China’s credit spiral

China’s credit spiral

David Keohane

| Jan 03 11:05 | 7 comments | Share

Just when you think there’s nothing left to say about China’s debt dilemma up pop some more pieces to greet the new year. Two of the most recent saw Soros on theself-contradiction in Chinese policy boat saying that “restarting the furnaces also reignites exponential debt growth, which cannot be sustained for much longer than a couple of years” and Patrick Chovanec providing a touch more detail about what all that messy debt actually means:To those who wrote off China’s first banking seizure in June as a fluke, this latest episode [interbank lending market spiked to near 10 percent again last week] appeared to come out of nowhere. They cast about for explanations: Perhaps some seasonal surge in cash withdrawals was to blame, or the U.S. Federal Reserve’s decision to taper its bond-buying policy. Optimists assumed the PBOC was tightening credit on purpose, as a warning to banks to rein in unsafe lending practices. With inflation at manageable levels, they reasoned, the People’s Bank of China had plenty of room to loosen monetary policy again and ease the cash crunch.

In fact, loose monetary policy is the problem, not the solution. Two simple words — bad debt — are the key to understanding why China has too much money, yet not enough. In the years since the global financial crisis, China has racked up impressive growth in gross domestic product by engineering an investment boom, fueled by a surge in easy credit. Total debt has risen sharply, from 125 percent of GDP in 2008 to 215 percent in 2012. Credit has spiraled to $24 trillion from $9 trillion at the end of 2008. That’s an additional $15 trillion – – the size of the entire U.S. commercial banking sector — lent out in just five years.

A lot of that money has gone into projects whose purpose was to inflate the country’s economic statistics, not to generate a return. Officially, China’s banks report a nonperforming loan ratio of less than 1 percent. In reality, they are rolling over huge amounts of bad debt, both on their own books and by repackaging it into retail investment products — many of them extremely short-term — that promise ever higher rates of return.

To that summary we might add one small point — it’s interesting that one of the larger holes in the China’s National Audit Office survey of public debt released on Monday was that left by the omission of corporate debt, which has surged to more than 100 per cent of GDP, from the calculations of contingent liabilities.

Just how big the hole is depends on how much of a contingent liability you think that debt is — how many corporates does the government actually stand behind? The answer is, at the least, some, which makes the circular vulnerability of those corporates and the banks all the more fun.

From Anne Stevenson Yang of J Capital:

More than half of bank loans are for one-year terms, and the loans are issued at the start of the year, paid at the end. Chinese corporate borrowers must keep their loans current in order to become eligible for new loans in the new year, but only a small minority of Chinese corporate borrowers can pay their loans out of operating cash flows. In almost every sector of China’s economy, corporates need new loans to service old ones.

This is not necessarily a seamless process, and typically the process of establishing new loans and resolving old ones creates a timing gap. That in and of itself is a symptom of the weak cash positions of corporate borrowers as a whole. Consequently, November and December are the months when Chinese corporations go to private lenders for high-priced bridge loans to carry them through the year, until they will become eligible for new bank loans. As soon as the New Year loans are available, they can pay off the gray-sector debt, and lower their costs of borrowing.

It is very hard to know how many borrowers are actually paying loans without requiring new credit to do so, but our interviews suggest something in the vicinity of 30%. That means that credit growth in China is a spiral: the more money goes into the economy, the more credit will be required to pay off the old. The speed at which this spiral ascends is a direct function of the interest rates: the higher the rates, the faster the spiral.

It would all be less scary if the banks had a bit more of a deposit cushion to fall back on, but the strong suggestion is that they don’t. Previous estimates suggest that almost “three-quarters of deposits now are made up of “quasi-money,” which includes commercial bills, wealth management products, and other liquid instruments rather than cash and cash deposits.” Since a lot of that is in illiquid infra investments which won’t pay out in the short term, banks need to keep paying up to cover old bets. But it’s not as if there’s anything on the horizon that might threaten inflows nowis there…

As Lombard Street’s Diana Choyleva said in a recent note, if Beijing wanted a smooth transition from investment-led to consumer-led growth, it should have begun the reforms at the start of last decade. Luckily for those who write about China debt, they clearly didn’t and we’ll have to wait and see if the reforms mooted in November make it through all of the contradictions in their way.