China's debt dragon

The dragons in China's history were not just mythical animals, but natural events, not understood, but cause of devastation and fear. Is China's debt manifesting into its next dragon?

Developed and developing nations are relying on China to drive the global economy through the global financial crisis in the face of the European Union meltdown and a slowing United States economy. China's media reports of continuing record growth and aggressive domestic and global spending allay fears of even a slowdown.

Despite China’s confident media reports, increasingly reports are raising serious concerns at what appears to be reckless lending practices and massive hidden debt levels in China's local government, state owned enterprises (SOEs), finance, property, and stock market sectors.

China's Banking Regulatory Commission (CBRC) has expressed its serious concern by introducing new lending regulations and cutting out-of-control local government borrowings that could affect China's overall economy.

The implications of debt combined with rising overcapacity in key industries questions China's continuing demand through 2010 and 2011.

Local government debt

Land sales traditionally generate about 45 per cent of local government revenues that in turn, drive property development and infrastructure projects generating employment, and local industry and services revenues. Stimulus lending fuelling the property boom has pushed these revenues to 60 per cent.

Local government borrowings totalled US$1.6 trillion in 2004-2009.

In 2008-2009, stimulus lending on infrastructure alone reached US$1.025 trillion.

Local governments ignore China's Budget Law by creating special purpose vehicles (SPVs) as "independent" financial institutions to raise capital against local government land, implied guarantees or "promises" for infrastructure, essential, and non-essential spending.

Of the current 8,221 SPVs, local governments incorporated about 4,000 just to exploit stimulus-lending opportunities.

Banks

In the mid 1990's, non-performing loans and assets (NPLs) derailed the proposed public floats of China's four major banks.

The banks were Bank of China, Industrial and Commercial Bank of China, China Construction Bank and the Agricultural Bank of China. The Agricultural Bank failed to qualify for listing.

Copying America's Resolution Trust Company (RTC) model after the Savings and Loan crisis, the Ministry of Finance (MOF) approved the formation of five asset management companies (AMCs) to acquire "selected" NPLs for warehousing, and auction to the highest foreign bidders.

Beijing ignored the RTC's success criteria of independent professional management, liquidating weakest entities, debt discounting, and market pricing, and took control, refusing discounting and liquidation of any state owned enterprise.

The MOF authorised the AMCs to purchase about US$204 billion of NPLs from the banks at book value, partly in cash loaned by the Central Bank, and partly in 10-year bonds, both guaranteed by the Central Bank.

The logic was simple. Since the State "owns" the AMCs and the banks, the state incurs no net loss by providing backing. Solvency problem solved. The debt goes around in circles. Some cash and central bank guaranteed bonds with substantial interest revenue replaced the NPLs on the banks' balance sheets.

NPLs again surged in 2002, and in 2003, the AMCs acquired an additional US$120 billion in NPLs, issuing more bonds, at undisclosed discounted values.

In 2002 and 2003, state media reported multi-billion dollar NPL sales to foreign investors.

In 2009, state media reported the AMCs as profitable.

The report defied economic logic, implying likely creative accounting, concealment, collusion, and questionable management standards by the AMCs.

Due to extremely poor asset quality, questionable security, and China's vague laws, among other things, auctions realised just 1.5 per cent to 9 per cent of the NPLs face value. By the end of 2005, only US$20.63 billion of the US$324 billion of saleable NPLs had sold.

Foreign interest evaporated leaving an estimated US$304 billion in unsaleable NPLs on the AMCs balance sheets accruing operating expenses and interest on bonds and cash loans.

Profitability implies that the remaining "dud" NPLs had sold well beyond face value, producing windfall profits clearing the estimated US$325 billion NPL residual, accrued operating expense debt, and interest.

Early 2009 the four state banks were reportedly discussing strategies to bail out their insolvent AMCs.

China's Banking Regulatory Commission stopped the Bank of China acquiring its AMC (China Orient,) that since failed to meet US$23 billion in bills due on June 30.

That the proposals were even under consideration seriously questions China's banking system as a whole.

June 2010, the CBRC revealed that AMCs could not pay interest or capital on their bank bonds.

2010 bank capital raising

The government guaranteed bonds represent substantial assets and inferred interest revenues streams on the four banks’ balance sheets.

The rush for nearly US$75 billion in capital raising by China's listed state banks to meet new capital asset ratio requirements is running parallel with the Agricultural Bank of China's world record initial public offering (IPO) and has a sense of unusual urgency bordering on panic. It also raises the question of why Beijing instructed the three listed state banks to defer their capital raising until the Agricultural bank completes its IPO.

This frantic rush for capital also coincides with a market flagging serious challenges for capital raising and serious concern that the US$75 billion appears seriously underestimated.

Unless Central Bank has problems of its own, the simple solution to capital raising is to call in the Central Bank guarantees on the bonds and outstanding interest, in line with the Ministry of Finance philosophy.

Stimulus effect

China's US$586 billion stimulus relied on 75 per cent bank lending of US$439.5 billion. Beijing directed the state banks to lend and SOEs to borrow.

Both readily embraced the challenge and bank lending reached US$1.466 trillion during 2009, nearly 350 per cent of the lending limit.

Anticipating lending restrictions, the 2010 first quarter lending frenzy was estimated to have driven total stimulus lending above US$2 trillion.

Companies borrowed not just for business needs, but speculation, reflected in the explosion of companies' property development divisions and subsidiaries. Using stimulus loans, companies also became private banks for their directors' investment activities, and for lending to individuals and private companies excluded from stimulus.

Property transactions were the main drivers of 2009 profits for many companies during a year of plummeting exports. Stock and property markets reportedly consumed more than 15 per cent of 2009 stimulus lending.

Post stimulus

A Beijing University academic recently stated that "... public debt could total 50 per cent to 70 per cent of GDP when correctly counted ..."

Exports comprise 40 per cent of China's real economy and that is of real concern for future growth with falling consumer exports.

Near term increase in demand from major importers Europe and America is unlikely, raising concern for resource export-reliant economies.

When stimulus spending terminates in the 2011 first quarter, China's new infrastructure will need to generate record revenues to meet operational and maintenance costs, interest and debt reduction in a slowing economy.

Stimulus termination will seriously cut demand for China's steel, cement, glass, aluminium, copper, plastics and construction industries. The effect will flow on to rail, road and maritime transport as well as coal mining, coke production and power generation. All are major employers and already feeling the effect.

Savings

Confidence in China's perceived economic invulnerability soared in 2009 when Ambassador to the US, Wu Jianmin proclaimed that China's domestic savings totalled US$3.5 trillion, and that this massive source of disposable income would shield China from the serious effects of the GFC, aided by consumer spending incentives in the stimulus package.

Despite glowing state media reports, those incentives failed to deliver. China's property boom drove the appliance subsidy scheme, not the rural sector. A second incentive subsidy scheme widened the scope in an effort to lift consumer spending and reduce the stockpiles of targeted appliances.

For the rural and urban poor, savings represent their only insurance against unemployment, sickness, injury, education and ageing. Savings mean survival, not spending on non-essential items.

Unlocking China's savings will require mammoth social reform spending by Beijing, equalling multiple simultaneous stimulus packages.

Savings at risk

China's US$3.5 trillion savings is the cheap funding pool for state bank lending and crucial for stimulus lending.

Following the money trail may prove interesting when balancing the US$3.5 trillion savings treasure chest with stimulus lending and total debt. Overlay that with the effect of reckless bank lending practices, lack of due diligence, NPLs, AMC failures, and massive questionable securities. There is also the need to factor in the ripple effects of falling property and stock markets.

There is reason for concern over the effect of debt on China's banks and the economy as a whole. What is more alarming and apparently ignored is the potential combined effect on, and reaction by, China's savings depositors.

Disguising debt

March 2004, official statistics reported non performing loans represented 19 per cent of bank loans. Standard and Poor’s however, estimated NPLs as high as 45 per cent. This represented serious risk for China's savings.

To reduce NPL levels, the "non-performing" classification no longer applies to hundreds of billions of risk loans that now come under the new classification of "special mention". Perhaps researchers should apply greater due diligence and clarify interpretation to "special mention" classifications when dealing with China's debt and capital raising.

The unknowns

If the AMC's have offloaded the "junk" majority of their NPLs disguised as wealth generation packages, which corporate, local government, state institutions and pension funds balance sheets now incorporate these toxic assets.

What percentage of borrowing security underwriting infrastructure, property and stock markets do these repackaged NPLs now represent?

The CBRC will not release its report in full on its investigation into the effects of local government debt until after the current banks capital raisings.

While the level of new NPLs and bad debt resulting from the 2009 stimulus and first half 2010 lending sprees are unknown, keep in mind that NPLs from this period have no asset management company or guarantee support.

Other debt

Despite being China’s biggest single borrower, China’s Aviation Industry Corp (AVIC) provides no details or repayment plans for borrowings.

China Development Bank's substantial foreign loans to developing nations are mainly reliant on counter trade in energy and minerals. A decline in demand due to a sliding China economy will not only delay payment, but will undermine the economies of countries reliant on China's largesse and demand for minerals.

China's Import Export bank also has major risk in developing countries.

China’s US$200 billion sovereign wealth fund, CIC, has suffered spectacular losses on Blackstone and Morgan Stanley. Subsidiary, Central Huijin Investment paid US$47 billion in 2008 to reduce debt for a 50 per cent interest in Agricultural Bank and pumped billions of dollars into the China Development Bank. CIC's earnings target of US$41 million a day is still a distant dream.

China's banks with branches in developing nations to fund Chinese companies operating in those countries are experiencing increasing risk from rising anti Chinese sentiment and civil unrest.

The 5th AMC

Huida Asset and Trustee Co was the AMC appointed to dispose of the Central Bank's bad debts and assets. Reporting on Huida activities has ceased due to the perceived effect on the standing of China's central bank.

That it reached that stage raises further questions on the extent of China's real level of debt and that of the Central Bank itself.

China's risk

The traditional triggers of unemployment, wealth gap, health care, population growth, corruption, pollution, water shortages and civil unrest etc., are considered the most likely to undermine the Chinese Communist Party's hold on power. The ready use of force by the police, Peoples' Armed Police and the army however, are a proven and effective deterrent.

China's real risk appears more likely to be debt hidden in the local government, financial, pension, and stock and property sectors threatening the hundreds of millions China's savings depositors. Indications suggest that this appears likely to surface in the second half of 2010 and first half of 2011.

China's historic lack of transparency, misinformation and concealment, combined with its banks poor risk management record and reckless management of stimulus lending, raises serious concern about reliance on China and current globalisation strategies.

Has China's experiments with AMCs and stimulus lending created the dragon to undermine confidence in China's economy with the potential to unleash a response from the hundreds of millions of Chinese reliant on their savings for survival?

If China is Plan A for resource exporting countries, what is Plan B?