China Debt Implosion: The First Domino Has Fallen

By Derek On January 6, 2012 Under Post

“A lot of fellows nowadays have a B.A., M.D., or Ph.D. Unfortunately, they don’t have a J.O.B.”  - Fats Domino

China is different, they say. China has a new economic growth model that is a shining light to the world. China’s economy has averaged almost 10% annual GDP growth for two decades, allowing them to finally acquire all the modern goods they desire; planes, trains and peanut butter. China is a rising superpower, quickly overtaking the west the army of China bulls continually tells us. Deng yi xia. Is China different? Actually, we are the same in many ways and aside from adopting western economic models “with Chinese characteristics,” China has followed Europe and the US in a much more disturbing way: I refer to their unrecognized love affair with debt. China loves debt. It can’t function without it. But the debt party is almost over and this ends badly for China. In fact, I think the first domino has just fallen and this will derail the whole China coming of age story for years.

Did You Know?

On October 24th, the Vice Chairman of the China Banking Regulatory Commission, Mr. Zhou Mubing, announced on the Sina web portal that LGFVs (local gov’t financing vehicles) would be allowed a “one time extension” of interest repayment on loans. Why? Beijing is realizing that many loans went to projects where there is no cash flow or it isn’t sufficient to cover the interest payments. Quietly, over the Christmas holidays it came to light in the China Daily that not surprisingly, in just two months since Mr. Zhou’s financial amnesty, quite a raft of these groups have decided to take him up on the offer:

Hunan Provincial Expressway Construction: delayed US$490 mn in interest payments

Guangdong Provincial Communications Group, Gansu Provincial Highway Aviation Tourism Investment Group Co. (what a mouthful!) and Sichuan Railway Investment Group Co. owe US$32 bn and plan to “defer” US$5.4 bn in interest payments this year alone.

Bond prospectuses from 55 LGFVs state they also will not pay US$4.8 bn in interest on newly issued paper.

Lei Wanming, Gansu Highway’s deputy Communist Party secretary insisted, “Our company can pay our interest and our principal payments with no problem.” We just don’t want to. Yeah, I feel the same way about my taxes but since the US gov’t has nuclear weapons to ensure compliance, ultimately I don’t get the free pass these guys do.

We’re All SPIVS Now

LGFVs are one of those “Chinese characteristics” mentioned above. These “Special Investment Vehicles” (SPIVS) were formed to get around budget restrictions imposed in 1995 designed to prevent local governments borrowing too much money directly. According to the CBRC in October, China’s local governments had US$1.7 tn in debt – and half of that amount is to be paid back before then end of next year. How big is that? Given the disparity in size of economies, that is US$5.1 tn in US terms. More than half of this debt was issued in the last three years during the financial fire hose of activity I mentioned in an earlier note where 40% of GDP was lent out in short order and 79% of that stuff sits on the books of the state-owned banks.

Let’s call a spade a shovel: LGFV defaults are set to soar. Local governments had a tough 2011 and things are worsening for them. Today, Centaline, a large private real estate agency, reported that last year nearly 900 land auctions failed in China. This is three times the level of auction failures in 2010. Government revenues from land sales fell 13% in major cities. This is important because 50% – 74% of local government revenues come from selling dirt, depending on the estimate. Less land sales (and all at lower prices) put local governments and their ability to pay back debt under more stress. Worse still, fully one third of the auction failures came in November and December, indicating a sudden deterioration in the market.

Simply Irresistible

Politically directed bank lending is an irresistible tool of policymakers not unique to China but it always results in uneconomic capital allocation. Given there is zero oversight of debt levels “outside” the system using an LGFV, Chinese gov’t officials are totally incentivized to borrow as much as they can to fund the biggest infrastructure projects they can to boost local GDP growth on their shift before they get promoted and rotated out to another position for their next term. Let someone else clean up the (inevitable) mess. This is analogous to US bankers whose compensation was tied to loan volumes: lend to anyone, collect the fees, get promoted and get out before it blows up in ya face. And in China, these similar incentives guarantee a similar explosion. This is the model for China’s astounding GDP growth: debt fuelled fixed asset investment into what will ultimately prove to be a lot of money-losing big statist glory projects that China will be paying off for years.

Ah, the China apologists will say, these debts will be rolled over. Aside from delaying the day of reckoning there is a further a cost to that, so says professor Patrick Chovanec at Tsinghua University in Beijing: “When companies start to roll over debt they’re not retiring debt and banks aren’t retrieving their capital, so you’re crowding out new lending.” The private sector in China, as we all know, creates most of the new jobs and has been starved of capital evidenced by soaring black market loan rates.

Whether it is a European can of caviar, a US can of Campbell’s soup or a Chinese can of toxic milk, we are just kicking these things down the same road. China already went through a massive (US$600 bn plus) recapitalization of its banking sector in the late ‘90s when banks diverted funds into speculation on real estate and the stock market. According to some estimates, 2/3 of China bank loans became non-performing and one half were written off. With US$1.7 tn now at stake, we are talking about a problem now almost one half of GDP.

Could this be why Japan in November approved new laws permitting Japanese government purchase of RMB bonds? Japan is acting in its national interest. They fear China’s domestic debt bomb will destabilize the region and wreck the economy of their largest trading partner.

Consider the listed state banks. They are considered cheap, trading at an average of 1X P/B and 7X PER. Everybody owns them because of a perceived golden guarantee from Beijing. But they should be much cheaper. Even with the rapidly growing number of LGFVs signing up for loan forbearance, the banks will not recognize these as NPLs. Nobody has “defaulted,” they are just on a repayment “holiday.” Amy Winehouse isn’t dead, she just isn’t breathing. Gottit. The solvency of a bank depends on the loan-loss provisions it has set aside and the capital built up on its balance sheet. As of Q3 2011, Chinese banks claim a “loan-loss coverage ratio” of 270%. That sounds comforting, until you realize this only covers loans the bank has determined non-performing… Look at what market action in Shanghai is telling us: GTFO!

Remember, China isn’t different. This is the same familiar story we all know and are suffering through with Europe and the US but with “Chinese characteristics.” Don’t look for China as an “economic growth engine” to save the world. They’ve made the same bad decisions as the rest of us.

Print Friendly

Related Posts

  • No Related Posts

Add a comment

  • Avatars are handled by Gravatar
  • Comments are being moderated