China – cracked or crocked?
The FT reported recently that Charlene Chu, a highly regarded ex Fitch analyst, estimates that bad debts in China could reach $7.6 trillion. This analysis is based on the surge of lending made during 08/09 and from extrapolating experience of similar credit booms in other economies. Once the boom turns to bust, bad debt ratios have peaked at an average of 34%, well above the 5.3% of loans currently being officially recorded as non-performing or in trouble within China. It would take a hard landing to sour loans to this extent, nevertheless anything like $7.6trillion represents a gigantic number. To put this number into perspective, US and European banks lost in the region of $3trillion during the financial crisis.
Concerns about the health of the Chinese banking system have been circulating for many years. How can so much money have been deployed so quickly, so effectively? How big are the problems hidden in the shadows, what is discounted in current market valuations and what steps have the Chinese authorities taken to address the problem loans? Square Mile sits in a privileged position within the asset management community and has access to some of the best Asian strategists, fund managers and economists around. Over the last few weeks I have been speaking with our contacts at Goldman Sachs, J.P. Morgan, BlackRock and others to gain an understanding of the potential threat to the Chinese economy and the implications for global financial markets.
As the chart demonstrates, there has been an extraordinary rise in debt across the Chinese economy. Household debt is comparatively low and largely mortgage related. This should present little threat. Likewise, the size of the Government’s debt is modest though there may be some issues in opaque areas such as some of the public private partnership deals in place with state owned enterprises (SOEs). Longer term, China’s pay as you go pension system, while not universal, will face pressure from the demographic overhang. However, it is the corporate sector where most concerns lie, especially the 60% of lending to SOEs. It is worth remembering that bank lending policies are determined by the State and much lending is channeled to the SOE, which are big employers. Lending to property developers is a further area that has raised concern.
The more I learn about China, the more I appreciate how little I know. China is a vast country and the sea of data is difficult to comprehend. However, some of the economists that I have spoken to have been encouraged by the improvement in the quality and granularity of the data. It seems likely that the Authorities have a better handle today of the potential issues that the economy faces than they have done in the past.
Evidently the Authorities plan to grow out of any potential issues and while nominal GDP growth remains high, this appears feasible. However, this presupposes that credit creation in future will be well directed and measured. Encouragingly, supply side reforms are taking place. Many of the biggest SOE employers operate in smokestack industries where large capex programmes are complete. Nevertheless, restructuring in many of these industries is required. Layoffs are occurring and the slack is being successfully absorbed by the private sector. If it costs around RMB100,000 to lay off an employee and 2m to 3m redundancies are required, the $300-500bn total cost to restructure these industries looks bearable. Pages 9 & 10 from this report by an Australian global fund manager make fascinating reading.
Sensibly, these reforms are made during buoyant economic times. There is a delicate trade off between growth and restructuring, and presumably reforms can be placed on hold if the economy hits the skids. Sorting out these loans will be a long journey that requires careful management. So far, most of the loans classed as troubled or worse are in the private sector. However, the authorities have five factors that are working in their favour, which will buy them time:
1. The savings ratio is high
2. The vast majority of loans are domestic
3. Capital controls ensure that savings keep being funneled into the banking system
4. Many of the debtors and creditors are state controlled
5. The Chinese central bank, the PBoC, has capacity to rescue troubled banks if required (however, some non-systemically important banks may be allowed to fail).
This is will remain a potential issue for many years to come but hopefully not one that is about to erupt in the near term as the economic tide lifts revenues. If however the economy stumbles, we should not be surprised if lingering problems in the banking system exacerbate the situation.
Concerns about the health of the Chinese banking system have been circulating for many years. How can so much money have been deployed so quickly, so effectively? How big are the problems hidden in the shadows, what is discounted in current market valuations and what steps have the Chinese authorities taken to address the problem loans? Square Mile sits in a privileged position within the asset management community and has access to some of the best Asian strategists, fund managers and economists around. Over the last few weeks I have been speaking with our contacts at Goldman Sachs, J.P. Morgan, BlackRock and others to gain an understanding of the potential threat to the Chinese economy and the implications for global financial markets.
As the chart demonstrates, there has been an extraordinary rise in debt across the Chinese economy. Household debt is comparatively low and largely mortgage related. This should present little threat. Likewise, the size of the Government’s debt is modest though there may be some issues in opaque areas such as some of the public private partnership deals in place with state owned enterprises (SOEs). Longer term, China’s pay as you go pension system, while not universal, will face pressure from the demographic overhang. However, it is the corporate sector where most concerns lie, especially the 60% of lending to SOEs. It is worth remembering that bank lending policies are determined by the State and much lending is channeled to the SOE, which are big employers. Lending to property developers is a further area that has raised concern.
The more I learn about China, the more I appreciate how little I know. China is a vast country and the sea of data is difficult to comprehend. However, some of the economists that I have spoken to have been encouraged by the improvement in the quality and granularity of the data. It seems likely that the Authorities have a better handle today of the potential issues that the economy faces than they have done in the past.
Evidently the Authorities plan to grow out of any potential issues and while nominal GDP growth remains high, this appears feasible. However, this presupposes that credit creation in future will be well directed and measured. Encouragingly, supply side reforms are taking place. Many of the biggest SOE employers operate in smokestack industries where large capex programmes are complete. Nevertheless, restructuring in many of these industries is required. Layoffs are occurring and the slack is being successfully absorbed by the private sector. If it costs around RMB100,000 to lay off an employee and 2m to 3m redundancies are required, the $300-500bn total cost to restructure these industries looks bearable. Pages 9 & 10 from this report by an Australian global fund manager make fascinating reading.
Sensibly, these reforms are made during buoyant economic times. There is a delicate trade off between growth and restructuring, and presumably reforms can be placed on hold if the economy hits the skids. Sorting out these loans will be a long journey that requires careful management. So far, most of the loans classed as troubled or worse are in the private sector. However, the authorities have five factors that are working in their favour, which will buy them time:
1. The savings ratio is high
2. The vast majority of loans are domestic
3. Capital controls ensure that savings keep being funneled into the banking system
4. Many of the debtors and creditors are state controlled
5. The Chinese central bank, the PBoC, has capacity to rescue troubled banks if required (however, some non-systemically important banks may be allowed to fail).
This is will remain a potential issue for many years to come but hopefully not one that is about to erupt in the near term as the economic tide lifts revenues. If however the economy stumbles, we should not be surprised if lingering problems in the banking system exacerbate the situation.