Early last month in “Chinese Cash Flow Shocker: More Than Half Of Commodity Companies Can't Pay The Interest On Their Debt,” we highlighted a report from Macquarie which showed that for many Chinese corporates, debt service payments have simply become too much to bear in the current environment.
As Macquarie put it "more than half of the cumulative debt in [the commodities space] was EBIT-uncovered in 2014, and all sub-sectors have their share in the uncovered part, particularly for base metals (the big gray bar on the right stands for Chalco), coal, and steel."
In short, last year about CNY2 trillion in debt was in danger of imminent default.
To be sure, this shouldn’t exactly come as a surprise. Lackluster demand (both domestic and international) combined with an acute excess capacity problem and an enormous amount of leverage spells disaster and as the growing number of defaults we’ve seen in China this year underscores, Beijing’s habit of bailing out anyone and everyone and the unspoken directive that compels Chinese banks to roll bad debt may no longer be enough to keep a lid on things. Meanwhile, multiple rate cuts are proving to be too little, too late.
So what do you do when you can't service your debt? Well, you either default or you go into full ponzi mode and take out new loans to pay the interest on your old loans. Don't look now, but that's exactly what's happening in China.
As Bloomberg reports, Chinese borrowers are set to take out some CNY7.6 trillion in new loans this year just to pay interest on their existing borrowings. That's according to Beijing-based Hua Chuang Securities Co., whose data Bloomberg used to construct the following chart:
Chinese companies are struggling to generate the cash flow needed to service their obligations as economic growth slows to the weakest pace in 25 years and corporate profits shrink. While the debt burden has been eased by six central bank interest-rate cuts in 12 months and a tumble in corporate borrowing costs to five-year lows, the number of defaults in China’s onshore corporate bond market has increased to six this year from just one in 2014.
China Shanshui Cement Group Ltd. became the latest company to default on yuan-denominated domestic notes last week as overcapacity in the industry hurt profits and a shareholder dispute stymied financing. State-owned steelmaker Sinosteel Co., which pushed back an interest payment on a bond last month, postponed it again this week.
And so, as we pointed out more than 18 months ago, China is about to reach its Minsky Moment. Recall what Morgan Stanley said last March:
It is clear to us that speculative and Ponzi finance dominate China’s economy at this stage. The question is when and how the system’s current instability resolves itself. The Minsky Moment refers to the moment at which a credit boom driven by speculative and Ponzi borrowers begins to unwind. It is the point at which Ponzi and speculative borrowers are no longer able to roll over their debts or borrow additional capital to make interest payments. Minsky states this usually occurs when monetary authorities, in order to control inflationary impulses in the economy, begin to tighten monetary policy. We would add that this monetary tightening often begins to occur at the time when the size of speculative and Ponzi borrowings have become so large that the demand for additional capital to keep these borrowers afloat becomes greater than the supply of such capital. We believe that China finds itself today at exactly this juncture.
To be sure China is is certainly doing its best to forestall this eventuality. The PBoC for instance, is not seeking to tighten monetary policy and deflation is a bigger risk than inflation. Additionally, the local government debt swap program is a sweeping effort to address provincial governments' inability to make interest payments on LGVF financing which in many cases came with punitive rates.
So while we may not have reached the breaking point just yet (i.e. the point at which borrowers can no longer obtain new financing to pay the interest on their existing obligations), we're getting there and were it not for the flood of liquidity (the tightening effect of PBoC FX interventions notwithstanding) unleashed by a series of RRR cuts and the implementation of various short- and medium-term lending ops, China probably would have gone over the edge long ago. For a preview of what comes next (and some of what you'll read below is already happening), here's Morgan Stanley again:
The unwind of this credit boom is likely in progress, and we expect it to pick up speed over the coming months and quarters. It will likely involve a steady drip of defaults and near-defaults as insolvent borrowers finally become illiquid. Market rates for all assets except central government bonds and central bank bills will likely continue to rise, reflecting increasing market fears of default by shaky borrowers. Asset values will likely begin to deteriorate as stressed borrowers attempt to sell assets to stay afloat. As a result, banks and other financial entities could begin to increase provisioning for bad debts and to reduce credit availability by gradually tightening credit standards. This could lead to a credit crunch where credit to the economy is choked off for all but the safest borrowers.
Xi's determination to show the world that China is set to liberalize capital markets will only serve to accelerate this dynamic as a free(er) market means allowing for more defaults.
You were warned.
We close with a quote from Shi Lei, the Beijing-based head of fixed-income research at Ping An Securities Co. who spoke to Bloomberg and who we imagine may be "summoned" for daring to offer the following assessment of the situation:
“Some Chinese firms have entered the Ponzi stage because return on investment has come down very fast. As a result, leverage will be rising and zombie companies increasing.”