Why China Is In A Classic Reflexive Feedback Loop

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Includes: CNY, CYB, FCA, FXI
by: Simon Daly

Summary

China is continuing to flood its credit system with new credit to roll over loans in sectors suffering from overcapacity.

Its banks are resorted to financial engineering to hide NPLs.

China needs to engage in restructuring and experience a loss cycle in order to move forward.

Karl Popper's principle of fallibility is based on the belief that in situations that have thinking participants, the participants view of the world will always be partial and distorted. His other well known theory is reflexivity. This is related to fallibility and holds that fallible or distorted views can influence the situations that they relate to because bad decisions and wrong actions flow from false views. A common example is that criminalizing drug addiction, creates crime. At present, China is positioned in a mega-reflexive feedback loop. It faces the most daunting set of economic circumstances ever faced by a country. Its government is faced with an array of policy options that it can utilize to deal with the situation, but attempting to predict how the government might proceed is futile. The reaction of market participants to China's current situation is a classic reflexive reaction. Confronted by the difficulty of the impossible reality of understanding China, while also being part of the situation, participants try their best to deal with the circumstances they find themselves in. To this effect analysts and investors have relied on the tools of simplification and generalization. The constructs that stem from these tools then take on a life of their own further complicating and adding complexity to the overall situation. With China the most commonly relied-on constructs are non-performing loans (NPLs) in the banking sector. Some participants feel that NPLs don't pose a threat and are manageable, others believe they not.

The Negative "House-View"…

Societe Generale's has a negative house-view on China, championed by its Chief China Economist Wei Yao. She has a very well researched and thought-through view that China's financial system is heading for a horrific credit crunch (Report title "Restructuring China Inc"). She feels that China's efforts to liberalize its corporate sector and capital markets, have opened the financial system up enough to massive excesses that have been built up, to become destabilized in the same way that a western credit system would experience a loss cycle. While other analysts have highlighted the ability of China's State Owned Enterprises (SOE's) to undergo restructuring efforts - she feels these efforts can only add to the overall destabilization, as profits will have to be reduced to account for equity investment. She sees the probability of debt restructuring at 50% in the medium term with total losses reaching CNY8 trillion, equivalent to more than 60% of commercial banks' capital, 50% of fiscal revenues and 12% of GDP.

In her methodology she applies;

"…a 15% non-performing ratio on banks' total claims on nonfinancial corporates and total debt of non-financial corporates gives us CNY12tn and CNY18.5tn, respectively. In order to capture banks' contingent risk currently hidden in the shadow banking system, we take the mid-point of CNY15tn - $2.3tn, 22% of 2015 GDP and 7.5% of banks' total assets - as the basis for the likely aggregate non-performing assets that the banking sector may suffer."

She then assumes a below average recovery rate of 30% (common approach in a stressed credit environment), to arrive at potential losses on NPLs of CNY10.5 trillion. At which point banks would deploy their loan loss reserves (CNY2.3 trillion at YE2015) leaving CNY8 trillion in losses. In comparison following the 1998 Asian Financial Crisis, China's debt-for-equity restructuring cost 25% of GDP at the time. To fund bank losses this time the PBOC will have to engage in large scale quantitative easing - much bigger than what was attempted in the US after 2008. This would lead to higher domestic interest rates or higher currency devaluation risk, if bond supply is absorbed through the PBOC. Using FX reserves would eliminate potential to prevent renminbi depreciation in the future and would reduce the value of domestic savings, which would be a difficult pill for Chinese savers to swallow and would induce additional pressure on capital outflow. This will imply greater currency flexibility as a consequence. She concludes by answering the question of whether China should approach restructuring hastily or in a gradual manner. A fast move will ensure that China endures large scale defaults and a massive drop in output, a currency devaluation and capital outflow. She feels that a slow move (which is the approach at present) is showing restructuring efforts to be even slower than the formation of new NPLs. This will see the final deleveraging bill continue to grow to the point that restructuring becomes impossible. With $35 trillion in bank assets at present and with the addition of nearly $3 trillion in assets a year, a slow approach risks Japanese like long-term stagnation and the ruination of the country's economic potential.

The Mainstream View…

The mainstream view on China's NPL situation is best summed by Tao Wang, Head of China Research at UBS. She feels that the issue is manageable as China has ample control over liquidity (unlike Western systems during GFC) in the system through a high savings rate and under developed financial markets. Under state control the SOE's and large banks can ensure slow NPL loss recognition with parties renegotiating and restructuring through government recapitalization. This view is supported by analysts at Macquarie and many other institutional analysts in China, Hong Kong and Singapore. However, this thought process might not take account of the size of NPLs within the system and the rising use of financial engineering in the shadow banking system to cover-up losses (more below).

The Credit Agency View…

In January 2016, Standard & Poor's released a report titled, "China's Banks Face Rising Risks from A Slowing Economy and Government Policy". The report asserts that the ingredients for a credit downturn in China's banking sector are coming together.

"Deterioration in banks' asset quality is likely to accelerate in 2016. Credit distress has been spreading from a few segments that private companies dominate - such as wholesale and retail trade, export-oriented light industry, shipbuilding, and coal mining-to broad-based manufacturing industries where large firms are common."

The analysts see the government shifting towards a trial and error approach to policy execution that will be marked by a material increase in tolerance for corporate credit defaults. They expect NPLs to reach 3% by the year-end up from 2.2% at YE2015. As a result, credit losses could jump to 1.5-1.6% in 2016 from 1.1-1.2% in 2015 and 0.8-0.9% in 2014.

The IMF's View…

The IMF's approach in its April 2016 Financial Stability Report took a much more optimistic (and telescopic) view of China credit problems. It focused on loans potentially at risk in the corporate sector as opposed to NPLs in the banking sector itself. NPLs trigger accounting recognition and are usually contingent on non-payment of interest or principal over a predetermined time. This methodology (interest coverage ratio below one) results in total commercial bank loans to the corporate sector of $1.3 trillion. The report assumes a 60% loss ratio to reach potential bank losses of $756 billion (7% of GDP). While, using a lower loss ratio of 45% (Basel II norm for defaulted loans) shows potential losses of $567 billion, or 5% of GDP.

What Might Actually be Happening…

Much of the confusion in understanding China's banking system comes from how the flow of credit through the system is reported. The Financial Times produced a total debt estimate of $25 trillion, or 237% of GDP, in March 2016, using PBOC data on Total Social Financing, adding Ministry of Finance and National Audit Office data on central and local government debt and using the Wind Information database to account for recently issued loans. The FT's methodology is similar to information from the Bank for International Settlements database released in September 2015. Mckinsey's report in mid-2014 placed China's debt at 282% of GDP (including debt owned by financial institutions). This showed China's debt growing more than 4x fold since 2007. It also takes account of shadow-bank lending that isn't captured in TSF figures. Wigram Capital Advisors an institutional provider of Asian macro analysis to institutional investors estimated China's debt-to-GDP ratio at 280% at the end of 2015 based on an analysis of more than 100 bank financial statements. This analysis showed that Chinese banks are using wealth management products and trust beneficiary receipts as financial engineering tools - covering up NPLs and disclosing corporate loans as financial debt. These efforts are needed to overcome financial regulations that prevent Chinese banks from lending more than 75% of their deposits (accounted for them as non-consolidated assets and liabilities). WMPs are akin to a money market fund with a higher yield than a plain vanilla bank deposit. These come with an "implicit" guarantee from the issuing bank so that when they fail they are brought back onto the banks' balance sheet as a consolidated asset. In S&P's January Report, the analysts comment that:

A growing reliance on WMPs to manage regulatory capital ratios could undermine the banks' true capitalization, in our view, because a majority of these off-balance-sheet WMPs just serve as a handy funding tool rather than a channel to offload credit risks.

In comparison to WMPs, it is feared that Trust Beneficiary Receipts (TBRs) are being used to directly hide loan losses. These are essentially trust companies that allow for asset transfers, where the issuing bank retains the credit risk but accounts for the transaction as a TBR. This requires less capital to be set aside at origination and the fear is that when reported bank capital ratios are adjusted for this effect Core Tier 1 capital ratios could already be undercapitalized. Below is a chart from the Financial Times showing economists' estimates of adjusted broad credit supply.

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Where is the credit going?

The fulcrum of the feedback loop that China is in arises from the structure of how credit needs to flow into the Chinese economy. This arises from the massive accumulation of debt in China's SOEs which are heavily invested in overcapacity industries particularly in mining, steel and oil. Although the SOEs could undertake slow NPL loss recognition and the central government could continue to flood the economy with new loans when signs of cracks begin to appear, the vast majority of this "rolling-over" effort has to be focused on the SOE's. In economic terms continued investment in overcapacity leads to increasing debt inefficiency and increasingly more expensive debt. It's likely that the government was forced to increase investment in the overcapacity sectors to prevent GDP from collapsing completely in Q4 2015. Below is a chart from the FT showing estimates of these investment trends.

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Societe Generale's Wei Yao's view is that at least 25% of China's SOEs are consistently loss making, having the most debt of any sector (127% of GDP), the worst profitability (3.4% of GDP), and the worst ROA (<2%). Increasing the supply of credit into these sectors is necessary just to ensure that debt repayments are met. At present the fall off in consumption is reducing profits making debt repayments riskier. Below is a chart from Societe Generale showing this debt inefficiency.

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Conclusion

The worrying aspect of the arguments in favor of China being able to muddle through is that they are based on the premise that increasing investment in overcapacity doesn't aggravate overall levels of capacity. This is based on the belief that the Government by creating final demand will be able to work excess industrial inventory out of the system while overall investment and GDP growth are kept steady. This final demand is likely to be infrastructure projects that are being progressed even though there is no demand for their use. The argument then goes that these projects will eventually be used some time in the distant future when population growth creates enough consumption. This is a very intellectually shaky argument and the evidence at present is that private consumption has fallen dramatically. The core of the argument in favor of China is based on the belief that the centrally planned system can experience a mega economic boom along with a massive credit expansion without having to experience a western-style reflexive loss-cycle. If this indeed proves to be the case then surely every economy in the world should gravitate towards adopting China's system?

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.