While everyone's attention is focused on just what unconventional policy Benny and the Inkjets will pull out of their collective sleeves to prevent another financial implosion (fear not, something will appear), it is time to redirect once again to the copper plated elephant in the room, China, which last week became the target of a "Hard Landing" vendetta by Bank of America's David Cui (noted here). Well, the China strategist just fired a follow up shot with "Four systematic risks & potential for financial market turmoil." So, for all those who need one more nail in the "China Bubble" coffin here we go, first textually... "we have sensed that the financial markets in China have become increasingly unstable and that the risk of a hard landing is rising. In this report we outline four systematic risks that we believe have the potential to cause financial market turmoil: 1) private lending (a current issue); 2) property price correction (potentially over the next three to twelve months); 3) bank bad debt write-off and eventual recapitalization (potentially over the next two to three years); and 4) “hot money” outflows (event driven and highly unpredictable). Many of these risks are intertwined which is why we refer them as systematic risks, i.e. difficult to mitigate via diversification. As a result, we suggest investors remain defensive in their portfolio construction in the medium to long term (although we recognize that some short term tactical bounces in the market are possible after the recent sharp sell-off)." And, more importantly, visually...
Systematic risk I - Underground lending
Chart 7 below shows how things could potentially unravel rather quickly in the private lending market. We see two potential significant near-term risks: 1) a bursting of some Ponzi schemes; and 2) defaults of real-business borrowers, including property developers.
Our channel checks indicate that the prevailing interest rate in the private lending market is about 2-3% per month in Jiangsu and Zhejiang, or 24-36% p.a. We doubt many businesses can afford to pay such a high interest rate as a going concern. As a result, we suspect that there are mainly two types of borrowers in this market: Ponzi scheme operators and desperate business people. During the past tightening cycles, we saw some borrowers came to this market because they could find even higher-return opportunities elsewhere, e.g. business, property or stock.
However, this type of borrower seems to be largely absent this time. Given such high rates have lasted for almost a year by now (Chart 4), our sense is that the burden has simply become too much for some borrowers in recent months. While default happens in normal times too, we have noticed a sharp rise in frequency since August (Table 5): some Ponzi schemes have unraveled (Local mind & where has all the money gone? (Aug 27–Sep 2), Sept 2) and many business people have also defaulted, sometimes involving Rmb billions (Economic Daily, Sept 23; CNWEST.com, Sept 23).
The financial market may get significantly disturbed by this.
If there are enough defaults, many private lenders could exit the market. This could result in a credit contraction in the economy which may lead to incomplete projects, fire sale of assets by developers, depressed property/land prices, stress on bank’s balance sheet (because many loans in China have property/land as collateral; land value is especially important to LGFV loans) and ultimately a possible capital flight as investors/depositors lose confidence in the banking system (more in the capital flight section). This in turn may lead to further liquidation of assets, so on and so forth, thus potentially setting up a negative feedback loop.
In addition, we understand that many private loans are collateralized by property/land. When borrowers default, the chance is high that many of these collaterals could be put onto the market under duress at a time when the property market is particularly vulnerable (more on this in the next section).
Systematic risk II - Property downturn
Because of the price control policies implemented by the government since Apr 2010, it appears to us that the physical property market is softening as sales volume in the all important golden month (September) has been disappointing. Despite this, we doubt that the government is prepared to ease up on its policies any time soon. Premier Wen wrote on Sept 1 in Qiushi, one of the most important media outlets in China, that the government will be steadfast in implementing its property policies to ensure the desired effect is achieved (Who’s who in the news media, Aug 30). The head of research at Ministry of Housing said on Sept 8 that the government will not reverse its home purchase limit policy (Nanjing Daily).
We believe that for social, economical and political reasons, the government is unlikely to allow people’s expectations of property price appreciation to be built up again – we believe the consequences would be too dire: inflation expectations, property bubble, public outcry and a complete loss of policy credibility (Property – Not out of the woods yet, Apr 6). This is particularly so after the policy flip-flop in late 2008. As such, we ascertain that the risk of the government over-tightening this round is higher than a quick policy reversal.
On the other hand, demand is highly uncertain in China, in part, because we believe a significant portion of the demand is for investment purpose (Property, wealth effect & the unhappy Chinese, 28 May 2010). Although few have accurate data on the demand breakdown, investment’s influence can be seen clearly from the fact that property markets in cities with no home ownership control tend to be much more buoyant than those that have this type of control.
Unfortunately investment demand is fickle – investors only purchase properties if they think prices will move up (only a few cities in China have a vibrant rental market). It’s our impression that, at least in the major cities such as Beijing and Shanghai, investment appetite has become tentative and is probably likely to soften considerably, judging from the latest transaction data.
If investment demand fell off, we may see negative loops kicking in here too (Chart 8): lower transaction volume and funding pressure could lead to developers cutting prices, which would cause a drop in investors’ desire to purchase properties, which could add more pressure for developers to lower prices. When a few developers reduce prices, potential buyers may think they can pick up some bargains; however, when many developers cut prices, we suspect that even genuine buyers may suspend their purchase decisions. Another potential loop is the property price-banks’ balance sheet-capital flight route that we have outlined in the previous section.
Systematic risk III – Bad debt/bank recapitalization
We believe that the LGFV loan issue may be serious but not imminent as a concern as the banks and the government could delay the issue for a considerable period of time by “evergreening” some of the loans. Nevertheless, we expect it could ultimately come to a head, at which time the government may have to recapitalize the banking sector. Unless circumstances and events precipitate an issue, we look to 2013, i.e. when the new administration is in place, for some potential action on this front (Seven market driven themes in 2011, Jan 3).
The size is big – likely Rmb10tr+ by now
Different government bodies have announced different estimates of the size of LGFV loans by the end of 2010:
- Rmb9.1tr, according the China Banking Regulatory Commission (CBRC), the banking regulator;
- Rmb10.7tr, according to the National Audit Office (NAO); out of 1,636 counties in China, only 54 had no LGFV loans as of 2010 YE;
- Less than Rmb14.4tr (30% of Rmb47.92tr loans outstanding), according to PBoC, the central bank. Its report does not provide an exact estimate; it merely states that the borrowing by LGFVs in most places accounted for less than 30% of local Rmb loans outstanding.
CBRC has warned banks publically about LGFV risks since at least late 2009 (Loans, local government funding vehicle, 21 Jan 2010; Risky LGFV loans, 14 Oct 2010; Severe crackdown on LGFV loans, 24 Jan 2011) and periodically, it had stepped on the brake for LGFV loan granting (LGFV, 28 Jan 2010). Despite the apparent wariness by the regulator, the size of LGFV loans has been expanding at a fairly fast pace over the past year and a half (Table 8).
The reason is very simply in our opinion: the local governments simply don’t have enough resources to fund their spending, including investment in infrastructure, land bank and social welfare expenditures (The visible hand – A reform roadmap & what it means, 23 Jul 2010). To clamp down on LGFV loans completely would mean a fundamental change in the way that China manages its growth, i.e. less reliance on public investment and to be more driven by private investment and consumption. This most likely means a lower overall growth speed by our assessment. The willingness to continue to lend to local governments over the past two years or so was also compounded by the desire to see the stimulus related projects through to completion in case the associated loans go bad straight away.
What the risks are
Looking at the share price performance of the Chinese listed banks in recent quarters, it’s clear to us that investors are concerned about the LGFV loan risks that the banks are facing.
Hypothetically, if some LGFVs default, this could trigger asset liquidation, potentially lower land price and potentially more LGFV defaults. This may cause great stress to banks’ balance sheet. The impact of any default on foreign capital’s psychology, i.e. whether it will cause capital flight, is also difficult to assess (Chart 9).
The decision on the ways to cover any eventual losses will have some significant impact on China’s economy and the financial market we believe. If it’s done via government debt, it’s likely to be deflationary and may slow down growth. If it’s done via central bank’s balance sheet, it’s likely to be inflationary. The government has to manage the process very carefully to avoid any significant disruptions to the economy and the financial market in our opinion. We believe one of the reasons why the 2007-08 round of inflation in China was so difficult to control was due to central bank’s participation in the last round of banks recapitalization (A short history of inflation & market, 18 Nov 2010)
Systematic risk IV – “Hot money” outflow
It appears to us that there is too much consensus in the market that Rmb should appreciate. In reality, things in China nowadays are expensive by international standard largely due to inflation over the past few years (The poor poor Chinese consumers, 16 Nov 2010). As a result, we feel that the argument that Rmb is significantly under-valued may no longer be appropriate.
Interestingly, we have seen increasing signs of capital outflow from China (Local mind & where has all the money gone? (Aug 27–Sep 2), including mainland Chinese buying properties around the world and record high gaming revenue in Macau (Chart 10).
We suspect that at some point, the expectations for Rmb appreciation may change, due to weak exports, risk-averse triggered by some international events or a disturbance in China’s own financial market. When there is volatility in domestic financial market, we consider it highly unlikely that domestic depositors will run on the banks as it’s unthinkable to most that banks could fail and their deposits disappear. However, foreign investors and some of the more sophisticated domestic capital holders may vote with their feet. This may have the potential to trigger a chain of events as shown in Chart 11.
Bank of America's conclusion:
Would the government allow all this to happen?
Eventually, we believe that the Chinese government can handle any potential financial market turmoil in China this time because of high domestic savings. However, this doesn’t mean that the ride will always be smooth.
One of the biggest misperceptions about China in our opinion is a belief that the government is monolithic, and run by “a few wise men in Beijing” whose policies are followed to the letter. In our view this could not be further from the truth (A big misperception about China, 23 Feb 2010). Many policies in China are the result of negotiations and compromises between different interest groups, and the policies are often behind the curve and sometimes bring about unintended consequences.
Our overall thesis is that the government has been too aggressive applying both monetary and fiscal stimulus to counter the last global financial crisis and that we are now living with the unintended consequences, chiefly among them economically, high inflation pressure and instability in the financial market.
In addition, it appears to us that in the near term, government policy options are fairly limited. If there is another round of global or domestic financial crisis, running a loose monetary policy again may be too inflationary; identifying more viable “mega” fiscal projects may prove too difficult; and turning around the property policy may create a property bubble that China has never seen before by our assessment. Because it would re-enforce people’s perception again that there is a policy put in the property market.
That said, if inflation pressures ease more rapidly than we currently anticipate, it may give the government more space to maneuver in terms of handling fresh disturbances, including those we expect in the financial market. This is probably the biggest risk to our thesis presented in this report.
Said otherwise, Bernanke, should he hit print once again, and export copious amounts of inflation to China once again, he will promptly put an end to the whole mercantilist-ponzi symbiotic relationship and force the global reset.
Perhaps, for the sake of restarting, it is best to just let Benny do what he does best: that is print.