China’s believe it or not

After last week’s China update, which focussed on the massive malinvestment taking place within the Chinese economy, I received a number of articles from readers for inclusion in this week’s round-up.

Thanks for everyone that sent articles in. If you find any articles that you wish to be included in next week’s summary, feel free to email these to me at [email protected].

On to this week’s summaries, which focus on a number of issues relating to the Chinese economy, including: continued malinvestment; the Chinese housing bubble; Ponzi finance; and ageing demographics.

To kick-off, I first want to return to the topic of last week’s summary – China’s malinvestment. An article appearing in Bloomberg provides yet another colourful example of the unsustainable building boom taking place within China, as well as some of the funny money deals being used to fund these projects (h/t Michael McC. for the link):

Workers toil by night lights with hoes, carving out the signs for Olympic rings in front of an unfinished 30,000-seat stadium, bulb-shaped gymnasium and swimming complex in a little-known Chinese city.

Loudi, home to 4 million people in Chairman Mao Zedong’s home province of Hunan, is paying for the project with 1.2 billion yuan ($185 million) in bonds, guaranteed by land valued at $1.5 million an acre. That’s about the same as prices in Winnetka, a Chicago suburb that is one of the richest U.S. towns, where the average household earns more than $250,000 a year.

In Loudi, people take home $2,323 annually and there are no Olympics here on any calendar.

“The debt isn’t a problem as Loudi is not a developed place,” Yang Haibo, an official at the city’s financing vehicle, says as he sits with colleagues in a smoke-filled meeting room under a No Smoking sign. “It’s an emerging city.”

A 3,300-mile (5,310-kilometer) tour of three cities in China, coupled with reviews of dozens of Chinese-language bond prospectuses that offer an unusually transparent view into local government debt, shows just how widespread such borrowing has become. In China, as in the U.S. before the collapse of the subprime mortgage market in 2007, local debt is backed by collateral that is overvalued, may be hard to sell and, in some cases, doesn’t exist.

Officials in Loudi, whose colonnaded government building is locally nicknamed the White House, value their 18 tracts of land at almost four times what a similar plot sold for in May. In the northeast city of Cangzhou, the man in charge of the assets financing a port expansion can’t locate the land his company posted as collateral for a 1 billion-yuan bond sale. And a spending spree in Yichun, a district on the Russian border covered by ice much of the year, is backed by promises of future land sales that officials acknowledge may never materialize…

Local governments set up more than 10,000 so-called financing vehicles in the past decade to get around laws prohibiting them from taking direct loans. One third of them don’t have cash flow to service their loans, China’s banking regulator says.

The similarities with special purpose vehicles in the U.S. hiding toxic repackaged mortgages from banks’ balance sheets are increasing. Subsequent losses prompted the U.S. government and central bank to lend, spend or guarantee a peak of $12.8 trillion in 2009 to rescue the financial industry, including a $45 billion direct investment to rescue Citigroup Inc. (C), then the biggest U.S. financial services company…

In a similar vein, an article published last week in Caixin provides a wonderful insight into the dodgy tricks being employed by Chinese banks to get around Government lending restrictions in order to finance risky real estate and local government projects. It all sounds eerily familiar to the CDOs and other securitised paper issued by US financiers prior to the financial crisis (h/t Bernard Hickey for the link).

Call it the Great Wealth Rollover of China.

The nation’s banks have been introducing new wealth management investment products at a blurring pace over the past year, dazzling upper-class clients with fat catalogues of high-yield investment opportunities.

Yet Caixin has learned from bank and regulatory sources that much of the wealthy investor cash pouring into short-term, high-risk products is being rolled over by banks to provide fresh financing for long-term investments, including unfinished property developments, local government financing platforms, railway projects and private equity.

The rollover game is providing badly needed funds for infrastructure projects for which credit has dried up over the past year with every notch of monetary tightening by the central government. It’s helped offset the government’s rising bank deposit reserve requirement, for example, which has crimped bank lending.

At the same time, some industry experts warn, the banks may be fobbing off long-term investment risks to their wealth management clients.

By offering the well-to-do a dizzying variety of investment products along with promises of near-double-digit returns, some fear banks are leading wealth management clients into the same trap that caught U.S. investors before they were fleeced during the 2007 subprime mortgage crisis.

About 9,000 types of wealth management products were available to Chinese investors during the first half of 2011, double the number offered in 2010. Capital turnover for these products topped 8 trillion yuan between January and June…

“Some products are expected to yield close to 10 percent,” said one bank executive. “But how are banks getting access to so many high-return investment channels?”…

Some bank critics say wealth management products have been used to build a shadow banking system beyond regulatory reach. Others warn of possible Ponzi schemes, or call the race among banks for wealthy clients maddening.

Some banks, critics contend, slyly use funds raised by selling short-term, high-yield investment products to fill financial holes as soon as they appear – and before these holes show up on accounting books…

A source at a joint-stock bank said capital from a bank’s short-term wealth management product goes into a capital pool. The pool’s size is maintained by continuously rolling through new products. And an ever-increasing share is steered into high-yield, risky assets, the source said…

Banks in general are scrambling to attract depositors, and the wealthier the better. Job performance evaluations are often tied to deposit growth. So bankers and bank staffers have strong incentive to attract new clients by offering high-yielding wealth products…

And a bank branch president told Caixin that innovative financial products have become more popular as bank staffers react to the pressure to pull in more deposits.

Likewise, a recent article published in Zero Hedge shines further light on the funny money tricks being employed through China’s shadow banking system:

China’s formal bank lending has been under restraint since the People’s Bank of China stepped up quantitative tightening late last year. However, unregulated financing activity is sprouting up like weeds throughout China. Trillions of yuan in capital have been raised through investment trusts, underground money markets and high-yield retail investment products to sustain short-term liquidity for those who are cut off from the formal credit market, especially small- and medium- enterprises, private property developers, and more recently, local government financing vehicles.

The currently unsupervised development of the informal financing market delays the intended impact of monetary policy tightening, but adds to the risk of precipitating a liquidity crunch of the entire financial system later…

Capital raised via shadow channels has largely gone to three types of companies – private small- and medium sized enterprises (SMEs), private property developers, and local government financing vehicles (LGFVs).

SMEs have been underserved by China’s banking system for years, and the PBoC’s quantitative policy tightening pushes this structural problem to its extreme. The scale of this credit market is the most difficult to gauge. According to the PBoC branch in Wenzhou, China’s No.1 city of entrepreneurship, 16% of SME funding came from underground banks in Q1, which charged an average annual interest rate of 25%. However, numerous reports suggest that interest rates on working capital loans have reached exorbitant levels of 6~10% per month in some cases.

Property developers have been turned down by banks since the central government got serious about curbing property prices late last year. The interest rates charged range from 15% to 30% per annum. LGFVs are also forced to borrow at higher cost from these channels because of tighter regulation…

Borrowing at such high levels of interest rates in the shadow banking system is clearly not sustainable. Resilient domestic demand may support this operation, but those enterprises probably operate on the hope that currently tight liquidity conditions will not last long. The availability of alternative credit channels merely reinforces this hope and delays the impact of the PBoC’s tightening. Therefore, if the PBoC continues to keep a firm hand on credit growth, the Chinese economy could run into a systemic crunch.

Meanwhile, following last week’s research in VOX confirming that China is in the throws of a housing bubble, The Telegraph’s Jeremy Warner reports that China’s spectacular real estate bubble is about to pop (h/t Bernard hickey). Warner draws much of his arguments from the IMF’s latest staff report on China (available here).

So you thought that UK housing was unaffordable. Try Beijing and Shanghai, where as can be seen from the graphic below, prices are off the scale relative to income, the commonly used yardstick for measuring affordability. OK, so these are the boom cities of the Chinese economic miracle, but even on a nationwide basis, affordability is no lower than in the UK…

With the example of the Western property bubble, which ended very badly indeed, serving as a salutary reminder of the dangers of unchecked real estate prices, the Chinese authorities have taken a number of steps to cool the country’s overheated housing market. And it is working; residential property prices have risen on average by “only” 7pc over the last year, and transaction volumes are lower.

But here’s the problem. Residential and commercial property development have been such a big component of growth in recent years that anything that damages the property market risks upsetting the entire apple cart. Nobody can forecast with any certainty when the crash will come, but come it will. You cannot cram that much development into such a short space of time without there eventually being a correction.

And when it comes, its knock on consequences are going to be extreme, possibly just as seismic as the rolling series of banking crises we’ve had here in the west. As noted in the IMF’s latest staff report on China, published this week, the property sector occupies a central position in the Chinese economy, directly making up some 12pc of GDP. It is also highly connected to the health of basic industries such as steel and cement, and to the success of downstream industries like domestic appliances and other consumer durables.

More worrying still, direct lending to real estate (developers and household mortgages) makes up around 18pc of all bank credit (see second graphic below). Again, even by UK standards, this is extreme. And for local authorities, which account for 82pc of public spending in China, property related revenues are an important consituent of the overall revenues used as collateral to back borrowing to fund property and infrastructure development. There’s an element of ponzi scheme here.

The problem with the US and UK economies, it is often said, is that they are unbalanced – too much consumption, not enough investment and net trade. In China, the difficulty is the other way around. Consumption remains in the low 30s as a percentage of GDP, the lowest of any major economy. Again, this is deliberate. The Chinese authorities set policy to prioritise investment over consumption.

Any reading of economic history reveals that in the end this path to growth and development is as unsustainable as excessive consumption.

While most commentators seem to acknowledge the deep imbalances developing within the Chinese economy, many still believe that China’s authorities can pull the economy through without too much collateral damage.

For instance, Canada’s TD Economics believes the Chinese government has enough resources to prevent a credit crunch and forestall a decline in domestic economic activity even in the face of a sharp increase in bad loans (h/t Ben Rabidoux):

To assess the potential global implications of a Chinese banking crisis, we need to characterize the latter by making assumptions on its probable dimensions. So, let’s assume 50% of loans to local governments default within two years.

Further, assume that the NPL ratio on the remaining loans rises to 15%. This would push the NPL ratio for the Chinese banking system as a whole to 25%. This is arguably a very severe, yet low-probability scenario. However, given our previous discussions of risks, it is within the realm of possibility.

As a reference point, it is worth mentioning that in the early 1990s, following a similar credit expansion; the non-performing loan ratio reached 35%. Moreover, both Moody’s and Fitch see the NPL ratio reaching 18% and 30% under their respective worst-case scenarios.

If in addition to the 25% NPL ratio we also assume full losses on the defaulted loans, the impact would be equivalent to 29% of projected 2011 GDP. This is an alarming figure. However, the key question is whether a sharp increase in NPLs would cause credit flows to contract in China as it did in other previous banking crisis. The most likely answer is no. This is where the strengths of the Chinese banking system, among other mitigating factors, play a big role.

First, we highlight that those losses would take time to materialize. This would allow authorities to react, reducing the actual economic impact. For instance, being the main shareholder in many of the country’s banks, the central government could delay dividend payments to build cash buffers.

Second, as bad loans start to mount, the central government could simply swap defaulted local government loans with Chinese sovereign debt, immediately reducing NPL ratios.

Third, recapitalization could take place after the latter and other measures were taken to improve banks’ balance sheet. Indeed, even under the extreme scenario, total losses would amount to 63% of total Chinese foreign exchange reserves. Those reserves and the discretionary power of central authorities would greatly facilitate the crisis resolution.

Lastly, this implicit government support and the lack of alternatives, make a run on deposits unlikely, even in the face of rising NPLs.

Therefore, the fact that the government has enough levers to prevent a credit crunch greatly reduces the likelihood of a negative feedback loop between rising NPLs and worsening economic activity. Hence, it is unlikely that over the next two years, the expected deterioration in assets quality would lead to a sharp reduction in Chinese economic growth.

TD Economics’ view is supported by Standard Chartered Bank, which believes that China’s looming trillion-dollar loan crisis can be defused by the authorities with limited damage to the banking system and the economy:

“We believe the problem, though large, is solvable,” wrote Green in the note entitled “China: Solving the local government debt problem.”

In fact, China has a successful debt-workout track record, having bailed out its banks following the Asian financial crisis in a restructuring that eventually cost about $480 billion.

Green foresees a more direct role by the Ministry of Finance in providing support for the most exposed commercial banks and in helping troubled infrastructure projects to completion. One option could be for the ministry to channel CNY500 billion to local governments before year end to help keep ailing airport, highway and other mega projects on track, he said.

In the second step toward fixing the problem, Beijing would need to designate a policy bank, such as the China Development Bank, to purchase toxic loans extended by banks to build unprofitable infrastructure projects.

About CNY1 trillion in 10-year bonds could be sold before year end to support the purchases, followed by CNY3 trillion in 2013.

The toxic loans would be purchased from commercial banks at a discount, perhaps around 90% of their original value.

“This haircut would need to be big enough to be an incentive to keep good projects on their books and to guard against moral hazard, but small enough not to destabilize the banks,”Green wrote in the note.

One reason to see the glass half full, Green said, is the fairly robust state of central government accounts.

Tax revenues are likely to grow 20% this year, which could see the government budget swing to surplus, providing about CNY1 trillion in extra funding.

The central government could implement a matching funds scheme, whereby it provides CNY10 million in funds for every CNY50 million repaid by local sources.

And finally, The Economist has attacked China’s one child policy, arguing that it is a demographic and economic disaster in the making that could prevent China from reaching its development goals (h/t Bernard Hickey):

…the [one child] policy has almost certainly reduced fertility below the level to which it would have fallen anyway. As a result, China has one of the world’s lowest “dependency ratios”, with roughly three economically active adults for each dependent child or old person. It has therefore enjoyed a larger “demographic dividend” (extra growth as a result of the high ratio of workers to dependents) than its neighbours. But the dividend is near to being cashed out. Between 2000 and 2010, the share of the population under 14—future providers for their parents—slumped from 23% to 17%. China now has too few young people, not too many. It has around eight people of working age for every person over 65. By 2050 it will have only 2.2. Japan, the oldest country in the world now, has 2.6. China is getting old before it has got rich.

Readers seeking a more detailed examination of China’s demographic time bomb are advised to read my earlier reports (here and here).

That’s all for this week. Once again, feel free to add any links to other relevant China articles in the comments thread. And if you happen to come across any articles worthy of including in next week’s update, feel free to email these to me at the below address.

[email protected]

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