Its China, Not Greece Again
The Chinese have a lot of debt. Perhaps, not compared to Greece, but it is certainly impressive. Without demand, creating more stimuli might delay defaults in China. If defaults are put off too long, the consequences can be dramatic. The time has come for China
According to the Financial Times Vítor Constâncio, vice-president of the European Central Bank (ECB), the market had likely overreacted to China's economic problems and that the episode need not prompt an immediate shift in western policy.
If he had read my article "Chinese Stimulus: Perception v Reality" published in May 2015 in Moneylife, he might have changes his opinion. I wrote, “For the past year, the International Monetary Fund (IMF) has been warning about the risks in China. Certainly, the overcapacity and real estate are obvious risks. But what the IMF is missing and which is far more serious are two issues with China. The first is that the economic system in China is Chinese. Specifically it is capitalism with Chinese characteristics. The second issue is information. It is far worse than the typical asymmetry issues: they have it and you do not. The Chinese government suppresses information. Worse, it has provided large incentives for distorting it. The result is that no one, not even China’s leadership are exactly sure of what is going on. Markets may think they understand the situation. They project their own experience on a reality that might be quite different.”
It is not surprising that Mr Constâncio feels the way he does. The numbers that he can see do not point to a problem, but that is exactly the problem. You cannot see the numbers, for the simple reason that the Chinese hid them. (see also my latest letter in the Financial Times )
The Chinese threw over $200 billion to support their stock market, but the debt is so huge that even they cannot do this forever. So Mr Constâncio might want to start to trust what the markets are telling him rather than listening to people like himself.
The word stimulus is magic for markets. Just the word or the hint of more stimuli will send markets to new highs. The highs are so dizzying that stimulus has often been compared to heroin. However, as any addict will tell you, to get the new highs you need a stronger dose. A slight mistake will lead to an overdose. Too much of a good thing and the addict drops dead. Central bankers and governments might take heed of the analogy.
Last year in November, the markets celebrated the news that the People’s Bank of China (PBoC) had injected a rather large amount into their banking system. They gave the five largest state banks Rmb500 billion ($81 billion). But had it done anything? Probably not. During the first half of 2014, each new $1 of credit added only twenty cents to GDP growth. This has been consistently coming down. In 2012, it was 29 cents for each dollar of credit and in 2007; it was 83 cents for each dollar. Therefore, the real amount of the stimulus was only about $16 billion.
Worse, the money went to the five largest state owned banks. Most of these lend only to large local state owned industries. These companies are very inefficient and many of these are either losing money or are on the verge of bankruptcy. For example, as I wrote in an earlier piece, 20 out of the 36 largest coal companies were losing money. Many of these are state owned. The same is true for other large state owned companies. About a third of steel, aluminium, and cement companies lost money. The new stimulus money might have been only used to roll over unpaid loans. It will not stimulate new growth.
The sector of the economy that really needs the money is the shadow banking system where half the lending takes place. The real problem is the asymmetry of maturity dates. The trust companies make up the largest part of the shadow banking system. They took in money for a term of a few months promising to pay high interest rates. They used the money for loans of several years, often to real estate developers. As the real estate market slows, developers often cannot pay. Without new injections of money from the PBoC, there will be more defaults. How many of these will be bailed out is the next question.
Trust companies were developed to provide borrowers, often municipalities and real estate developers with funds that were not available because of restrictions by the traditional state banks. They also provided investors with far better rates of returns. Often, 5% or more over official bank deposit rates. The authorities tolerated them because they provided additional capital. Over the past few years, they have exploded. Since they were often sold through the state owned banks, investors assumed that the bank and the government would stand behind them even though there are no specific guarantees.
Products offered by two trust companies went in default. Both provided credit for the troubled coal industry. One product was sold by the Jilin Trust. The product worth Rmb 1 billion ($165 million) backed exclusively by loans to Liansheng Resources Group. Liansheng is a big player in the Chinese coal industry and it is insolvent. Its debts have reached Rmb 30 billion and it filed an application with the local court to restructure. Unfortunately, Jilin did not take any collateral for the loans. It only has a guarantee from another coal company that is also having problems. Liansheng loan product sold by Jilin Trust was distributed in part via China Construction Bank. 
Another trust company, China Credit Trust, distributed a Rmb 3 billion ($495 million) product that also provided money for another coal company, the Shanxi Zhenfu Energy Group. China Credit distributed its product through China’s largest bank, the Industrial and Commercial Bank of China (ICBC).
The Chinese have a lot of debt. Perhaps not compared to Greece, but it is certainly impressive. The money owed by Chinese companies shot up from 90% of GDP in 2007 to 124% by the end of 2013, a total of Rmb 64 trillion ($10.6 trillion). But companies were rather conservative compared to local governments. Their debt increased 70% in just two years to Rmb 17.9 trillion ($2.95 trillion). It is not just the debt itself, but the money has been spent in very inefficient ways. It now takes Rmb 3 of credit to create Rmb 1 of growth. 
The Chinese government created this orgy of lending. Much like the orgy of money printing by central banks in developed countries. It was supposed to help China grow and avoid recession. It was very successful until 2010; since then growth rate, though still impressive, has been declining. 
The reason was simple. Just because a government can create a plethora of cheap money does not mean that it will be spent wisely or even used at all. Quite the contrary, something that has a low value is bound to be thrown away. This is especially true of China where locals used massive borrowing to finance industries that were successful in neighbouring provinces. This led to overcapacity especially in the steel and solar-cell industries. Cheap money and local pride prevented the less efficient from being weeded out.
China has stuffed itself with credit. Its economy is about half the size of the US and its money supply is 61% bigger and growing. The Chinese simply cannot use more money. The loan demand fell to 66% from 71%. Without demand, creating more stimuli might delay defaults but it would not prevent them. The choice for the Chinese government is whether to let the defaults take place. Throwing good money after bad is never a good idea, but if you put too much stress on an overleveraged system, you risk a systematic impact. If you do not allow some defaults, it just delays the day of reckoning. Either way, the Chinese government, like other governments, will reap what they have sown. The only question is when?
Mario Draghi, the president of the European Central Bank (ECB), had a similar problem. He has been telling anyone who would listen for months that he could use “unconventional policy measures” to stimulate the Euro zone economy and avoid deflation. So far, this has meant a program known by its acronym, TLTRO. Under this program, the ECB offered three-year ultra-cheap loans to banks. The program offered €400 billion to the banks. Most economists did not believe that the banks would want that much. They forecast that banks would take only €150 billion. In the end, the demand was not even for that much. The auction of the loans resulted in banks borrowing only €82 billion. Worse, some banks paid off earlier ECB loans for €19.8 billion. In short, this unconventional policy measure failed.
The next “unconventional policy measure” will involve the ECB purchasing bundles of securitized assets. The ECB would love to purchase hundreds of billions of these things. But loan demand has been contracting since 2012. Securitized assets got a bad reputation in the crash, so there are simply not enough of them out there for the ECB to buy. This is especially true since the ECB is trying to reduce its credit risk by only buying the best. However, why should anyone want to sell anything that is paying a decent return?
Because of the problems with the other “unconventional measures”, markets expect the ECB to try quantitative easing. But this will involve the purchase of peripheral Eurozone bonds, specifically Italy’s.
Italy has a major problem. It has a very high debt to GDP ratio (over 130%). Its credit rating by Moody’s is Baa2 and by S&P BBB low medium investment grade, a notch above junk. Its growth rate is very low even negative. Its working age population is falling and those Italians who are educated and still work are leaving. This combination of high debt, falling inflation or even deflation and a shrinking population is a recipe for default.
If Draghi wants to invoke QE for Europe, he has to convince the Germans that they should buy debt that may require a 50% write off. For me that sounds a bit far-fetched. No sane politician would agree to spend taxpayer money to buy anything with a high probability of losing money no matter what the benefits. QE has not necessarily shown major benefits other than inflating stock markets.
The real problem is that both the Europeans and the Chinese are trying the wrong type of stimulus. The right type of stimulus is the one proposed by Indian Prime Minister Narendra Modi. He wants to bring India’s ranking in the World Bank’s Doing Business Index up from its present rank of 134 to 50. This is a monumental undertaking but it is the only one that will work. Injecting more money into economies that certainly do not need it is far easier, but eventually those economies, like other addicts, will collapse as well. 
(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and speaks four languages.)
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