Is China Due For Its Version Of A Subprime Crisis?

by: Darrel Whitten
  • Global investors have backed away from the precipice of cataclysmic scenarios about Euroland by statements from Euro officials that they get it and promise to do something about it soon. Euro officials have bought some time, but forced bank recapitalizations will not solve the root problem, which is steadily deteriorating sovereign debt.
  • While keeping a wary eye on Euroland, investor concern is shifting to China, on growing signs the USD600 billion China pumped into its economy after the global financial crisis caused a massive credit bubble now on the verge of imploding. Analysts closest to the ground in China tend toward the soft landing scenario, whereas China bears see a repeat of Japan’s and the U.S.’s property bubble aftermath. The sheer size of China’s excess credit bubble makes Japan’s bubble look mild in comparison.
  • Leaders in Beijing hope to deflate the bubble without popping it, but history is against them, i.e., no country has been able to deflate a true bubble without triggering a stock and property market crash that creates a huge overhang of bad debt. China’s manufacturing PMI recovery already peaked in 2009, and the Shanghai Composite remains in a bear market, still trading 60% below its 2007 peak and 31% below a July 2009 rebound peak.
  • The prospect of declining China demand, the dominant factor in global demand, is fueling sell-offs in copper, zinc and other basic commodities, while stock piling of key commodities used as collateral for further property speculation could cause a significant negative overshoot should China’s property bubble implode.
  • For Japan’s once-hot China related stocks, China exposure is now seen as a risk factor, with representative stocks like Komatsu (OTCPK:KMTUY) plunging 45% from a May 2011 high. Japan’s exports to China YTD have been oscillating between year-over-year declines and low, one-digit growth compared with 20%~40% growth rates in 2010, thereby removing a major driver of export growth and a very welcome source of earnings for related companies.
  • For the time being, both Euro- and China-exposed Japanese exporters remain susceptible to foreign selling pressure, while Japanese consumer staples companies with growing Asia exposure will offer some haven. The turning point for China stocks is contingent on the Chinese government shifting from its currently tight monetary policy.

Soft or Hard Landing for China?

As investor perception of the Euro crisis has at least temporarily shifted from “all is lost” to “hope for progress,” at least until the October 23 EU Debt Crisis Summit, investor attention has turned to China.

To counter the shock of the 2008 global financial crisis, China was quick to announce a nearly USD600 billion stimulus package, and city planners across the country rushed headlong into a frenzy of infrastructure projects. This excess investment-led infrastructure boom helped insurlate China’s economy from a collapse in exports. In 2009, China’s lending institutions lent a record high USD$1.4 trillion (equal to the U.S. annual deficit), with most of this going for infrastructure projects and property development. Domestic investment -- much of it in property and infrastructure development -- accounted for 70% of China's gross domestic product in 2010, a far bigger share than in developed economies.

For experienced China-watchers like GaveKal in Hong Kong, China is in for a soft landing, but global investors are becoming increasingly concerned about growing signs that the government’s efforts to reign in speculation have already burst an excess credit bubble. According to the McKinsey Global Institute, the proportion of China's total debt to gross domestic product was 159% at the end of 2008, even before it began the massive stimulus program that racked up piles of local government debt.

The IMF estimates the stimulus-instigated loan spree raised credit from 100% to almost 200% of China’s GDP, including off-books trusts, letters of credit and sub-radar loans from Hong Kong. The 30% annual pace of loan growth is unprecedented in any major country in modern history. It is double the pace of America's housing boom and Japan's Nikkei bubble in the late 1980s, and may match US loan growth in the late 1920s, according to the Telegraph’s Evans-Prichard. By comparison, a study by Fitch Ratings found that credit in America rose by just 42% of GDP in the five-year period before the housing bubble popped, and rose by 45% of GDP in Japan from before the Nikkei cracked in 1990, while it rose to 47% before the Korean crisis in 1998.

The lesson from other such excess credit bubbles in history is that such bubbles are impossible to deflate in an orderly manner and inevitably end in crashing stock and property prices that leave mountains of unpaid debt. The modern (Keynesian) solution for such crashes is an effective transfer of irrecoverable debt in the corporate and private sector onto the books of the government through deficit spending and an equally large increase in government debt—as is seen in the sharp deterioration in government finances in Euroland, the U.S. and Japan. Further, once this government debt reaches 80%~90% of GDP, it begins to choke off economic growth. Thus Barclays Capital has predicted the next global recession would trigger a "hard landing" in China, with gross domestic product sinking well below the 8% mark seen as the minimum for assuring enough job creation to keep up with urban migration and preventing social unrest. China bears like Kynikos Associates’ Jim Chanos see an incipient property bust, the scale of which could make Japan’s infamous stock and property market bust from 1990 look relatively mild.

There are already obvious signs of strains from non-performing loans and excess debt even before the next global recession has arrived. Evans-Pritchard of the Telegraph is reporting that government bail-outs are coming fast and furious. In the past week, the government has stepped in to prop up the banks, rescue an insolvent railway system, and rescue near bankrupt Wenzhou city.

Shoring Up Bank Capital

The state investment fund Central Huijin is buying stakes in China's four top banks to restore confidence and halt the slide in share prices. The investment fund bought shares in Industrial & Commercial Bank of China (1398.HK), Agricultural Bank of China (1288.HK), Bank of China (OTCPK:CICHY), and China Construction Bank (OTCPK:BACHY). Huijin said it would buy more shares over the next 12 months. This despite an apparently adequate bad loan coverage ratio in the banking system at the end of 2010, of 218% to cover any losses, up from 80% at the end of 2008 and 155% percent at the end of 2009. China bank analysts also claim that the loans-to-deposit (LTD) ratio (derived by dividing gross loans by total deposits) of Chinese banks is above 60%, indicating the banks are sitting on a pile of cash, which should be enough to cover future loan losses.

GaveKal points out that China over the past 12 years has transferred USD862 billion in bad loans to state-run asset management companies in repeated bailouts of the banks, and claims such bailouts make sense from a macro-perspective at this stage of China's development, where the growth rate is high enough to "amortize" bank losses over time, whereas the costs of allowing a financial crisis would likely be higher. UBS AG’s Hong Kong-based economists believes the worst of the "panic and hysteria" over informal lending in China may be over as the city of Wenzhou works with businesses and the central government to stabilize credit.

Just like the US, China has too-big-to-fail banks, with five banks accounting for 50% of the lending in China. In a July 2011 report, Moody’s cautioned that the non-performing loans on the balance sheets of Chinese banks could rise to between 8% and 12%, versus the 1% proclaimed by Chinese officials, which equates to 65%~100% of these banks’ equity.

Bailout of the Railway System

China's finance ministry is quietly intervening to underwrite China's railway system. This behemoth is drowning with USD307 billion of debts (about 5% of China’s GDP) after breakneck expansion, is in arrears on USD25bn of debts to its two largest suppliers and has run out of money to pay workers on the Lanzhou-Chonqing rail project. In a signal that Beijing will stand behind the system, the finance ministry offered a 50% tax break on railway debt auctioned last week in an attempt to lure back investors following the high-speed rail crash in July, even though there is no concern of default because the state-owned railway is backed by the financial resources of the central government.

Can Beijing Bail Out All Heavily Leveraged Local Governments?

At the end of 2010, local governments in China had amassed USD1.7 trillion in debt, and the government expects up USD470 billion (up to 30%) of that will turn sour, while Standard and Chartered reckons as much as USD1.2~USD1.4 trillion (over 80%) will not be repaid. A Business Insider article claims that estimates leaked by Chinese bank regulators suggest that 23% of loans to local government-sponsored infrastructure projects are an outright loss, with another 50% at risk of cash default. That makes the potential debt defaults from local governments in China larger than the whole $700 billion U.S. bail-out program during the 2008 crisis. China's National Audit Office estimates that nearly 25% of the USD1.7 trillion in local debt will expire by year-end, followed by about 17% next year and about 11% in 2013.

Last week, Bejing was negotiating a $15bn bail-out for the enterprise hub of Wenzhou south of Shanghai, where a panic set off a credit crunch for small business and builders. Reuters reported in mid-2011 the Chinese government was working on a relief plan for local governments, including allowing them to tap the municipal bond market for the first time as an alternative to bank loans, which are becoming harder to get.

While Wenzhou is small enough to contain, it may be an early warning of toxic debts in countless other cities. Roughly 60% of the region's loans come from non-bank lending beyond control, some of it Ponzi finance. Reuters is also reporting that nearly 85% of local government finance vehicle loans in northeast Liaoning province missed debt service payments in 2010. The mind-set of local officials is that, "What we do is all decided by the government. We don't have any project that belongs to us," "We are like a sportsman, not a coach or a referee. How can you ask a sportsman something only known by a coach or a referee?" After building the roads, railways and bridges that China said were so desperately needed just a few years ago, the local officials running financing vehicles now resent being made scapegoats for the so-called mounting risk in the financial system.

Local governments in China have long had to tap other sources of income such as raise money by selling or taxing property or borrowing money to supplement their meager share of the country's taxes. Beijing controls the bulk of tax revenues to prevent local officials from spending wastefully, and as a way of redistributing wealth between poor and rich provinces. Since local governments are barred from borrowing directly from banks as government entities, there has been a proliferation of local government-run property developments financing vehicles. Thus local officials have a strong interest in keeping property prices high as a key source of revenue despite Bejing’s efforts to reign in a property bubble. Reuters quotes China Real Estate Information Corp. as estimating 40% percent of local government revenue came from land sales in 2010, and land also is often used as collateral backing the loans to their financing vehicles.

In Chengdu, city officials borrowed some USD474 million to build a railway hub modeled after London’s Waterloo station, only much bigger. Their plan for generating revenue to pay for the station is more real estate development in the form of large residential and commercial projects around such stations, again financed with borrowed money through many of China’s 10,000 local government financing vehicles.

Wuhan, capital of central Hubei province, has been feverishly building bridges, railways and expressways. Wuhan Urban Construction Investment and Development Co., the vehicle set up to finance much of this infrastructure, had taken out USD10.7 billion in bank loans as of September 2010, a sum far in excess of its operating cash flow of USD23 million. The city is also expanding its subway system by adding another 215 km of track by 2017, with financing coming from big state-owned banks. Here again, Wuhan is counting on land sales to secure the loans. Its land authority says land prices for high-end residential property have more than doubled since 2004, despite a proliferation of housing developments. Wuhan Urban Construction Investment and Development is the largest government financing vehicle in the city, employing 16,000 workers and sitting atop total assets of USD19 billion. Credit Suisse has called Wuhan one of China's "top 10 cities to avoid," warning in a report this year it would take eight years to sell off its existing housing stock, let alone the tens of thousands under construction.

Shadow Banking Suits Everyone's Political Needs?

Having trouble getting loans for projects to keep the local economy humming, boosting local employment and growth, and therefore enhancing one’s standing in the Communist Party? Not to worry. Enter the "shadow bankers." These underground lenders and trust companies extend credit to people and companies that may not qualify for loans otherwise. They then slice and dice those loans into investment packages, similar to what American banks did with subprime mortgages for much of the past decade.

Credit Suisse describes the burgeoning growth of informal lending as a “time bomb” that posed a bigger risk to China’s economy than even the local government debt. The Swiss bank estimates the size of China’s informal lending at USD627 billion, or some 8% of formal bank lending. Interest rates on these loans runs are juicy, running as high as 70% and are expanding about 50% year over year.

Shadow bankers have lent USD33 billion to real estate developers so far in 2011, nearly as much as formal bank lending. Thus even healthy developers could become vulnerable to a liquidity crisis, given the short tenor and high rates of these loans. In addition, formal banks have transferred some risky loans off their balance sheets to the shadow banking industry. Consequently, Fitch Ratings warns that lending has not slowed as much as official data suggests -- or as much as Beijing would like. Official banks have also been restructuring and reclassifying loans to dress up their books. For example, they can now classify local government borrowings as corporate loans, which allows them to set aside less in provisions and thus add to their quarterly earnings. Chinese banks reportedly plan to reclassify some USD439 billion Yuan worth of loans. Unlike the late 1990s when the government forced the banks to admit to a huge amount of non-performing loans, the strategy this time apparently is “just not admit to NPLs."

Politically, this arrangement apparently suits everyone. Beijing wants to keep the financial system from becoming destabilized, particularly given the financial crises in the West, and local officials are keen to keep growth strong in the run-up to a critical Communist Party Congress next fall, when Party chief and President Hu Jintao is expected to hand power to younger leaders headed by the anointed next leader, Xi Jinping.

This notwithstanding, China's central bank has deliberately sought to prick the bubble with a variety of loans curbs, and is cracking down on the "shadow banking system", aiming to choke off $150bn in credit by March 2012. As a result, housing prices are beginning to fall across the country from September, according to China Index Academy. IMF data show that the price to income ratio for housing is 20 in Beijing, and 14 in Shanghai and Huangzhou, triple the levels in US cities during the subprime bubble. The head of China's International Finance Forum calls the central bank’s tightening policy and defaults “our version of subprime”.

GaveKal's Benign Soft Landing Scenario

Yet Hong Kong-based GaveKal is convinced there will be no hard landing in China, i.e., where growth falls below 8%. It believes the easing on the property and financial sector will come only gradually, and that companies in other sectors, such as consumer goods, will have an easier time of it in the next year. In the worst-case scenario, the financial, property and railway sectors may ultimately be defensive, because of beaten-down valuations and government support. In case of serious downturn in the Chinese economy, these sectors are ironically also the sectors that Beijing would feel the need to support aggressively—because they have broad economic reach, and add to China's long-term structural growth story.

Can China Handle All of This Debt?

While many investors closest to the ground in China are confident that the Chinese government will not hesitate to bail out debt laden local governments and systemically important financial institutions as well as government entities, the Chinese government’s contingent liabilities by some estimates were already well over 150% of GDP in 2010, and global investors fear that an economic slowdown could expose huge hidden liabilities.

However, mitigating this mountain of debt is very high economic growth potential by developed nation standards, fact that China, like Japan, doesn’t need foreign creditors to fund its debt, and the world’s largest hoard of forex reserves, at over USD3 trillion. Consequently, China, like Japan could tolerate much higher debt/GDP ratios for longer than the U.S. or Euroland could. A growing debt burden will however act as an increasing drag on China’s growth potential, and thus foreign investor expectations for a significant slowing in China’s GDP growth in the coming years.

(click charts to enlarge)

Best Hope for China Stocks is Slowing Inflation

Despite the massive fiscal stimulus, China’s Shanghai Composite was already peaking in July-August 2009, or two years ahead the S&P 500 (NYSEARCA:SPY) rebound peak, and despite the risk-on, risk-off gyrations in the U.S. and other developed markets, continued to consolidate through the U.S. Fed’s QE2 as the Chinese government continued tightening monetary policy and reigning in credit. Like equity markets in Euroland, the U.S. and Japan, Chinese bank stocks have taken the hardest pounding, with the MSCI China Financials Index losing more than 43% of its value over the past year, and half of that loss coming in the past 30 days...which is
actually worse than the benchmark bank gauges for Europe, the United States, Japan, and other emerging markets.

On the surface, China's economy is still going strong. While Q3 2011 GDP growth was the slowest since 2009 at 9.1% year over year, the U.S., Euroland and Japan would kill for such growth. Industrial production in September was still perking along at over 13% year over year, fixed asset investment was up over 24% in the first nine months and retail sales are growing at 17%+ year over year. The biggest risk to China's high growth are a property slump and slowing export growth, as China's biggest export market is Europe. High inflation is another reason the Chinese government is still in a tightening mode. If inflation, as some expect, does fall to 4% by December and money supply growth continues to slow (September's growth was the slowest in a decade), the Chinese government will have room to ease, and this would be the first sign of a turning point in China stocks.

But Japanese company stocks are being hit on signs of slowing China demand, such as demand for construction equipment, where excavator sales in August were down 11% YoY for the fourth consecutive month. China accounts for more than half of global demand for construction equipment, and debt-ridden China Railway Group Ltd., is also the nation's biggest construction company. China’s automobile industry, which overtook the US in 2010 with sales of 18 million autos, has experienced a dramatic slowdown, with growth of only 3% through June versus 32% growth last year. For all of 2011, the China Association of Automobile Manufacturers expects sales to decline versus 2010. Global investors are not optimistic. A quarterly Bloomberg Global Poll of global investors and traders revealed that 59% believed China's econom could slow to less than 5% by 2016, with 12% seeing such a slowdown within a year, and 47% believing it would occur in two to five years.

Further, while China consumes more steel, iron ore, cement and basic materials per capita than any industrial nation in history, some believe it’s all going to railways that will never make money, roads that no one drives on and cities that no one lives in, as well as some speculative hoarding. If this is true, commodities markets may be in for a secular slowdown in demand if the China bubble pops. China Non-Ferrous Metals Industry Association disclosed that Chinese copper inventories stood at 1.9 million tons at the end of 2010, more than the US consumes in a year. The estimate is significantly higher than the 1.0m-1.5m tons range that foreign executives had assumed in the past. There are also persistent reports that Chinese entrepreneurs and state enterprises were financing copper stockpiles and then using the copper as security to fund their real estate speculation.

As property prices fall, entrepreneurs who funded real estate speculation via copper stocks will be in dire straits if both property prices and copper prices fall, despite recent reports that China buying is again supporting copper as well as zinc prices.

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