China’s state of debt deteriorates

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From Soc Gen’s Wei Yao via FTAlphaville:

…a look at the composition of borrowers and lenders reveals the secret behind this exceptional stability. Government bonds, local and central taken together, are barely more than 20% of GDP and households, with 80% of GDP deposits, account for another 20% of GDP debt. Corporates are the biggest borrowers, but two groups of government-related entities – local government financial vehicles (LGFVs, 30-35% of GDP) and state-owned enterprises (SOEs, 90-100% of GDP) – account for the lion’s share. Among lenders, nearly all aspects of China’s financial system are still dominated by state players, from formal banking, insurance and asset management to shadow banking (finance companies and trust companies, for instance).

As a majority of creditors and borrowers are related to the government, the usual financial market dynamics of risk discovery often get suppressed. And, local governments play a critical role along the credit risk chain. They extend credit guarantees to LGFVs, local SOEs and even some private companies that are deemed local champions. In troubled times, they are also often seen at the negotiation table with creditors.

…Since we last wrote about fiscal reform in December, developments have, so far, confirmed our concern that local government financing conditions are deteriorating.

Investors, in the corporate bond market at least, continue to catch up on fiscal reform and, as a result, local governments’ borrowing channels continue to tighten. In mid-December 2014, the China Bond Clearing House disqualified the lion’s share of LGFV bonds as collateral for repurchase agreements and made it clear that not all LGFV bonds would be considered equivalent to government instruments. Thereafter, two LGFVs were forced to clarify to investors that their bonds were not guaranteed by the state and called off their planned bond issuance. Entering the New Year, LGFV bond issuance dwindled further to about CNY10bn so far, from CNY73bn in December and over CNY100bn in prior months.

The property investment remains on a downtrend, squeezing land sale revenues. Property investment growth collapsed to -1.9% yoy in December 2014 from +7.6% yoy in November 2014, its first contraction in 18 years. There has been visible damage to land sales. In seasonally adjusted terms, sales volumes dropped by 12.5% qoq in Q4 14 to the lowest level since Q2 09. The recent default by the developer Kaisa on its offshore bond has only worsened funding prospects for the whole sector, pointing to a further correction in land sales. Worse still, any fall in land prices will also dilute the value of credit guarantees extended by local governments since nearly 40% of their debt relates to pledges on future revenues from land sales.

2015 is likely to be the first year that local governments will see both a deceleration in credit growth and declining land sales.

More on the impact of that from Investing in Chinese Stocks:

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The WSJ has a great piece on Chinese debt: Debt That Once Boosted Its Cities Now Burdens China

A little over a year ago, a Chinese credit agency downgraded a government-owned financing company in this dusty industrial city. Default—nearly unheard-of in China on government bonds—was a possibility, it said.

But during discussions with lenders, city officials made sure Wuhan Urban Construction Investment & Development Corp. could keep borrowing…

…Wuhan Urban, whose debt jumped 20% in 2013, has borrowed big. A listed unit raised 650 million yuan ($103.9 million) in November from bond sales to underwrite a construction blitz that earned Wuhan’s mayor, Tang Liangzhi, the nickname Mr. Dig Dig…

…“When it comes to raising funds for the purpose of developing the city, we leave no stone unturned,” Wuhan Urban said in a July report…

…“The guys running local government financing operations won’t roll over and die,” says Fraser Howie, co-author of “Red Capitalism,” a study of China’s financial system. “These companies take on a life of their own.”

…Roughly 8,000 local-government-financing firms across China are responsible for the rapid development of cities but also the glut of housing, industrial parks and other projects economists and officials say threaten China’s economic health. “If you’re building projects that can’t cover their cost, you’re spending money on keeping them going,” says Mr. Howie. “Some hospital somewhere isn’t being built; some small company isn’t getting money.”

The punchline is that China is adding debt faster than Japan and Korea prior to their recessions.

Also, land sales had fueled a lot of this development, but as Deutsche Bank pointed out, land sale finance will be hit this year: Deutsche Bank Says Land Sales Slowdown Only Started Hitting in Q4

“There is a common misperception that land revenue has already dropped sharply in 2014. The market appears well aware of the slowdown of property sales and land auctions in 2014. It likely overlooked the lag between land auctions cooling off and the decline of fiscal revenue. The reality is, land market started to cool down sharply in March 2014, but land sale from a fiscal revenue perspective in yoy terms remained positive until Q3 2014. We believe the fiscal shock to local government revenue only started in Q4. The full impact will likely be seen in H1 2015.”

What happened to real estate investment in December 2014? It went negative for the first time in at least a decade and probably much longer.

Any guesses where Jan-Feb will land, short of a massive increase in credit?

There’s more, Local borrowing sounds alarm bells:

“Recent estimates from China International Capital Corporation put local government debt levels at around 22 trillion yuan ($3.51 trillion) by the end of 2014, with 15 to 20 percent of this amount tied up in “highly risky” projects.

The local government bond market is now valued at about 5.6 trillion yuan, most of which will mature in 2016. By that point, local governments could face enormous repayment pressure.”

And more again, Local govts lower 2015 GDP forecasts:

“Fifteen provincial-level governments out of 17 that had published their economic growth targets as of Tuesday have cut their forecasts for 2015, to focus on quality and efficiency of growth amid a slowing economy.

Three out of China’s four municipalities have lowered their 2015 growth targets. Beijing set its 2015 growth target at 7 percent, down from 7.5 percent in 2014. North China’s Tianjin cut the 2015 forecast to 9 percent from 11 percent in 2014, and Southwest China’s Chongqing has set a 10 percent growth goal for 2015, compared with 11 percent in 2014.”

Many provinces have missed their growth targets for 2014. For instance, North China’s Hebei Province saw GDP growth of 6.5 percent in 2014, compared with the target of 8 percent.

The forecasts are still too optimistic: 2015 growth will be slower than 2014.

Which brings us back to credit again and Wei Yao:

…LGFVs: in our previous report, we noted that the market’s count of LGFV bonds is three times the size recognised by the central government. Not to our surprise, shortly after local governments submitted the final debt figures to Beijing on 5 January, some local media caught hints from government sources that the count could be “shocking”. Some other reports suggested that the recognised number would be “only” 30-50% higher than the mid-2013 audit result. In our view, such a count would still not include a meaningful portion of LGFV debt from lenders’ risk-free list. In the meantime, repayment pressure is building up rapidly. In the bond market alone, CNY600bn LGFV debt is coming due in 2015, while LGFVs are ill-prepared. According to our credit strategists (report link), of the one-third of LGFVs that have reported financial data, 85% generate negative net cash flows.

– Local SOEs: there are over 100,000 of them and their profitability underperforms central SOEs who are in turn less efficient than private corporates. In light of their poor financial performance, local government credit guarantees are probably an important factor behind their survival, especially for those who have suffered severely from excess capacity. The persistent growth deceleration has pushed inefficient SOEs to financial brink. In the industrial sector, 30% of SOEs were loss-making in 2014, up from 25.5% in 2013 and compared with 12.5% of private enterprises. The situation deteriorated sharply towards end-2014 as SOE profits contracted 21.8% yoy in Q4 14 (vs. -1.3% yoy of private enterprises). Of all the SOEs in all sectors, local players’ return on assets (1.5% in 2014) or return on equity (4.4% in 2014) slid for five years and have always been less than one-half the level of their centrally-controlled peer. Their total liabilities stood at CNY31tn as of end- 2014, much more sizeable than LGFVs.

…Private companies: in aggregate, they are the most efficient sector in the Chinese economy but some of them have also enjoyed a number of concessions from local governments directly or from local government-related entities, in the form of cheap land, cheap utilities, tax rebates and sometimes credit guarantees. Tax reform and land reform will substantially cut back irregular fiscal subsidies and discounts on industrial land. In terms of credit guarantees, as it gets harder for local governments, private companies are mostly likely to be among the first to experience collateral damage. We have already seen one such case, in fact. An LGFV in Jiangsu recanted its credit guarantee to a bond issued by a private company back in 2012. This bond missed the payment on the due day.

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I hope this gives you some idea of the sheer magnitude and complexity of the reform underway in China, and the commensurate risks.

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.