For Some, China In 'No Win' Situation

Apr 1 2014, 1:57pm CDT | by

For Some, China In 'No Win' Situation
Photo Credit: Forbes Business

There’s good news and bad news on China’s credit markets. It all depends on who you talk to, and what they focus on.

For the emerging market specialists at Schroders and Ashmore in the U.K., China’s default rate will rise, but will be more in line with that of the U.S.  China’s notorious shadow banking system — a form of informal lending — will also grow, but the Central Bank of China has been keen on plugging up holes where needed.  When Industrial and Commercial Bank of China (ICBC) saw one of its trust funds collapse under the weight of a poor investment that dominated its portfolio, the government came to the rescue.

ICBC said last week that real estate loans accounted for less than 1% of its non-performing loans.  However, defaults from commercial real estate developers are on the rise. Some, like Zhejiang Property, will need a government hand out or face bankruptcy.

Of course, not all entities in financial crisis will be saved.  The government might actually be fine with that. The country could use a shake out in sectors that have been overbuilt —  mainly automotive, solar and real estate.  That cleansing is good news for long term sustainability.

In the short-term, China continues on its leverage binge.  The Central Bank can put the breaks on it. But that will surely slow the world’s No. 2 economy even more than Beijing would like.

“I’d rather be highly leveraged on a good investment than unleveraged on a bad investment. It’s the asset quality that counts,” says Patrick Chovanec, Chief Strategist at Silvercrest Asset Management, a $15.3 billion financial advisory firm in New York.  ”The issue isn’t so much the total level of credit, but the rapid rise in that level, which usually implies malinvestment,” he noted in a conversation with FORBES via Twitter on Monday after-market  hours.

Chovanec has emerged as one of the more prolific bears on China, along with columnist Gordon Chang and Swiss fund manager Marc Faber of the famous Gloom, Boom & Doom newsletter. For them, going long China is walking the plank on a pirate ship.

Since the 2008 financial crisis, China’s economy has doubled from $4.5 trillion to $9.2 trillion GDP per year.  Most of that was done on fixed asset investment by the government in things like railroads, airports, and even entire towns.

That leverage is primarily in the private sector via bank loans and credit trusts such as ICBC’s problematic China Credit Equals Gold #1. 

In Zhejiang, an eastern seaboard province that is home to 54.9 million people, debt accounts for 220% of its $577 billion GDP, according to CEIC data. In major cities like Beijing, debt is 570% of its GDP of roughly $300 billion. In Shanghai, companies are levered up to 280% of that city’s GDP.  All told, China’s debt equals about 189% of its GDP compared to 260% in the hyper-levered U.S. economy.

Money from the U.S., U.K., Australia and Japan have flowed into the residential and commercial property markets in China. Worth noting, all of those countries have historic low interest rates, with U.S. and Japan rates near zero thanks to QE. The investment flow of foreign capital into property has helped make Hong Kong one of the most expensive cities in the world, and has put rents in Shanghai neighborhoods on par with Manhattan’s.

China’s housing prices have been tightly correlated with Fed QE, according to analysis by Newedge.

“The government is trying to curb these hot money flows from foreign investors and this will mean a lower account surplus for China,” says Robbert van Batenburg, Director of Market Strategy at Newedge, a broker/dealer in New  York.  Van Batenburg warns that a tightening of credit — not necessarily higher rates, but stricter regulations by financial authorities — will cut into the Chinese economy more than people think. And this will have ramifications in other markets, namely commodities and commodity exporters with close ties to China.

Tighter Credit Markets

The Shanghai Interbank Offered Rate skyrocketed in May 2013 to double digits, declined for the rest of the year and began its steady rise in Dec. 2013.  It’s now a very low 2.86%.  The one week lending rate is nearly double that at 4.2%.

Despite rates being far below where they were last summer, the Wall Street Journal reported last week that 30 companies have canceled bond sales due to lackluster appetite for China debt in the local market.  In March alone, five companies ran into credit problems, including two steel companies that couldn’t service their loans of over $500 million.  Chaori Solar become China’s first-ever bond default after missing payment of just $15 million in interest.  Zhejiang Property’s loan default — the biggest story of the week — now has the developer requiring government help to avoid insolvency./>/>

As credit tightens from the mainland as well as from abroad, China property prices are declining in second and third tier cities.  The tide is going out.  This will put added pressure on developers like Zhejiang, how may not have a rich uncle in Beijing to save them.

The slowdown in housing, exacerbated by credit, has led investment banks to lower their China growth forecasts.  Last week, China International Capital Corporation lowered its growth forecast to 7.3% from 7.6% in January.

Lowdown on China’s Slowdown

Heibei province is the home of Beijing.  It has the highest GDP per capita in the country.  Thanks to a cut in fixed asset investment, Heibei’s industrial productivity has dropped below that of summer 2008 — now less than 2.5%.  Only, in 2008, the government forced companies in the province to restrict industrial production in an effort to reduce pollution ahead of the Summer Olympics.  That’s not a problem in 2014.  Heibei IP is now below the national average growth rate of 9.5%, according to the National Bureau of Statistics.

As the economy slows, there is another China woe waiting in the wings: commodity credit financing deals.

Van Batenburg of Newedge says this is “a bubble waiting to explode.”  Such deals allow for Chinese companies to get trade-related loans based on the commodities they have in storage — such as soybeans and gold.

Goldman Sachs estimates that since 2010, such deals accounted for 31% of China’s short term foreign currency loans, or around $120 billion.  The Central Bank thinks this is too risky, and it is asking exporters and their brokers to clamp down on this form of leverage finance.

“China will strive to bring down this type of financing before U.S. interest rates rise,” says Van Batenburg. What does that mean? Less demand for certain commodities. China accounts for more than half of the world’s soybean imports, most of which come from the U.S., Brazil and Argentina.  China also accounts for around 30% of the world’s cotton and copper imports, and consumes half of the world’s cotton production and nearly half of global coal production.

Countries that export finished goods to China will turn out okay. But countries like South Africa will suffer most. In Brazil, companies like Vale, China’s leading supplier of iron ore, will have a tough time as China demand falters.   Vale shares are down 9.7% year-to-date, underperforming the MSCI Emerging Markets Index and the Bovespa in São Paulo.  But a worsening Chinese economy won’t make Vale’s performance any better.

This is the ‘no win situation’ argument.

China’s economy is highly leveraged and rife with speculative bubbles. Policy makers are determined to squeeze speculative capital out of the markets.  This risks the domino effect of tightening credit markets, rising defaults, and a further slowdown of the Chinese economy.

For Van Batenburg and others in the China bear cave, the leverage, one part an outgrowth of development, another part because of China’s unregulated shadow banking system, has led to a home-grown credit crunch that has the potential to cause systemic risk if this thing escalates.

See: Shadow Banking In China –The Economist

China’s Investment In U.S. Commercial Real Estate Surges – Bloomberg

On Credit, Beijing Embraces Failure – Reuters/>/>

Top Global Real Estate Markets For Affluent Chinese

Source: Forbes Business

 
 

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