Cross-posted from Kate Mackenzie at FTAlphaville.
The bull/bear arguments about China are evolving — or so we’d like to think — into a more nuanced debate about how the country’s leaders are going to respond to the pressing need for change (which they themselves have acknowledged), and how these responses might play out.
One of the key questions is how the large amounts of risky debt in China will be addressed.
Fitch’s Charlene Chu estimates the country’s total debt at about 200 per cent of GDP; Goldman’s estimate is 219 per cent. Both think the rate of growth has been very fast in the past five years, which is another risk indicator in itself.
Bloomberg yesterday published a round-up of what various bank analysts are thinking about China’s debt problem, which is where the economy’s shortcomings seem to be manifesting. Half of the strategists thought bad debts incurred by local government and corporations would have a “significant impact” on China’s credit and economic growth.
The question right now, however, is: how are the riskier borrowers being kept afloat, and how are banks managing their non-performing loans?
It’s an important question, especially if we consider that the People’s Bank of China is continuing to tighten, or at least is not adding liquidity through the normal, transparent channels. Meanwhile iron ore spot rates are holding up remarkably well around the $130 mark, and this is despite slowing GDP growth, falling fixed-asset investment growth, and signs that Chinese steel mills were opting for local suppliersearly this year. While banks rolled over their existing debt, the growth has to come from somewhere — and local government debt could be growing faster than is reported (a new audit is under way now). Who’s financing all this, and how?
Here are the strategists’ theories, from the Bloomberg survey:
While 11 analysts unanimously said China would expand municipal bond sales, five respondents said China may also sell non-performing loans to bad-debt managers or create new managers. Three said China would allow some local-government financing vehicles to default on debt. Respondents could choose more than one answer.
China has prior experience with moving non-performing loans into bad banks, and today there exist four big asset management companies, or AMCs, that were created to take on bad debts when the NPL rates of China’s big state-owned banks reached as high as 30 per cent in the late 1990s.
Anne Stevenson-Yang of J Capital Research says that the AMC solution may be already happening in some form. Her staff, after talking to “financiers of all types” in different parts of the country, also heard of various ways that new credit is getting to property developers and local government financing vehicles who might have otherwise defaulted:
• Private equities: In several cities, we have met with private equity funds that funnel bank loans into property. The funds purchase equity in a project company under a real estate developer, signing an agreement stipulating that the developer will repurchase the equity after a given period of time at a fixed rate of interest.
• Asset management plans: Several interviewees said that banks were moving “irregular assets” into related AMCs established for the purpose. The bank buys bonds and equity in the AMC. These funds increasingly purchase projects are operate them for cash flow but often also package loans as equity injections backed by buy-back agreements.
• LGFV subsidiaries: One bank told us that regulatory scrutiny had reduced their ability to lend to LGFVs. Therefore, the bank instructs LGFV applicants to establish subsidiary companies. These subsidiaries become eligible for loans—often at preferential rates—by virtue of being designated small and medium enterprises. The subsidiaries can then lend to their parent companies.
• Using related companies: If a property developer seeking cash owns an industrial company, such as a power plant or a refinery, it can use that company to apply for loans, which are then lent on to the developer.
• Insurance companies: Insurance and securities companies have become very active partners to the banks, effectively taking over for trusts. These institution may invest in or lend to property projects and then sell their stakes to banks. Particularly popular now are retirement home projects and tourism projects, such as holiday villas. Insurers also securitize future income streams, bundle them, and sell to banks.
• Industrial funds: Local governments are setting up funds designed to support industry, and banks may lend to these funds. The funds may be used to finance construction of a new factory to replace one that is being moved to make way for new property development. In that way, land clearing costs are financed.
• Using hard currency to collateralize RMB loans: A few banks in designated regions are able to take hard-currency deposits from foreign-invested companies are issue RMB loans against them.
In otherwords, the challenge of propping up heavily-indebted borrowers is being met, for the time being, by China’s incredibly innovative shadow banking sector (which confusingly, isn’t entirely unregulated and has strong links to the formal banking sector).
