China To Kick Bad Debt Hornets Nest

The last (and first) time China's National Audit Office conducted an audit of local government debt two years ago, in June 2011, it found that local governments and their various financing vehicles had taken on 10.7 trillion yuan of debt as at the end of 2010, which brought the issue of "underreported" high leverage in China to the fore. In the then words of Liu Jiayi, the country’s auditor-general, "some local government financing platforms’ management is irregular, and their profitability and ability to pay their debt is quite weak."

Others quickly chimed in: UBS estimated that local government debt could be 30 percent of gross domestic product and may generate around 2 to 3 trillion yuan of non-performing loans. Credit Suisse economist Tao Dong said it was the biggest "time bomb" for China’s economy. This was the most explicit warning about a credit bubble in China both internally and from "credible" outsiders (not fringe blogs and "conflicted" short-sellers) that had be uttered to date. It certainly wouldn't be the last as the recent aggressive attempts at deleveraging and reform in the financial system have shown.

Overnight, nearly two years after the first such audit, China announced it is conducting a follow up nationwide inquiry into government borrowings, "as the nation’s growth slowdown puts pressure on the new leadership to determine the extent of potential bad debts weighing down the economy."

So why now? Bloomberg has some suggestions:

The State Council, under Premier Li Keqiang, requested the National Audit Office to conduct a review, according to today’s statement from the audit office’s website, without providing any more details. The first audit of local government debt found liabilities of 10.7 trillion yuan ($1.8 trillion) at the end of 2010, the National Audit Office said in June 2011. 


Local-government financing vehicles need to repay a record amount of debt this year, prompting Moody’s Investors Service to warn Premier Li may set an example by allowing China’s first onshore bond default. Local governments set up more than 10,000 LGFVs to fund the construction of roads, sewage plants and subways after they were barred from directly issuing bonds under a 1994 budget law. A 4-trillion-yuan stimulus plan during the 2008-09 financial crisis swelled loans to companies, which they have been rolling over or refinancing with new note sales.


LGFVs may hold more than 20 trillion yuan of debt, former Finance Minister Xiang Huaicheng said in April. That’s almost double the figure given by the National Audit Office in 2011. Refinancing will be a challenge after corporate bond sales slumped to a two-year low in the second quarter and policy makers cracked down on shadow banking activities that bypass regulatory limits on lending.

In other words, China is preparing to admit that the level of problem Local Government Financing Vehicle debt is double what was first reported just two years ago, something many suspected but few dared to voice in the open. But not only that: since the likely level of Non-Performing Loans (i.e., bad debt) within the LGFV universe has long been suspected to be in 30% range, a doubling of the official figure will also mean a doubling of the bad debt notional up to a stunning and nosebleeding-inducing $1 trillion, or roughly 15% of China's goal-seeked GDP! We wish the local banks the best of luck as they scramble to find the hundreds of billions in capital to fill what is about to emerge as the biggest non-Lehman solvency hole in financial history (without the benefit of a Federal Reserve bailout that is).

Of course, now that China has set off on a reform path of active deleveraging, the "disclosures" about the true state of the world's biggest housing bubble (one that makes even Bernanke green with envy) are about to start coming fast and furious. And since LGFV debt is just one small part of the Chinese debt bubble and accounts for a tiny fraction of total consolidated Debt/GDP (recall that just Chinese corporate debt is the largest relative to the nation's GDP anywhere in the world), another theme we have covered extensively in the past, most recently here, one can only wonder what other "discoveries" lie in store.


For a few suggestions of what else may be uncovered soon, here are some excerpts from Morgan Stanley's recent report "China Deleveraging: A Bumpy Ride Ahead":

In the aftermath of the global financial crisis, monetary rather than fiscal policy likely played a bigger role in boosting domestic demand in China. This can be seen by the rise in bank credit to GDP. China’s total outstanding bank credit picked up from 102% of GDP in December 2008 to 133% of GDP in June 2013, thereby boosting domestic demand. Indeed, total outstanding bank credit has increased by US$7.2 trillion over December 2008 to June 2013 (Exhibit 9). Also, the non-loan sources of credit such as wealth management products, trust loans and bonds (total social financing) increased by US$3 trillion over the same period. Though policy makers’ stimulus was targeted at both investment and discretionary consumption by households, a  large part of this funding was channeled into investment, with 70% of the loans going towards the corporate sector over this period.



China’s incremental GDP return from leverage has been declining...



Credit-Driven Growth Has Reached Its Limits


Signs abound that the strategy of pursuing growth via credit has reached its limits. Indeed, policy makers are getting concerned about financial stability risks and the misallocation of capital. Some of the key indicators, raising questions about the sustainability of the current trend, are as follows:


#1: Weakening productivity of incremental credit


The asset quality issue in the banking system is the other side of the coin to the loss in capital productivity that we described earlier. Following the 2008 global financial crisis, there was only a brief period of four quarters in 2011 when nominal GDP growth outpaced credit growth. However, in the past six quarters, loan growth has again been outpacing nominal GDP growth. As of June 2013, nominal GDP growth was 8.0% compared with credit growth of 15.1% YoY (Exhibit 16).



This is a reflection of the weakening productivity of incremental credit in our view. If one instead uses social financing (the broadest possible measure of credit) as the gauge, the divergence with nominal growth is even more concerning. In light of current trends, we believe any attempt to push the overall investment growth engine further will only increase the risk of a deeper and prolonged shock later on as it exacerbates the problem of excess capacity, and the continued buildup of leverage and weak profitability growth weighs further on corporate  balance sheets.


#2 Interest rates higher than nominal output growth of secondary sector


The nominal benchmark 1-year lending rate at 6% and producer price inflation at -2.7% imply a real borrowing cost of 8.7% for the corporate sector. However, the true cost of borrowing for the corporate sector is likely higher, given that the weighted average lending rate in the banking system was 6.7% in March 2013 and non-banking borrowing would come at an even higher cost. In comparison, real growth in secondary sector output stands at 7.6%YoY in June 2013 (Exhibit 17).



While CPI is typically used to compute real rates, we have used PPI in China because the bulk of the leverage buildup has been predominantly due to corporates and not households. In any case, the conclusion remains unchanged even if we were to compare nominal interest rates with nominal output growth of the secondary sector (Exhibit 18).



The latter now is 5.1%, lower than nominal corporate borrowing costs. A higher interest rate relative to the underlying income growth means that debt is compounding at a much faster pace than underlying income growth and the debt trajectory ultimately becomes unsustainable. This challenge has emerged because nominal GDP growth has decelerated significantly in the last few quarters. On the other hand, policy makers have been hesitant to cut rates owing to concerns about sending the wrong signals to entities that have overinvested. The current real  interest rate environment will likely exacerbate the asset quality issues in the banking system. Indeed, historical episodes of risk aversion in the financial system in both the US and Japan have also taken place when real rates exceeded real GDP growth.

And so we get to the point where one more country has reached the end of the can-kicking road, and is about to kick the only remaining thing it can instead: the hornets nest of a truly epic debt bubble.