When I come back after a few weeks off, it always strikes me how little has changed in my absence.
The news cycle gives the impression that things happen at a frenetic pace. But in the markets, it’s usually the same old stories. If you only checked the news once a month, I’m not sure you’d miss much.
This time, I came back to find two China stories in the headlines. Both stories have been rumbling around for over a year now.
Still, it’s worth catching up on the latest events. Not least because there’s a slight connection between the two …
Is China bailing out its local governments?
The first story was yet another piece about the Chinese banking sector. Reuters reported at the end of May that the government will be carrying out an RMB2-3trn (US$310-465bn) bailout of over-indebted local governments.
This led to quite a bit of excitable comment. But it isn’t new. We’ve known all along that when China instructed its banks to go out and lend in late 2008, it must have resulted in a substantial amount of money going into projects that would never earn a rate of return. I wrote about the problems with these local government financing vehicles (LGFVs) a year ago.
The Reuters story has yet to be confirmed. Caixin magazine reported that it’s simply a debate among a few officials at the ministry of finance, not an advanced proposal. However, if it eventually materialises, the size of the proposed write-off is in line with the more sober estimates I cited last year.
While not trivial, it’s not too onerous. It boils down to taking local government debt and stimulus spending onto the national balance sheet, where it should be. And even with this and other off-balance-sheet liabilities added in, China’s public finances are not stretched.
Interestingly, the report indicates that while the government will take on some of the costs, part will also have to be written down by the banks. Of course, this hurts shareholders, reinforcing once again my view that Chinese banks are too politicised to be attractive investments.
Official bank lending is slowing
However, these rumours so far don’t really tell us much we didn’t know. The LGFV problem is an old problem that relates to what’s already happened. As I mentioned a few weeks ago, I’m more inclined to pay attention to what’s going on in lending now.
China ramped up bank loans substantially in 2009, both to those LGFVs and to businesses. More recently, new lending has been quietening down as the central bank and banking regulator tighten policy. The chart below shows that loan growth is running at around 17% year-on-year. And it appears to be slowing further.
That’s still higher than has been typical historically, but not obviously excessive for an economy with nominal GDP growth in the mid-teens.
But as I mentioned last time, official bank lending is not the only thing that we need to watch. The Chinese financial system has a number of conduits for lending money: official, quasi-legal and blackmarket.
This is largely due to private companies’ need to get financing. While banks may be lending enthusiastically and the 12-month benchmark lending rate may look fairly low at 6.31%, this generosity is often only available if you’re a large state-owned enterprise. Banks prefer to lend to them because they are politically connected and they’re seen as a good credit risk.
If you’re a small private business, you’ll pay a much higher interest rate, or not be able to get bank loans at all. This is where some of the other lending channels come in.
The importance of Chinese shadow finance
Obviously, larger firms that meet regulatory approval can issue bonds, as in most economies. This market is growing quickly. That’s probably a good thing – it diversifies the financial system and makes it more transparent.
A less orthodox route is designated or entrusted loans. Here one cash-rich firm puts cash on deposit with an intermediary bank, which is then lent out to another company. Both of these are closely tied into the official banking system.
Things get a little greyer with the trust companies. These resemble a mix of a bank, a hedge fund and private equity. They get their capital from wealthy private individuals and companies. They are not supposed to take retail deposits, although undoubtedly some have. They are more lightly regulated than mainstream financial institutions, and charge higher rates (there isn’t much data, but Capital Economics reckon 15-20% is typical at present).
Beyond this, there are the illegal, completely unregulated lenders, such as informal credit cooperatives and underground banks and money lenders. These are often referred to as the ‘Wenzhou kerb market’ after a famously entrepreneurial city in Zhejiang province, where such unregulated lending is common.
This is far from a complete account – but you get the point. Official bank lending is just one part of the picture. And while the explosion in lending from banks was the most important factor to watch in 2009, what’s going on in the shadow banking system is becoming more important.
The good news is that the People’s Bank of China recently began publishing a wider measure of credit called social financing. This captures a much wider range of lending. At you can see in the chart below from UBS, total new financing has dropped off less quickly than bank lending.
China: net financing by source, annualised
Of course, this still isn’t complete – it doesn’t include the underground banks, for example. By their nature, there isn’t much data on these. Over the years, I’ve heard estimates that this ‘shadow finance’ accounts for another 15-30% of GDP.
However, these loans tend to be short term at very high interest rates. The indications are that they are not growing especially quickly. That makes sense given the structure of the business. Your local pawnbroker has limited capital and can’t grow his loans via fractional reserve banking like the official financial system. Perhaps he can borrow from a bank and lend on, but then that should still be captured in the official lending data.
It’s also worth noting that regulators have also been tightening controls on trust companies and on ‘wealth management products’ (where banks shift loans off balance sheet by selling them on to investors). This may account for some of the growth in social financing shown above, as hidden loans are brought back.
However, the key point is that banks alone don’t tell us everything. If we want to know whether China is storing up problems for the future, we need to look more widely. I think there are encouraging signs that credit growth is easing off – but we need to watch it carefully.
A big victim in the China stock scandals
Our second ongoing story is the problem of fraud in US-listed small Chinese stocks, which I wrote about here. In the last few days, this has ensnared its biggest victim yet.
One of the short-sellers responsible for publicising several confirmed frauds has accused Toronto-listed timber group Sino Forest of multiple deceptions. It’s testament to how nervous investors now are that the share price collapsed by almost 80% in the days afterwards.
If the allegations are true, this would be a big scandal. This is not a relatively obscure small cap, a part of the market that sees plenty of scams at any time. (Anyone who thinks this is solely a Chinese issue should take a close look at some of the firms on Aim.) Before the allegations were aired, the company had a market cap of almost C$5bn. Investors sitting on large paper losses include John Paulson of subprime mortgage-shorting fame.
The claims remain unproven. The company denies them and has issued specific rebuttals for many; it says more details will follow.
I don’t have a view on whether they are true or not. I think it’s impossible to know. Where a business is small or opaque (and Sino Forest is rather opaque in some respects), the main source of information an investor has is the company’s disclosures – and if you have doubts about these, how can you form any conclusions?
I have taken a look at some of the stocks that have been beaten down in this scandal to see if there might be value there, but I can’t come to any conclusions.
Equally, I would be very cautious about joining in the shorting frenzy. I think short-selling serves an important purpose and I’m always grateful to people who uncover scams. But the firms doing the exposés are generally talking their own books. Some of them seem honest, but some are run by people who have shaky records.
With this business now building into a frenzy, sooner or later one of these revelations is going to involve a firm that is completely legitimate. Short-sellers who pile in late are going to take heavy losses. And I would not want to bet on the investors who first floated the allegations still being among them.
A manufacturer or a lender?
Finally, I mentioned that this week’s threads of Chinese banking and small caps scandals are tied together. So where’s the link?
Earlier this week, I was reading a blog entry from John Hempton, a hedge fund manager who has written about and successfully shorted several of these stocks. He commented on a company called China Fire and Security, a fire safety equipment business, which is being bought out by private equity group Bain.
There are some curious features about this company that might well lead you to wonder if all is above board. As Hempton says, it actually looks like a promising candidate for shorting, which would have been expensive given the buyout. But since Bain seems comfortable with it, this raises the question of whether these suspicions are wrong.
Whether the firm is on the level is hard to know. I can think of explanations for many of the points in the analysis. But one possibility struck me as soon as I saw that vast receivables positions.
It seems plausible that this is less a manufacturing business and more a financing business. In fact, it’s clearly doing some financing of its clients. This may just be vendor financing related to the sale of fire safety systems, which is fine (although I’d still worry about those ballooning receivables).
But equally it could be that the firm is dabbling in grey-market lending, disguised as industrial sales, which is not something I’d want to buy into.
I’m not saying that this is definitely what this company is doing – only that this is a conclusion you could draw from the accounts and that it’s a question that any prudent investor should ask.
There certainly are plenty of Chinese firms that digress into informal lending, real estate speculation or other activities not related to their core business. Investors need to be aware of this and ask themselves whether what a firm claims to be doing is plausible and provable.
If I’d ever looked at China Fire and Security before, I would have passed on it. If Bain has done its due diligence properly, I would clearly have missed out on a successful firm. But I don’t think there’s any way that a private investor could ever have been comfortable concluding that. Emerging markets offer great opportunities, but caution is important – as these frauds are proving once again.