China’s Multitrillion-Yuan Debt Poses Scary Risk To Global Markets

• JED GRAHAM
• 6/03/2016
After financial tremors in China sent global stock markets cascading lower in August and again in January, a period of calm has returned, and risk-aversion has receded.
Triggered by yuan devaluation fears, the Shanghai composite tumbled more than 25% from the end of 2015 to its Jan. 27 low, hitting its worst level since the tail end of 2014. The Nasdaq fell 16% to start 2016, bottoming on Feb. 11.
Yet the risk of even more major shocks coming out of China, rather than going away, has continued to grow. The reckoning has only been postponed by Chinese government efforts to keep the economy afloat with an unsustainable rise in debt.
China’s $1 trillion first-quarter credit surge, equal to an annualized 46.5% of GDP, was “one of the highest ratios ever,” wrote Societe Generale economists Wei Yao and Claire Huang.
Unlike China’s debt binge at the end of 2008 that helped lift the global economy out of recession, this latest surge of government-funded infrastructure spending and an easy-credit-fueled spike in property values didn’t buy much growth. China’s GDP expanded just 6.7% in the first quarter, the slowest pace in seven years.
Slowing growth amid rapidly escalating debt has troublesome implications. Much of the credit is going to unproductive uses and propping up bad debts. The longer that continues, the bigger the eventual debt implosion may be.
A China debt crisis would ripple through the global economy. Commodity producers that rely on China demand would buckle. Global financial markets would see a stampede away from emerging markets and risk generally, exacerbating the direct effects of a China hard landing. U.S. Treasuries, gold and other traditional safe havens may fare well, but not much else.

Bad Loans Far Worse Than Official Data

The Shanghai composite rose 0.5% Friday, capping its first up week in seven weeks. The Nasdaq fell 0.6% Friday while the S&P 500 slipped 0.3%.
China’s official data suggest no great cause for alarm. They put problem loans to the corporate and household sectors at a moderate 5.5% of the total, equal to $641 billion or 6% of GDP. Yet few analysts are willing to depend on China’s government data. The International Monetary Fund took a deeper dive into corporate balance sheets and concluded that up to 15.5% of commercial bank loans to the corporate sector, equal to $1.3 trillion, were potentially at risk.
from Hong Kong-based brokerage CLSA included banks’ off-balance-sheet lending. It concluded that 15% to 19% of outstanding loans are nonperforming, with the potential to rise as high as 25% as the economy deteriorates. CLSA sees potential losses of $1.5 trillion — nearly 15% of GDP — or more. That’s about twice the amount at risk seen by the IMF, assuming the banks will recover some assets even on bad loans.
Now, with Moody’s Investors Service and Standard & Poor’s in March putting China on notice of possible credit downgrades to come, adding to warnings from the IMF and others, China’s leaders are talking up a new era of moderation and reform: “A tree cannot grow up to the sky — high leverage will definitely lead to high risks,” declared an unnamed “authoritative person” (speculated to be President Xi Jinping) in a page-one interview published by the People’s Daily. “Any mishandling will lead to systemic financial risks, negative economic growth, or even have households’ savings evaporate. That’s deadly.”
Here’s the problem: China has given up trying to rev up the pace of growth. But it’s still trying to maintain 6.5% to 7% GDP gains for fear that a bigger slowdown will be too painful and destabilizing. Even that target is likely to be unobtainable, Goldman Sachs predicted earlier this year in a report advising investors to further reduce emerging market exposure.

Doom Or Gloom?

China is “walled in” between two likely fates, Goldman Sachs said. It could try to keep the economy from slowing further, letting bad debts fester and swell, ultimately triggering a financial crisis. Or China heads off a debt meltdown with reforms that aren’t aggressive enough to prevent “a prolonged period of slow growth and possibly deflation,” similar to Japan.
“Every major country with a rapid increase in debt has experienced either a financial crisis or a prolonged slowdown in GDP growth. History suggests that China will face the same fate,” Goldman wrote.
From the end of 2007 through mid-2014, China’s government, corporate and household debt surged from 158% of GDP to 282%, McKinsey noted in a 2015 analysis. Nominal debt levels quadrupled from $7 trillion to $28 trillion. A more up-to-date analysis from the Institute of International Finance finds debt-to-GDP rising to 295%.
Whichever path it takes, most analysts think China has ample resources to stave off a crisis for a year or two, thanks to a high level of domestic savings and prospects for government stimulus and financial bailouts.
George Soros, who made $1 billion betting against the British pound in 1992, has said China’s credit growth looks reminiscent of the period before the U.S. financial crisis. “Most of the money that banks are supplying is needed to keep bad debts and loss-making enterprises alive,” Soros told a crowd at the Asia Society in New York in April. But he noted that the country may be able to keep feeding its bubble for somewhat longer.

Implicit Guarantees Fuel Risk

The comparison with the U.S. subprime real-estate bubble seems apt because it was only when lower-credit-quality mortgage securities lost their AAA credit ratings that liquidity dried up and the financial house of cards started tumbling. China’s credit bubble is likewise built on a belief that high-risk investments there are essentially risk-free, writes Shanghai Advanced Institute of Finance professor, Ning Zhu, in “China’s Guaranteed Bubble.”
Unlike in the West, many “bond-like” products in China “carry implicit guarantees from their underwriters, regulators and, in the end, the Chinese government,” Zhu writes. “Many investors believe that, as long as financial institutions are concerned with their reputations, as long as the regulators are concerned with career advancement, and as long as the Chinese government is concerned with social stability, they will take care of the risks that investors themselves should bear when investing in such products.”
Zhu cites $500 million in financing provided to the Shanxi Zhenfu Energy Group via the trust product China Credit Equals Gold #1 with a promised annual return of 9.5% to 11.5%. Financing was arranged via state-owned giant Industrial & Commercial Bank of China. After coal prices plunged, the mining company appeared set to default in January 2014, with ICBC denying any responsibility for repaying investors.
Nevertheless, investors and lawyers remained calm, Zhu writes, which “cannot be attributed to Chinese Taoism or Confucianism,” but only to the expectation of an eventual bailout.
As The Economist wrote in 2014, “Days before the threatened default, a mystery buyer suddenly appeared and acquired some of Zhenfu Energy’s assets. That allowed all the principal to be repaid; in the end, investors lost only a portion of their last interest payment.”
In other words, the Chinese government was unwilling to risk the fallout from the removal of its implicit guarantee, which would cast “dark clouds over China’s economic growth and its economic growth model transition,” Zhu wrote.
But this moral hazard only encourages investors and banks to take more and more excessive risks.

Safe As Houses?

Chinese authorities’ failure to prevent the stock market rout over the past year following a massive run-up has set off a flight to safety for investors. But in China that means a rush into areas of the economy and financing vehicles more assured of government support. Real estate has been the prime benefactor, with home prices rising 12.4% in May from a year earlier, including a 28.3% surge in tier-one cities.
Property might seem like an odd choice for a safe haven. China has a glut of unsold apartments — 13 million, mainly in mid-sized and inland cities, according to Reuters. But local governments, which went on a borrowing binge in recent years to fund infrastructure, rely on property sales for about one-third of revenue and can’t afford a prolonged real estate slump. And regulators, trying to revive soft demand, cut down-payment requirements for first-time buyers to a record-low 20%.
Demand for new apartment construction, along with stimulus-fueled infrastructure spending, helps keep orders for commodities such as steel afloat and keeps a lid on bad industrial-sector debt. But that props up inefficient industrial state-owned enterprises (SOEs) and delays a transition to a consumer- and services-based economy.

SOE Reform Too Hard?

Despite becoming an increasingly important market for the likes of Apple (AAPL), Nike (NKE),Starbucks (SBUX) and Under Armour (UA), China has mostly moved in the wrong direction from its goal of rebalancing the economy, notes Goldman Sachs. Since 2007, when then-Premier Wen Jiabao set the goal of moving away from an export- and investment-driven economy, investment has climbed from 40% of GDP to 45.3%.
Goldman says China desperately needs productivity-enhancing reforms that would help revive economic growth without the fuel of rising debt. The largest industrial SOEs generated $1.8 trillion in profits from 2001 through 2013, with a deteriorating performance since 2010. But even that was only thanks to $2 trillion in subsidies, implying a net loss. The investment bank sees dim prospects for much of a lift from reforming SOEs, noting the inherent conflict between economic efficiency and protecting the position of the ruling Communist Party.
Productivity growth is so important to China’s future in part of because of its demographics, which resemble Japan’s shrinking workforce since 1990. China’s working-age population is set to decline by 0.5% a year over the next 25 years, a legacy of its one-child policy replaced last October.
“Will China grow old before it grows rich? That was an oft-asked question over the past couple of decades. The probable answer, which seems more apparent every day, is: ‘Yes,’ ” wrote investment strategist Ed Yardeni.
One move by China to begin addressing high corporate debt levels would have banks swap nonperforming loans for equity stakes in the borrowing companies. But such efforts “could actually worsen the problem, for example, by allowing ‘zombie’ firms (nonviable firms that are still operating) to keep going,” the IMF said in a blog post.
No matter how hard China tries to keep growth going, the days of it rescuing the global economy appear to be over. Data from April suggest that the government began tapping the brakes on the rise of debt in the second quarter, with areas outside of real estate showing further slowing.
“Industrial output and investment surges in March led many in China to expect, or unrealistically wish for, a sustained rebound in the economy. In our view this is almost impossible,” wrote IHS Global Insight economist Brian Jackson.
Moody’s sees growth slowing from 6.9% in 2015 to 6.3% this year. “Near-term downside risks to China’s growth have receded for now, due to the ample support provided by the government. However, the sheer scale of leverage … exposes the economy to the risk of a rapid deterioration in the event of a negative shock.”
If and when a China debt crisis erupts, U.S. investors will find few stock winners. Utilities and other defensive stocks outperformed early this year amid China fears, but in a true crunch such stocks may only fall less. U.S. Treasuries, gold — and moving to cash — would once again likely be the safe harbors.

http://www.investors.com/news/economy/paper-tiger-has-claws-china-debt-woes-stalk-global-economy-markets/