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

Home grown credit risks look to come back home to roost. I am actually
shocked the following development didn't get more traction in the mains
stream 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".

Additional and relevant commentary on the bubble in China:

1. It

   Doesn't Take a Genius to Figure Out How This Will End

2. Can

   China Control the “Side-Effects” of its Stimulus-Led Growth? Let's Look
   at the Facts

3. HSBC

   is Performing as Expected

4. Part

   2 of the Mechel Overview is Available

5. Some

   Light Shown on My Developing China Thesis

6. Follow

   Up to the China Short Thesis Debate

7. China's

   Most Expensive Export: Price Inflation

8. Believe

   Those China Growth Stories at Your Own Risk - Just Ask Google!

9. He

   Who Bloweth the Bubble With Wet Lips Should Stand Back Lest Spittle and
   Saliva Spray Upon Ye Face

10. Goldman

    Seems to Trust the Chinese Economic Reporting a Tad Bit More Than I Do!

11. All

    of my warnings about China are starting to look rather prescient

12. Now

    that the world is forced to agree with Reggie on China's growth
    propsects...

Comments

[Great Depressio...]

When China, Japan and EU go bust who will buy US treasuries. Uh oh.

[Anonymous]

I think shorting the Chinese market is a capital offense which they can execute you for.

[bingaling]

Hey Reggie great article , I was looking for more info on this . How do you go about shorting China though ,wouldn't they be the first to close the door to negative outside influences affecting their markets , or even the inside influences if bets started paying off ? 

[Anonymous]

There are two basic types of loads made in China, one to private enterprises and one public enterprises. In the case of the private enterprises it is very difficult to get so most loans are made in kind rather than actual money, ie leasing. In the case of the public enterprises the loans are made but only paid out annually as required, if the targets are not met the taps are turned down or switched off. In the case of the public enterprises it is important to understand why the are public; mostly they are monopolies and such are unlikely to fail, more likely would be a change of management.

[Reggie Middleton]

What is your opinion on 100%+ debt to revenue ratios and insolvencies? An entity does not have to go bust to be insolvent.

[Anonymous]

Solvency is relative and ratios are not important in the China business model. 30 years ago in China everyone had nothing. China is a family business, important debts are internal as are assets, wealth is kept in the family though export controls.

If a business is insolvent it is either because it is bad business and you stop doing that business, or through bad management in which case you change the management.

Whereas the system we use is a pressure cooker that blows up in our faces every so often doing with deadly force, the Chinese system is one of a stir fry which is constantly sizzling, hot yet quickly cooled simply by tossing it up a little.