The recent scare surrounding the possible default of the US$500 million Credit Equals Gold No. 1 Trust saw China observers the world over scrambling to understand the implications of the event.
The trust was rescued from default by an unnamed “third party”, which bailed it out. But the unease surrounding the near-bankruptcy was best encapsulated in the title of a Bank of America Merrill Lynch Global Research report: “Before Lehman, there was Bear Stearns”. Many wonder whether it is a portent of worse things to come.
These fears arise from the very real explosion of credit in China over the past five years. The country’s credit burden is believed to have risen by 71 percentage points since 2009, taking it to around 230% of gross domestic product (GDP). And this growth hasn’t come purely from lending to reliable businesses. Almost everybody outside of China’s official circles agrees the country’s wealth management products, and the balance sheet of its banks, contain many less than squeaky-clean assets.
Certainly, bad debts are the country’s banks are likely to be many multiples of the under 1% figure quoted by its largest lenders. A big reason the figure isn’t higher is down to the banks’ willingness to rollover debt to borrowers unable to repay it.
Economic observers of China fall into two broad sets of opinion about the outcome to this situation. One set points to the bad lending practices ever since the global financial crisis. In many cases, banks have lent to state-owned enterprises at the policy whims of the federal and regional governments. Plus extensive corruption within lenders and borrowers alike means nobody fully knows how far China’s bad debts stretch.
Meanwhile trust companies were set up to absorb some of these loans from the banks, which they packaged into high yielding investment products that they sold to retail investors. The reason these instruments are high yielding, of course, is because the loans underneath them pay high interest rates—because the borrowers are risky.
These observers believe that the country’s banks and trusts will eventually have to admit that far larger amounts of their assets are comprised of debts that need to be restructured or written off. That could cause a credit crunch, as concerned lenders refuse to offer money to any business or financial institution in which it isn’t fully confident, or ratchet up the cost of doing so. It could also lead to a run on the banks, as panicked account holders pull their deposits out of weaker-looking institutions, denting the country’s Rmb100 trillion (US$16.5 trillion)-worth of deposits.
The other faction believes that China’s credit issues are manageable, based on available data. Jan Dehn, head of research at Ashmore, noted in a report on January 29 that even in the unlikely scenario that all of China’s Rmb10 trillion-worth of trusts went bust and had to be bailed out by the government, it “would take total public sector debt in China from 56% of GDP today to 72% of GDP, [which] would still not make China’s debt burden unsustainable”.
While the Chinese government may have the financial flexibility to cope with a heavy spate trust defaults, it is far harder to assess the damage this could cause in terms of market panic and associated bank loan defaults. One way or the other, the prospect of a credit crunch isn’t that far-fetched. A single significant failure of a regional lender could be enough to lead national banks to start rationing credit.
“The central bank must be worried about the broader possibility of a debt cliff in China, because there are a lot of companies that have borrowed a lot of money from state banks and it is clear they will never be able to repay those debts,” says Neil McDonald, a senior restructuring and insolvency lawyer and partner with Hogan Lovells in Hong Kong.
The government has been taking some steps to combat these concerns, but they do not seem anywhere near sufficient.
“They put measures in place to restrain free credit and stop bad lending practices. But there are different views as to how successful this has been and some feel that it does not fix the historical problem while at the same time punishing good businesses that now cannot get credit,” added McDonald.
Should a high-profile failure initiate a credit crunch it would not hit China’s economy uniformly. Rocky Tung, economist with credit insurer Compagnie Française d'Assurance pour le Commerce Extérieur (COFACE), says two sectors would be particularly vulnerable: the metal and construction sectors.
In the metal sector, Tung points in particular to the steel industry. “Their debt to capital ratios are climbing rapidly, there is a situation of general over-leveraging. In addition, the steel industry’s profitability is extremely low [due to falling commodity prices]. The government also wants to address the overcapacity in the sector. It is likely that some industry players will go out of business.”
Tung says he is even more concerned about the construction and real estate sector. “The risk there is not only because of leverage levels, but more about market conditions. Given the recent development in places like Shanghai and Beijing, the big developers are facing pressure from the government due to the quick rise in property prices,” Tung added.
In China’s inland the pressure is not as strong, and the government has put urbanisation back onto the reform agenda, but margins are unlikely to be anywhere near those made in the larger Chinese metropolises.
Despite some of the bigger property developers having repaid a lot of their debt, the risks of stagnation and oversupply are very much present in China. “Property development is the most obvious sector to watch, but all sectors with high start-up and operating costs will suffer if they cannot get ready access to credit,” says McDonald.
Solutions at hand
Two possible solutions stand out for fixing the situation in the short- to mid-term.
One would be government intervention. If signs rise of potential financial damage from bad loan increases Beijing could opt to either shore up bank and trust balance sheets or force some of the financial institutions to restructure their debt and clean their balance sheets.
The former, however, would pretty much mean more of what it has already been doing to this point, and has hardly helped the situation. The latter might raise faith that the country’s bad debt issues are finally being addressed, but it would not solve the problem of credit availability for good corporates in China.
Capital markets reform stands as the real alternative solution, as they could provide struggling companies with more capital to repay their debt. McDonald believes Beijing should start by “dramatically opening up the domestic bond market to make available to domestic companies a proper pool of capital. However, that would require a policy directive and an infrastructure to facilitate issuance”.
Nevertheless, Hong Kong’s high-yield bond market could serve as an example. “For any capital market to work effectively there needs to be proper corporate governance and financial transparency, including adherence to proper accounting standards. If China is to have a successful domestic bond market, domestic issuers need to take collective responsibility for the implementation of appropriate standards that investors and rating agencies expect and can rely upon,” McDonald said.
These changes will take time to fully implement, but they can be done. But the government and financial regulators need to act quickly if they are to mitigate the impact of a likely rise in bad debts.
China is entering the year of the horse. It’s an apt animal; unless Beijing acts quickly the country could be set for an unsettling ride.