Signs of a China Credit and Real Asset Bubble Are Now Unmistakable

Homegrown credit risks look to come back home to roost. I am actually shocked the following development didn't get more traction in the mainstream media. The recent announcement by the Chinese finance ministry to nullify all guarantees for local governments for loans taken by their financing vehicles, and its plan to issue rules banning all future guarantees by local governments (see Bloomberg article), fuels (even further) our concerns about credit risks on such loans.

The primary concern is that most of these were non-recourse loans to provinces, municipalities and counties through shell companies, known as Urban Development Investment Corporations (UDIC). Some went to fund projects backed by assets, such as commercial real estate, others to projects with future cash flows such as subways and toll roads. Still others are social in nature and backed only by an implicit guarantee of the City/Provincial Investment Holding Corporation (CIHC).

This post should be taken in context of the discussion had regarding regarding the prospects of the highly levered Russian energy company. Subscribers please see Mechel (MTLR) 2010-02-26 18:32:58 366.23 Kb and
Mechel (MTLR) Overview, pt2 2010-02-28 06:09:51 532.89 Kb

The China Macro Discussion 2-4-10 is also quite relevant.

And the most concerning part of these loans primarily includes the estimated 3,000 billion Yuan ($450billion) of local infrastructure loans extended in 2009, which represents 30% of the record new bank lending last year.

• Most UDIC loans have sparse local equity and limited cash flow prospects for repayment. For 2009, local governments and CIHCs have been able to meet interest payment gaps with healthy land sales, which totaled 1,600 billion Yuan in 2009, as well as central government transfers.
• However, at the end of 2009, the UDIC liability is estimated at close to 6,000 billion Yuan or 14% of the outstanding loan base. And a 30% default rate could in effect wipe out the paid-in capital of top banks such as China Construction Bank and Bank of China.

According to Central bank governor Zhou Xiaochuan, during the National People's Congress, "while ‘many' local financing vehicles have the ability to repay, two types cause concern. One uses land as collateral, while the other can't fully repay borrowing", which means that for such loans the local governments may become liable, leading to ‘fiscal risks' for the government.

Similar concerns have been previously raised by Northwestern University's Professor Victor Shih, who estimates China's local- government outstanding debt at the end of 2009 at 11.429 trillion Yuan ($1.674 trillion)

and agreed credit lines with banks for an additional 12.767 trillion Yuan ($1.87 trillion). Additionally, and as per his estimates the total local government outstanding debt may result in bad loans of up to 3 trillion Yuan ($439 billion) as projects have been left without funding.

Further, Shih also stated that this rise in debt in "the worst case" could trigger a financial crisis around 2012.

China's local governments have been raising funds through investment vehicles to circumvent regulations that prevent them borrowing directly, (which is not counted in official calculations currently), inclusion of this debt could lead to debt rising to 96% of GDP ratio (total debt reaching 39.838 trillion Yuan or $5.8 trillion) next year, much higher compared to IMF's estimate of 22% which excludes local-government liabilities (WallStreetPit.com).

Harvard University's Professor Kenneth Rogoff has also highlighted fears of a debt bubble crisis in China. According to Rogoff "China's economic growth will plunge to as low as 2% following the collapse of a "debt- fueled bubble" within 10 years, sparking a regional recession. ...You're not going to go a decade without having a bump in the business cycle. ...We would learn just how important China is when that happens. It would cause a recession everywhere surrounding" the country, including Japan and South Korea, and be "horrible" for Latin American commodity exporters" (Bloomberg).

A February 2009 OECD report has also cautioned that China faces risks from bank lending surge. According to the report "While Chinese banks have so far weathered the global slowdown well, the acceleration in new lending since early 2009 raises the risk of a renewed surge in non-performing loans (NPLs) in the years ahead."

The probability of financial crisis is further supported by the Chinese state entities' poor record in preventing faulty provincial lending practices and low quality asset formation. During the 1990s Asian financial crisis, the Guangdong International Trust went bust, in spite of an implicit Guangdong state government guarantee (Nation.com).

The Consequence

The banning of local government guarantees will constrain the number of infrastructure projects that local governments launch in 2010, resulting in a smaller boost to the economy since the majority share of this 2^nd year of stimulus consists of enormous lending by state banks and not of government funding (Postbuletin.com).

• With overall credit tightening, the Chinese regulatory authorities are curbing loans to local governments through all ways possible as they are concerned that some local governments' financing vehicles have used loans to pay taxes or buy property or shares, i.e. used money for purposes not approved by banks, or put cash into projects with no capital, cash flow or guarantees.
• Recently, the Shanghai Securities News reported that banks had been ordered to stop issuing new loans to investment vehicles that were backed only by local governments' future revenue and have no registered capital.
  

Counter-arguments

Though there are risks of debt crisis if the government is unable to handle the current surge in local government borrowing and overall unprecedented lending, the country's high saving rate can help the country meet its liabilities if the government is unable to control the current lending outburst, in turn averting the crisis.

• According to UBS AG economist Wang Tao "China won't face a debt crisis because national savings and government assets mean that the country will be able to finance its liabilities".

Counter-counter arguments Never short a country with $2 trillion in reserves?

Michael Pettis, professor at Peking University's Guanghua School of Management specializing in Chinese financial markets, and a Senior Associate at the Carnegie Endowment for International Peace, draws very interesting parallels between China's massive foreign reserve build-up and the only other two countries that have managed to accomplish such a feat. This is an excerpt from his highly recommended blog linked above.

... Let us leave aside that the PBoC's reported reserves are a lot more than $2 trillion, and that if correctly accounted they would be pretty close to $3 trillion. China's foreign reserves are certainly huge. They add up to an amount equal to about 5-6 % of global gross domestic product.

But they are not unprecedented. Twice before in history a country has, under similar circumstances, run up foreign reserves of the same magnitude.

The first time occurred in the late 1920s when, after a decade of record-beating trade and capital account surpluses, the United States had accumulated what John Maynard Keynes worriedly described as "all the bullion in the world". At the time, total reserves accumulated by the US were more than 5-6% of global GDP. My back-of-the-envelope calculations suggest that this was probably the greatest hoard of central bank reserves ever accumulated as a share of global GDP, but please check before you accept this claim.

The second time occurred in the late 1980s, when it was Japan's turn to combine huge trade surpluses, along with more moderate surpluses on the capital account, to accumulate a stockpile of foreign reserves only a little less than the equivalent of 5-6% of global GDP. By the late 1980s, Japan's accumulation of reserves drew the sort of same breathless description - much of it incorrect, of course - that China's does today.

Needless to say, and in sharp rebuttal to Friedman, both previous cases turned out badly for long investors and brilliantly for anyone dumb enough to have gone short. During the early years of the Great Depression of the 1930s, US stock markets lost more than 80 per cent of their value, real estate prices collapsed, and the US economy contracted in real terms by an astonishing 30-40 per cent before recovering in the 1940s.

Japan's subsequent experience was economically less violent in the short term, but even costlier over the long term. During the period following its astonishing accumulation of central bank reserves, its stock market also lost more than 80 per cent of its value, real estate prices collapsed, and economic growth was virtually non-existent for two decades.

The idea that massive levels of reserves are a guarantor of economic stability is, in other words, based on a profound misunderstanding both of history and of the nature of reserves. Reserves of course are not useless as an enhancer of financial stability, but their use is for very specific forms of instability. Having large amounts of reserves relative to external claims protects countries from external debt crises and from currency crises.

Great, but neither Chanos, nor even the most pessimistic Sino-analyst, has ever said that these are the kinds of risks China faces today, any more than they were the risks faced by the US in the late 1920s or Japan in the late 1980s. The risks that China faces today (and the US in the late 1920s and Japan in the late 1980s) is of excessive domestic liquidity having fueled asset and capacity bubbles, the latter requiring the uninterrupted ability of foreign countries to absorb via large and growing trade deficits. These risks include an explosion in domestic government debt directly and contingently through the banking system.

These are, very typically, the kinds of risks that threaten rapidly developing large economies, unlike the external debt and currency risks that typically threaten small economies. And reserves are almost totally useless in protecting these economies from the risks they face (and, no, no, no, reserves cannot be used to recapitalize the banks - only domestic government borrowing or direct or hidden taxes on the household sector can be used to recapitalize the banks).

In fact, it was the very process of generating massive reserves that created the risks which subsequently devastated the US and Japan. Both countries had accumulated reserves over a decade during which they experienced sharply undervalued currencies, rapid urbanization, and rapid growth in worker productivity (sound familiar?). These three factors led to large and rising trade surpluses which, when combined with capital inflows seeking advantage of the rapid economic growth, forced a too-quick expansion of domestic money and credit.

It was this money and credit expansion that created the excess capacity that ultimately led to the lost decades for the US and Japan. High reserves in both cases were symptoms of terrible underlying imbalances, and they were consequently useless in protecting those countries from the risks those imbalances posed.

Whether the country will face a debt driven crisis remains dependent on how well China tackles the current situation, one certain outcome of unprecedented lending is a plunge in the current high economic growth rate of the country as infrastructure spending takes a hit from loan tightening.

• According to Michael Pettis, former head of emerging markets at Bear Stearns Cos, "China's mounting debt may hamper policy makers' ability to maintain many more years of high growth through stimulus, and slash growth to between 5% and 7% annually over the next decade. That's "still healthy but much lower than the more than 10% growth rates of the past decade."

Disclosure: No Positions

Comments

[Ben Gee]

Lets take a look at the difference between China today and the US in the 1920's.
In the 1020's, gold was the reserve. Gold was the medium of trade. World trade collapsed when US had all the gold. Today, currency is the medium of trade, there will never be a shortage of that. Unless the world get into a trade war, history will not likely to repeat itself.
In the 1980's, Japan allowed its currency to appreciate from 300 yen per $ to less than 100 yen per $. Japanese trade collapsed, which led to Japan's lost decades. Today. if China allow its currency to appreciate the way Japan did, the same may happen to China. China will not likely allow its currency to appreciate the way Japan did.
If China is going to collapse, it will be a new way. It will not be like the 1920's nor the 1980's.

Mar 09 11:39 PM

[Ben Gee]

Inspite of China's claim to have a market economy, China does not have a market economy, China has a planned and controlled economy. China started building freeways 10 years ago when China did not need the freeways. Those freeways were filled only the last few years. China is building offices, malls, high speed rails for the future. These are not signs of market forces. These are planned activities. Up till now, things worked out reasonably well. Was it luck or was it good planning? If thing do not workout in the future, China may have a huge problem!

Mar 10 12:01 AM

[jimmy46]

The recent announcement by the Chinese finance ministry to nullify all guarantees for local governments for loans taken by their financing vehicles,"""""""

And people with no memories have been suggesting using the Yuan as a world reserve currency ???

Mar 11 05:18 PM

[Kratos]

The Great Depression in the United States was not caused by the stock market bubble bursting in 1929. That bubble burst was rather small by modern standards, and only caused a rather ordinary economic recession.

What created the Great Depression was:

1) herbert Hoover signed the Smoot-Hawley tariff, a massive tariff on some 20,000 different imports. Other countries then responded with similar tariffs and global trade ground to a halt.

2) Hoover signed a massive tax increase (the top tax rate went from 24% to about 65%).

3) The Federal Reserve cut the money supply, raising interest rates, the complete opposite of what you do in a recession. This led to massive failures of the banking system as the "lender of last resort" was not lending.

The economy then went into a massive depression. Then FDR came in and continued what Hoover had been doing, along with raising taxes even further and infringing on the private-sector economy even moreso.

Thus we ended up with what came to be known as the Great Depression.

Had Hoover, Congress, and the Federal Reserve not made such drastic mistakes, the 1929 stock market crash would have given us a mild recession, then things would have returned to normal.

Japan experienced something a little different, a real-estate bubble bursting. A real-estate bubble is a lot harder on an economy than a stock market bubble when it bursts. Some say the actions of Japan's government are what have caused their "lost decade" since then.

Mar 13 11:57 PM