The bad loans hobbling China

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From Soc Gen via Zero Hedge:

As the growth deceleration intensifies and financial market liberalisation accelerates, denying the debt problem is becoming an increasingly unviable strategy. The Chinese government may be able to keep papering over the debt problem by continuing to offer implicit credit guarantees to everyone for another year or two. However, developments in the past year suggest that top policymakers are now willing to face up to the problem and work on a deleveraging plan. One recent announcement in this direction came from Premier Li, who told a roomful of international and domestic media in March this year that allowing credit events to occur and leaving them to the market to work out will be necessary to address the moral hazard problem.

Market pricing of interest rates is at the core of interest rate liberalisation, which policymakers are keen to push through. That is simply impossible without the existence of risk. Besides installing a deposit insurance scheme, which implicitly admits the possibility of bank restructuring, onshore bond defaults have started to emerge alongside the acceleration of interest rate liberalisation. By the time of this publication, we have counted four credit events in the onshore secondary bond market, including one SOE, and close to a dozen private placement bond defaults (Table 1). While in a few default cases (e.g. Chaori and Zhongsen) investors were eventually paid, the occurrence of these credit events have kick- started risk revaluation in the bond market (Chart 7). We think that, due to its signalling effects, the bond market will continue to be a cautious test ground for the government.

The fiscal reform will also bring more credit risk to the fore. The fiscal reform has started to limit local governments’ ability to extend credit guarantees at a time of slowing domestic growth and tightening global liquidity. Local governments have played 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, and it is also a common practice for LGFVs and local SOEs to provide credit guarantees to small and medium-size private enterprises. As this critical domino chain of local governments in China’s credit risk situation begins to wobble, there could be significant ramifications for broad financial market stability. Such a chain reaction seems to have begun: SOEs and LGFVs are the guarantors in a majority of private placement bond default cases but have failed to provide credit protection as promised (Table 1).

SocGenChinaNPLCycle

Apart from reform, the pressure exerted by the multi-year growth deceleration is already weighing on commercial banks, whose NPLs have doubled since 2012 (Chart 8), indicating that private sector debt restructuring has begun and that the process so far is rightly being left to market mechanisms. Consequently, for the first time Chinese loan officers are prioritising containing credit risk over growing loan books, and this has gotten in the way of the transmission of monetary policy easing.

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.