Neil Macneale, is well known for compiling an ongoing model portfolio based on companies that have a...
China is working to push its own debt crisis down the road into 2013
10/14/2011 8:30 am EST
That’s exactly what happened in China on Monday. Central Huijin, which is the domestic arm of China’s sovereign wealth fund, bought $30 million in shares of China’s biggest banks. The stocks moved barely 2%--amazingly little given that shares of Chinese banks were down 30% for the year--and the wider Shanghai Composite Index, which had closed at a 30-month low the day before--squeaked out just a 0.2% gain.
China’s investors have seen this all before in 2008 and they’re determined to wait for the big payoff when China dumps real money on stocks or—more likely—reverses policy at the People’s Bank and starts cutting interest rates.
Until Beijing shows the markets that it’s serious about turning the money taps back on—with something like the volume that it did in 2008--investors look like they’re going to sit on their cash. There are reasons, after all, why China’s Shanghai stock market is down 22.6%, in bear territory from its November 2010 high to the close on October 12 and why the Hong Kong market is down even more at 26.3%.
China’s investors have at least an inkling of the dimensions of the problem, know that $30 million is a laughably small gesture, and are waiting for the big money. It will flow—and when it does China’s stocks will rally hard. But while we’re getting closer, I think we’re still months away from the day that China turns the spigot on.
To understand what’s happening now in China’s financial markets you need to understand how 2011 is both similar to and different from 2008.
In 2008 while the global financial system was reeling from the shock waves of the Lehman bankruptcy, China pumped $600 billion into its economy. And that was only the money officially authorized by the central government. Beijing also leveraged that stimulus by encouraging local governments to go on an infrastructure spree to finance roads, airports, factories, rail lines and other projects. Local governments in China have very limited sources of tax revenue so to finance all these stimulus projects local governments borrowed. To make that borrowing possible Beijing kept interest rates low and encouraged the big state-controlled banks to lend first and ask questions, well, never.
China escaped 2008 with just a scare—even as the rest of the world fell into recession. For all of 2008 China’s economy grew by 9%, the lowest rate of growth since 2003. But the end of 2008 was much scarier than that annual number suggests. In the fourth quarter year-to-year growth dropped to 6.8% and sequential growth—that is from the third quarter to the fourth quarter—was either only barely positive or slightly negative.
Looks pretty good in comparison to the annualized 6.3% drop in U.S. GDP in the fourth quarter of 2008.
As China moved into 2009, the economy revved up again with growth rates rising from 6.2% in the first quarter to 7.9% in the second quarter and finishing at 8.7% for the year as a whole. Growth in 2010 soared to a too hot to handle 10.4% and the Chinese government has spent 2011 trying to slow the economy and get inflation, which hit 6.4% in June, under control. In the second quarter economic growth slowed to 9.5% and in August inflation dipped to 6.2%.
All’s well, then, right?
Not at all. China is suffering a massive debt hangover at both its big state-controlled banks, at local governments, and in what has become a massive unofficial financial sector.
Let’s start with the bank’s themselves. Officially they look reasonably solid. Not stellar mind you but solid. According to China’s banking regulators China’s banks had an average Tier 1 capital ratio of 10.1% at the end of 2010. That compares to an average of 12.3% for the world’s 100 largest banks by market capitalization, Bloomberg calculates.
But as the euro debt crisis has amply demonstrated, Tier 1 capital ratios can be wildly deceptive. The ratio is supposed to compare risk-weighted assets (loans for banks) to the bank’s own capital. In Europe Tier 1 ratios were distorted because bank regulators decided that sovereign debt (you know the bonds of countries such as Greece and Portugal) should be considered risk free. That had the effect of driving up Tier 1 ratios. In China the distortion comes from the huge volume of loans to big state-owned companies. Bank regulators have given these loans low risk ratings even though many state-owned companies are marginally profitable at best and manage to pay interest on their loans only by taking out new loans.
A way to correct for that distortion is to compare total equity with total assets (loans). So China’s biggest bank, Industrial and Commercial Bank of China (1398.HK), had an official Tier 1 capital ratio of 9.82% at the end of June, but, the Wall Street Journal calculates, its ratio of total equity to total assets was just 5.77%. In comparison, the Journal notes, the total equity to total assets ratio at Bank of America (BAC), not the strongest of U.S. banks, was 9.8%.
China’s other big banks show similarly low total equity to total asset ratios: China Construction Bank (CICHY) 6.28%, Bank of China (3988.HK) 5.83%, and Agricultural Bank of China (ACGBY) 5.14%.
Now China’s banks could buttress their capital by retaining more earnings but the banks currently pay out most of their earnings as dividends to other state-owned companies or to the government itself.
The other option is raising capital in the financial markets. Lots and lots of capital. Estimates of how much capital start at $131 billion over six years to meet stricter capital rules, according to one industry regulator who gave that figure, anonymously, to Bloomberg, and then grow to include another $185 billion to keep the bank’s capital ratios steady as the economy expands and credit demand grows.
Looking at those numbers you can understand why the market wasn’t impressed by Central Huijin’s $30 million capital infusion.
The problems of local government lending—and local governments have set up an estimated 10,000 investment companies--make the capital requirements of the big Chinese banks, though, look like pocket change. Local government debt is officially estimated at $1.68 trillion. Not all of that consists of loans to businesses ranging from construction companies to developers to factory operators—some of that represents debt that local governments took on for their own projects.
But whether to companies or to the governments themselves, too many of the loans share the same two problems. First, the projects the loans funded aren’t generating returns large enough to pay the interest on the loans let alone pay off the loans. In some provinces estimates of bad loans made by local governments run as high as 85%.
Second, the loans ultimately rest on real estate collateral. Local governments have relied on land sales to make up for insufficient tax revenues. Borrowers from local governments used land to back their loans. But now the volume of real estate sales is falling and so too is the value of the land used as collateral.
The result has been a kind of national fire sale with companies and local government affiliated investment companies selling off assets to meet their debts. The State Assets Supervision and Administration Commission sold off $487 million of corporate assets between January and June of 2011, reports the Financial Times. That compares to sales of $346 million in all of 2010.
But as quickly as the pace of asset sales is increasing—and we’re looking at a 40% increase from the 2010 total in just the first half of 2011—the proceeds are wildly inadequate for addressing a $1.68 trillion problem.
And let’s not forget the third part of this problem, the unofficial financial system of trust companies, private banks, and completely off the books lenders. This world has grown thanks to an official government policy that capped interest rates for bank depositors below the inflation rate. Money fled that money-losing proposition to unofficial lenders paying higher rates for deposits because they were charging, not the official 6.5% rate for a loan, but 30% to 70%. Who would pay that kind of rate? Companies cut off from the official banking system when Beijing started to restrict credit to slow the economy. Big state-owned or well-connected companies didn’t have any problems in getting loans. Small and medium size businesses, though, borrowed from this unofficial banking system or they didn’t borrow at all.
No one knows how big the unofficial banking financial system is, but it is large. (China’s big banks helped fund some of these unofficial lenders as a way around Beijing’s efforts to tighten credit.) Nomura Securities estimates that loans in China’s unofficial financial system rose to $1.65 trillion in the first quarter of 2011 and now make up about 20% of all loans outstanding. No one knows either how many of these loans have gone bad or are in danger of going bad. But China’s press is starting to report scattered anecdotes of local business owners who have gone into hiding in an attempt to avoid some of the more violent methods of debt collection used by some of these unofficial lenders.
If you try to put all these numbers together, the total gets very large very fast. Nomura estimates that if China’s government was to assume responsibility for all this debt the country’s debt to GDP ratio could top 135%.
That’s higher than Italy’s 120% debt to GDP ratio.
It’s clear that China won’t assume all this debt, but this being China where the economy mixes the government and private realm in a sometimes capricious manner, it’s equally clear that it’s totally unclear where the line will get drawn.
Yes, China will have to spend some of its reserves and construct some of its patented you-buy-my-bonds-and-I’ll-buy-your-bonds investment vehicles to capitalize its big banks. It will have to find some way to bail out local governments and at least some of the government affiliated lenders. I think that here again it’s likely that China will set up special purpose financial vehicles, as it did after the Asia currency crisis of 1997, to bury some of this debt. What Beijing will do about the unofficial financial system is anyone’s guess at this point. Mine would be that unofficial lenders will each wind up with an individual deal that reflects its clout with officials in the national or local governments—or with their children.
One of the reasons that China’s leadership so fears slowing the economy too much is that slow growth makes all these problems worse by increasing the rate at which loans go bad. This is one reason that I think the People’s Bank will start to loosen credit and cut interest rates as soon as it can while saving face. Look to the September inflation numbers, due to be released today, October 14. If inflation drops again—from August’s 6.2% to, say, 6.1% or 6.0%--I think we might see interest rate cuts before the end of 2011.
That, of course, would be exactly the kind of big money commitment—no paltry $30 million that—investors in Shanghai, Shenzhen, and Hong Kong are waiting for.
At this point, you’re entitled to shake your head and say, “But that won’t solve anything. It’s just papering over the problem.”
And I’d reply exactly. It’s the Chinese version of the game of kicking the debt can down the road that the United States is playing with its debt and that the EuroZone is playing with its debt.
Can everybody put off paying the piper forever? No way. Are things going to get really nasty—so nasty that 2011 might seem like the good old days—when the bill comes due? You bet.
Does that mean there won’t be profits to be made by cynically holding your nose and investing in the moment? Of course not.
The grasshopper had a great time singing “Winter is far away and it is a glorious day to play”
All we have to do is figure out a way to enjoy some of the profits of summer and avoid freezing to death when winter comes.
That’s all. Piece of cake.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did not own shares of any stock mentioned in this post as of the end of June. For a full list of the stocks in the fund as of the end of June see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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