Returning To Chinese Debt Concerns (Part I)

by: Christopher Balding

A New Year and another round of end of month Chinese liquidity concerns. Probably the most concerning aspect of the near monthly or at least quarterly money market and bond rate spikes is the regularity with which they are occurring. These are not one off events but indicators of enormous underlying problems in the Chinese financial markets.

While much of the concern over Chinese debt has focused on either over leveraged consumers buying inflated apartments or public debt, both of these focuses which flow from the 2008 financial crisis and the European experiment rather than considering the big picture of China. The Chinese National Audit Office released its anticipated report finding that public debt at all levels was reasonable and not excessive. The headline number reported of $3 trillion USD is large and has grown rapidly but still not excessive. (Though any public economic or financial number from the Chinese government should be deemed more public relations than fact for our purposes, let's assume the number is real.)

Focusing solely on the headline debt level number overlooks the real importance of the report and the accompanying big picture. First, while bank lending has remained quite constrained shadow financing channels and related liabilities have exploded. The Wall Street Journal sums up the problem noting that a "…major increase in funding came from arrangements by local governments to pay later for goods and services, effectively pushing the cost of financing projects onto developers and contractors." The net result is not a decrease in the total debt level but rather where the debt is counted, in this case private rather than public debt.

In another example of reshuffling the deck chairs the WSJ notes that the biggest increase "…was (from) state owned enterprises, or 'wholly state-owned firms and state controlled firms ….accounting for 43.7% of new funds raised….SOE's didn't even make an appearance in the 2010 audit." In other words, debt and guarantees, implicit or explicit, by governments to cover corporate debt is exploding. This matters because the governments have an enormous incentive to move liabilities just far enough off the balance sheet to avoid detection or provide guarantees. Furthermore, the line between public and private is so blurred in China that studying simply the strictest definition of public debt fails to capture the true picture of the debt problem.

Second, though most of the focus has been on the public debt level, the number that should concern investors is the aggregate corporate debt level. China's second largest brokerage noted its concern over the rapidly rising corporate debt level saying it could trigger a financial crisis. Liabilities at non-financial corporations may exceed 150% of GDP in 2014 and already passed 139% of GDP at the end of 2012, the highest level of major economies. To put this level in perspective, France is at 108%, Japan at 103%, and the profligate US a relatively small 78% of GDP. Given the blurred line between public and private interest in China, even if the official public Chinese debt number is true, until a true division of public and private financial interest exists, the corporate debt level should concern any China watcher.

Third, overlapping interests between public and private are not the only cross guarantee concerns. In China it is very common for companies, governments or individuals to guarantee the debts of others. This creates a domino effect where one bad debt can create a cascade if the guarantors cannot cover the debt they co-signed. Given the explosion of trust company and shadow financing in the past few years, this is not an unrealistic concern. According to one report, "98% of companies" in the prosperous area of Wenzhou have cross guarantee loans. Though data on these types of guarantees does not exist nationwide, it is believed that this is a very common practice between a web of actors throughout the Chinese economy simply raising the risks in the case of default. According to one report, even public entities pay in excess of 10% to borrow from trust companies which accompany additional guarantors. Even in 2010 50% of local government financing vehicles were receiving payments from guarantors and outside parties to service the debt as revenue from project or public sources was unable to cover repayment. Domestic Chinese financing institutions are giving as clear a picture as possible about their perception of risk to the corporate and public sector.

While the headline number of public debt, if it is real which is a dubious proposition on so many levels, this should not bring relief. Public liabilities have exploded in the past few years, more expensive non-bank financing is the driver, and corporate debt levels which may or may not be a quasi-public debt are among the highest in the world create a worrying picture. Focus on the headline number of the Chinese economic public relations machine at your own peril.

Disclosure: I 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. I have no business relationship with any company whose stock is mentioned in this article.