China’s Bills Come Due

This could be  one of the major reasons for China's behavior towards the some members of the UN and their neighbors . The leaders are concerned about losing the position that they are currently enjoying in the world stage.

China’s Bills Come Due

Financialist
By: John Watling and Ashley Kindergan

Published: March 27, 2014

With over $500 billion of debt from overleveraged Chinese local governments and companies coming due to lenders outside the formal banking sector later this year, China is bracing for a wave of credit defaults. It is coming at a bad time for the world’s second-largest economy, which is also experiencing a marked slowdown in economic growth. Retail sales, fixed-asset investment, and industrial production all came in far below consensus forecasts for the first two months of this year, and Credit Suisse analysts have lowered their first-quarter GDP growth estimate to 6 percent, which would be the lowest quarterly growth in five years. The key questions: Will Chinese policymakers rescue troubled borrowers? And will they intervene to stimulate growth if what seems like a slowly unfolding debt crisis threatens the overall economic outlook?

 

China’s credit problem is rooted in the very rapid growth over the last six years of its shadow-banking sector, shorthand for a mélange of lightly regulated special-purpose financing vehicles, wealth management products and trusts. These products have given local governments and small companies that lack access to institutional credit a way to borrow substantial sums of money. And they have done so: Credit Suisse’s Head of Non Japan Asia Research Dong Tao noted in a report this month entitled “Embracing Higher Risks” that “shadow banking counts for more than 40 percent of total lending and is the key credit channel for marginal lending.” Last year, Tao estimated the size of non-bank debt financing in China to be 22.8 trillion yuan ($3.7 trillion) – equivalent to 44 percent of China’s GDP.

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After years of pretty much zero defaults, problems are emerging. A 3 billion yuan ($480 million) loan originated by the China Credit Trust Co. for a coal mining company narrowly escaped default in January when an unknown third party took over the debt. Investors recouped their principal, but had to forfeit the final interest payment. In late February, Shanghai Chaori Solar Energy Science & Technology Co. became the first Chinese company to default on corporate bonds onshore. And they are unlikely be the last: Credit Suisse’s Tao told investors on a conference call earlier this month that markets could be seeing a dozen defaults a week come summer.

 

Credit Suisse does not believe these anticipated failures pose a systemic threat to either the Chinese or global financial systems. But the bank’s fixed-income strategists cautioned in a note this month called “To Blink Or Not To Blink” that liquidity could decline significantly if private investors begin to shun the wealth management products that provide the lion’s share of funding for the corporate bonds and trusts that accounted for 21 percent of new credit issued in 2013. And that, in turn, would pose a significant threat to economic growth.

 

As with many things China-related, it is not exactly clear what the country’s leaders intend to do about the debt problem, if anything. The People’s Bank of China clearly wants the economy to deleverage, Tao says, having twice issued repurchase agreements this year to drain liquidity from financial markets. The Chinese authorities have also been trying to shift the economy from near-total dependence on exporting goods and building infrastructure – a model that requires substantial amounts of credit – to a heavier reliance on domestic demand.

 

Officials set on deleveraging are not likely to be particularly keen to step in if local governments that used shadow banking products to raise money for infrastructure projects—many of which were not economically viable in the first place—are unable to pay their bills. Local government debt now stands at 10.9 trillion yuan ($1.76 trillion), 3.5 trillion yuan ($560 billion) of which is maturing in the second half of 2014. Credit Suisse’s Tao sees higher-than-usual risks in a particular 2.3 trillion yuan ($370 billion) batch of trusts created in 2012 that is maturing in the second half, and he noted on the investor call that “the prevailing sentiment in the central government is that local governments need to be taught a lesson.”

 

Eliminating moral hazard in China’s debt markets would be one of the surest signs yet that the country truly intends to modernize its capital markets, but letting trusts and other shadow banking vehicles flounder en masse could have serious consequences. China’s high savings rates and limited investment options have fueled demand for shadow banking products among millions of individual investors looking for higher interest rates than the paltry deposit rates offered by traditional banks. But here’s the problem: those short-term investment vehicles have been funding long-term infrastructure projects. That maturity mismatch doesn’t pose a problem as long as the debt can be rolled over, but it can quickly turn ugly if short-term financing markets run dry. A handful of defaults is no big deal, but a rash of them might just spook investors enough to threaten the integrity of the system, at which point the central government would likely be forced to intervene. If local governments are suddenly unable to roll over their debts, Credit Suisse says Chinese officials could create a series of ‘bad banks’ to deal with the non-performing loans. Such bailouts would not teach the hardest lessons about excessive borrowing, but they might prevent a panic.

 

While it is still unclear how the government intends to handle the likely impending problems in its credit markets, at least some fresh government spending is on the way—something Tsinghua University’s Professor David Daokui Li referred to at Credit Suisse’s 17^th annual Asian Investment Conference in Hong Kong this week. The National Development and Reform Committee recently approved five railroad construction projects, something Credit Suisse called a “minor stimulus.” Tao said in a short note last week that he expects more stimulus measures, including some clean energy projects and measures to address China’s air, soil and water pollution. But such small fiscal boosts will probably merely stabilize the economy. “This administration has a higher threshold for stimulus, and is more cautious about local government debt than the previous one,” Tao wrote in the note. “That means the fiscal stimulus is likely to be measured and selective.”

 

China’s leaders face a tricky few months as they attempt to balance the country’s unhealthy reliance on debt with moderating economic activity. Borrowers, for their part, are hoping they’re not the first to be ‘taught a lesson.’ And the rest of the world? According to Credit Suisse, the seeming turbulent times ahead for China and its borrowers should not threaten the global economy in a meaningful way. The country isn’t nearly as important to the world’s total final demand as either Europe or the U.S., both of which are expected to grow steadily this year against a backdrop of 3.8 percent worldwide GDP growth. In the end, any debt crisis in China seems likely to stay within its borders. Of course, a likelihood is not a certainty—and that’s something many Chinese lenders appear about to find out for the very first time.

 

Above, a construction site in Beijing. China’s rapid infrastructure development has been financed in part through shadow banking. Photo by TonyV3112 courtesy of Shutterstock.com.