With all eyes on Greece and Europe’s massively insolvent banking system and bankrupt political class I want to look at what is incubating in China. It may seem perverse but I don’t think it is, because if China suffers a debt and banking implosion of its own, then that will end the lingering hopes that ‘China is going to bail out Europe’. And I think China is heading straight for a rather massive implosion. How big an implosion? Well the headline is 10.7 Trillion Yuan of loans to local governments of which up to 80% may be failing. I have written about his for a while and think the evidence has only grown more ominous.
Back in April I wrote about how I was convinced the Chinese Local authorities, the Chinese banks and possibly also Western Banks in Hong Kong, were between them recreating almost every aspect of the Sub Prime catastrophe. For those who want to read about the genesis of the problem see “Making the New Sub Prime – Backdoor to China” and“Making the New Sub Prime – What’s in Store”. I now believe there is growing evidence to support those speculations.
China’s sub-prime is a hybrid of America’s and Europe’s. In America banks lent to individuals who were unlikely to be able to pay back what they were borrowing. But were lent to hand over fist anyway. In Europe the same banks who lent to America’s sub prime lent to Europe’s as well. In Europe the sub prime were whole nations that where unlikely to be able to pay back their loans. But here too the banks fell over each other to lend anyway.
In China the sub prime is local governments. These local governments depend on selling land to speculators for a very large part of their income. So they have every incentive to sell as much land as they can to developers. So much so that many have ‘helped’ the developers fund the developments. There is now undoubtedly a web of indebtedness of epic proportions which now binds together the local governments and all of China’s big banks.
The questions now are how big is the debt, who is exposed and how unstable is it?
By the end of 2010 local governments in China were 10.7 trillion Yuan (well over 1 trillion Euros) in debt. That is a big number even for a country as huge as China. That was as of Dec 2010. It will be considerably more by now. So the answer is quite big enough to stop China being the saviour of Europe. China will have to divert a lot of attention and money to buying up and burying hundreds of billions of Euros worth of bad debt of its own. And remember the last bail out and the last lot of bad debts from the last bank bubble are still being dealt with. China will save Europe? I don’t think so.
Who is exposed? All we can certain of is that China’s big banks will be drowning in this debt. A more interesting question is if any Western Banks or investors have been tempted to buy in to it as well. I think there is a good chance that western speculators (banks and funds) have, in their eagerness to chase high returns bought into this bubble as they bought in to every other bubble.
My reason I believe this is because of Hong Kong and the way Chinese banks, developers and Regional Government have used Hong Kong as a way of circumventing central government limits on lending. It was the genesis of this new ‘off shore’ funding for China that I described in the earlier articles. I will come back to this later.
So how stable or unstable is all this new lending? This is the crux of the problem.
Initially the money was lent in straight loans from China’s Development Bank (CDB) and china’s big ‘private’ big banks. But increasingly as China’s central authorities have tried to cut down on all bank lending, local governments have set up Special Investment Companies who have avoided lending and borrowing limits by going to Hong Kong. These SIVs were set up as the front end of construction projects. The SIV would ‘own’ the income from the proposed construction project and sell bonds/debt in Hong Kong which were backed by the income stream from the construction project. So the Chinese central authorities found that as fast or faster than they put limits on bank lending and local government indebtedness, the banks and local authorities simply went to Hong Kong to lend and borrow.
And the amount of borrowing and indebtedness quickly ramped up till we have local governments owing the banks 10.7 trillion yuan. Question is will they pay or default?
In an article by Ambrose Evans-Pritchard at The Telegraph he quotes the rating agency Fitch on this point saying,
The agency fears that non-performing loans could rise from 2pc of GDP last year to up to 30pc.
30%! It’s not just teh 30% raw number its the jump up which is worrying. According to Reuters, Fitch will downgrade China’s debt if the banks get into trouble again and require another bail out. A bad loan rate heading up to 30% say s to me the banks will drown. And I am not alone in thinking this.
Head of Standard Charter Bank Greater China, Mr Stephen Green, was quoted in Caixin as saying that he thinks
“…up to 80 percent of local government loans won’t be able to cover the debt service….”
Meaning up to 80% of the local government financing vehicles, the SIVs, are insolvent. They cannot pay the interest on their loans and therefore have no hope of repaying the principle. Of course, Mr Green, being a proper banker, say this is no problem and advocates the elegant solution of the central government setting up a fund to ‘absorb’ – put on public’s tab – all the bad loans. Brilliant! They are so clever these bankers aren’t they!
Elegant solutions aside the situation is as fimiliar as it is grim and stupid.
To see why Mr Green thinks 80% of the loans made to local government funding vehicles will fail, we have to look at the detail of how unstable this vast pile of debt has become.
Another very good article in Caixin, on investment in China’s vast road building projects paints a very ugly picture.
Of the 10.7 trillion Yuan of local government debt, 1.12 trillion yuan of it is tied to road building projects and the article gives us a pretty good picture of the loan structures. There is absolutely no reason to suppose that lending for the road projects is in any way better or worse that the rest of the lending that has been done for other construction so I will take this as a good first approximation of the larger problem.
So how bad is the problem in road building? Well according to the article these loans were audited by the Central government and
The auditors also found that more than 54 percent of all new borrowing by government financing vehicles was being used to pay old debt.
Taking on new loans just to pay old off old ones is never a good sign, but it gets worse. It turns out that the old loans were from the China Development bank who at some point declined to lend further either because the government had told it to close off the taps on lending a bit, or because the bank itself came to recognize the project was unwise, unfinished and un-likely to ever make the return on its money that the local government bureaucrats and their friends the developers had said it would. The article suggests all three in various combinations.
So what did the local government and developers do? They turned to ‘alternative’ sources of funding often as not in Hong Kong.
At which point a unwise, failing project began its morph in to a successfully, fully armed financial time bomb. Where the government controlled development bank had belatedly said no. The private banks said – sure. Here we are talking of private banks in china and in Hong Kong. In both places, in place of longish term loans from the development banks, in the private banks and in Hong Kong the local governments were told of the soft caresses of short term liquidity in the private market. As the article says,
They [the local government financing vehicles] won loans, but with short-term payback agreements, because they apparently never expected liquidity risks and a nationwide credit crunch.
They never expected there could be a nation wide credit crunch?! Obviously news from the outside world really doesn’t get much play in rural China. And the private banks didn’t feel it necessary to enlighten them.
For example, short-term borrowing from banks rose from 1.5 billion yuan in 2006 to 5.7 billion yuan the next year and 11.4 billion yuan in 2008 at Hunan Expressway, a provincial construction financing platform.
So now we have a runaway train of debt rolling over and over on shorter and shorter time scales. Sound familiar? Time goes by debt increases, projects get further and further in to the red. But the banks kept lending from the short term wholesale funding markets (the same ones that used to fund such success stories as Northern Rock, Depfa and Lehmans) and at rates which undercut what government development loans were set at. The banks of course told the local government rubes that there were no risks, that in a global market money was always available, that someone will always want to pick up new business.
And the locals believed them. They turned their backs on the restrictions of government controlled loans and embraced the free market of issuing bonds which banks and investors would buy. Debt by another more modern name. But of course once you are hooked on short term debt you cannot easily get off it. Not only that but as credit conditions globally have deteriorated – as everyone outside the global elite knew it was doing – we have all watched it happen – the local government financing vehicles (SIVs) have been caught with high debts, low or no income, unfinished projects and short term loans\bonds from banks who are themselves often fighting for their own short term financing. Stop me when you think you’ve heard this before.
So now the pile of debt has become unstable as payback times become the enemy.
The Chongqing group could issue bonds to cover short-term liquidity needs. It’s already issued 2.8 billion yuan in corporate bonds and plans to issue about 1 billion yuan in medium-term notes.
“We told them commercial banks had erred, and that there were liquidity risks. They did not believe us then, but they do now: Commercial banks are chasing their debts.”
Few expected “that the present maturing of short-terms loans would arrive with the credit crunch,” said a source at a major bank. “Without a subsequent release of funds, liquidity risks emerged.”
And here we are caught up to today.
Since mid-June, nearly 10 provincial-level transportation platform companies have issued debt to repay bank loans, mainly short-term financing bills, mid-term notes and corporate bonds. Five highway platforms have issued short-term financing bills.
If even 50% rather than Mr Greens 80% of a trillion euros worth of unstable debt defaults then this is bigger than Americas sub prime. Of course the Chinese will buy it and bury it. And of course they can do it. But as I said I think this will somewhat eat in to their appetite for dodgy European bank debt.
And one more thing. Will the losses be confined to Chinese banks and Chinese investors? I don;t think it will. All the data out of Hong Kong is that Chinese bond issuance there has grown massively and it is not just Chinese banks and investors in Hong Kong. The number of Western banks continues to grow. Those banks are not just helping Chinese investors buy Chinese bonds. They are helping western money buy the returns on Chinese bonds. Risk assets!
In a world where banks want high returns and where risk is good (a variation on Greed is good) Chinese bonds might well have been marketed as a lucrative opportunity.
Which brings me to a final question and piece of speculation. What is up with Morgan Stanley?
What does some one in the market suspect about Morgan Stanley that the cost of insuring its debt has equally the cost of insuring Italian bank debt? That’s the question.
My speculation is I wonder if Morgan Stanley has been playing in in this Chinese bond/debt market? This article from ZeroHedge notes that the rapid ramp up in the cost of Morgan Stanley CDS (debt insurance) does not correlate with the rise in the cost of insuring French bank debt as it would if Morgan Stanley was exposed to them. But it does correlate with the huge increase in insuring Asian and Chinese debt which has happened on the Asian markets.
Of course it just a correlation. But perhaps it’s worth remembering that Morgan Stanley used to have large investments in Chinese property on which it lost very heavily. But I wonder if the bank decided to tap into its network of knowledge and connections in China to ride the last two years of bubble growth. If it did then it would now find itself horribly exposed to all these loans going bad and bonds not being repaid.
…Sorry I forgot to add this..
IF and it is a big IF I am anywhere near correct on this and MS is badly exposed to the Chinese Sub Prime and IF it does get crushed …then I wonder if we might have the entertaining question of who would rescue it. Obvioulsy the US would be expected to. But with debt ceiling as it is would they…could they? If there was any doubt is it possible – I konw this is specualtion upon specualtion but it is so entertaining I can’t resist – might we see China suggesting it might rescue MS from its exposure to Chinese debt with direct recapitalization/new preferred shares? Giving us the wonderful notion of one of the BIG American Banks, one of the Primary Dealers no less, being owned by the Chinese state?
Utterly ridiculous? Certainly almost unthinkable. But you have to admit it’s entertaining just to think of the hyperventilating on Wall Street and in DC.