The Next Credit Crisis Will Originate in China

Throughout 2007, every quiver in the global stock markets has been blamed on increasing default rates in U.S. mortgages. The low-income, high-risk segment of the mortgage market we now know by its sanitzed euphemism “subprime” accounts for just about 10% of the U.S. mortgage market.

(That means that less than 1% of total mortgages are in subprime foreclosure. Keep this in mind for perspective, if you will…)

Those numbers might go a long way to explain the rough water in the markets that so unceremoniously wrecked my beautiful forecast of a 2007 year-end rally.

We've seen what miscalculating risk scenarios did to the balance sheets of the world's most powerful financial institutions. Their reflexive (if in all probability short-lived) tightening of credit certainly isn’t helping to move any excess real estate inventory that has built up.

The Credit Crash of 2009 is Building Up NOW!

If a few billion in shaky loans can trigger what the pundits now call a “global financial crisis,” I’d like to point out another bit of a crisis brewing that makes subprime look like the broadway version of Now I Pronounce You Chuck and Larry.

China Construction Bank, the Bank of China and the Industrial and Commercial Bank of China have launched mega-IPOs in the last couple of years. But after decades of rapid loan growth, they — along with other Chinese banks, state investment companies, credit co-operatives — are now sitting on record nonperforming loans (NPLs).

The Chinese NPL market is one of the largest in the world with a total outstanding principal balance of over a trillion dollars. That’s about 40% of China’s gross domestic product. Every now and then, the big credit rating agencies point out that China’s efforts to clean up the balance sheets of its big four banks have been slow. Worse, they have completely failed to eliminate financial risks for the lenders.

In 1999, China established four distressed debt companies to take loans off the books of the big four banks. Progress has been challenging, especially in the early years. In the past, Beijing has spent the equivalent of 25-30 per cent of GDP in previous bank bailouts.

Accounting firm Ernst & Young calls the main reason for why these bad loans were generated in the first place political. Much like Maryland, China is a one-party state. And that one party is still Mao's old Communist Party.

All in the Family

The Communist Party relies on the state-controlled banks to maintain an unreformed core of what at the core remains a command economy. And like anywhere else where one-party regimes have mixed business with running the country (Maryland!), waste, corruption and nepotism are running rampant. In the face of triumphant capitalism, the party uses perks and careers in government and state-owned enterprises to keep the party faithful in line.

That includes access to capital.

The party appoints about 80% of the chief executives in state-owned enterprises and 56% of all senior corporate executives, who are under pressure to hit fixed growth targets quickly no matter how. The World Bank estimates that about one-third of fixed investments made in the 1990s were wasted.

Politically directed lending accounted for 60% of loans in 2000-2001. And in a 2002 survey, over 80% of polled bank employees said corruption in their branches was either prevalent or took place quite often.

New loan growth has been running at 15%. A healthy supply of nonperforming loans continues to be generated due to the sheer growth in total loan volume. At least 2% of loans made since 2000 have been reported as nonperforming. The proportion was as high as 60% for older lending. And a substantial portion of the loans that went out were issued to keep bad loans floating.

China’s banks could soon face a fresh wave of nonperforming loans arising from the rapid expansion of lending in 2003 and the first half of 2004.

Structural Problem

China’s bad debt issue is a structural problem that Beijing seems ill-equipped to deal with. Japan, whose banks had built up a similar problem in the 1980s, was punished with more than a decade of economic stagnation. I believe we will be seeing the first cracks to appear in the system when the Chinese real estate bubble begins to deflate about three months after the conclusion of the Beijing Olympics.

If you think subprime was bad, you ain’t seen nothing yet!

So far, there is no indication that this is of concern to anyone — or at least of less concern than new U.S. government debt is to the dawn chorus of doomsday prophets that constitute the financial punditry. Both cases in a way illustrate how valid Benjamin Franklin's observation still is that "The sound of your hammer at five in the morning or nine at night heard by a creditor makes him easy six months longer."

In growing economies, even bad debt is good debt. Economic growth in China is coming in at over 11%. And since Wall Street and Europe started their subprime shake-and-bake in July, the Shanghai stock exchange quietly packed on another 1,000 points, doubling its worth over September 2006, before dropping back into the 5,000 range in early December.

Soaking up Liquidity

Apparently, China investors — and Chinese investors — are not buying into the assumption that low-income loan foreclosures in the in Springfield is anywhere close to putting a dent into the consumption habits of their largest and most important export market. By floating state-owned companies in Shanghai, Shenzhen, and now Hong Kong, Beijing has managed to soak up unheard of amounts of liquidity within the system. This partly supplements its endeavors to curb inflation (in addition to the three interest rate hikes so far this year.)

It also had the additional benefit of converting passive savings into active capital, reducing the need for further credit — and redistributing existing debt (including bad debt) from banks to shareholders. It's what's meant by the democratization of capital… and the spread of risk.

The Last Bull Run

Of course, this method of risk management is not without a hefty price on the national economy. In Shanghai alone, retail investors have pulled between $2 and $4 billion in savings out of savings each month, converting them into at-risk stock market capital. For the time being, there seems to be no impediment to a further expansion both of the Chinese economy and the Chinese stock markets — especially in view of the Beijing Olympics less than 8 months from now.

Much like Japan in 1964 and Seoul in 1988, Beijing considers this its coming out party as an economic and military superpower. China is spending around $40 billion on its Olympics — building stadiums, airports, expressways, rail links, and infrastructure. That is a smaller percentage of GDP that both Japan and South Korea devoted to their respective Olympics — at least as far as the direct costs are concerned.

While China may not be actively propping up economic growth in a targeted fashion until the Olympics are over, the direct cost reported may just be a small part of the actual bill, given the nature of the centralist and political management of Beijing's affairs. Beijing will make sure that its still centralist economy runs smoothly throughout the Olympics, providing a continued a boost to A shares and H shares throughout next year.

After record numbers of IPOS in the last two years, there will be a pre-Olympics mini-boom in state-controlled companies going public. If South Korean stocks in 1988 are any guide, this post-Olympic boost could push Shanghai up another 50% — on top of a potential doubling of the index between now and the lighting of the Olympic fire next year. Japan's GDP growth almost halved from 11.2% in 1964 to 5.7% in 1965.

Cooling down of economic growth maybe just what Beijing is after. But it also would have a dampening effect on new institutional and retail investment in the Chinese markets — making an A share crash quite more likely after the Olympics. What makes the prospects of an A-share crash so daunting is not necessarily the effect on the small investor. But state-owned companies are at the forefront of punting in the markets… more often than not with money borrowed from the big four Chinese banks.

Comments

[J.D]

I'd be interested in knowing which of China's 600 000+ SOEs the senior executive is NOT appointed by the party. I'm surprised it's not 100%. It doesn't really matter though given the other controls available.

As President Hu reminds us, State Owned Enterprises will remain the dominant force in China's socialist market economy (and the largest of them grew by 21% by assets in 07). That includes State-owned banks so systemic issues will certainly one day return in force. The urge for market-based reform has waned.

But a credit crisis? NPL issues in China have been managed by loan expansion and government bailouts and in the case of a slowing economy, the cycle would just repeat. It's not credit if you're not really expected to pay it back, so there can't be a real credit crisis in China.

[p2pvoice]

Great but scary insight. The following in the article may be an oversight:

"The Chinese NPL market is one of the largest in the world with a total outstanding principal balance of over a trillion dollars."

You probably don't mean "NPL"?

I would be more scared if it was.

[Ehp246]

You said it yourself, those NPLs are not economical but political. So whether they are performing or not should be judged accordingly. Then a different conclusion will arrive.

[H.W.]

haha, i hope that this is not another kind of retaliation or negative propaganda?! or like after ADB or World Bank disclosed reports sometime in latter 2007 about China's 40% discounted "economic might" !!
all these write-ups will be valued substantially given objective data from "unprejudiced and professional entities". we will be more than glad to scrutinize into all these potential NPLs and its insolvency ratio from "long time" loan releases....

[huangjin]

China has the capital to pay off their NPLs—all those Treasuries they hold. The victim of a credit crisis will be the Chinese yuan.

[droskoph]

Say it isn't so. China can't fold - they're underwriting our bad debt with their "Hail Mary" soverign funds. Wait till they lubricate the Yuan printing press.

[Huangthomas]

China has public debt of only 12.5% of GDP. State-owned banks are being used as Treasury. All infrastructure construction & other none-productive investment have been supported by bank loans with clear understanding that they will not be paid back. They are not NPL, but rather are public debt. China has a track record of paying off public debt with foreign currency reserve (~$1.4 trilion) in the Central Bank.

[nick gogerty]

an interesting point to note is that china has recently raised tier one bank capital requirements to 16%. this has the dual effect of reducing asset price inflation and shoring up the banks. It probably isn't enough for such a flawed system, but is a start.

[H.W.]

May i ask how do we define credit crunch? What the US credit crunch is experiencing now is not only the subprime mortgage defaults which are measured by only about 1% of all mortages, but worse, the financial innovation, the financial engineering this has created by chopping and packaging into CDOs, SIVs, ABCPs, and maybe more others to be discovered in the months to go.
Do you think China's "limited" potential "NPL"s or "public debts" were capable of expanding into financial innovations like what the US has created to form a crunch like the US financial did?
Public debts are covered by China's vast reserves from surpluses, not to mention, with pegged collaterals. The net losses will be covered, provided that there are no ABCP's, SIV's or CDO's Chinese banks had ventured into, when the giant was still hibernating!

[Siwei Zhong]

First of all I do agree and believe the NPL issue with the banks (including the 3 listed in Hong Kong) is not fully solved yet. And yes they have been enlarging the denominator of the NPL formula (NP/Total Loan) to lower the NPL ratio.

However ,

1) chinese leaders are not stupid, they know better than anyone else what they are doing. You think they don't know about the NPL with those banks?

2) if you agree that chinese leaders are smart, do you think they will destroy what they have achieved painfully in cleaning up the books and list the 3 major banks (Agricultural Bank of China is still not listed yet, because it's almost an impossible job to clean up the book. Farmers in China are miserable and there is simply no way for them to repay the 'debt')

3) if you look at China as a whole rather than just pinpointing the NPL with banks, do you think China is unable to solve the NPL issue if you look at the trade surplus which is growing month by month?

4) agree with what H.W. said. The subprime in US is not about the 1% of foreclosure, the acutal effect has been drastically multiplied by those creative financial vehicles CDO and the like.

5) Singapore is also a '1-party' environment, but I have to say they have done an excellent job in the past 40 years.

[William Place]

When the Wall street bankers are selling apples on fifth avenue and the analysts are sweeping the streets do you suppose the out of business American middle class will still be buying Chinese poison products? Not likely. The economic meltdown will be swift and planetary, it has happened before and is in process again as we discuss the minutia of the possibilities of financial redemption. We are in serious trouble, folks, and we need some new ideas posthaste!

[WAKEUP]

Greed is global. China is going to lose its ass, same as us. Nothing's going to stop an austere 10 years from camping out on top of us; not this rhetoric, nor any other.

[Jack in Maryland]

Big question:

Some others have said, similar to comments here, that most of the non-performing loans at Chinese banks are cases where one Chinese State entity owes money to another, which can therefore be resolved with the stroke of a pen in a totalitarian society. And that hence, the apparent liability is eminently fixable.

Or will actual money have to be used to clear the balance sheet, the way it will IF the US government honors its Social Security commitments?

[Jack in Maryland]

Big question:

Some others have said, similar to comments here, that most of the non-performing loans at Chinese banks are cases where one Chinese State entity owes money to another, which can therefore be resolved with the stroke of a pen in a totalitarian society. And that hence, the apparent liability is eminently fixable.

Or will actual money have to be used to clear the balance sheet, the way it will IF the US government honors its Social Security commitments?

[Philly Jim]

It's about time someone wrote about Asian Non Performing Loans. These are representative of how many Asians perceive credit - as free money they don't have to pay back.

The property boom that started in America and moved East and the same bust that hit America and is moving East is about to find its end and in Asia is where it will be! The biggest bust.

[iman]

China has something that that the US doesnt have, manufacturing, productivity and personal savings. The Chinese will soon realise that they dont need to keep taking on our debt and sending us thier products. The dollar is falling soon they'll decouple the yuan from the dollar and start consuming the goods they produce themselves. How long do you think they'll keep sending goods to a country that just sends back empty container ships and debt?

[perfuseme]

ok..so i think the ultimate question here has not been asked. how do we make the most money off this, and when is the time to be shorting china. i have always thought china bubble would pop after the olympics. it makes plenty of sense to me.

[calvino]

It's so easy - found money. I can not believe how easy you made this game. I am going to buy Chinese stocks now - and I am going to sell them right after the olympics! I just want you to do me a favor, if you don't mind. Don't tell anyone else about this secret knowledge. WE son't want to crownd the trade now and lose some of our profits> I want all the profits for myself. Thanks for your unusual insight!

[amdinvestor]

The negative effects of a Chinese crash will naturally have a direct effect on American stocks. Already sentiment is low due to the chance , no whisper, of a recession here. However perhaps this is a good time to stock up on cash, and pick up some bargains, post olympics.

Dan

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My Blog:

amdinvestor.com

[tessant]

i have a bunch of info on my social network dedicated to growth stocks/tech/china...think of it as facebook meets yahoo finance...feel free to take a look, dload some equity reports, chat. etc..i am not looking for $$ or personal info, just somewhere to get and exchange good ideas.

growthportfolio.ning.com /

thanks guys

scott