Chicken Little does China

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I receive many “sponsored” emails from the likes of Breitbart.com, warning of imminent financial ruin and urging savers to contact some dodgy financial advisor. Americans send such things straight to the spam box along with Nigerian phishing emails, because they can see with their own eyes that businesses aren’t boarding up and banks aren’t foreclosing on homeowners. News reports about the so-called Chinese debt bubble are of the same quality as the Breitbart blast emails. Because Americans know little about China, they can’t fell the facts from the tall tales.

Asia Times will recall that I warned about the impending 2008 crash in this publication starting in October 2007. In July 18, 2007, I went on Larry Kudlow’s CNBC show to warn that a “trillion-dollar AAA asset bubble” threatened the banking system. I wrote about the “Great Crash of 2008” in early July 2008, two months before Lehman Brothers went under. I’ve predicted and survived financial crashes. And nothing like this will happen in China.

China has two economies: the old smokestack-and-export machine built during the 1980s and 1990s, and a tech-driven, consumption-led new economy where e-commerce sales are growing by 40% a year. It faces a bumpy transition from a model that reached its use-by date some years ago to a tech-and-consumer-driven model. Shrinking world trade makes China’s transition all the bumpier. That’s an annoyance, not a crisis.

Hedge fund manager Kyle Bass made headlines earlier this month by claiming that China’s financial crisis is four times as bad as the 2008 subprime debt crisis in the US, when US homeowners took out “liar’s loans” with 0% to 5% down. Fear of a financial crisis has battered Chinese bank stocks, which now trade at an all-time low price/earnings ratio.

Chinese Banks' P/E in Hong Kong at All-Time Low
Chinese Banks’ P/E in Hong Kong at All-Time Low

The facts tell otherwise. China’s minimum down payment for a first home was 30% until Sept. 2015, when regulators cut it to 25%. The minimum down payment for a second home is 40% (and was 60% until March 2015). Overall loan-to-value ratio for US mortgages was 71% in August 2008, vs. 33% in China, according to a June 2014 study by the Hong Kong brokerage firm Reorient Group. More important is that every home mortgage in China has a big equity buffer.

That’s true across the whole Chinese economy. Chinese homeowners hold much more equity than their US counterparts; Chinese corporations hold much more cash than their US counterparts; and China’s government lends trillions of dollars to the rest of the world while the US government borrows trillions of dollars from the rest of the world. In econo-speak, China has the world’s highest savings rate—nearly 50% of personal income vs. a world average of 22%.

Source: World Bank
Source: World Bank

Households, corporations and governments put a big part of their income into the equivalent of a rainy-day fund. Before the talking heads discovered China’s so-called debt bubble, they complained that China was saving too much, and  therefore buying too little from the rest of the world—in other words, that China need more debt. You just can’t please some people.

The aggregate amount of debt never is the problem—it’s how much of it is likely to default. You can drown in a river with an average depth of six inches. When banks lend money, they typically put up about $1 of their own money for every $10 to $12 of depositors’ money. A 10% loss rate will wipe out their shareholders, which means the bank is bust. It doesn’t matter if the other 90% of loans are bulletproof.

Banks can and do run loss rates of 10% and higher. Nonperforming loans at Italy’s banks stood at 17% of all loans at the end of 2014. The loss rate will be lower; some borrowers will get current again, and creditors will recover some of their losses by liquidating assets. But there’s a reasonable case to be made that Italy faces a financial crisis. With 12% unemployment, that’s not a surprise.

We know that Chinese households are rich in cash and assets, and that mortgages are far above water. There are pockets of distress among corporate borrowers. Collapsing commodity prices and shrinking world trade have squeezed some corporate borrowers.  Financial data is available for more than 2,700 publicly traded Chinese companies, including most of the country’s largest, so it’s not difficult to identify prospective problems.

Overall, EBITDA (earnings before interest, taxes, depreciation and amortization) cover six times the interest cost of Chinese companies. About 12% of Chinese companies, though, have cash earnings that only just cover, or do not cover, their debt expense, according to tabulations by the Hong Kong brokerage firm Reorient Group.

Distribution of Debt Service/EBITDA Ratio for 2,700 Listed Chinese Companies
Distribution of Debt Service/EBITDA Ratio for 2,700 Listed Chinese Companies

Some of these companies, though, show rebounding sales, indicating that their financial strains are temporary. And some of them have a cash cushion so large that  default is extremely unlikely.

Using data for the first half of 2015, Reorient’s screen indicated that about 7.5% of the outstanding debt of listed Chinese companies was at risk of default.  
Assume that all of the corporate debt that is likely to default will default—a very pessimistic assumption—Reorient argued that an 8% corporate default rate with 50% recovery was probably the worst-case scenario for corporate debt. Chinese companies tend to maintain very high cash balances—on average a third of their total debt outstanding. The companies of the S&P 1500 Index, by contrast, have cash equal to just 18% of their debt (if the top ten cash-rich companies like Apple and Google are excluded).

An 8% default rate translates into a 4% loss rate for corporate debt—painful, but hardly critical. Mortgage and personal loan default rates are likely to be quite low because household finances are very strong.

There remains opaque business of “trust loans,” that is, loans which the banks buy, wrap into a “trust”, and sell to customers looking for high yields. Reorient analysts assumed an extremely high default rate of 15% and an extremely low recovery rate of 25%, and further assumed that banks would have to make all the defaults out of their own capital.

Add it all up, and Chinese banks would have a one-time loss rate of 4.9% of assets. That’s painful, again, but far from life-threatening. Reorient summarized the prospective losses at Chinese banks in the table below:

Dec-15 Balance
(RMB trn)
Default
Rate
Recovery Loss
(RMB trn)
Mortgage 10.4 5.0% 90% 0.1
Personal 16.6 5.0% 70% 0.2
Corporate 68.8 8.0% 50% 2.8
Trust 16.3 15.0% 25% 1.8
Total 112.1     4.9
NPL ratio 4.4%

 

Bank lending has grown rapidly in China, but not nearly as rapidly as in the United States during the bubble years, or for that matter Spain.

bankcreditgdp

Private credit provided by the US banking system grew from 120% of GDP in 1995 to 200% of GDP in 2008. Chinese bank credit only reached 120% of GDP in 2013. China is still underbanked: its households have enormous savings and enormous wealth in the form of residential property, and enormous capacity to borrow. Internet finance will probably advance more quickly in China than anywhere else in the world, as a new generation of Chinese skips the bother of visiting bank branches and conducts its personal finance business by smartphone. Big data makes it possible to score consumer credit in real time with great accuracy, integrating e-commerce and e-finance into a  far more efficient consumer economy.

Consumption only accounts for 35% of China’s GDP, compared to 75% in the US. Some of that probably is due to a difference in the way Chinese GDP is calculated, but it is clear that China has enormous room for consumption-driven growth.

Some of the Chicken Little stories about China point to a scary-sounding statistic: total debt in China amounts to 2.4 times GDP. That’s a big number, but it is matched by a much larger volume of savings. Some areas of debt, to be sure, are growing too fast. Some of the older state-owned enterprises remain money sinks, and it will take time for China to slim them down and phase them out. That is a management problem, not a debt crisis.

China’s central government and provincial governments have the cleanest balance sheets among major world economies. Public debt securities outstanding are only a fifth of GDP, compared to 100% of GDP in the US.  That gives the Chinese government enormous scope to use its balance sheet to reorganize other forms of debt before they turn into a problem.

usvschinadebtgdp

That gives China a lot of flexibility, and the government is using it to pre-empt possible financial problems. One area of concern is local government finances. China’s infrastructure boom is the great wonder of today’s world. Fly into any major city in China, and you pass through a brand-new airport to new superhighways and high-speed rail lines. American cities seem like Third World backwaters by comparison. Local governments created development corporations backed by land and project revenues (called “local government financing vehicles”) and ran up 20 trillion RMB of debt. Most of the land behind the local government vehicles has soared in value, but problems might crop up in certain cities. Local governments, moreover, pay much higher interest rates than the central government. So the government will swap the whole RMB 20 trillion of local government debt for bonds issued at lower rates by China’s provinces, backed by tax revenues. The swap will be completed in three years. It will bring public debt securities up to about 45% of GDP, still half of the US level.

The sky may not be falling in China, but the stock certainly has fallen. Part of this is the result of a generalized run out of all emerging market equities in response to the Federal Reserve’s ill-advised decision to raise short-term interest rates.

mxcieem

There is no economic reason for China to trade in lockstep with (for example) Brazil, a commodity exporter with little manufacturing industry. China gains and Brazil loses when commodity prices fall. Rather, the near-perfect correlation between the broad emerging market index and the China MSCI Index (internationally tradeable Chinese stocks) arose from the broad liquidation of risk positions in response to the Federal Reserve.

China, to be sure, made a number of policy blunders that compounded its problems. By linking the RMB to the soaring US dollar, China allowed its own real effective exchange rate to soar. The dollar link forced China to keep real interest rates at the highest level of any of the world’s major economies.

Source: BIS
Source: BIS

China has taken steps to correct the problem (by shifting from a dollar target for the RMB to a trade-weighted basket of currencies), but it acted too late to avoid the impression that it was driven by events, rather than in charge of them. Regulatory mistakes (failing to stop banks from circumventing limits on stock market leverage, for example) made the problem worse. The factors affecting Chinese equity prices require more detailed explanation on another occasion.

The good news for equity investors is that the combination of market panic and official fecklessness conspired to reduce Chinese equity valuations to levels that now seem extremely attractive.

 

David P. Goldman
David Paul Goldman (born September 27, 1951) is an American economist, music critic, and author, best known for his series of online essays in the Asia Times under the pseudonym Spengler. Goldman sits on the board of Asia Times Holdings.
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