a bandage to help pay back debts already due, rather than new asset investment.

Meanwhile, the engine for all this demand of coal, steel and cement, the real estate market continues to slow. It slumped 9.2% in the first half of the year. With sales slowing, the developers aren’t building. The demand for steel and cement is depressed along with coal and the red ink continues to flow.

So is my friend right? Can the 1% of Chinese, who own one third of the country and run it under the guise of the Communist Party, keep going into debt indefinitely? Even though there are incentives to do so, they can't continue indefinitely. How long they can keep it up, no one knows, no one knows the levels of debt or who owes what to whom. Of the 289 cities, only 14, or 4.84 percent of the total cities, released relevant statistics on their government debts. But the communists made a mistake, they introduced the shadow banking system into the real estate market, which are subject to forces beyond the government’s power. So a slowdown will at some point turn into a rout.

(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and speaks four languages.)