UNRAVELLING CHINA’S DEBT BURDEN

07 APRIL 2014 PAGE 1

PROPERTY INFLATION STALLED BY SLOWER GROWTH In recent months there has been much focus regarding the Crimean Crisis, Eurozone inflation and US Federal Reserve Quantitative Easing actions, not only as sources for short term market volatility but long term price drivers. Although these issues have great importance, both the escalation of Chinese economic concerns surrounding debt and their subsequent impact on growth forecasts is likely to rise in prominence and severity throughout 2014. The rapid economic development of China has been well documented by many sources. Double digit growth in the early 2000’s has not been sustainable in the light of mixed global demand post 2008. This has not been offset by effective development of internal demand conditions for Chinese goods as the economy is still heavily export orientated and as a result, dependent. Politically China has allowed regions relative autonomy over growth plans which has led to mass migration from rural to urbanised areas with 53.7% of Chinese citizens now stated to live in urban areas by government sources. In addition to the negative social and environmental effects, this rapid development has caused rampant property price inflation. However, in the past quarter national real estate metrics such as house prices (-12.1%), property sales value (-3.7%) and urban investment (-10%) have started to slow, as a consequence of weakened internal demand, a price plateau in terms of rent price/mortgage affordability, and oversupply with the much publicised “ghost town developments” becoming more prevalent. Although this could be a short-term “ripple effect” from mixed global demand, any weakness in real estate prices could pre-empt stimulus based monetary policies (such as quantitative easing) which would impact other economic and financial elements of the economy and would reflect below-par global economic health. Escalation into a fully-fledged “pop” of the real estate bubble could show similar effects to the subprime mortgage crisis, as a result of the substantial linkages, both between the Chinese and the Global financial sector, and Chinese real estate inflation. THE BURDEN OF DEBT LADEN ECONOMIC DEVELOPMENT A more pressing issue than domestic demand and real estate bubble situation is the reason behind them; increased debt. Properties are being built using cheap local government funded credit to meet the export led demand and increased migration, some of these local governments are close to bankruptcy themselves with local government debt rising 70% in 2013 according to the National Audit Office (NAO). This has been a factor that has helped to push overall Chinese debt to GDP to 230% (Q1 2014). In isolation this figure highlights severe strain on the Chinese economy is likely. Yet, this debt figure is negated by high capital reserves (both at a commercial and governmental level) and is domestically generated through the intricacies of the Chinese banking sector, these intricacies being a greater source of risk than the overall debt burden itself.

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China’s industrial growth has been funded by cheap debt from a variety of sources which (at least on a macro level) is serviceable as long as growth is consistently high. A greater focus on Chinese debt against a firmer economic climate has increased global stock market volatility. The two (interrelated) news streams that have caused the most alarm in recent months are: The first company-level defaults for inefficient companies and the gravity of the issues facing the Chinese shadow banking sector.

This research article does not constitute investment advice.

UNRAVELLING CHINA’S DEBT BURDEN
07 APRIL 2014 PAGE 2

INEFFICIENT DEBTORS TO DEFAULT Many companies in China are funded through numerous credit sources whether that be through foreign direct investment (FDI), local government loans or shadow banking. This has led to a reliance on excessive debt funding by the majority, in fact there are several companies that are underperforming significantly which still have access to credit and have been ‘propped up’ by the government in the past. As a retort to rising overall debt levels (with local and corporate debt rising to 53% and 11% of GDP respectively) the Chinese national government has imposed more discipline regarding fiscal policy starting at a corporate level by allowing its first ever corporate default. It is likely that an increased number of companies will follow, especially those related to underperforming commodities such as steel and copper. On face value this process will ensure that the worst debts can start to be reduced and governments and corporations can be weaned off government debt. However, it is likely that the defaulting companies will be meticulously selected with defaulters not being from economically sensitive areas (e.g. real estate). Such an event could signal the beginning of the end of the property bubble, dent FDI inflows and further increase market volatility. SHADOW BANKING: MULTI-TIERED LEVERAGE With government and FDI flows increasingly becoming available to only to the most trusted debtors, the estimated $2.2trillion (Bank of America) shadow banking industry is becoming an increased source of credit. According to UBS and Bank of America, the relative size of the shadow banking industry is estimated to be 10-25% of the total credit system which is much lower than other nations around the world. Despite these size deficiencies the shadow banking sector still has the potential to cause severe financial distress as a result of the multiple interdependencies between shadow banks and financial sector, the high leverage of supplied credit and crucially; the fact that most shadow banks operate non- transparent investments that could contain severely underperforming assets. Shadow banking loans sourced from banks at a low interest rate by the shadow creditors and lent at a higher interest rate to riskier borrowers, which in turn can create a deeper cycle of indebtedness and insecurity if more borrowers default due to economic stress. These loans come in a variety of sources; from pawn shop creditors to packaged investment/wealth products and “underground” banks, all of them offering high interest and often multi-tiered products with a complex, creditor repayment makeup. A notable example of how complex these arrangements can be, is seen with the recent volatility surrounding copper, as an increasing number of companies now use copper (and steel) credits as collateral to obtain these loans. China is the largest global user of many commodities ensuring that the additional risk and default pressure assigned to these commodity contracts has created negative pressure on commodity prices as payment structures are more prone to collapse.

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There is increasing ambiguity regarding the validity of asset collateral and the cyclical nature of the assets used. When this ambiguity is combined with an increased reliance on shadow banking by industries that are pivotal to economic growth, (According to Societe Generale, since 2011 “Other” sources of finance have exceeded traditional bank loans as a source of finance for property developers) it is clear that a degree of contagion could affect established financial sources. This would require a large government bailout (at least) to counteract the inherent risk to continued FDI inflows and subsequent GDP growth in the absence of internal demand.
This research article does not constitute investment advice.

UNRAVELLING CHINA’S DEBT BURDEN
07 APRIL 2014 PAGE 3

PBOC POLICIES AIM TO CONTAIN A POTENTIAL CRISIS Although the risk surrounding the shadow banking sector and burgeoning debt levels could escalate in a similar fashion to the subprime mortgage crisis of 2008-2009, a commendably tough stance on fiscal imprudence from the Chinese policy makers will go some way to protect against these forces, such as the aforementioned credit defaults and removal of credit stimulus from the banking system. In light of long term economic health, this does create some negative short-term consequences such as liquidity shortages for smaller companies who may actually be forced into taking shadow banking loans rather than formal bank loans in order to make operational obligations and a reduction in government and banking credit funded growth projects. In addition, the Chinese central bank (PBoC) have also been altering exchange rates to deter against carry trades between the onshore Yuan (which features monetary controls and trades within a pre-set range band) and the cheaper, unrestricted offshore Renminibi rate which is based in Hong Kong and used predominantly for Chinese trade settlements. This has seen intentional deflationary pressure upon the value of the Yuan which not only deters speculation against further Yuan appreciation (and subsequent arbitrage opportunities) but makes the currency susceptible to a relative rise in taper led dollar prices, which could lead to capital outflows, further short-term credit shortages and increased stock market volatility. It is clear that the PBoC has the resources (namely large currency reserves) to weather any potential storm for a long period of time. Whilst growth estimates are within touching distance of double figures the slowdown will in effect be a short-term readjustment to protect future growth prospects. Debt figures in China are increasingly concerning, especially those related to the increasingly unstable shadow banking sector, which in many aspects cannot be tamed due to the adverse effects that strict regulation would have upon Chinese growth and the multifaceted collateral ownership of the credit in question. As a result, near term volatility movements will be increasingly driven by Chinese actions as traders focus on increased risk that is unlikely to fully materialise with strong central bank control.

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This research article does not constitute investment advice.