China's Bad Debt Problem Is Much Deeper Than Just Real Estate

Among the bigger financial problems covered in depth on Zero Hedge over the past several years, have been China's massive amount of newly created credit adding to an already unsustaimable debt load (estimated as high as 350%), its rapidly growing bad debt pile (what we call China's "neutron bomb" which as we first estimated last October is about 20% of total bank debt), and its sub-prime real estate bubble. Lately many others - especially Kyle Bass - have also started looking the same problems and asking a simple question: what is the real repayment ability of Chinese corporates now that this credit monster has been unleashed, and is the NPL problem isolated to just real estate.

For those answers, we look at a recent Natixis report.

The note starts by pointing out that the incredible credit binge that took place in Q1 2016, actually exceeded the previous peak that was seen during the 2008-2009 financial crisis. This is a topic we will touch on later today when we look at the sustainability of this record credit impulse. 

 

To show where China's corporate leverage resides Natixis breaks sectors into two groups, old and new. The purpose is to reflect how Chinese policy makers have been working to rebalance the economy toward consumption and services.

 

As the following chart shows, while leverage (total liabilities/common equity) has climbed steadily since the financial crisis across the board, the concentration of debt is on the balance sheets of the Old industries. Old industries are carrying much more leverage than the overall average, significantly higher than China's "New industries."

 

Knowing where the leverage resides, we can evaluate which industries can actually repay such massive amounts of debt, or even just cover the interest expense.

To achieve this, we look at EBITDA which shows a very distinct picture. While the economic slowdown has impacted both sectors, "Old" is growing at a more subdued rate, roughly a third of the "New" industries growth rate, which makes the ability to service and repay the additional debt-load much more difficult.

The slower EBITDA growth has lead to the critical deteriorating interest coverage ratios, or repayment ability, something we first covered last fall when explicitly looking at China's levered commodity sector, where we found that over half of corporations can not fund even one interest payment with organic cash flow.

Gone are the days where massive stimulus provided enough corporate growth to give a nice cushion, and with China's hands currently tied on providing more stimulus (discussed here), the downward pressure EBITDA will continue and Chinese corporates ability to repay will only get worse.

 

As expected, an increasing number of Chinese companies cannot cover their interest payments with their cash flow. In 2010 about 8% of overall companies couldn't cover interest payments with ETBIDA; that number has since exploded to nearly 18%. This means that the debt burden is so large, that companies will only be able to survive by adding more debt.

In other words, roughly a fifth of China's entire corproate sector is now in the Ponzi stage of the infamous Minsky cycle.

Natixis goes on to help us understand the severity of the sub-prime real estate crisis as well. New loans are skyrocketing, and the percentage of real estate companies unable to service interest payments with their revenue is over 30%.

The real estate sector: from engine to beast
One of the key beneficiaries of the 2008-09 massive credit binge was the real estate sector. In fact, the assets of property developers to total corporate assets jumped from 8% in 2004 to 21% 2015.1 The interesting fact is that this trend is not yet changing, on the contrary. The most recent data on loan growth to real estate developers shows a record high at 1.5 RMB trn, which is almost twice the level of 2009 (Chart 7). In other words, there is no sign of a deleveraging cycle in china’s real estate sector.

 

While not telling much we didn't already know, what we can learn from this report is just how deeply over leveraged Chinese corporates are across the board, and how much the economic slowdown as impacted the ability of these firms to service debt. Worse, as cash flows continue to deteriorate, only even more (cheap) debt will delay either a default tide, although it will ultimately make the problem even worse.

While the real estate bubble has been highlighted often, the interesting revelation is just how much other industries have levered up in the face of declining cash flow growth. The NPL problem China faces is much more widespread than perhaps many first believed.