China does not look well

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There is more economic and financial congestion in China’s reform process today and although it’s not panic stations it’s not great, either. According to Professor Minxin Pei, far. From the FT:

Mr Li’s remarks last week suggest that Beijing may have decided to accept some intense pain now to forestall a future calamity. If so, we should applaud the Chinese leaders’ courage. Nevertheless, Mr Li and his colleagues will encounter serious difficulties in restructuring China’s debt-laden economy. Four challenges stand out.

First, Beijing’s newfound reluctance to offer bailouts indiscriminately may have the unintended effect of undermining confidence in the solvency of a wide range of borrowers. This could prompt a credit squeeze that produces more default than is desired.

…Second, many Chinese debt contracts are guaranteed by third parties. If one borrower is unable to make good on its promises, the event could trigger a series of further failures, as entities that have stood behind the defaulting borrower are themselves unable to fulfil their obligations. Systemic risks could be far bigger than the Chinese authorities assume, and may reside in unexpected corners of the financial system. 

…Third, the task of determining which borrower should go bust is unavoidably political. At present China lacks market-based institutions and procedures for bankruptcy, restructuring and liquidation. Government officials will be deciding which borrowers should be bailed out, and which should be allowed to go under.

…Finally, imposing financial discipline on the Chinese economy through default and credit retrenchment will make it harder to meet Beijing’s growth target of 7.5 per cent for 2014. To strengthen the credibility of their commitment to reform, Chinese leaders need to consider abandoning this artificial objective…

Moreover, there are a number of hard data points to support events turning in this direction. First, yesterday’s story about the collapse of the Chinese developer Zhejiang Xingrun Real Estate has gone hot. Also from the FT:

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China’s central bank and one of its largest state lenders are holding emergency talks over whether to bail out a defaulting real estate developer.

…In a case which offers a microcosm of the cracks emerging in China’s shadow banking system, Zhejiang Xingrun Real Estate, the provincial developer, had been offering usurious rates of interest to individuals after being shut out by conventional banks.

Officials from the government of Fenghua, a town in eastern China with a population of about 500,000, the People’s Bank of China and China Construction Bank, which was the main lender to the developer, were on Tuesday thrashing out ways to repay the company’s Rmb3.5bn ($566m) of debt.

…The company appears to have stopped functioning after its chairman and his son were arrested in November and January for suspected “illegal fundraising” and engaging in usury, according to state media reports.

But Zero Hedge is reporting that no such bailout discussions are underway. Via Weibo, the PBOC is in full denial:

[Condemned individual foreign media untrue] March 18, individual foreign media reports, “China’s central bank to discuss emergency aid small real estate company,” inconsistent with the facts: First, the People’s Bank did not participate in the text referred to “convene an emergency meeting on Tuesday.” . Second, the People’s Bank of Zhejiang Xingrun not involved in the disposition of property-related risks. False reports to the media release behavior in unverified cases, the People’s Bank strongly condemned.

It’s always wise to take ZH’s hysteria with a grain of salt but that looks clear enough. Meanwhile, lower quality developer bonds are tightening. From Bloomberg:

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Some 66 percent of new Chinese developer dollar-denominated bonds sold this year are trading below their issue price amid the collapse of a private real estate company and news the housing market is cooling.

About $6.3 billion of notes in the U.S. currency sold by property companies including Guangzhou R&F Properties Co., KWG Property Holding Ltd. and Shimao Property Holdings Ltd. (813) have fallen in secondary market trade, according to data compiled by Bloomberg. Prices on Kaisa Group Holdings Ltd. (1638)’s 2018 8.875 percent debentures dropped to a seven-month low yesterday while Shimao Property’s $600 million of 8.125 percent notes due 2021 and sold to investors at par in January were trading at 97.646 cents on the dollar.

…“We’re cautious on property bonds short term, with the developers expected to report weaker year-on-year monthly sales data for March,” said Owen Gallimore, a Singapore-based credit analyst at Australia & New Zealand Banking Group Ltd. “For the majority of high yield property developers, January and February sales fell as tier three and four cities suffered from over supply and the smaller developers faced a credit squeeze.”

FTAlphaville has more on the macro implications using yesterday’s spectacular Nomura note:

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More so, the property market in China may well pose the kind of systemic risk that banks and LGFVs do not — it’s not clear at all that China can cover up a crash in the sector. Since it made up 16 per cent of GDP, 33 per cent of fixed asset investment, 20 per cent of outstanding loans, 26 per cent of new loans, and 39 per cent of government revenues in 2013, according to Nomura, it’s doubly unclear where alternative growth might come from.

Maybe urbanisation will save the day and continue to support the property market but we really don’t recommend going out and buying into a third or fourth tier city any time soon.

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And as Nomura note, it appears most foreign investors and many Chinese investors are not aware that first-tier cities only account for 5 per cent of housing under construction. Comforting.

And one wonders how much more of this is coming so long as the downward trend in real estate price growth persists. From BofAML:

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We’re clearly still some distance from the house price falls that ended the commodity super cycle in late 2011 and formed the backdrop for the 2012 iron ore price crash. But is that reassuring or more concerning? Broad credit is much less tight than it was then even if specific prudential tightening is still in place for city-specific property:

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Yet we’re still seeing what appear to be early collapses in ponzi borrowers. Are interbank markets loose owing to the PBOC or a lack of desire to lend and borrow? One could easily conclude that we’re headed towards some kind of credit event in China this year.

About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.