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Is Chinese Debt the Great Financial Crisis - Part Two?

The recent default on interest payments due on a bond issue by Shanghai Chairo Solar Energy Science and Technology is the latest development to strike fear into the hearts of those who see China and its debt mountains as the next source of financial Armageddon.

The recent default on interest payments due on a bond issue by Shanghai Chairo Solar Energy Science and Technology is the latest development to strike fear into the hearts of those who see China and its debt mountains as the next source of financial Armageddon. Doomsters also point to excessive property lending, offshore borrowing, (in USD, say), shadow banking, local government debts-you name it. Unease has grown due to the general flight from emerging market (EM) investments following the Ukraine crisis, and a realisation on the part of investors that risk-free returns in US Treasuries are going to become more and more attractive as tapering continues and the US economy surges after the extended period of 'snow stopped play' in January and February. I feel concerns over China's liabilities are overblown and unwarranted. Let's look at the facts.

Touching briefly upon the Ukraine - we could indeed see a widespread risk-off move in emerging markets, should the situation escalate badly, but there is also an argument that Eastern European and near Middle Eastern markets would suffer the brunt of this, with Asia becoming a relative safe haven for EM investors.

Total Chinese credit outstanding (including government debt) stood at roughly 230% of GDP at year-end 2013, up by 20% of GDP on the year, and it is true that this total debt was only 80% of GDP as recently as 2002; so admittedly we have seen a prodigious increase in indebtedness. In 2008, the People's bank of China, (PBoC), introduced a measure of Total Social Financing (TSF) and Fitch estimates total outstanding credit ended 2013 at $22trn - 18% more than the PBoC's TSF figure.

So what about property lending, surely that's a problem, isn't it?

Headline news about the Chinese property market continues to give a picture of froth, if not bubble, but the detail tells a rather less disturbing story. Although the national volume of sales grew by 20% last year, and the value of same by 33%, official figures show that price surges are centred on cities such as Beijing and Shanghai - no surprise given the continuing surge in the population of the biggest cities - but prices in the country's largest 70 cities rose a more reasonable 10% last year and in the top 760 by just 5%. Meanwhile 'flippers' accounted for only 15% of sales last year, down from nearly 50% in 2011. Inventories of housing stock, at 10months, remain comparable to long-run experience. Look beneath the headlines.

What about external or offshore debt?

China's external liabilities amounted to USD 3.8tn as of September 2013, equivalent to 43% of GDP, but foreign direct investment, (FDI), represents 60% of this figure. This is not 'hot money'- it represents 'real' investment in plant, factories, machinery, infrastructure, etc, and is therefore very 'sticky' indeed. So, excluding FDI, external debt is about 17% of GDP; a drop in the ocean of China's total indebtedness, (230% of GDP). Foreign bank loans to Chinese borrowers amount to 10% of GDP, vs. 20% in India, and 40% in Taiwan.

It is true that the advent of major quantitative easing programmes in the US, UK, Switzerland and Japan, coupled with near-zero rates, has led to a rapid growth in seemingly cheap offshore, foreign currency-denominated financing, but the aggregate amount is still small, at roughly 9% of GDP. Another key driver has been the assumption that the Yuan would only ever appreciate in value, thus reducing the capital cost of these unhedged loans.

Learning from the experience of other countries during the Asian financial crisis in 1997-98, Beijing was extremely cautious about foreign debt, restricting firms from borrowing offshore. They have no desire to repeat the Thai narrative, where a painful devaluation followed the acquisition of huge external debt, which had seemingly been rendered cheap and risk-free by a pegged exchange rate.

'Shadow Banking'?

The phrase "shadow banking" covers an ill-defined multitude of 'sins', but even the broadest definition amounts to only 14% of GDP.

The good news is that China non-bank finance is not characterised by the widespread use of securitisation, nor off-balance sheet special purpose vehicles, nor the sort of complex financial engineering, such as CLO's, CDO's, CDO's squared and cubed, etc, that contributed so much to the great financial crisis!

We must focus on the fact that banks are still the primary source of new credit, and the PBOC is amply capable of regulating and controlling them-it palpably has the means and also the will to do so.

Local government debt?

Actually pinning down an accurate estimate for local government borrowing is rather difficult-due to both questionable audit practices and the proliferation in channels used by local governments to access debt-bank loans, bond issuance, IOU's, insurance company loans, trust company loans, entrusted loans, etc, etc. A credible estimate puts total local government borrowing at 40% of GDP. As ever, the first hurdle is recognition of a problem and development of a desire to tackle it-this is certainly now the case, with reform of local government financing firmly in the crosshairs of the Ministry of Finance. A key part of this will be to reduce moral hazard, and recent evidence suggests central government is now willing and able to allow defaults of many kinds-not only on wealth management products aimed at retail consumers, but also on local government bonds, for instance. This 'stick' will be accompanied by measures to reduce the amount of debt which local government is allowed to acquire and also 'carrot' in the form of some debt relief and centralisation of liabilities to Beijing. At 40% of GDP, it is well within the scope of Beijing's resources to handle these issues.


We see therefore, that although by no means insignificant, the usual suspects as catalyst for a Chinese debt meltdown are manageable in quantum, but what about government resources to handle any issues?

Government debt stands at 90% of GDP, with a 2013 deficit of just under 2% of GDP. Inflation is roughly 3.3% and foreign exchange reserves amount to just under US$4trn.

Premier Li indicated recently that though he did not want to see defaults of financial products, some defaults cannot be avoided. He also stated that the government must ensure that there is no systemic financial risk arising from debt market problems.

There is ample scope for counter cyclical action by central government, whether fiscal or monetary; even as I write. various indicators speak of a small slowdown in growth and already the PBoC is said to be mulling a reduction in the reserve requirement ratio it imposes on banks; if necessary, there is also ample scope to cut rates. As in all things Chinese, we in the West are being too impatient; there is a medium-term plan to re-balance away from export and investment led growth into consumption, and there is also a plan to reduce credit growth, and the resources with which to accomplish both goals, whilst avoiding either an extreme slowdown or a debt debacle.

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