By Paul Harding for China Brain
The idea of a Chinese slowdown has gone from the isolated warnings of a few academic economists a few years ago to a generally held consensus today. Even the normally bullish sell side analysis teams at investment banks are acknowledging the situation. Annualized quarter-on-quarter growth rates have been below 8% for 3 consecutive quarters, meaning absent a strong rebound, annual growth will come in below 8% too.
Currently, the most bullish scenario is for a “soft landing”, which was originally supposed to see Chinese growth bottom out in the second quarter 2012, and then recover through the second half of the year as government stimulus policies take effect. This timeframe is now gradually beginning to creep backwards due to weaker than expected monthly data since Chinese New Year, but signs of a pickup are already emerging.
Certain stresses in the Chinese economy are now so well known that casual newspaper readers across the world are familiar with them, including difficulties facing the property sector, domestic demand and consumption, along with last year’s struggle against inflation.
The news of the collapse of Zhejiang Zhongjiang Holding Co Ltd, a conglomerate with over 5billion RMB of debt outstanding, has brought the issue of China’s non-performing loans (NPLs) back into the limelight. The case in question is relatively small - China Construction Bank (CCB) has 3billion RMB at risk, while Bank of China (BOC) is owed 1billion RMB. However, aside from this case, and a few signs of trouble from Wenzhou along with other distress reported in Hangzhou, the issue of NPLs has been getting little attention. This is probably due to two reasons; firstly, there seems to be little sign that they are emerging on a significant scale yet; secondly there is a totally false, yet widely held, perception that “last time around” China dealt with a relatively large NPL problem painlessly, and can thus do so again.
NPLs are difficult because they emerge just when an economy is least able to deal with them. Equally, they become submerged when an economy is strong and there is ample credit, growth and profits in the system. Added to this, complicated credit structures between borrowers, lenders, collateral and guarantee companies in the unofficial lending system obfuscate risk and make it hard to predict how any shock from a crisis might be transmitted through the economy.
As mentioned above, one of the reasons that NPLs are often not accepted as a danger to China’s economy is the way in which they were resolved “last time” around. Beginning in 1999, and essentially carrying on over the following 6 years, (longer if you include the final cleaning of the Agricultural Bank of China), a huge portfolio of NPLs were removed from the balance sheets of China’s Big 4 banks’ and “sold” to four Asset Management Companies (AMCs). These AMCs paid face value for the loans, and did so with some government capital injections and also through issuing 10 year bonds, which were purchased by the corresponding bank whose bad assets they were buying.
The AMCs were supposed to chop down the bad debt portfolios with restructuring, debt-equity swap deals and the involvement of foreign distressed debt players, etc. In reality these bonds could never be repaid, and even the interest on them had to be guaranteed by the Ministry of Finance when the banks listed. When the bonds matured in 2009 /2010, they were simply rolled over for another ten years.
The trouble of course, is that nothing comes for free. Accounting alchemy such as this does not mean that China magically resolved the bad debts. They still exist, and have been dragging on the system ever since. Banks have to be given unnaturally large interest margins (by decree) to help them deal with NPLs resulting from politically motivated lending. This financial repression punishes savers, undermines consumption, and acts as a large block on financial liberalisation and reform, exacerbating dependence on investment and exports. Equally importantly, it under-prices capital – by how much remains unclear - meaning that the true economic value of many projects, even those showing “book profits”, is unknown. Any business only able to make profits due to these repressed interest rates is actually destroying value for the Chinese economy.
In exchange for this “bailout” Chinese banks were supposed to improve their risk management and lending practices. Whether or not this happened is hotly debated, during the good times (until late 2008) the answer seemed irrelevant, bank profits ballooned as international expansion and internal modernizations continued. The crisis of 2008 / 9, however, saw a tidal wave of credit released in what seemed to be a return to the “old ways”. In fact the crisis of 2008 and the impressive Chinese reaction may well have sowed the seeds of a much more serious problem in the future.
The New Wave
As the world fell into a credit crunch and recession in late 2008, China responded to a serious downturn (which may have seen growth fall to zero for one quarter) by unleashing a massive wave of new credit as the following chart shows:
This shot of adrenalin was at first provided by the state owned banking sector. Projects were approved with lightning speed and needed quick financing which the banks provided at high speed. Fixed asset investment (both corporate and government infrastructure) and capacity expansion boomed, real estate investment exploded. Exports picked up, with cheap financing, cheap labour, political pressure on companies to keep operating despite having to slash prices for sales, and the “Wal-Mart Effect” meaning that China’s exports flooded world markets even more than previously – taking up a larger share of falling net global demand. Investment levels had already been high, but even these increased and China’s growth became even more reliant on investment and the debt that lurks behind it.
In fact, despite accusations that loose US monetary policy was fuelling commodity bubbles and price booms, data shows that it was in fact the People’s Bank of China and the Chinese Banking system that was responsible for nearly half of all world liquidity (M2) growth in 2009, 2010 and 2011.
With the massive boom in investment, seemingly politically directed lending practices re-emerging, and a scary build up of debt in local government financing platforms (linked to property by the use of land sales to capitalize borrowing entities) and the Ministry of Railways, it is inevitable that China’s banks were again creating an NPL headache. An apparent property bubble and blatant overcapacity in certain sectors only highlighted the problems. The authorities were well aware of these risks, along with the remerging threat of inflation, and in 2010 started trying to rein in lending and ordering provision ratios to be increased.
As the government reined in formal lending, the economy’s thirst for credit began to shift to the shadow banking sector and underground lending. Off-balance sheet lending, private lending, trust products, re-lending by SOEs and entities with access to credit, loan guarantee companies, etc all kept the credit boom going, even as formal lending declined (although not to pre-crisis levels). Debt creation was continuing, but now was more opaque, with risks diffused around the economy. Innovations that are still not completely understood were spreading – particularly in the area of trust products and the innovative use of various forms of collateral, China was responding to a crisis sparked by subprime lending and financial innovation in the West with a boom of “subprime” lending and innovation of its own.
The property bubble and CPI inflation came to be the focus of attention. Bubbling property markets in several cities were seeing prices climb so far beyond the means of average citizens that social unrest was feared. The market became a frenzy, with totally unrelated but cash rich companies becoming property developers, and “prices will never fall” exuberance spreading at an alarming rate. Asset booms in markets with such high barriers to entry can only increase wealth gaps, as only the richest can play. Related land seizures in many cities were another cause of social distress. So the government stepped in, introducing a host of administrative measures against the property sector, and leaning on banks to control lending to property developers. Whilst the US housing boom saw the mortgage holders taking on worrying amounts of debt, in China it is the developers themselves who are worryingly reliant on borrowing.
As with their ill timed 2008 anti-inflation tightening, the 2011 tightening emphasis came at just the wrong moment. As tightening measures began to bite, the Euro crisis worsened, global stimulus measures were becoming exhausted amidst anaemic recoveries and a return to austerity. China’s growth fell several percentage points, and too much for comfort. Today we find ourselves with the government “pushing on the accelerator again”, although with much more caution than in the 2009-2010 period. Lending is picking up, (and seems set to increase further through July) and property prices have lifted again.
Yet the title question remains: “Where have all the NPLs gone?”
In 2009, during the height of the lending binge, even bullish analysts were predicting an NPL uptick by year end 2011. We know they must exist, given the massive surge in credit after 2008 which was poured onto an economy already seeing record high levels of investment to GDP. What we don’t know is how many of them there are, beyond dubious classifications in bank results – where ratios are generally low and total acknowledged NPLs have only increased modestly to 438.2billion RMB at the end of March 2012.
There are several possible reasons as to why the inevitable uptick in NPLs is yet to show up in accounts books.
1 – There are no significant NPLs.
This is surely a poor explanation, at least in terms of actual non performance. The huge credit / liquidity binge since 2008 would make a total absence of actual nonperforming assets extremely unlikely at best.
2 – There are non performing loans, but…
…Borrowers are following the unsustainable practice of borrowing more to pay off interest and/or principal on existing debt. The corporate equivalent of an individual using one credit card to pay off another, this could explain why the emergence of an NPL problem has been delayed. This practice was probably reaching its limits early 2012, but may get a new lease of life if another bout of credit easing (as appears to be underway) emerges to combat the current slowdown. In buying time however, borrowers following this practice are increasing the end cost to the system.
3 – There are non performing loans, but…
…lenders are colluding with borrowers (as the CBRC pushed them to do last year) to restructure debt in the Special Mention category (special mention loans are not classified non-performing) before it migrates to the non-performing classifications. Restructuring in such a way involves de facto partial debt forgiveness, which eventually must be paid for by households (since government entities are by far the largest shareholder of Chinese banks.) Of course this motivation may be true for banks the world over, however in China the political dynamic and financial system’s structure make it much more likely, especially with dubious accounting practices being an issue.
4 – There are non performing loans, but…
…local governments (especially) are shuffling assets, revenues and funds to delay / hide their emergence. During the investment binge, local governments often offered implicit guarantees or joint debt servicing promises along with their local government financing platforms (LGFPs), which banks were happy to accept since local governments had real assets – land, and tax revenues both at present and in the future. This model came under stress as central level restrictions on property threatened land sale revenues (note some governments were relying on land sales for 50%+ of their revenues – and there are reports that revenues from land sales are plummeting in certain cities / provinces.. There is speculation from within certain state owned banks that local governments have been skirting these restrictions for months already, following the greater need of preventing defaults by their LGFPs. Most local government officials shuffle around every few years, so have little incentive to make sure their area finances are sustainable in the long run.
With the apparent ease with which China “resolved” its previous NPL build-up, there is little attention or worry being paid to the possibility of future NPLs emerging in the economy. However, as explained above, not only has the previous NPL build up NOT been fully resolved, but its partial resolution has nonetheless created a drag on China’s economy, mainly by delaying and increasing the pain of urgently needed rebalancing and effectively transferring wealth from households and workers to companies.
The argument that with GDP growth rates of 10% or more, any debt burden rapidly shrinks is a valid one. There are however, three reservations. The first is that it is generally accepted that when Debt /GDP ratios reach a certain level (possibly around 70%) then the debt itself becomes a drag on GDP - swallowing up an increasing amount of corporate or government revenues. Adding together China’s MOF, MOR, Local Government, AMC, State Owned Enterprise and potential bad bank debt produces an implicit central government debt responsibility at well north of 70% of GDP.
The second problem is the implications of the debt / investment build up. As examined above, the debt / investment model is hindering economic rebalancing, which in a climate of falling external demand is slowing growth rates anyway. Unable to substitute consumption for investment, due partly to the issues mentioned above surrounding debt, China’s growth can only rely on more investment or the now weakening export markets. Slower growth, even if not a hard landing, seems inevitable, which in turn weakens the process of “growing out of the debt”, just at time when more debt seems necessary to maintain much of what growth there is.
The third problem is that GDP growth and value / wealth creation are not the same thing. With financial repression and China’s skewed economic system, over-investment can often create GDP without actually increasing real wealth (and sometimes destroying it). Empty apartments, industrial overcapacity creation and even some infrastructure are all positive for GDP, yet are not so positive for “wealth”.
This process can go on for a long time, unless there is a significant emergence of NPLs, which would sever the link between debt and investment led growth, further delay / reverse rebalancing, and ultimately put government finances under stress. Reforming an economic model is easiest at times when the motivation to do so is least (for China this would have been between 2003 and 2007). Now the government’s general desire to do so is clear to see, yet policy has become increasingly short term in the face of this year’s leadership change and quarter after quarter of slowing growth. The struggle to rebalance China’s economy will be tough enough in any case, but an emergence of NPLs (acknowledged or otherwise) will complicate matters greatly. Analysts would do well do keep a close eye on the issue over the coming 12 months.