China’s debt denouement
Time is running out for the Chinese Potemkin economy
By Satyajit Das
Friday, 29th May 2015
Shenzhen Stock Exchange. Source
China’s looming debt crisis is reaching a crucial point, with the recent default of Kaisa, a property developer.
The high and low roads
Pessimists are concerned about a catastrophic crash. Optimists are more sanguine, expecting a soft landing with gradual reforms correcting the systemic issues.
The crash scenario assumes there will be continuing increases in debt levels and over-investment. Policy adjustments are fatally delayed. Ultimately, authorities are forced to tighten credit aggressively, triggering failures in the financial system and a sharp slowdown in growth.
Weaknesses in the financial structure exacerbate the money market tightening, which causes liquidity-driven problems for both vulnerable smaller banks and the shadow banking entities. The rapid decline in credit availability results in problems for leveraged borrowers, such as those in local governments and property sectors. The larger banks, which are likely to benefit from the flight to quality, are unable or unwilling to expand credit to cover the shrinkage from smaller banks and the shadow banking sector, due to risk aversion or regulatory pressures.
The deceleration in credit growth and liquidity results in lower levels of economic activity. Combined with cost pressures and weak external conditions, Chinese businesses, who are major suppliers of cash to the economy, experience a decline in cash flows, which compounds the liquidity problems.
Foreign capital inflows, which have enabled the People’s Bank of China (PBOC; the central bank) to provide liquidity to the financial system, slow and then reverse. At the same time, increasing capital outflows, especially from corporations and also the politically well connected and wealthy, drive further contraction in credit.
The confluence of a liquidity crisis, financial system problems, slowing growth and capital outflows would feed accelerating negative feedback loops, which would be difficult to deal with.
The optimists counter that the debt levels, while high, are manageable, because of high growth rates, the domestic nature of the debt, high savings rates and the substantially closed economy. They argue that the banking system has low leverage, a large domestic funding base and low levels of non-performing loans. They also rely on the high level of foreign exchange reserves and modest levels, at least by developed-country standards, of central government debt.
The optimists believe that reform programs, while slow in implementation, will ensure a smooth transition. China will rebalance its economy from investment to consumption. Deregulation and structural changes will improve the resilience of the financial system.
The Middle Kingdom’s middle path
The most likely strategy will entail continued credit expansion, providing liquidity, managing non-performing assets, and using transfers from households to the financial and corporate sector.
The central bank will continue to provide abundant liquidity to the financial system through a variety of mechanisms.
Lenders have been instructed to roll-over loans to local governments which cannot be repaid out of cash flow. Authorities have altered regulations to allow local governments to issue public bonds, for the first time in 20 years. Chinese authorities subscribe to the theory that “a rolling loan gathers no loss”.
Defaults in the shadow banking will also be managed. Where considered appropriate, banks and state entities will intervene to minimize investor losses, by taking over the loans or re-integrating assets into regulated banks. A number of trust company and “wealth management product” investments have missed payments, with many having been rescued, sometimes under mysterious circumstances. One analyst told a reporter: “Moral hazard in China is state policy”.
As in previous Chinese episodes of bad lending, non-performing loans (NPLs) will be sold to government-sponsored asset management companies (AMCs) to avoid a banking crisis.
In effect, instead of resolving the debt problems, the Chinese government will oversee a process of supporting over-indebted borrowers and the banking system. As in a shell game, bad debts will be shuffled from entity to entity, delaying the recognition of losses.
The actions will reduce the immediate financial pressure, but merely defer the debt problem. The primary objective of the strategy is to maintain high growth for as long as possible and also preserve social order. It reflects the fact that a financial and economic crisis in China would be synonymous with a loss of confidence in the state itself and the Chinese Communist Party.
Price to pay
The ultimate price of this strategy will be to lock the Chinese economy into a lower growth path with the risk of destabilising crash.
Over time, increasing amounts of capital and resources will become locked into unproductive investments that do not generate sufficient returns to service the debt incurred to finance them.
The need for economic growth will continue to drive debt-fuelled investments with inadequate returns. When the debt incurred cannot be serviced or paid back, more capital will be tied up in warehousing the losses to avoid a banking crisis.
If returns on investment are insufficient, then there must be a transfer from one part of the economy to another to cover the shortfall. This cost will be borne by households, with slower improvement in living standards and erosion of the value of their savings.
Authorities will have to keep saving rates high to provide the capital needed to pursue this strategy. They will ensure that the bulk of funds remain in the form of low-yield deposits with policy banks, which can be directed by the central government as required. Interest rates will remain below inflation. Banks will need to maintain a large spread between borrowing and lending rates to ensure sufficient profitability to absorb the cost of non-performing loans. Borrowing rates and the cost of capital will also need to be kept low to support the investment strategy and also reduce pressure on unprofitable or insolvent businesses.
The loss of purchasing power of household savings will provide the economic basis for the transfer of resources, amounting to as much as 5% of GDP, to banks and to borrowers, primarily state-owned enterprises and exporters.
The necessity of high saving rates will impede the rebalancing from investment to consumption. It will also impede the development and deepening of the financial system. China will also have fewer resources available to improve health, education, aged care and the environment.
In the short run, continued mal-investment and deferring bad debt write-offs will provide the illusion of robust economic activity. Over time, households will discover that the purchasing power of their savings has fallen. Wealth levels will be reduced by the decline in the prices of overvalued assets. Businesses and borrowers will find that their earnings and the value of their overpriced collateral are below the levels required to meet outstanding liabilities.
The alternative is equally problematic. If the government moved to liquidate uneconomic businesses and unrecoverable debt, then it would need to finance the recapitalization of businesses and banks. This cost would require a sharp increase in taxation, which would also result in a slowdown in economic activity.
In reality, China’s Potemkin economy of zombie businesses and banks will continue for the foreseeable future, giving the appearance of normality but creating progressively less real economic activity.
© 2015 Satyajit Das
About the author
Satyajit Das Satyajit Das is a former banker, and is the author of Extreme Money and Traders, Guns & Money.
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