China’s Debt Endgames

Quick And Slow Deaths…

Understandably, the major focus now is on the denouement of the crisis.

Pessimists are concerned about a catastrophic crash. Optimists are more sanguine, expecting a soft landing with gradual reforms correcting the systemic issues.

The crash scenario is predicated on continuing increases in debt levels and over-investment. Policy adjustments are fatally delayed. Ultimately, authorities are forced to tighten credit aggressively triggering failures in the financial system and a sharp slowdown in growth.

Weaknesses in financial structure exacerbate the money market tightening causing liquidity driven problems for both vulnerable smaller banks and the shadow banking entities. The rapid decline in credit availability results in problems for leveraged borrowers, such as those in local governments and property sectors. The larger banks which are likely to benefit from the flight to quality are unable or unwilling to expand credit to cover the shrinkage from smaller banks and the shadowing banking sector, due to risk aversion or regulatory pressures.

The deceleration in credit growth and liquidity results in lower levels of economic activity. Combined with cost pressures and weak external conditions, Chinese businesses, who are major suppliers of cash to the economy, experience a decline in cash flows which compounds the liquidity problems.

Foreign capital inflows, which have enabled the People’s Bank of China (“PBOC”), the central bank, to provide liquidity to the financial system slow and then reverse. At the same time, capital outflows, especially from corporations and also the politically well-connected and wealthy, increase, driving further contraction in credit.

The confluence of a liquidity crisis, financial system problems, slowing growth and capital outflows would feed accelerating negative feedback loops which would be difficult to deal with.

The optimists counter that the debt levels while high are manageable because of high growth rates, the domestic nature of the debt, high savings rates and the substantially closed economy. They argue that the banking system has low leverage, a large domestic funding base and low levels of non-performing loans. They also rely on the high level of foreign exchange reserves and modest levels, at least by developed country standards, of central government debt.

The optimists believe that reform programs, albeit slow in implementation, will ensure a smooth transition. China will rebalance its economy from investment to consumption. Deregulation and structural changes will improve the resilience of the financial system.

The strength of the banking system is probably overstated, primarily because of the understatement of bad loans and the relationship with shadow banks. Real levels of non-performing loan may be as high as 5-10% of assets, about 5 to 10 times the reported levels. The risk of a significant portion of assets held in the shadow banking system may ultimately come back into the banking system.

China’s foreign exchange reserves (invested in high quality securities denominated in US$, Euro and Yen) may prove difficult to realize without triggering losses or currency issues. More fundamentally, the reserves are not true savings, being matched by Renminbi created by the PBOC and paid to domestic entities in exchange for foreign currencies.

In effect, the flexibility of Chinese authorities to deal with any problems may be more constrained than assumed. But the risk of a major collapse while always present is, at this stage, low. A familiar endgame, entailing bank failures, depositor runs, massive outflows of foreign investors or a sovereign default, is unlikely. The Central Government is seeking to steer a middle path, which is both difficult and has significant risks.

Middle Kingdom, Middle Path…

The strategy will entail continued credit expansion, providing liquidity, managing non-performing assets and using transfers from households to the financial and corporate sector.

The central bank will continue to provide abundant liquidity to the financial system through a variety of mechanisms.

Lenders have been instructed to roll-over loans to local governments which cannot be repaid out of cash flow. Maturities are being extended for up to 4 years, to alleviate refinancing pressures on the around US$1.5-2 trillion of debts that mature over the next three years. Chinese authorities subscribe to the theory that “a rolling loan gathers no loss”.

A variety of alternative funding structures are now being used to circumvent regulations. Authorities have altered regulations to allow local governments to issue public bonds, for the first time in 20 years.

Synthetic loans are common. Private equity funds subscribe equity which the sponsor contracts to repurchase at a future date at an agreed price. Insurance and security companies are partnering with banks to invest in real estate projects, which are then re-sold to banks at an agreed future date at an agreed price which guarantees the investor a fixed return.  Securitisation of future cash flows is used to raise debt.

With banks unable to increase their exposure to local governments, LGFVs have established subsidiaries, designated as small and medium enterprises with preferential access to finance, to raise funds which are then on lent to the parent. Property companies use related industrial companies, to apply for loans which are on-lent to the real-estate venture.

Provinces and local governments have established development funds, which are permitted to borrow from banks and then on lend to the relevant sponsor, ostensibly to support industry. For example, the fund can finance construction of a new factory which will inevitably include the cost of clearing the land where the old factory stood and building the infrastructure needed for a property project.

Defaults in the shadow banking will also be managed. The failure of a bond issuer (Chaori 11) has been incorrectly interpreted as a shift in policy where the authorities will allow default. The reality is more complex. Where considered appropriate, banks and state entities will intervene to minimize investor losses, by taking over the loans or re-integrating assets into regulated banks.

In a recent case, investors in the US$500 million Credit Equals Gold No.1, managed by China Credit Trust (“CCT”), one of the country’s biggest Trust Companies, faced losses. The Trust principal asset was a loan to an unlisted mining company Zhenfu Energy which could not meet repayments. Investments in the vehicle had been distributed by ICBC, China’s largest bank, to around 700 wealthy individuals expecting a return of around 10% per annum.

With default threatening, ICBC made it clear that it had not guaranteed or assumed liability for returns or investment. After a period of uncertainty, an unnamed third party agreed to purchase an equity stake in the underlying venture, which then was granted a valuable mining license. With the borrower’s ability to repay restored, investors in Credit Equals Gold No.1 suffered only modest losses.

The case is not isolated. A number of Trust Company and WMP investments have missed payments, with many having been rescued, sometimes under mysterious circumstances.

Authorities have chosen to intervene to avoid a loss of confidence in these vehicles, resulting withdrawal on investments, forced selling of assets and crippling the sector which has become an important source of credit within China. One analyst told a reporter: “Moral hazard in China is state policy”.

As in previous Chinese episodes of bad lending, non-performing loans (“NPLs”) will be sold to asset management companies (“AMCs”) to avoid a banking crisis.

In the late 1980s and early 1990s, Chinese state owned banks had large NPLs from policy driven loans to loss making state owned enterprises that were unable to repay. In the late 1990s, the banks incurred NPLs exceeding 30% of assets, primarily from the collapse of a property and equity boom. The problem was resolved by a combination of recapitalization by the government, restructuring of loans, debt write-offs and transferring bad loans to AMCs. The actions were taken to allow the Chinese banks to list on the Hong Kong Stock Exchange, in order to raise new capital.

As part of this process, in 1999, the Central Government established four big asset management companies (one for each of the major policy banks) to purchase US$170 billion of bad loans generally at face value. The AMCs issued government guaranteed 10 year bonds back to the bank to finance the purchase.

With recoveries insufficient to repay the bonds when they matured in 2009, the AMCs replaced the original funding with new 10 year bonds. Since 2012, the AMCs have repaid around 45% of these bonds. The source of funding is not clear but appears to be from the government. It appears that this was done to provide liquidity to the banks forced to hold the original AMC bonds. It was also designed to allow the AMCs to raise new capital. At least, one AMC has undertaken a successful IPO in Hong Kong, with other such equity raisings likely.

These actions may be part of a strategy to allow the government to use the AMCs to deal with the expected rise in NPLs from the current round of credit expansion. There is currently some evidence for this with the AMCs purchasing certain assets from banks.

In effect, instead of resolving the debt problems, the Chinese government will oversee a process of supporting over indebted borrowers and the banking system. As in a shell game, bad debts will be shuffled from entity to entity, delaying the recognition of losses.

The actions will reduce the immediate financial pressure, but merely defer the debt problem. The primary objective of the strategy is to maintain high growth for as long as possible and also preserve social order. It reflects the fact that a financial and economic crisis in China is synonymous with a loss of confidence in the state itself and the Chinese Communist Party.

 The Price To Pay…

The ultimate price of this strategy will be to lock the Chinese economy into a lower growth path with the risk of de-stabilising crash.

Over time, increasing amounts of capital and resources will become locked into unproductive investments which do not generate sufficient returns to service the debt incurred to finance it.

The need for economic growth will continue to drive debt fuelled investments with inadequate returns. When the debt incurred cannot be serviced or paid back, more capital will be tied up in warehousing the losses to avoid a banking crisis.

If returns on investment are insufficient, then there must be a transfer from one part of the economy to another to cover the shortfall. This cost will be borne by households, with slower improvement in living standards and erosion of the value of their savings.

Authorities will have to keep saving rates high to provide the capital needed to pursue this strategy. They will ensure that the bulk of funds remain in the form of low yielding deposits with policy banks, which can be directed by the Central Government as required. Interest rates will remain low below inflation. Banks will need to maintain a large spread between borrowing and lending rates to ensure sufficient profitability to absorb the cost of non-performing loans. Borrowing rates and the cost of capital will also need to be kept low to support the investment strategy and also reduce pressure on unprofitable or insolvent businesses.

The loss of purchasing of household savings will provide the economic basis for the transfer of resources, amounting to as much as 5% of GDP, to banks and to borrowers, primarily SOEs and exporters.

The necessity of high saving rates will impede the rebalancing from investment to consumption. It will also impede the development and deepening of the financial system. China will also have fewer resources available to improve health, education, aged care and the environment.

In the short run, continued mal-investment and deferring bad debt write-offs will provide the illusion of robust economic activity. Over time, households will discover that the purchasing power of their savings has fallen. Wealth levels will be reduced by the decline in the prices of overvalued assets. Businesses and borrowers will find that their earnings and the value of their overpriced collateral are below the levels required to meet outstanding liabilities.

The alternative is equally problematic. If the government moved to liquidate uneconomic businesses and unrecoverable debt, then it would need to finance the recapitalization of businesses and banks. This cost would require a sharp increase in taxation, which would also result in a slowdown in economic activity.

In reality, China’s Potemkin economy of zombie businesses and banks will create progressively less real economic activity.

Historical Convergence…

There is increasing concern that China risks turning Japanese. There are points of correspondence and divergence between the positions of Japan in the early 1990s and China today.

In both cases, Investment levels were high, in similar areas such as property and infrastructure. Chinese fixed investment at around half of gross domestic product is higher than Japan’s peak by around 10 per cent and well above that for most developed countries of 20 per cent.

Like Japan before it, China’s banking system is vulnerable. Rather than budget deficits, China has directed bank lending to targeted projects to maintain high levels of growth.

The reliance on overvalued assets as collateral and infrastructure projects with insufficient cash flows to service the debt means that many loans will not be repaid. These bad loans may trigger a banking crisis or absorb a big portion of China’s large pool of savings and income, reducing the economy’s growth potential.

One difference is that whereas Japanese bad debts affected private banks and businesses. In contrast, the state effectively underwrites Chinese banks and many debtors. In addition, China is less developed economy and has greater growth potential.

But at the onset of its crisis, Japan was much richer than China, providing an advantage in dealing with the slowdown. Japan also possessed a good education system, strong innovation, technology and a stoic work ethic which helped adjustment. Japan’s manufacturing skills and intellectual property in electronics and heavy industry made it less reliant on cheap labour, allowed the nation to defer but not entirely avoid the problems.

In contrast, China relies on cheap labour, to assemble or manufacture products for export using imported materials. Labour shortages and rising wages are reducing competitiveness. China’s attempts at innovation and hi-tech manufacture are still nascent.

China’s credit-driven investment model may have reached its limits. Continuing existing policies increase domestic imbalances, misallocation of capital, unproductive investments and loan losses at government-owned banks.

Chinese achievements over the last 30 years are considerable. But until 1990, Japan too was successful, growing strongly with only brief interruptions. After the bubble economy burst, Japan has had almost two decades of uninterrupted stagnation. Today, with or without change, China faces a prolonged and difficult period of adjustment. French author Marcel Proust was correct when he stated that: “The real voyage of discovery consists not in seeking new landscapes, but in having new eyes.”

© 2014 Satyajit Das

Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money