Amid all the excitement over Greece last week, very few people noticed the tale of another dodgy debt going bad, many miles away.
Chinese news site Caixin reported that the company building toll roads in the Yunnan province in southwest China had failed to repay its debts. Income from toll roads fell short of hopes, meaning the company couldn’t repay the loans granted to it by various banks.
In the end the local government bailed it out. But as one source told Caixin: “the issue has merely gone from [being] on the table to [being] under the table.”
Why does this matter? Because it might be the tip of the iceberg. China’s banking system is riddled with loans made on optimistic assumptions that could turn bad very easily.
Being saddled with a malfunctioning banking system could in turn slow China’s economic growth sharply. What would that mean for the rest of us?
How China’s bail-out could turn bad
It’s almost easy to forget now, but the financial crisis of 2008 hit everywhere hard. No country, east or west, was spared. For most, the route out was simple: cheaper money.
As the West embarked on quantitative easing , China ordered its banks to lend a huge amount of money. Much of this went to local governments, who spent it on infrastructure projects. Local governments can’t borrow directly, but they do so through local government financing vehicles. I won’t go into these right now – they’re a bit like the off-balance sheet funding that got our own banks into trouble.
Suffice to say that local governments have stacked up a lot of debt. The People’s Bank of China reckons that local governments now owe in the region of ¥14 trillion (around $2 trillion). In total, says Minxin Pei in The Diplomat, if you factor in these debts, then China’s debt-to-GDP ratio clocks in at around 70-80%. That’s in the same region as the US or the UK.
So why worry? As long as these infrastructure projects are necessary, and will generate a decent return, the debt will be serviced, and the loans repaid. But that’s the problem. How many of these projects can genuinely pay for themselves?
We already know that when money is cheap, lenders get careless about what they do with it. You only need to look at the sub-prime debacle to realise that.
So how much more careless do lenders get when they’re given a specific, emergency lending target by the government? I think it’s safe to say that there’s not going to be much in the way of proper due diligence going on when you decide to back a project. Indeed, according to Pei, one banking regulator says that “only one third of these projects can produce enough cash flow to service their loans”.
This suggests that a good proportion of these investments will go bad. And that means the local governments won’t be able to repay their debts in full. And this is all before you even start thinking about the sort of corruption that’s likely to have arisen with all that free money sloshing around.
A warning for investors in Chinese banks
Credit ratings agency Moody’s is now – unsurprisingly – fretting about the state of Chinese banks. “Banks’ exposure to local government borrowers is greater than we anticipated,” Yvonne Zhang of Moody’s told Bloomberg.
Pei notes that about half of local government bank loans will fall due in the next two years. Chinese state-owned banks will do what everyone is doing these days: they’ll ‘extend and pretend’. They’ll roll over the debts and pretend everything is fine.
That’s not a huge short-term problem, says Minxin. Beijing can afford to bail out local governments. Indeed, regulators are already planning to shift two to three trillion yuan of debt off local governments’ balance sheets.
Trouble is, a big bail-out will leave the country short of capital to invest for the future. “For an investment-led economy, this implies even more sluggish growth.” It’s also a disaster from a moral hazard point of view. If all loans are underwritten by central government, then what incentive is there to lend more sensibly? Of course, this applies to our own system too, so we can hardly point the finger.
So what would all this mean for investors?
We’d avoid Chinese banking stocks for a start. One Victor Feng of Everbright Securities in Shanghai tells Bloomberg that “even if the worst-case scenario happened, it’s not going to be fatal. Profits may drop, but banks will not go bankrupt.” However, why have exposure to banks at all, with this hanging over them?
Singaporean sovereign wealth fund Temasek seems to agree. It’s just offloaded $3.6bn worth of shares in Bank of China and China Construction Bank. As one fund manager told Bloomberg, “If major strategic investors are getting out, minority shareholders have to ask why they’re doing so at this very moment.”
But given that you probably don’t hold Chinese banks anyway, what are the wider consequences? Well, let’s think it through. Capital investment accounts for more than half of Chinese GDP growth. It’s not quite as important to them as consumption is to us, but it’s not far off it.
We all know that the British economy isn’t doing too well now that the consumer has stopped spending. So it seems reasonable to imagine that China’s growth will drop off if it stops spending all this money on infrastructure.
This is all part of the grand ‘rebalancing’. China starts to derive more of its growth from internal consumers, and relies less on spending on infrastructure. However, as with Britain, rebalancing is not painless.
I’m not saying there’ll be a dramatic bust in China (though I’m not ruling it out either). But any sign of a slowdown there would hit the commodities sector in particular very hard. Luxury goods and asset classes such as art and fine wine would probably take it badly too.
My colleague James Ferguson recently looked at the threat of a Chinese slowdown in a MoneyWeek magazine cover story. Subscribers can read the piece here: China is heading for a fall – here’s what it means for you (if you’re not already a subscriber, subscribe to MoneyWeek magazine.)
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