The Chinese Debt Problem...

The Problem

One of the more underappreciated risks on the investment horizon is the debt problem of China.  China has been beholden to debt for the last decade, and it has relied on this to fuel its tremendous economic growth.  Once again, however, this leverage is rearing its ugly head in the country, and the issue could become acutely worse than in previous trips down this road.  In other words, China will likely experience greater difficulty masking its problems due to lower economic growth in the months and quarters ahead relative to historical trends.  In response, I decided to pull together at least a few discussion points that I felt were worth noting.

We all know that Chinese demographics are changing, as is its national income.  We all know about the outsized growth of its economy during the last decade, and the vast currency reserves available for the central government to stabilize the Yuan against the dollar.  Also, we understand that underlying at least part of China's tremendous growth over the last decade has been a growing shadow banking sector.  Along with several other publications, The Economist recently published a great expose on China a few months ago, and the finer points of this recent discourse are certainly worth highlighting here. 

China's Banking Sector Larger Than Most Believe

The Chinese financial system is larger than most believe, and its banks are the largest in the world.  Its banking sector has more than $30 trillion in assets, which is equal to 40% of global GDP.  Its bond market is already $7.5 trillion and perhaps growing faster than any such market in the world.

Interestingly, the Chinese government's own industry advisers now warn that leverage in the system could spark a Chinese financial crisis.  They have begun to talk more openly about the need to slow the rise in debt to GDP.  This will naturally slow the economy, and the hope is that it won’t do too much damage in the process.  Credit would be limited to state-owned and other non-governmental institutions, especially to those which have been most profligate. 

Some of the larger institutions are already calling for government support, and others are trying to raise equity in a very turbulent stock market in an attempt to enhance their balance sheets in advance of the coming storm. 

Background

During the late 1990’s, only 5 million households in China made between $11,500 and $43,000 per year, according to The Economist.  That number today is more than 225 million.  Within a few years, the Chinese emerging middle class could exceed the entire European population.  National income has certainly gone up, but the majority of it has wound up in savings, as China continues to struggle to increase consumption.

However, also during the late 1990's, almost 40% of bank loans in China had become non-performing, leaving the banking landscape in a tough spot.  In response, the government created so-called "bad banks" where all the problem loans went, which also had the effect of shoring up, albeit artificially, the balance sheet of the issuing banks.  Many of these banks have since gone public, but the overall problem wasn't resolved.  A similar dynamic is playing out now, with the government applying its own balance sheet to the banking sector through a new loan swap program (exchanging the bad loans for safe lower yielding notes from the central bank).

Current Circumstances

China remains reliant on exports for growth, which a weaker Yuan will certainly promote.  The Chinese government has been trying to generate more personal consumption, of course; however, most of its historical response to bad loan problems has acted to "tax" households and decrease, not increase, consumption by increasing savings (national savings rate is ~50%).  Increased consumer savings typically find their way to government owned financial institutions, and as a result, the government has used these funds to direct "investments" in a wide array of projects, etc. designed to provide jobs and keep the masses happy.  All the while not really working to increase personal consumption. 

As China witnesses continued migration to the urban centers, lending in the countryside has been dominated by the shadow banks.  Lending schemes build on continued growth have begun to stall in the wake of the slowing economy, leaving much speculation over the real health of the financial system.  Many of these fringe operators defaulted a couple of years ago; this represented just another crack in the financial dam over the last 3-4 years, including a bank run and a stock market collapse.  The Central government has spent almost $300 billion to fight these various trench battles, but China's lost almost $600 billion in capital flight since.

Growth of Debt

China’s total debt went from 150% of its GDP in 2008 to more than 250% just a year ago.  A disproportionate percent of non-financial sector debt is in the corporate sector, accounting for roughly two-thirds of the total.  Compare that to the US, where corporate debt is only 25% of the total.  According to The Economist, the interest expense for 16% of China's 1000 largest companies exceeded pre-tax income. 

The increased debt load is becoming an anchor for growth, and as the Economist notes, less credit is going to the better firms.  In addition, loan loss provisions at the bank level is declining, which portends financial market disruption on the horizon.  This comes following the central bank's decision to liberalize interest rates, which will no doubt compress net interest margins for the banking sector.

Nevertheless, the number of bad loans continues to increase, as the sins of the past catch up with China's future.  Non-performing loans doubled in just two years to 1.3 trillion yuan, equal to roughly 1.7% of all loans (not catastrophic).  Debt as a percent of GDP has accelerated in the last 7-8 years, outpacing the rate of growth in both the US and the Eurozone. 

Another interesting dynamic is that the number of so-called "zombie" companies is on the rise, especially in hard hit industries with overcapacity like steel.  Zombie firms are  under-performing companies with loans at below-market interest rates for years at a stretch.  Low rates for poor companies are a sure signal that they are being propped up by  the local or national government.  The underperformance is also manifesting in other ways, like cash flow.  According to Standard & Poor's, the time required by China's largest firms to pay their invoices has almost doubled to 117 days from 2007 through last year.

Shadow Banking

In the early years of the 21st century, most lending was in fact done by banks; however, that has changed.  Following several years of 30% annual growth, China's own information services indicates that shadow banking now accounts for roughly 25% of all debt, representing almost 70% of GDP. Shadow banking originated to fill a void not provided by conventional banks; however, it has turned into sort of a destination sport for investors seeking higher yields.  .

Online banking is also on the rise, notably from companies like Alibaba, but outside of the few key players, much of the remaining landscape is plagued by fraud.

The problem is that the government owns and controls both the major banks as well as their major customers (the so-called state-owned-enterprises or SOE).  This represents a quite incestual situation, but it does allow the central government to exert its control in managing the solution.  In this role, the easiest thing to do with problem loans is to extend maturities, or perhaps re-classify non-performing loans as equity.

The Path Forward

Amidst slowing overall growth, the government can either move toward financial market deregulation, or it can continue to put the band aids on the problems when they come up.  Considering China has ruled with the iron fist for so long, change could be difficult, and each options comes with its own attendant problems. 

Acknowledging the problem and modernizing the financial system would certainly help in the long run, but it would further expose all the current warts and cause the credit problem to get worse before it gets better.  Meanwhile, continuing the sweep bad loans under the rug by suppressing bad news and transferring debt from corporate balance sheets to the government's own balance sheet will help the domestic credit market but will clearly weaken the state over the long run.

To be fair, the recent literature on this suggests that the underlying credits behind these problem loans are indeed better businesses with more robust business models than before.  Proponents of this notion believe that both credits and collateral are better than before, and that loans are better structure this time around.  That may be the case, but workouts will require a sound and equitable application of the rule of law, which may be difficult considering many of the lenders and credits are owned and/or controlled by the same entity.   

Reform?

To, wit, the Chinese financial system is not sophisticated in the way the West sees it.  With the slowdown in the Chinese economy, capital efficiency is flagging, and lending just doesn't generate the same levels of returns than it used to before the financial crisis.  China's lending practices are mostly direct party-to-party loans, not the syndicated and securitized products we are familiar with in the US. 

China has initiated reforms before, but it typically has abandoned the reform movement at the first sign of economic duress. Some reform has been made, however, notably the addition of deposit insurance.  In addition, we learned this week that the regulatory arm of the Chinese central bank is planning to launch a market for credit default swaps to hedge investors against potential losses.  Without adequate oversight, however, a default swap market could increase, not hedge, risk.

China - like the US - has embarked on the creation of bad banks (as noted), which isolate the problems loans away from the critical financial institutions.  This is more a band aid than a true reform, which is sorely needed.  To be sure, the best course ultimately for China is for the government to steer clear of interference and let the banks work toward recapitalization. Just how much it will take to recapitalize is the real question, and that figure is likely much higher than the state would want to tolerate.  The fact that Chinese banks are, to some degree, already reacting to the non-performing loan problem is helpful, as is the fact that a large percentage of bank loans are to the state-owned-enterprises or SOE's. 

Notwithstanding, for China to improve the health of its financial sector overall, it must also address the broader capital markets.  Volatility in the stock market over the past year has inspired considerable reactionary intervention by the central government, thereby muting the ability of the free market to operate on its own.  China's bond market is growing exponentially, but tight credit spreads in the market currently seem to belie the overall direction of the Chinese economy.  China has attracted global firms driven by new business opportunity (and the quest for yield), and the hope is that this will bring more sophistication and depth to the capital markets. 

Progress will take time, though, and the news may get a little worse before it gets better.

 Source: The Economist, Bloomberg, Wall Street Journal