After I wrote about some long-term threats to emerging markets (EM) last week, some readers told me they were quite surprised. Was I turning pessimistic on EMs?
That wasn’t my intention, so let me just clarify. My point was that the boom will end in a bust, as all booms do. We need to be awake to the problems when that time comes.
For now, I think a lasting shock to the EM story remains a long way away.
But development is never smooth and we can expect lots of smaller crises along the way. This week I’m going to talk about how four problems in China could be coming together to create a quite a shock for the economy.
If this plays out, it will certainly frighten the markets. But if tackled correctly, it would leave the Chinese economy sounder – and less vulnerable to the risks I discussed last week …
Part One: the stimulus
Let’s look at each part of the problem separately, starting with the banking sector. During the global financial crisis, China decided to boost the economy by instructing its banks to lend more freely. In an economy that had been deleveraging – ie paying down debt – rather than leveraging up in recent years, this was extremely effective.
Banks were keen to lend, especially where there was a good chance of the state stepping in to pay back any bad debts. This was good for state-owned enterprises and local governments, but less helpful for small private firms.
Local governments borrowed heavily to invest in building and infrastructure projects. This was mostly via special purpose entities set up for the projects. These are known as local government financing vehicles (LGFVs).
Some of these projects will earn a decent rate of return, some will be substandard and some will be white elephants or outright frauds. Estimates of the amount of bad loans created by local governments vary, but I believe it will be at least RMB3trn (US$470bn).
Do bear in mind that this borrowing was a central government-directed stimulus measure. That means that if the bad loans prove too much for the banks to deal with, the state – which controls virtually all the banks in China – will have to recapitalise them.
It can afford to do this. But shareholders should beware that they may be asked to accept their share of the pain through rights issues – ie raising more capital – and slow earnings growth.
Part two: land sales
Next, we need to consider local government finances. Raising money is a struggle for many local governments in China. The tax base is limited, and their ability to raise money by issuing bonds is tightly restricted.
So too is their ability to borrow from banks. This was loosened to bring about the LGFV lending surge, but the central government decided that had gone too far and began limiting this again last year.
So the standard way to raise money has been by selling land to real estate developers.
Now, long-term readers will know that I think the “Chinese property bubble” is a more complicated story than the headlines suggest. If you spend any time walking around older housing developments where most people still live, you’ll come away wanting to tear down and rebuild half the housing stock. This is a country that needs to build a lot of new homes.
However, there has certainly been a huge amount of real estate construction in recent years. And that means local governments have earned a significant amount of revenue from land sales.
This in turn has enabled many to service the LGFV loans on projects that will either never earn the money back or are still some way from doing so.
Part three: the real estate squeeze
This takes us to part three. The government is rightly concerned about a property bubble. It’s especially concerned about large numbers of higher-end flats (which developers prefer because they are more profitable) going up, while the less well-off feel they are being priced out of the market.
So as policymakers have tightened credit over the past year or so, they have paid special attention to restricting credit to real estate developers. This doesn’t mean they want to squash construction altogether – it’s a major part of the economy and a crucial sector for employment. But they have focused on trying to increase the amount of affordable housing built, while choking off many other developers.
Now the property market is cooling. Sales have slowed and asking prices have fallen. As a result, many developers are very short of cash and need bridge finance to tide them over until they can hopefully sell some developments. It’s a vain hope in many cases, but they’ll stick it out as long as they can.
But banks aren’t lending to real estate firms. So they have only one option: the grey market.
Part four: shadow finance
I’ve written about China’s shadow finance system before. It’s a very loose term that can include a variety of practices. Some show up in the wider measures of lending published by the People’s Bank of China; others are completely off the books.
At one end we have entrusted loans. A cash-rich firm (quite possibly a state-owned enterprise with easy access to credit) lends money to another firm via an intermediary bank. The bank gets a fee, but the loan isn’t on its balance sheet.
At the other end, you have illegal, but tolerated underground banking and lending institutions. Wenzhou, a city in Zhejiang province, is especially famous for its informal loan network and is seen as a barometer of underground lending conditions.
In some ways, shadow finance sounds worse than it is. When you have a dysfunctional banking system that lends to state entities and well-connected private firms at very low rates, but refuses other private borrowers or charges them larcenous fees, it’s no surprise that an alternative network will spring up.
And when individuals have to contend with low official deposit rates on bank accounts, a stock market that functions more like a roulette wheel, a very limited bond market and a real estate sector that the government is very clearly saying needs to cool down, it’s no surprise that at least some will choose to channel funds into greymarket loans in the hope of earning a better return.
To some extent, it works. More than one analyst has told me that the quality of loans in the informal sector is probably better than the ones the banks make. After all, a Wenzhou ‘banker’ has his and his associates’ money on the line, unlike a loan officer in a bank.
But the stories we’re hearing about the Wenzhou market tell us there’s a major liquidity squeeze. Short-term loans reportedly cost annualised rates of around 70% (obviously nobody pays that for a year – this is short-term bridge finance for distressed borrowers).
This presumably represents a huge increase in demand from real estate developers (there isn’t that much elasticity of supply in shadow finance, so an increase in desperate borrowers can send rates soaring). It’s also possible that a worsening export market means there’s less liquidity from export earnings flying around.
Importantly, this is not just affecting real estate firms. SMEs that depend on the grey market for finance – such as exporters financing an order or getting through a slow patch – are having difficulty raising funds. There have been several high-profile stories of SME owners committing suicide or skipping town when their business failed as a result.
Is this a threat to China’s banks?
This all adds up to a possible crisis in the making. Real estate developers are squeezed for finance. They can’t buy and develop land from local governments. Without land sales revenues, governments can’t continue to support LGFVs. Hence loans to these go bad and begin piling up in the banking system.
In addition, the funding squeeze on SMEs continues, accompanied by weak exports to the US and Europe. Since these are a major source of employment and the more dynamic part of the economy, growth suffers. This further hits real estate, tax revenues, bad loans and so on.
I don’t know if this is how things will pan out. But it stitches together several of the problems in China’s banking system. And we know that when one problem can no longer be hidden, others often come to light at the same time.
So what happens if this turns out to be roughly correct? A lot of people worry about even a hint of lower growth in China. Less than 8% a year and revolution will follow, goes the thinking.
But history doesn’t support that. For example, Chinese growth fell well below 8% during 1998 (the statistics were fudged, so they don’t show it). And this period was accompanied by a major shake-up in the economy: closing thousands of state-owned enterprises, putting people out of work and starting to acknowledge the bad loans in the banking system from a lending spree a few years early.
This was the kind of upheaval that China is often supposed to be unable to manage. Yet it did – and the economy emerged sounder.
So what might China do if growth slows as a result of fallout from real estate and weak exports? One option would be to try to engineer another lending surge, as in 2008. Or perhaps state-owned enterprises will be encouraged to grow to fill any gaps left by a weaker public sector. All of this would work – but would store up other problems for the future.
Alternatively, the country could spend more on healthcare, education and so on. And it could try to support SMEs, while clearing up the banking sector and local government finances. By that, I don’t mean shovel bail-out cash to them, but force more reforms.
So while I can see that there might be problems ahead, I find it hard to get from this to the ‘China implosion’ scenario that some investors are keen to bet on. China has the financial strength and the tools to keep the economy growing over the next few years, whatever happens in the next few months.
A best case scenario could result in bumpy growth, but accompanied by the kind of structural changes and rebalancing that everyone agrees China needs – changes that are frankly impossible without some upheaval. The worst case probably sends it down a path that is less good for the future, but supports growth now.
I certainly do not want to invest in Chinese banks or real estate firms, but I’ve never wanted to do so anyway. And I’d be concerned about what a more sober China means for property in Hong Kong, and perhaps other cities such as Singapore and Vancouver, all of which have been buoyed by cash-rich mainland buyers.
The more difficult question is what sentiment might do to many of the higher quality China companies. Many of these stocks rightly trade on premium ratings. If investors take fright over China more than they already have, they could sell off.
In that case, they should present an outstanding long-term buying opportunity. In terms of what might be on your buy list, well-run pure plays include Tingyi and Uni-President China (noodles and soft drinks), Want Want (snacks), Hengan (personal care), and Lianhua, Sun Art and Wumart (food retail). Other good firms that have China as their key growth market are Vitasoy (soymilk), Café de Coral (fast food) and Amorepacific (cosmetics).