Corporate Leverage

Curious how Abenomics is progressing six months after its announcement? These charts courtesy of Diapason should provide a convenient status update.

For the first time, a mainland Chinese company has defaulted on its bonds. SunTech Power Holdings has been clinging on by its teeth but after failing to repay $541mm of notes due on March 15th - and following four consecutive quarters of losses through the first quarter of 2012 and since then having failed to report quarterly earnings - owed to Chinese domestic lenders, the firm is restructuring. As Bloomberg reports, Chinese solar companies are struggling after taking on debt to expand supply, leading to a glut that forced down prices and squeezed profits - and most notably were unable to renegotiate its liabilities and obtain “additional flexibility” from creditors. This is highly unusual and perhaps is the beginning of a trend for Chinese firms. We already know the little discussed but gargantuan size of China's corporate bond market (which dwarves the US relative to GDP) as the mis-allocated credit tsunami of the last few years begins to hit its lending limit - just as Chinese corporate leverage is surging. If Suntech, the world’s largest solar-panel maker as recently as 2011, could not renegotiate its loans, we humbly suggest there are more problem firms out there about to find their friendly local banker a little less enthusiastic - just as Marc Faber warned recently.

In one sentence, during 2013, we expect imbalances to grow. These imbalances are the US fiscal and trade deficits, the fiscal deficits of the members of the European Monetary Union (EMU) and the unemployment rate of the EMU thanks to a stronger Euro. By now, it should be clear that the rally in equities is not the reflection of upcoming economic growth. Paraphrasing Shakespeare, economic growth "should be made of sterner stuff". Many analysts rightly focus on the political fragility of the framework. The uncertainty over the US debt ceiling negotiations and the fact that prices today do not reflect anything else but the probability of a bid or lack thereof by a central bank makes politics relevant. Should the European Central Bank finally engage in Open Monetary Transactions, the importance of politics would be fully visible. However, unemployment is 'the' fundamental underlying factor in this story and we do not think it will fall. In the long term, financial repression, including zero-interest rate policies, simply hurts investment demand and productivity.

The Chinese economy has been enjoying a cyclical rebound since the beginning of Q4 2012. SocGen's central scenario is that this recovery will last until early Q2 2013 and then gradually lose momentum. In the medium term, they still anticipate a bumpy path of secular deceleration, leading to an average growth rate of 6-7% over the next five to seven years, down from 10% per annum over the last three decades. This piece focuses on what is probably the most popular “what-if” question about the Chinese economy – what if China hard lands (with real GDP growth rate plummets to below 6%)? As China undergoes demographic ageing and growth of the working-age population slows, this minimum stable growth level will decline further. However, if progress in rebalancing and structural reform remains slow, the probability of a hard landing will rise over the medium term. In the tail risk scenario set out below, 2013 will see several quarters with just 3% growth and full year growth would stand at just 4.2%, but what are th triggers, how would it evolve, how would the government respond, and how bad could things get?

The question whether China will suffer a "hard" or "soft" landing is, in the long-term, largely irrelevant and misleading. A far more critical question is whether the period of 10%, or even 7% annual growth, for the world's biggest marginal growth dynamo of the past decade, is now over. Read on for the answer.

While Chinese government and consumer debt can be whatever China wants it to be (and when it isn't, any discharged and non-performing debt is merely masked over with more debt: China doesn't have $3 trillion in foreign reserves for nothing) corporate debt, in keeping with Western-style reporting requirements, is far more difficult to obfuscate and falsify in recent years. It is here that we get the first glimpse of the true sheer extent of the Chinese credit bubble, which as the chart below shows, is already the largest in the entire world.

Over the past months (and particularly in the last weeks), we have increasingly read negative comments on the ongoing zero-interest rate policy (ZIRP) and in some instances, negative-interest rate policy (NIRP). Today, we want to examine the origins of the idea that ultra-low rates of interest can exist, how this idea came about, why it was flawed and how it leads to an informal economic system. It was a fallacy based on misunderstanding of the rate of interest and human action. Another way of examining this is the following: The zero interest rate indicates that time is free. And as anything that is free is wasted, time will also be wasted. It should be clear that there is an inconsistency in simultaneously believing that investment demand and savings are mainly driven by income but that it is necessary to lower the interest rate to boost investment, as the Fed does... and the Fed is Keynesian! Finally, we note one last thing: As productivity, employment and production decrease, even a steady and low rate of inflation has the potential to morph into hyperinflation.

The reality is that the Fed is stuck in ZIRP and will never be able to leave it. In 2011, the US made $454 BILLION in interest payments. And that’s with interest rates at or near 0%. Things are only going to get worse. According to the Congressional Budget Office, the estimated interest that will be due on the US’s debt load by 2015 will be $533 billion: an amount equal to 1/3 of all federal income taxes collected that year (assuming of course that the current GDP growth projections are accurate...)

While Zero Hedge already noted that fund flows into bond funds and out of equity funds have once again resumed (a fact that was barely mentioned if at all on CNBC, contrary to the day-long segment on fund flows dedicated to the first equity inflow after 33 weeks of outflows), digging through the actual composition of debt receiving inflows reveals some curious details. EPFR reports a very disturbing development, namely that in the last week, Floating Rate debt saw $859 million inflows which was the largest inflow by dollar amount in history. Implicitly what this means is that bankers are currently pitching another massive round of refi deal to companies (particularly those that are past the non-call window, which in 2011 would mean quite a few of them), one which seeks to replace fixed debt with floating, or debt based on a Libor floor and a fixed margin. And for thousands of corporate treasurers, at a time when the Fed is guaranteeing ZIRP for the next 3 years at least, this is a slam dunk decision: after all why pay even a modest fixed interest when one can part with a modest refi fee, and still pay a fraction of the current interest expense. To some this may seem familiar: after all this is precisely the last push in refis in the housing bubble when everyone was jumping into an adjustable rate mortgage, which had a floating rate in its first 5 or so years. Are we starting to see the Option ARM wave in corporate refinancings? And if so, is this the same top tick indicator in the credit market currently that it was in the housing bubble of 4 years ago? The answer: it all depends on how much longer Ben Bernanke can succeed in defying gravity and the rules of the free market, courtesy of his ponzified central-planning artificial economy. And just like with Paolo Pellegrini, the one who can time the flip properly will be able to retire shortly thereafter.

Using the Fed's Flow of Funds (Z.1) report allows readers to calculate overall corporate leverage: a quick and dirty proxy for a top down leverage analysis. Much in the same way that corporate leverage is derived, the Z.1 provides the data needed to calculate the ratio of net debt to LTM internal funds/adjusted after-tax profits.

Using the Fed's Flow of Funds (Z.1) report allows readers to calculate overall corporate leverage: a quick and dirty proxy for a top down leverage analysis. Much in the same way that corporate leverage is derived, the Z.1 provides the data needed to calculate the ratio of net debt to LTM internal funds/adjusted after-tax profits.