Tuesday, April 29, 2014

China’s Debt Endgames...

Author: Satyajit Das

Quick And Slow Deaths…
Understandably, the major focus now is on the denouement of the crisis.

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 is predicated on 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 financial structure exacerbate the money market tightening causing 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 shadowing 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, capital outflows, especially from corporations and also the politically well-connected and wealthy, increase, driving 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, albeit 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 strength of the banking system is probably overstated, primarily because of the understatement of bad loans and the relationship with shadow banks. Real levels of non-performing loan may be as high as 5-10% of assets, about 5 to 10 times the reported levels. The risk of a significant portion of assets held in the shadow banking system may ultimately come back into the banking system.

China’s foreign exchange reserves (invested in high quality securities denominated in US$, Euro and Yen) may prove difficult to realize without triggering losses or currency issues. More fundamentally, the reserves are not true savings, being matched by Renminbi created by the PBOC and paid to domestic entities in exchange for foreign currencies.

In effect, the flexibility of Chinese authorities to deal with any problems may be more constrained than assumed. But the risk of a major collapse while always present is, at this stage, low. A familiar endgame, entailing bank failures, depositor runs, massive outflows of foreign investors or a sovereign default, is unlikely. The Central Government is seeking to steer a middle path, which is both difficult and has significant risks.

Middle Kingdom, Middle Path…
The 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. Maturities are being extended for up to 4 years, to alleviate refinancing pressures on the around US$1.5-2 trillion of debts that mature over the next three years. Chinese authorities subscribe to the theory that “a rolling loan gathers no loss”.

A variety of alternative funding structures are now being used to circumvent regulations. Authorities have altered regulations to allow local governments to issue public bonds, for the first time in 20 years.

Synthetic loans are common. Private equity funds subscribe equity which the sponsor contracts to repurchase at a future date at an agreed price. Insurance and security companies are partnering with banks to invest in real estate projects, which are then re-sold to banks at an agreed future date at an agreed price which guarantees the investor a fixed return.  Securitisation of future cash flows is used to raise debt.

With banks unable to increase their exposure to local governments, LGFVs have established subsidiaries, designated as small and medium enterprises with preferential access to finance, to raise funds which are then on lent to the parent. Property companies use related industrial companies, to apply for loans which are on-lent to the real-estate venture.

Provinces and local governments have established development funds, which are permitted to borrow from banks and then on lend to the relevant sponsor, ostensibly to support industry. For example, the fund can finance construction of a new factory which will inevitably include the cost of clearing the land where the old factory stood and building the infrastructure needed for a property project.

Defaults in the shadow banking will also be managed. The failure of a bond issuer (Chaori 11) has been incorrectly interpreted as a shift in policy where the authorities will allow default. The reality is more complex. 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.

In a recent case, investors in the US$500 million Credit Equals Gold No.1, managed by China Credit Trust (“CCT”), one of the country’s biggest Trust Companies, faced losses. The Trust principal asset was a loan to an unlisted mining company Zhenfu Energy which could not meet repayments. 

Investments in the vehicle had been distributed by ICBC, China’s largest bank, to around 700 wealthy individuals expecting a return of around 10% per annum.

With default threatening, ICBC made it clear that it had not guaranteed or assumed liability for returns or investment. After a period of uncertainty, an unnamed third party agreed to purchase an equity stake in the underlying venture, which then was granted a valuable mining license. With the borrower’s ability to repay restored, investors in Credit Equals Gold No.1 suffered only modest losses.

The case is not isolated. A number of Trust Company and WMP investments have missed payments, with many having been rescued, sometimes under mysterious circumstances.

Authorities have chosen to intervene to avoid a loss of confidence in these vehicles, resulting withdrawal on investments, forced selling of assets and crippling the sector which has become an important source of credit within China. 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 asset management companies (“AMCs”) to avoid a banking crisis.

In the late 1980s and early 1990s, Chinese state owned banks had large NPLs from policy driven loans to loss making state owned enterprises that were unable to repay. In the late 1990s, the banks incurred NPLs exceeding 30% of assets, primarily from the collapse of a property and equity boom. The problem was resolved by a combination of recapitalization by the government, restructuring of loans, debt write-offs and transferring bad loans to AMCs. The actions were taken to allow the Chinese banks to list on the Hong Kong Stock Exchange, in order to raise new capital.

As part of this process, in 1999, the Central Government established four big asset management companies (one for each of the major policy banks) to purchase US$170 billion of bad loans generally at face value. The AMCs issued government guaranteed 10 year bonds back to the bank to finance the purchase.

With recoveries insufficient to repay the bonds when they matured in 2009, the AMCs replaced the original funding with new 10 year bonds. Since 2012, the AMCs have repaid around 45% of these bonds. The source of funding is not clear but appears to be from the government. It appears that this was done to provide liquidity to the banks forced to hold the original AMC bonds. It was also designed to allow the AMCs to raise new capital. At least, one AMC has undertaken a successful IPO in Hong Kong, with other such equity raisings likely.

These actions may be part of a strategy to allow the government to use the AMCs to deal with the expected rise in NPLs from the current round of credit expansion. There is currently some evidence for this with the AMCs purchasing certain assets from banks.

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 is synonymous with a loss of confidence in the state itself and the Chinese Communist Party.

 The 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 de-stabilising crash.

Over time, increasing amounts of capital and resources will become locked into unproductive investments which do not generate sufficient returns to service the debt incurred to finance it.

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 yielding deposits with policy banks, which can be directed by the Central Government as required. Interest rates will remain low 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 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 SOEs 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 create progressively less real economic activity.

Historical Convergence…
There is increasing concern that China risks turning Japanese. There are points of correspondence and divergence between the positions of Japan in the early 1990s and China today.

In both cases, Investment levels were high, in similar areas such as property and infrastructure. Chinese fixed investment at around half of gross domestic product is higher than Japan’s peak by around 10 per cent and well above that for most developed countries of 20 per cent.

Like Japan before it, China’s banking system is vulnerable. Rather than budget deficits, China has directed bank lending to targeted projects to maintain high levels of growth.

The reliance on overvalued assets as collateral and infrastructure projects with insufficient cash flows to service the debt means that many loans will not be repaid. These bad loans may trigger a banking crisis or absorb a big portion of China’s large pool of savings and income, reducing the economy’s growth potential.

One difference is that whereas Japanese bad debts affected private banks and businesses. In contrast, the state effectively underwrites Chinese banks and many debtors. In addition, China is less developed economy and has greater growth potential.

But at the onset of its crisis, Japan was much richer than China, providing an advantage in dealing with the slowdown. Japan also possessed a good education system, strong innovation, technology and a stoic work ethic which helped adjustment. Japan’s manufacturing skills and intellectual property in electronics and heavy industry made it less reliant on cheap labour, allowed the nation to defer but not entirely avoid the problems.

In contrast, China relies on cheap labour, to assemble or manufacture products for export using imported materials. Labour shortages and rising wages are reducing competitiveness. China’s attempts at innovation and hi-tech manufacture are still nascent.
China’s credit-driven investment model may have reached its limits. Continuing existing policies increase domestic imbalances, misallocation of capital, unproductive investments and loan losses at government-owned banks.

Chinese achievements over the last 30 years are considerable. But until 1990, Japan too was successful, growing strongly with only brief interruptions. After the bubble economy burst, Japan has had almost two decades of uninterrupted stagnation. Today, with or without change, China faces a prolonged and difficult period of adjustment. French author Marcel Proust was correct when he stated that: “The real voyage of discovery consists not in seeking new landscapes, but in having new eyes.”
© 2014 Satyajit Das

Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money
- See more at: http://www.economonitor.com/blog/2014/04/chinas-debt-endgames/?utm_source=contactology&utm_medium=email&utm_campaign=EconoMonitor%20Highlights%3A%20The%20Big%20Picture#sthash.7cDlfYzF.dpuf

Tuesday, April 22, 2014

China’s Shadow Banking System

Author: Satyajit Das

Chinese debt concerns are complicated by two structural issues – the rise in borrowing by local governments and the increase in the role of the shadow banking system.
Both sectors are testament to Chinese entrepreneurial spirit, but also point to deep problems in China’s financial system.
Local But National…
Outside of security matters or foreign affairs, China’s provinces, regions and centrally controlled municipalities enjoy a degree of autonomy. After the global financial crisis in 2007/ 2008, the aggressive stimulus measures to boost economic activity required the central government to relax controls on local government spending programs.
But by law, China’s local governments are not allowed to borrow, requiring creative solutions with the tacit approval of Beijing. Local governments created LGFV (Local Government Financing Vehicles), also known as UDICs (Urban Development And Investment Companies). These special purpose arm’s length vehicles, which are separate from but owned or controlled by the local government, can borrow.
The LGFV generally borrows funds predominantly from banks (as much as 80% or more), with the remainder raised by issuing bonds or other equity like instruments to insurance companies, institutional investors and individuals. In recent times with pressure on banks to curtail loans, LGFV has borrowed from the shadow banking system.
There are several issues around local government borrowings.
With over 10,000 LGFVs in China, the exact level of borrowings remains in dispute despite increasingly scrutiny.
There is concern about the quality of the underlying projects financed, which are sometimes expensive politically motivated trophy projects.
Many of the LGFVs do not have sufficient cash flow to service debt, being reliant on land sales and high property prices to meet debt obligations. The LGFVs also have significant mismatches between short term borrowings and long term investments being financed. With cash flow insufficient, many LGFVs now use new borrowings to repay maturing debt.
Probably something more than 50% of LGFVs have unsustainable debt levels and face the risk of insolvency.
Local governments also may not have the financial capacity to guarantee the solvency of their LGFVs. According to the World Bank, China’s local governments have responsibility for 80% of total spending but only receive about 40% of tax revenue.
With few assets other than land, reliance on land sales and development taxes as a large portion of revenue also restricts their financial flexibility especially if the real estate prices fall.
The pathology of China’s local government financial problems is recognisable. The combination of excessive borrowing, capital misallocation and debt servicing based on increasing property prices is familiar.
Eager for growth and increased revenue, local governments increase borrowings to create ever larger development projects resulting in a rapid increase in supply on new properties and land inventory held by the LGFVs. Land and property sales slow and prices come under pressure constraining the ability to monetize the assets to meet debt obligations.
Lender concern reduces credit availability and interest costs further straining cash flows. The LGFV have insufficient finance to continue, resulting in slower completion or leave incomplete projects. Contingent liabilities are not honoured. Ultimately, the LGFV and its local government must be bailed out or face insolvency.
There are political complications. Local government debt financed investments helped maintain China’s growth after the onset of GFC. This was crucial in assisting the Central government to save face and maintain social stability. Deep seated links, systems of patronage and factional competition within the Chinese Communist Party (“CCP”) make it difficult for Beijing to take drastic steps to abruptly reverse policy.
An ancient Chinese proverb – shan gāo, huángdì yuǎn- states “The mountains are high and the emperor is far away”. The saying implies that Beijing’s control over its regions is historically weak, with local autonomy and little loyalty, meaning that central authorities have limited influence over local affairs.
Lengthening Shadows…
Shadow banking, a term used by US investment manager PIMCO’s Paul McCulley in 2007, refers to a diverse set of institutions and structures used to perform banking functions outside regulated depository institutions. In recent years, China has evolved its own substantial shadow banking system, which has several layers.
There is the informal sector which encompasses direct lending between individuals and underground lending, often by illegal loan sharks (referred to as curbside capitalists and back-alley bankers) that provide high interest loans to small businesses.
The larger sector consists of a range on non-banking institutions, which are subject to various degrees of regulatory oversight. It involves direct loans of surplus funds by companies to other borrowers or trade credit (often for extended terms). It involves non-bank financial institutions such as finance companies, leasing companies or financial guarantors. There are also more than 3,000 private equity funds, funded in part by foreign investors. In personal finance, it encompasses micro-credit providers, consumer credit institutions and pawn shops. The largest portion of the non-banking institution sector is trust companies and wealth management products (“WMPs”).
There are also capital markets allowing insurance companies and institutional investors to purchase debt and equity securities.
Need Shade…
The growth is driven by the structure and regulation of China’s financial system.
The credit markets are dominated by the four major. State controlled banks (Bank of China, China Construction Bank, Industrial and Commercial Bank of China, and Agricultural Bank of China) that focus on lending to State Owned Enterprises (“SOEs”), firms associated with the government and officially sanctioned projects. Other businesses have more limited access to bank credit. The shadow banking sector fills this market gap.
Government regulation of deposit interest rates has also facilitated the growth of the shadow banking systems. For much of recent history, bank deposit rates have been below inflation rates. Negative returns and the loss of purchasing power have led savers to seek higher available rates in the shadow banking systems.
In recent years, the central government has sought to rein in runaway credit expansion, by reducing loan quotas, limiting lending to specific sectors such as local government, property and restricting riskier transactions. This has perversely encouraged growth of the shadow banking sector.
Trust WMPs…
Trust companies are the most important component of the Chinese shadow banking sector. They finance riskier borrowers and transactions that banks cannot undertake due to regulations.
Trust assets are estimated at more than US$1.8 trillion (20% of GDP). While only a small part of total credit in China, trust assets have been growing at an annual rate of over 50% in recent years and constitute 10-20% of new TSF.
Trust companies raise money from investors which are then invested in loans or securities. Investors are usually high net worth individuals or corporations that can meet required minimum wealth standards (several million Renminbi (“RMB”) in assets) and the minimum investment size (typically RMB 1 million (about US$160,000)).
The major attraction for investors is the high returns; around 9-12% per annum compared to bank deposits rates in low single digits. After adjusting for the trust company’s fee of 1-2% of loan value, the ultimate borrower must pay around 10-15% per annum for the funds, well above the 7-8% charged by banks.
The funds primarily finance local government infrastructure projects (via LGFVs), real estate and industrial and commercial enterprises. Following the central bank’s decision to restrict banks financing of local governments and property projects, trust companies have become major providers of finance to these sectors.
The high interest rates mean that the borrowers are riskier. Problems with assets supporting Trust loans are well documented, most notably the “Purple Palace,” a half built and abandoned luxury development in Ordos.
WMPs are higher yielding deposit or investment products, with a variety of seductive monikers – Easy Heaven Investments, Quick Profits and Treasure Beautiful Gold Credit. WMP assets are estimated around the small level as Trust assets and are also growing rapidly.
WMPs are sold through banks or securities brokers to a broader investor base than Trust Company investments. The minimum investment is RMB 50,000 (around US$8,000). Investments are typically short, around 6 months. WMPS offer investors a return of around 2% above bank deposits. WMPs can be sold with or without a guarantee of the payment of interest or principal from the sponsor.
WMPs invest in a variety of assets, ranging from low risk inter-bank loans, deposits and discounted bills to higher risk trust loans, corporate securities and securitised debt.
A central feature of China’s shadow banking sector is its relationship with its regulated counterpart. Banks may arrange and act as an agent in a loan from one non-financial company to another (known as entrusted loans). Banks can sell assets to trust companies or create WMPs to channel client funds to them. Banks use undiscounted bankers acceptances to transfer assets to the shadow banking sector, against a partial or full payment guarantee from the issuer. Corporate bonds may be bought by Trusts, which are then repackaged into WMP products for bank depositors.
China’s shadow banking system exemplifies a popular Chinese saying -shang you zhengce, xia you duice-meaning “policies come from above; countermeasures from below”.
Dark Shadows…
The Chinese shadow banking system poses increasing risk.
While the exact size is disputed, the Chinese shadow banking system is large, estimated at around 70-100% of GDP (US$6-9 trillion) and growing rapidly.
With Chinese banks’ share of new lending having fallen to around 50%, from 90% a decade ago, the economy has become increasingly reliant on shadow banks as an important source of finance,, especially true for local governments, property companies and small and medium-sized enterprises (“SMEs”).
While the majority of Wealth Management Products (“WMPs”) are invested in interbank deposits, money markets and bond markets, the credit quality of many borrowers from shadow banks is uneven. Collateral securing loan is variable. A high proportion of trust loans and some WMP investments are secured by real estate. This exposes investors to losses if property values fall sharply. The Golden Elephant No 38 WMP, which offered investors 7.2% per annum, was found to be secured by a deserted housing estate in a rice field in Jiangxi province.
Increasingly other forms of riskier collateral, such as industrial machinery and commodities, have become more common. In a few more extreme cases, the collateral has been more exotic (tea, spirits, graveyards etc.).In some cases, lenders seeking to foreclose loans have discovered that the underlying collateral has been pledged more than once or does not actually exist.
The products entail significant asset-liability mismatches, with short dated investor funds being used to finance long term assets, which are sometimes non-income producing e.g. undeveloped land. The constant repayment or refinance requirement exposes the vehicles and the financial system to the risk of a liquidity crisis. For example, in 2014, around US$660 billion of trust products alone mature.
The trust companies and financial guarantors frequently lack adequate capital. Trust companies have average leverage of over 20 times, which is high given the nature of the investments.
Many products do not detail the exact use of investor funds. The documentation is vague. Due diligence by the sponsor or investment managers, enforceability of security interests and investor rights are unclear. As the system operates with only limited regulations, controls and oversight are weak.
Inter-connections between the shadow banking system and the traditional banking system create additional risk and moral hazards.
Banks frequently use the shadow banking to shift loan assets off their balance sheets and “window dress” financial statements for regulators and investors. Banks also use Trust Companies and WMPs to arrange high interest loans to companies, such as property developers, that they are unable to lend to due to risk of regulatory reasons.
Banks work closely with Trust Companies and Security Brokers to create investment products for depositors seeking higher returns, effectively acting as a conduit between savers and borrowers. Bank issuance of WMPs has increased by around 25/ 30 times, from around US$ 100 billion US$2.5 to US$3 trillion. Banks increasingly rely on these products to maintain market share and earnings, via fees and commissions received from distributing shadow banking products.
The linkages can be complex. Banks sell acceptance bills or risky loans to a trust which is then repackaged as a WMP to be sold to bank clients. There are transactions between different shadow banking entities. A financial guarantee can be used by a firm or individual to borrow from a bank with the proceeds invested in a trust or WMP. Banks, trusts and WMPS sometimes pool deposits as well as assets or securities from different schemes. New products are created to raise funds to meet repayments of maturing products.
In principle, the risk of these structures and investment rest with the investors. WMPs state that returns are expected rather than guaranteed or promised returns. WMP investors are typically required to confirm that they will bear the financial shortfall if assets funded by the pool default. In part, these provisions are included to ensure that WMP sponsors are able to keep the liabilities raised from investors and the assets purchased off balance sheet. But the ultimate responsibility for defaults is more complicated.
Investors in trusts may believe that they are protected from loss because the trust companies risk losing their operating license if their products suffer losses. In recent years, trust companies have sometimes concealed losses by using their own capital, arranging for state owned entities to take over impaired loans or using proceeds from new trusts to repay maturing investments.
Investors may also assume that banks will guarantee repayment and returns on shadow banking investment. This impression is reinforced by the transfer of bank assets to trust companies and WMPs and the distribution of shadow bank products by banks.
These problems are compounded by the lack of sophistication of some buyers and wilful ignorance of others. Banks also bear reputational risk.
Regulators would be concerned about systemic risks.
Failure of a riskier trust or WMP may lead to inability to issue fresh products or withdrawal of funds, requiring sponsoring banks to support these vehicles as happened in 2007/2008 in developed markets. The resulting losses and cash outflows could trigger wider problems within the financial system, which would affect solvent businesses and growth.
Policy makers would also be concerned about customer anger. In recent years, there have been a number of scandals where investors who had invested in products believing that they were guaranteed by the selling banks laid siege to the sponsoring bank. The high political risk may result in governments forcing banks to support the structures to avoid any threat to social stability.
Putting Worms Back In Cans…
In recent years, policy makers have taken steps to slow the rapid growth in debt and the expansion of the shadow banking system.
Policy makers have used quantitative measures to reduce credit creation, increasing reserve requirements to reduce bank lending. Qualitative measures, primarily loan quotes and specific restrictions on certain types of loans, have been used to control borrowing growth.
In early 2014, the Central Government announced plans for measures designed to rein in shadow banks. Banks are to be subject to more rigorous enforcement of existing rules and bans on moving certain loans and assets off-balance sheet. Banks would be required to set up separately capitalized and provisioned units for wealth management businesses. Co-operation between banks and trust companies or security brokers would be restricted.
Trust companies would be prohibited from pooling deposits from more than one product or investing in non-tradable assets. Private equity firms would not be allowed to lend to clients.
The Central Government also announced plans for three to five new private banks to increase the capacity of the banking system, outside the dominant state-owned lenders.
In mid-2013 and again in early 2014, authorities also intervened in money markets, draining liquidity and increasing interest rates to restrict excessive credit growth and to improve bank risk management practices. The actions resulted in a sharp rise in interest rates (in June 2013 they reached more than 13%) and increased volatility. They also revealed weaknesses in the structure of the financial system, particularly the instability of the shadow banking system.
The large Chinese state banks control the major proportion of customer deposits. Other banks tend to have smaller deposit bases. They are more reliant on wholesale funding, particularly from the interbank market. Liquidity in the interbank market depends on the larger banks who are net lenders in this segment and WMPs which invest in money market instruments, many of which are sponsored by smaller banks.
Reduced liquidity and higher rates can quickly set off a chain reaction. Tighter conditions in the interbank market place pressure on smaller banks. It also triggers redemption of WMPs which further reduces availability of funding in the interbank markets, setting off a cycle of increasing rates. Unlike large banks, smaller banks hold lower amounts of government bonds limiting their ability to raise funds using the securities as collateral in repos. Smaller banks may be forced into distressed selling of illiquid assets, causing prices to fall.
The deteriorating financial position of smaller banks would force up their cost of borrowing. Some banks can lose access to funding, due to concerns about their solvency.
The actions of authorities can affect solvent and viable businesses in an undesirable way. In June 2013, the interest rate for AAA rated corporate bonds rose rapidly by 2.00% per annum. Like the experience of money markets in developed countries during 2007/ 2008, scarcity of funds, payment issues combined with payment or solvency issues in small banks or the shadow banking system can quickly trigger broader economic problems
Despite the increasing urgency of intervention, the actions have had limited success in slowing in the growth of borrowings.
A central problem is the reliance on debt funded economic growth and the need to expand credit to maintain high levels of economic activity. In addition, the increase in the size and complexity of the shadow banking sector reflects structural problems. The need is for major and widely based economic, financial and structural reform, which is politically unpalatable.
As a consequence, attempts to slow credit growth, regulate the shadow banks and reduce speculation are inconclusive. After both episodes of intervention by the central banks, authorities stepped in and supplied significant amounts of liquidity to alleviate concerns about a slowdown in growth and financial problems.
Responding to the regulations covering shadow banking in January 2014, Anne Stevenson-Yang at J-Capital wrote: “The hilarious new Document 107 on shadow banking betrays how toothless the government is in the face of the mounting debt, because the only solution presented is more debt.”
© 2014 Satyajit Das
Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money
- See more at: http://www.economonitor.com/blog/2014/04/chinas-shadow-banking-system/?utm_source=contactology&utm_medium=email&utm_campaign=EconoMonitor%20Highlights%3A%20The%20Good%20the%20Bad%20and%20the%20Strategic#sthash.2RNSW0sM.dpuf

Tuesday, April 15, 2014

China’s Debt Vulnerability...

Author: Satyajit Das     

Western understanding of China has never greatly progressed beyond Charles de Gaulle’s statement that: “China is a big country, inhabited by many Chinese”. Despite constant analysis of developments in China in excruciating detail, economists seem to have only recently its identified debt problems. In fact, the country has had a 35-year addiction to cheap credit.
Quantum Without Solace…
Since the 2007/2008 global financial crisis (“GFC”), China has experienced strong credit growth.
The crisis and the resulting rare synchronous recessions in the developed world exposed China’s economy, especially its export sectors, to a large external demand shock, slowing growth.  Beijing deployed massive resources to restore growth to counter the economic and social impact of the slowdown.
In late 2008, China announced a fiscal stimulus package of Renminbi 4 trillion (about $600 billion) over 2 years, a budget deficit of around 2.2% of Gross Domestic Product (“GDP”). The modest fiscal measures  were augmented by a significant expansion in credit (known as TSF (total social financing) covering a mix of loans, bonds, bills and even some equity financing) via the large policy banks, which are majority government owned and controlled.
Post GFC, new lending by Chinese banks has been consistently around 30% or more of GDP. Around 90% of this lending was directed towards investment in building, plant, machinery and infrastructure, especially by State Owned Enterprises (“SOE”). According to the World Bank, almost all of China’s growth since 2008 has come from “government influenced expenditure”.
This expansion led to a rapid increase in the level of debt. Due to unreliable data and measurement problems, the exact level of debt remains unclear. Most estimates now put Chinese government (including local governments), corporate and household debt at around 200-250% of GDP, up from around 140-150% in 2008.
According to a 2013 report from China’s National Audit Office (“NAO”), Chinese government debt, including local government debt is around 55% of GDP (around US$5 trillion), an increase of around 60% from 2010.
The NAO argues that this figure includes around US$ 1.6 trillion of contingencies (debts of government owned financing vehicles) of which the government in the worst case would only have to cover a small portion (say 20%). This would reduce the actual public debt to around 39% of GDP.
Official Chinese government debt figure may not be complete, as it may exclude debts from local governments and central departments outside the Finance Ministry. It may also exclude debt of large state owned enterprises, state-owned policy banks and special purpose asset-management companies that hold nonperforming loans purchased from state-owned commercial banks, which all trade on the basis of an explicit or implicit government support. For example, China’s Railways has debt of US$270 billion, which may not include, despite the fact it is run by a central government ministry.
If these items are included, then China’s government debt including contingent liabilities would be higher, perhaps 90% of GDP.
There has been a parallel increase in private sector debt. Business and household debt levels have reached around 150-170% of GDP, a large increase from around 100-115% in 2008. Corporate debt has increased sharply, approaching 150% of GDP. Historically, Chinese governments have supported many large, strategically important or politically well-connected private corporations meaning that some corporate borrowing may end up as public debts.
Traditionally considered compulsive savers, Chinese household have increased borrowing levels from around 20-30% to 40-50% of GDP. Household debt has been driven by inflation. Sharply higher home prices require greater borrowings. The devaluation of purchasing power encourages debt fuelled consumption.
In a little more than 5 years, total credit in China has expanded from around US$9-10 trillion to US$20-25 trillion, effectively replicating the entire US commercial banking system.
Beijing City Limits…
There is now belated concern about the sustainability of Chinese debt. Analysts’ behaviour recalls George Eliot in Middlemarch: “We are all humiliated by the sudden discovery of a fact which has existed very comfortably and perhaps been staring at us in private while we have been making up our world entirely without it.
Whilst high, China’s debt level is lower than developed economies, allowing government officials to claim that it is at a “safe level”. But developed economies may not be an appropriate benchmark as generally emerging nations, like China, have lower debt capacity reflecting shallower and less developed financial markets which are in the early stages of “financial deepening”.
If all debt is included then the China overall debt is high, especially when benchmarked against comparable emerging markets. Many Asian emerging markets had lower debt and higher per capita GDP prior to the Asian monetary crisis of 1997/ 1998. Interestingly, China has similar debt levels but lower per capita income as Japan prior to the collapse of its bubble economy in the late 1980s.
Private sector debt levels are lower than that in developed markets such as the US or UK (200% of GDP) but is much higher than the 50-80% levels common in emerging markets. Household debt remain well below personal debt levels in the US or Europe (above 100% of GDP) but are increasing.
Corporate debt levels are above developed countries (averaging around 90% of GDP) and well above those of firms in other emerging markets (less than 100% in Brazil, around 80% in India and 60% in Russia).
The high debt levels are exacerbated by an inverted debt structure (described by Michael Pettis in his book The Volatility Machine). In emerging nations, when the economy slows debt levels, both direct and contingent, increase rapidly.
In addition to the absolute levels, the rapid rate of increase in debt is also concerning. There are a number of empirical measures.
An increase in debt of around 30% of GDP in 5 or less years is regarded as problematic. Several economies – Japan in the late 1980s, South Korea in the 1990s, the US and UK in the early 200s – experienced such rapid growth in credit resulting in serious financial crises. China has experienced a similar expansion in debt. Such consistent above trend increases in borrowing levels have historically provided early warning of problems.
Another measure is the credit gap – the difference between increases in private sector credit growth and economic output. Research studies have found that 33 countries with credit gaps experienced a subsequent rapid slowdown in growth, typically by at least 50%. In China, the credit gap since 2008 is over 70% of GDP.
Chinese credit intensity (the amount of debt needed to create additional economic activity) has increased. China now need around US$3-5 to generate US$1 of additional economic growth, although some economists put it even higher at US$6-8. This is an increase from the US$1-2 need for each dollar of growth 8-10 years ago. The increased credit intensity reflects the use of funds.
Debt can be used to finance investment, consumption or on assets that already exist. Consumption or investment contributes to economic activity. Purchase of existing assets does not add directly to economic activity.
In China, debt has primarily financed investment but increasingly to fund purchases of existing assets. Chinese data measures two different types of investment – gross fixed capital formation measures investment in new physical assets which contributes to GDP and fixed-asset investment measures spending on already existing assets including land. In 2008, gross fixed capital formation and fixed interest investment were roughly equal. Today, gross fixed capital formation has fallen to about 70% of fixed-asset investment, consistent with increasing turnover of already existing assets at frequently rising prices.
Investment in new assets is heavily focused on frequently large scale infrastructure and property. The major concern is that many of the projects will not generate sufficient income to service or repay the borrowing used to finance the investment.
Stories, some apocryphal, abound about wasteful expenditure. Significant investment in politically driven super-fast trains, new airports and express roads is likely to prove unproductive. Excessive investment has created significant over capacity in many heavy industries, such as steel.
China has also benefitted from a large expansion in residential construction in recent years, resulting in a glut of properties. Official data estimates that unfinished housing stock is equivalent in value to more than 20% of GDP. The most infamous is the “ghost city” of the Kangbashi district of Ordos in Inner Mongolia, which at one stage had apartments to shelter a million persons, about four times its current population.
But other less obvious but equally troubling examples are available. The city of Tiajin, about a half hour by high-speed train southeast of Beijing, has invested more than US$160 billion in an effort to create a financial centre. The amount spent is almost three times the amount spent on China’s Three Gorges Dam, one of China’s costliest projects. Changde, a city of 6 million in Hunan province in Southern China, has raised more than US$130 million in debt to finance amongst other things an international marathon course, following the 2008 Beijing Olympics.
Increased debt fuelled investment in dubious projects reflects the need of ambitious government officials, especially in the provinces and at the municipal level, to meet centrally set growth targets. As Yuan Zhou, then mayor of Guiyang, capital of the south-western province of Guizhou, stated in a radio interview in 2011: “We need to struggle for GDP. Only with higher GDP will people’s lives be improved.”
The increased level of debt and the often uneconomic projects financed has led to increasing concern as to whether the debt can be serviced.
A 2012 Bank of International Settlements (“BIS”) research paper on national debt servicing ratios (“DSR”) found that a measure above 20-25% frequently indicated heightened risk of a financial crisis. Using the BIS, analysts have estimated that China’s DSR may be around 30% of GDP (around 11% goes to interest payment and the rest to repaying principal), which is dangerously high.
The debt problems are compounded by other factors. A large portion of the debt is secured over land and property, whose values are dependent of the continued supply of credit and strong economic growth.
A high proportion of debt may be short term, with around 50% of loans being for 1 year, requiring refinancing at the start of each year. As few Chinese borrowers have sufficient operating cash flow to repay loans, new borrowings are needed to service old ones.
Around one-third of new debt is used to repay or extend the maturity of existing debt. With a significant proportion of new debt needed to merely repay existing debt the amount of borrowing needs to constantly increase to maintain economic growth. The process is not seamless and the requirement for regular refinancing exacerbates the risk of financial problems.
The concern is that debt fuelled investment has created economic growth but in the medium to long term will result in rising bad debts and financial problems.
Economist Hyman Minsky identified three phases of finance during periods of prosperity, with financial structures become progressively more risky. Hedge financing is where income flows can meet principal and interest on debt used as finance. Speculative financing is where income flows cover interest payments but not principal, requiring debt to be continually refinanced. Ponzi finance is where income flows cover neither principal nor interest repayments, with the borrower relying on increasing asset values to service debt.
China observers now worry about whether the high absolute levels of debt, rapid increases in borrowing, increasing credit intensity, servicing problems and the quality or value of underlying collateral are likely to result in a financial and economic crisis – a Minsky Moment.
© 2014 Satyajit Das
Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money
- See more at: http://www.economonitor.com/blog/2014/04/chinas-debt-vulnerability/?utm_source=contactology&utm_medium=email&utm_campaign=EconoMonitor%20Highlights%3A%20A%20Coiled%20Spring#sthash.bGynLwhX.dpuf

Tuesday, February 25, 2014

The European Debt Crisis: Karlsruhe & Quantum Physics...

Satyajit Das

Interpreting the Karlsruhe based German Constitutional Court’s February 2014 ruling on the legality of the OMT (“Outright Monetary Transactions”) program requires knowledge of German, Germany’s basic law and (a little) quantum physics. Whatever the interpretation, its potential effect on the evolution of Europe’s debt crisis is being underestimated.
Don’t Know BUT!
Announced in 2012, the OMT would theoretically allow the European Central Bank (“ECB”) to make unlimited purchases of government bonds issued by Euro-Zone members under specified conditions, providing funding and lowering borrowing costs. In conjunction with the austerity plan to reduce budget deficits and public debt and the banking union, the OMT has underpinned the relative stability of European financial markets over the last 18 months.
Prompted by a petition filed by 37,000 Germans, the Constitutional Court reviewed the OMT’s legal status. Following several months of consideration and often heated hearings, the court did not decide the matter, referring it to the European Court of Justice (“ECJ”) in Luxembourg.
The court ruling was by a 6-2 majority. The two dissenters ruled that the suit should be dismissed on the grounds that it was outside the court’s jurisdiction.
The court requested that the ECJ clarify several issues: the legality of the conditions of the OMT, the absence of any limit on purchases, the ECB’s ability to selectively purchase bonds of only some members, the lack of consideration of the credit quality of the bonds, the ability to purchase in the primary market, the need to hold the bonds to maturity and the interaction between the OMT and other ECB and European Union (“EU”) programs.
But the Court also stated that the OMT may be incompatible with German basic law. It found that the program exceeds the ECB’s limited monetary policy mandate, infringes upon member states and also circumvents the prohibition of monetary financing of Euro-Zone members. The Court found that the program was an act of economic policy, beyond the powers of the ECB.
Interestingly, the German court announced that it would rule separately in March 2014 on the European Stability Mechanism (“ESM”), the fund set up to aid distressed Euro-Zone members.
Endless Possibilities
The referral creates an intriguing set of potential outcomes.
If the ECJ agrees with the court that the program is illegal, then the ECB program cannot be implemented.
The ECJ may agree with the German court that it is not legal in its current form, leaving the way open for a compromise left open by Karlsruhe. This would entail a more limited OMT program with a limit on the quantity of bond purchases, protection of the ECB from loss in a debt restructuring, imposition of the same conditions applicable to ESM aid recipients to issuers benefitting from the bond purchases and no interference with market prices where possible.
If the ECJ rules that the OMT is legal in its present form, then the program would theoretically be legal under European but not German law. Should the OMT be utilised, it is not clear if the Bundesbank, the German central bank, could participate.
The way the issue would arise is clear. Potential users of the OMT have to apply for a conditional credit line from the ESM, which requires government approval. If the German government and parliaments approve the credit line, then a legal challenge is likely.
Based on its current position, the constitutional court would have to declare the program illegal under German law. But the constitutional court would then be in violation of EU treaties for not accepting the ECJ ruling. It is unclear whether this would lead to initiation of treaty infringement proceedings against Germany.
This would trigger a legal crisis, preventing Bundesbank participation in the OMT, withdrawing German support for various rescue programs or, theoretically, forcing Germany to exit the Euro and the EU itself.
Defender of the Commons
The decision has a political dimension.
The constitutional court’s decision is predicated on protecting democratic rights, establishing “legal boundaries” to the powers of the ECB mandate and strengthening “the guarantees provided by [the German] constitution“.
It reflects the court’s increasing concern that the German government, parliament and the EU may not protect German citizens from the exposure created by the ECB and various policies to rescue beleaguered Euro-Zone members. It also reflects concern about the abrogation of German voter’s rights on economic and budgetary policy.
The court is also concerned about the secretive process underlying much of this decision making. The court sought information regarding the ECB’s OMT programs but was rebuffed on the ground that details are “classified”.
Complementarity and Uncertainty
Financial markets have generally remained unmoved by the court’s ruling.
In part, this reflects the view that the OMT was never activated and may be no longer needed. It also reflects an exaggerated view of the powers of the ECB. One banker dismissed the court as “the crimson-robed weirdos in Karlsruhe”.
But if the European debt problems re-emerge, then the court’s decision may restrict the ability of the ECB to act.
European politicians, especially those favouring ECB intervention, and non-German central bankers are also frustrated by the constitutional court. They believe the authority for the OMT lies properly with parliament, government or the central banks. With the European Parliament elections due in May 2014, they also fear that the decision will strengthen the political position of Euro sceptics, making future intervention in support of weaker member nations more difficult.
In physics, the Complementarity Principle, suggested in 1928 by Danish physicist Niels Bohr, posits that the behaviour of phenomena, such as light, exhibits both wave and particle properties at the quantum level. Suggested by Bohr’s pupil Werner Heisenberg, the related Uncertainty Principle states that it is impossible to exactly measure simultaneous values of the position and momentum of a physical system. These quantities are calculable with characteristic ‘uncertainty’.
Complementarity and Uncertainty define the ultimate limitations of physical property and actions.
The Court’s decision embraces Complementarity. OMT proponents claim that it supports the ability of the ECB to undertake OMT program. Opponents claim that it actually prevents the ECB from engaging in such purchases. The decision also fits with the Uncertainty principle as its effects are impossible to quantify, other than in a probabilistic manner.
Whatever happens, the debate about the scope of the ECB’s powers, which underpins the Euro and the fate of many deeply indebted European countries, has not been settled. It highlights the unstable confluence of politics, finance and law that lies at the heart of the Euro-Zone crisis.
© 2014 Satyajit Das
Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money
- See more at: http://www.economonitor.com/blog/2014/02/the-european-debt-crisis-karlsruhe-quantum-physics/?utm_source=contactology&utm_medium=email&utm_campaign=EconoMonitor%20Highlights%3A%20The%20Winter%20of%20Our%20Discontent#sthash.6tQxvcnL.dpuf