{"id":21354,"date":"2011-11-23T22:43:00","date_gmt":"2011-11-23T21:43:00","guid":{"rendered":"http:\/\/beta.next-finance.net\/opinion\/on-debt-watch-why-china-cant-save-the-world\/"},"modified":"2019-12-30T22:19:54","modified_gmt":"2019-12-30T21:19:54","slug":"on-debt-watch-why-china-cant-save-the-world","status":"publish","type":"post","link":"http:\/\/beta.next-finance.net\/en\/opinion\/on-debt-watch-why-china-cant-save-the-world\/","title":{"rendered":"On debt watch: why China can\u2019t save the world"},"content":{"rendered":"

When European leaders appeared to go \u2018cap in hand\u2019 to China to help fund the eurozone bail-out, it marked a meaningful moment in world politics and further consolidated the shift in economic power from west to east.<\/p>\n

While China may be the only country with sufficient cash reserves to help the eurozone out of its crisis, the world\u2019s second largest economy has a debt problem of its own brewing and more than a few skeletons in its economic closet that put it in no fit state to save the world.<\/p>\n

Having followed the Chinese economy for twenty years, I like to call its financial system the fifth dimension. The sector is veiled in such secrecy that no one knows the genuine state of China\u2019s banks. In fact, analysts have largely come to accept that imagination must play a part in their valuation model! Aside from saving the world, China is itself at an economic crossroads that could serve to dismantle some of the systems that got the country into this mess.<\/p>\n

In recent months, markets have finally woken up to the truth of the Fitch report on local government investment vehicles (LGIV). These are investment corporations set up by local governments which cannot borrow in their own name. During the course of the credit crunch, Chinese banks were encouraged to lend to these entities and these loans were used to fund the building boom that has left the country strewn with half-built bridges, unused buildings, broken railways, and tracts of land miles from anywhere. In addition, many of the loans have turned so bad they threaten the balance-sheets of the banks that made them.<\/p>\n

Beijing has previously said that LGIVs have piled up to \u00a510.7 trillion, ($1.6 trillion) as of the end of 2010, in debt. While our own estimates put this figure even higher, \u00a510.7 trillion is still a lot of debt for the banking sector to bear. The government will almost certainly have to step in. Meanwhile, the market is also realising the scale of off-balance sheet lending in China.<\/p>\n

<\/p>\n

It is clear that almost half of credit creation in China is off-balance sheet. The cause of this boom in shadow finance is
\nsimple:
\n– strict on-balance sheet loan quotas
\n– very negative deposit rates
\n– very strong demand for credit
\n– the banking sector\u2019s desire for profit growth (fee income) at all costs
\n– and loose regulation<\/p>\n

All these have proved to be the perfect environment for-off balance sheet credit creation.<\/p>\n

As the detail emerges \u2013 showing the extent of such lending; the practices involved; and the calibre of end borrowers
\n(property companies, struggling Wenzhou SMEs etc.) \u2013 the horror stories have also started to come through. These
\nhave included questionable practices on the part of end borrowers. Local media is full of reports of financial scandal
\nand skullduggery: tales of Wenzhou entrepreneurs disappearing into thin air with recently acquired loans. This comes
\nalongside evidence of the extent of the LGIV defaults. For example, the Liaoning province in northeast China is
\nreported (in the Xinhua Press) to have 156 out of its 184 LGIVs already in default due to lack of cash flow<\/p>\n

Estimating an 80% loss rate, we predict a potential black hole in the banking system equivalent to 25% of GDP.
\nScary numbers but, fortunately, China can afford it given its low starting government-debt-to-GDP levels, and the fact
\nthat losses are likely to be spread over many years \u2013 through a process of forbearance and denial!<\/p>\n

However, even as the first property companies begin to go bust, the outlook isn\u2019t all bad. The Chinese authorities
\nappear to have woken up to the problem and the country\u2019s markets fell 30% in the third quarter of this year. In our
\nview, this is positive, and signals that the market recognises the problem. As good a start as this may be, debts are
\npretty stubborn things, and we are braced for things to get a lot worse. Chinese property is particularly vulnerable at
\nthe moment, due to large-scale oversupply, extended affordability and rampant speculation (Chart 1 shows negative
\ndeposit rates and capital controls mean property is the main avenue of saving for the Chinese middle classes).<\/p>\n

\"Tableau<\/p>\n

We are also very worried about corporate cash flow. It has been clear that monetary policy and credit creation in
\nChina was not tightening as claimed. Instead, what drove the price of credit in the underground markets up to sky
\nhigh levels was the extraordinary demand for credit. This appears to have been the result of very high levels of
\ncorporate capital expenditure despite deteriorating cash flows.<\/p>\n

It is evident that across all segments \u2013 government related (LGIVs), state-owned enterprises (one of the main lenders
\ninto the shadow-banking system), corporates (high gearing, weak cashflow), property (yuck!) \u2013 the country is facing
\nsignificant debt problems. We think the situation could unravel fairly quickly over the next three to six months (as
\nfinancial crises are apt to do). In particular, off-balance sheet lending is effectively a chain that, when broken, tends to
\ntrigger a cascade of defaults.<\/p>\n

Having said this, there may be light at the end of the tunnel for China. The problems within the financial sector could
\nprove the first stages of the dismantling of the old model of government-directed lending and loan quotas. We could
\nstart to see a move towards market-driven interest rates, the proper pricing and rationing of credit, and realistic rates
\nfor deposits. This would be a huge step forward in the rebalancing process that the market has been calling for for
\nsome time, and could help shift China away from a fixed-asset investment economy to a more consumer-orientated
\neconomy.<\/p>\n

Either way, what happens next in China will be fascinating for observers, but nerve-racking for investors. Some
\n\u201ccreative destruction\u201d (kicking out the crooks and the favoured few) is likely to be the end result of this crisis. But
\nprogress isn\u2019t inevitable. We could, instead, see a panic move back to the same old policies of 2008\/09 (i.e. a bankdirected fixed asset investment program), which would be deeply damaging for the Chinese stockmarket, long term.<\/p>\n

The next step for investors?<\/strong><\/p>\n

We think the noise surrounding China\u2019s banks and the problems in the financial system have the potential over the
\ncoming months to give us a crisis-level buying opportunity in Asia. However, we don\u2019t think the current problems,
\nalthough serious, will lead either to a complete collapse in China\u2019s growth rate or a full-blown financial crisis.<\/p>\n

The event does, however, have serious implications for what you might want to buy in China and related sectors in
\nAsia. We think fixed-asset investment has now peaked as a percentage of GDP, and will slow sharply or contract
\nfrom now on. Soaring cement consumption gives us a good idea of just how crazy China\u2019s investment bubble has
\nbeen. No country has ever consumed cement at a faster rate per capita than China and, as seen in Spain, this
\nnumber can come off sharply as the cycle turns. Given these concerns, we are avoiding all construction, property,
\nmaterial, infrastructure-related names in China and any companies across the region that are heavily exposed to this
\nsector (Korean and Taiwanese industrials and cyclicals, as well as commodity names).<\/p>\n

We also see little merit in trying to \u2018bottom fish\u2019 in Chinese property names. Balance sheets across the board in this
\nsector are very weak and accounting practices in many companies are questionable. The sector has always been
\nopaque and we think it is best to follow the clever money here. We were recently told by one of Hong Kong\u2019s largest
\nand best-connected conglomerates that it has no interest in acquiring bankrupt Chinese property companies (or
\nbuying their land directly) as titles and practices are questionable, and the real value of assets remains impossible to
\nverify.<\/p>\n

As the crisis unfolds we are likely to see some attractive opportunities to bolster our stance in China. On the back of
\nrecent weakness, we have already begun nibbling on a few quality names that were bombed out by the Q3 sell off. In
\nparticular, we are interested in the strongest consumer and internet names, however, we still think it is too early and
\nvaluations are too high. Although cautious on China overall, we are still building positions in transparent companies
\nwith solid business franchises, strong managements and a good track record because, despite the problems on the
\nhorizon, China\u2019s long-term growth story hasn\u2019t gone away.
\n