Barron's Cover

SATURDAY, JUNE 22, 2013

Where Will It End?

By JONATHAN R. LAING

China's credit growth to back lavish construction and infrastructure projects is similar to that of the U.S. and Japan before they faced financial calamities.

  

 Of all the global economic powers, China would seem the most immune to the threat of a financial crisis.

It sailed through the post-2008 global credit implosion largely unscathed, by pumping up housing construction and infrastructure spending to compensate for slackening exports. First-quarter 2013 growth in gross domestic product, although the weakest in more than two years, rose at a rate the rest of the world would envy, 7.7%. Bad debts inside the Chinese banking system stand at a negligible 1%, compared with 3.4% in the U.S. and double-digit figures in much of the euro zone.
 
And Beijing seemingly has plenty of additional resources to employ to spur growth. China's economy boasts a debt-to-GDP ratio reckoned conservatively at about 30%, less than half the national debt rate of the U.S. In his recent summit talks with President Barack Obama, China's President Xi Jinping pointedly expressed his satisfaction with the Chinese economy.

[image]
Yan Runbo/AP Photo
A symbol of wasteful spending, the Jiaozhou Bay Bridge spans 26 miles and sees little traffic.


But appearances can be deceiving, especially in China. Skeptics always have insisted that China's economic numbers paint too rosy a picture. Now those statistics show a worrisome downshift in growth for both exports and industrial production. Signs of trouble abound.

A post-2008 credit bubble in China seems to be yielding increasingly limp GDP growth, as spending on gaudy new infrastructure projects and housing no longer packs the same punch. Miles upon miles of empty apartment buildings rim hundreds of Chinese cities; industries suffer from rampant over-capacity; and largely empty new highways, bridges, shopping malls, railroad stations, and airports more than hint at problems.

A number of observers, including some former China bulls, see the country headed for a potentially serious economic downturn, or possibly a Japanese-style purgatory of anemic growth, with all the baleful side effects. These could include collapsing prices for assets like real estate (stocks already sell at big discounts), diminishing wealth, and, in extremis, frenzied capital flight by rich Chinese.
 
"I would say that China is now roughly at the stage [of indiscriminate credit growth] the U.S. was in March 2008, when Bear Stearns had to be rescued and the subprime market was unraveling," says David Cui, Bank of America Merrill Lynch China strategist, working out of Shanghai. "What will tip the scale will likely be a major event in China similar to Lehman's bankruptcy six months after the fall of Bear Stearns, which will be some bailout of a major player that Beijing will do everything it can to disguise so as not to shake confidence."

Echoes George Magnus, a London-based economist and independent advisor to UBS who has written extensively about China: "The financial situation in China has become quite alarming. Cracks are appearing all through its financial structure as a result of debt-fueled overinvestment in infrastructure, industrial capacity, housing, and commercial construction. There's likely to be big trouble coming in the next year or two."


Moreover, a major cash crunch has erupted this month that could be a tell of systemic liquidity problems. Overnight rates in the key interbank credit markets soared last Thursday to more than 13% from under 8% the day before and less than 4% in May. A medium-size state-owned bank, China Everbright, recently defaulted on a six-billion yuan ($980 million) loan from another bank.

Some commentators dismiss the cash crunch as Beijing's attempt to drain liquidity from the system to slow the runaway growth in lending. A flight of foreign capital out of China has also strapped the banking system. But the crunch could be a sign of ebbing confidence in loan quality in the Chinese financial system, similar to what occurred in the U.S. and elsewhere in the fall of 2008 when Libor soared and the credit system froze up.

THE PRIMARY FAULT LINE in the Chinese economy that worries many has been the explosion in the credit-to-GDP ratio since the onset of the 2008 global financial crisis and economic slowdown, as China sought to stimulate its economy in the face of a lag in its longtime growth engine, exports. 

This total societal debt load has followed a similar growth trajectory to that of the U.S. and British economies in the six years leading up to the 2008 crisis; Japan's credit orgy from 1985 to 1990, a prelude to two decades of stagnant growth punctuated by bouts of deflation, or Korea prior to the Asian financial crisis (see charts below). 

 
image
To enlarge click here


According to a report from analysts at Fitch, China's recent credit bubble has topped them all with total debt (a broad measure which includes business, household and local government debt but not central government debt) rising from 130% of GDP in 2007 to 210% in the first quarter of this year. In Japan, by comparison, during the fateful six-year credit bubble, the jump in the ratio was just 45 percentage points, from about 150% to just over 195%.  

SUCH RAPID CREDIT booms tend to come to sorrow because of slipshod analysis and misallocation of resourcesThe quality of China's credit-fueled investment boom in the past four-and-a-half years has been suspect. The obvious low-hanging fruit of projects had already been plucked. Smart investment is far tougher as economies like China move up the value chain.

Likewise, gobs of new liquidity tend to spawn asset bubbles, which can dull the appreciation of risk. With prices of, say, houses in the U.S. levitating upward in the years before the bust, investors become emboldened and lenders confident in the strength of the collateral underlying their loans.

Xi's cockiness in his talks with Obama is understandable. China has enjoyed more than three decades of extraordinary economic gains spurred by the internal migration of workers from the countryside to the city and heavy spending on industrialization and infrastructure improvements. Build it, and they will come. Economic growth can trump mistakes and excesses.


The Chinese credit explosion, however, has sluiced funds into sectors that hold much peril. For example, money has been lavished on giant state-owned enterprises that dominate such key basic industries as steel, cement, electrolytic aluminum, plate glass, coking coal, solar panels, and wind-turbine production. This has created severe overcapacity in these industries that, ominously, has sent China's producer price index into negative territory in the last 12 months, slipping another 2.9% in May, and sharply curtailed corporate profitability.

There has also been a huge surge in infrastructure spending since 2008, primarily on the part of local-government financial vehicles, which are special investment platforms. Many of the projects -- roads, bridges, international ports, and airports -- don't seem to have a good economic rationale.
 
 
image
How Hwee Young/Corbis
Apartments of Ordos in Inner Mongolia are mostly empty.


A new railroad station in Wuhan is like "something out of a science-fiction movie" because of its size, which dwarfs citizens' needs, and over-the-top architecture, says Anne Stevenson-Yang of the Beijing equity research firm J Capital Research. Then there are the gargantuan exposition halls in improbable places such as Hefei and Binhai. Or Olympic-size stadiums in dozens of Chinese cities.

A number of projects have produced allegations of graft, often against party operatives who sometimes demonstrate more interest in getting rich than serving the public. 

In any event, many recent, debt-financed projects won't generate cash flow for years, if ever. They were merely big, splashy projects that temporarily boosted employment and economic growth during their construction phase before sinking into a moribund state. The New South China Mall, twice the size of the U.S.'s Mall of America in Minnesota, has been 99% vacant since its 2005 opening.

In fact, a recent working paper by the International Monetary Fund concluded after a cross-country survey that excessive investment on infrastructure and industrial projects, amounting to about 10% of GDP, or about CNY5 trillion, would have "little impact on future growth" or long-term "favorable spillover into household income or consumer spending."

BUT NO CHINA CREDIT STORY would be complete without mention of the real-estate construction boom that has pumped up perhaps the biggest bubble of all. For example, nine times the commercial space sold last year is under construction nowResidential construction has been in a white heat for some time and has attracted much notice in the financial press and elsewhere.

Stories about the "ghost city" of Ordos in Inner Mongolia have become a staple, showing the eerie empty streets and deserted modern, high-rise apartment buildings, stores, and public buildings of a megapolis expected to attract more tan one million people. It has been empty for the six years since its construction.

Stories abound about similar projects in other cities either still under construction or sitting vacant. 


Word came last month that Broad Group, a Chinese maker of central air-conditioning systems, had been green-lighted to break ground this month on the tallest building in the world, near the unprepossessing capital of Hunan Province, ChangshaSky City, as the project has been dubbed, will include a hospital, school, hotel, and retail and office space in addition to living quarters. And new modular construction techniques pioneered by Broad will enable the company to build the project in just months. 

Yet even with the overbuilding, market prices of apartments haven't cracked, at least according to government reports. Developers can still borrow money for new projects even while trying to roll over and carry debt on their inventory of unsold apartments.

Faith remains undiminished that continued migration from the countryside to the cities will cure all housing oversupply. Besides, apartment purchasing has become the No. 1 investment game in China after the stock market crapped out in 2007, with the Shanghai Index falling nearly 70% since. 
 
image
Imaginechina via AP Images
The huge Wuhan Rail Station seems to dwarf rider demand for train transport.


Apartments are now more than living space -- they have become a store of value and an insurance policy against penury in old age. Living in them or even renting them out is deemed to diminish property value should someone ever show up to lease one. So they remain vacant. Press reports recently said a party official was busted for, among other things, secretly owning some 50 apartments.

A collapse in the Chinese real-estate market would require only a slight shift in investor psychology. And once prices start to crumble, the results to the credit system and, ultimately, the general economy promise to be severe and widespread. Likewise, buildings and land are bedrock collateral supporting many corporate and local government loans.

GONE ARE THE DAYS when the central government exercised tight control over credit through the Chinese banking system, in which it held a roughly 95% stake. The past five years has seen the explosion of China's shadow banking system that largely operates in a regulatory realm outside the direct control of Beijing, and yet last year was estimated to have accounted for more than 45% of China's credit creation.

This burgeoning nonbank channel comprises a crazy quilt of institutions and investing instruments that extends from off-balance-sheet offerings of wealth-management products from traditional banks to the credit wares of brokerage houses, pawn shops, and credit-guarantee loan paper. Even the fast-growing Chinese bond market can be chaotic, with four regulators, poor disclosure, and credit-rating inflation.

The popularity of shadow-banking products is easy to grasp. Chinese consumers are starved for investment yield with official deposit rates set so lowMany private firms lack access to bank lending, either because of government policy or the favoritism enjoyed by state-owned enterprises. But a number of products offered are reminiscent of the worst structured investment vehicles and collateralized debt obligations issued in the U.S. prior to 2008.  Their structures are opaque, with debt maturities mismatched with underlying assets, and disclosure is risible.

A credit crisis would likely begin somewhere in the shadow banking system with a large credit default or the bankruptcy of a major player, observes Charlene Chu, Fitch's senior banking analyst in Beijing. "In China, trouble starts on the fringes of the system and then moves into the core," she says.

Signs of financial trouble abound even in China's official numbers, which many say are designed to obscure problems. The post-2008 credit surge, for example, seems to be losing its ability to generate actual growth. During the boom period of 2005 up to early 2008, statistics show that one yuan of credit yielded nearly one yuan of GDP growth. But no more. Last year, it took four yuan to generate just a single yuan of increased GDP, according to government-based figures.

This collapse in capital efficiency indicates several things to China watchers. Much of the money was being wasted, going into projects that weren't generating sufficient ongoing revenues or, possibly, any revenues at allLikewise, many suspect that much of the new credit went to "evergreen," or roll over, old loans gone bad, or at least coverage of the debt service and operating expenses of debtors with cash-flow problems.

Debt is building up with particular speed in the corporate sector just as revenue growth is flagging. According to GK Dragonomics researcher Andrew Batson, corporate debt jumped from 108% of GDP to 122% just between 2011 and 2012.

Much of that rise is occurring in accounts receivable, or unpaid bills by customers, that reside on the asset side of corporate balance sheets. Official numbers put that total at CNY8.5 trillion in April, up 13% from a year ago. Yet many private estimates claim that the increase may be as high as 20% or more. Zoomlion, China's biggest heavy-construction-equipment maker, has seen its accounts receivable leap to CNY2.7 billion in 2012 from CNY912 million the year before and just CNY106 million in 2008.
 
image
Nelson Ching/Bloomberg News
The new streets of Ordos in Inner Mongolia are mostly empty.


At a minimum, the surge in receivables indicates growing liquidity problems in Corporate China. A lot of companies aren't generating enough cash to meet their financial obligations, no matter the degree to which uncollectible receivables might artificially inflate corporate revenues and profits on paper.

Many of the receivables are turned into cash when banks purchase or "accept" them on a discounted basis. These acceptances, in turn, show up as supposedly safe money-market instruments in all manner of investment products sold to households, such as wealth-management investments.
Thus, any surge in defaults on China's pile of corporate receivables, if unchecked, would cascade through the financial system, hurting households, banks, local governments, manufacturers, and the chain of suppliers.

How much debt will go bad is anybody's guess, but the total is much higher than the 1% that Beijing officially reports in the Chinese banking system. Some estimate the eventual total, including sources outside the banks, could be as high as 20% of 2012 year-end total debt of about CNY100 trillion. Losses of just CNY6-7 trillion would wipe out the capital of the state banking system.

BEIJING HAS WEAPONS to fight off a financial crisis, either by directly or indirectly papering over shortfalls, Chu concedes. It could unleash some of the CNY19 trillion that its central bank holds as loan reserves, or deploy the $3.38 trillion (CNY20.7 trillion) in foreign-currency reserves, though much of that has already been committedBeijing also could sell part of its interests in its state-owned enterprises, though Chu reasons that the central government would be reluctant to dump such assets at "fire-sale prices." As a last resort, China could also print money, adding to the rapid monetary growth of recent years.

China doesn't have to look too far for a cautionary tale. Japan in the late '80s and early '90s faced a similar slowdown in economic growth. Like China today, it sought to compensate by first unleashing a flood of credit, creating a real-estate bubble, and then engaging in infrastructure spending on the proverbial bridges to nowhere.

"But it didn't work, despite the fact that Japan, like China today, boasted a high savings rate, plenty of fiscal capacity, and little foreign debt," says Patrick Chovanec, who spent a decade doing private-equity deals in China and teaching business at Tsinghua University in Beijing, before becoming a strategist at Silvercrest Asset Management, a New York money manager.  "The flaw is that sometimes it takes so much capital to fill an existing hole that there's not enough money left to promote growth."

That could be the case for China and its flawed economic model. It is fast running out of effective responses to the iron law of diminishing returns.        
 
Copyright 2013 Dow Jones & Company, Inc. All Rights Reserved


June 23, 2013

Central Banks Criticize Europe for Political Gridlock on Economy

By JACK EWING and JAMES KANTER



FRANKFURT — FOR European officials, it may have been an especially untimely — and embarrassingexample of political gridlock.
       
Their failure early Saturday to agree on a crucial pillar of the euro zone’s new banking architecture, despite 18 hours of haggling, occurred just as the world’s central bankers were about to criticize politicians for exactly that kind of dithering.
      
The Bank for International Settlements, a group representing central banks including the Federal Reserve and the European Central Bank, warned political leaders on Sunday that they should not expect central banks’ cheap-money policy to hold the global economy together forever. The organization, based in Basel, Switzerland, said in its annual report that politicians should do their share of “the hard but essential work of adjustment.”
      
Returning to stability and prosperity is a shared responsibility,” Jaime Caruana, the general manager of the organization, said Sunday in Basel, according to a text of his remarks. Monetary policy has done its part.”
      
The report was published a day after a political leaders’ meeting in Luxembourg had provided a vivid example of what the central bankers were complaining about. Despite debating well into the early morning on Saturday, European Union finance ministers could not agree on new rules to reduce the chances of taxpayers bearing the burden if commercial banks collapsed.
      
“We ran out of time,” Michael Noonan, the Irish finance minister, told reporters as he left the meeting at about 4 a.m. “There are still core issues outstanding, so we’ll need a full meeting next week, and there’s no guarantee it will reach conclusion.”
      
The message from the group in Basel was that central banks cannot enable such inaction indefinitely. “The balance between costs and benefits is deteriorating,” said Stephen Cecchetti, head of the monetary and economic department of the Bank for International Settlements, referring to central bank policies that have flooded the world with cheap money since the financial crisis began in 2008.
       
There are already clear signs of central bank retrenchment. The Federal Reserve chairman, Ben S. Bernanke, indicated last week that the American central bank was likely to wind down the purchases of bonds it has used to push down market interest rates. The European Central Bank seems to be running out of ways to stimulate the euro zone, and there is doubt about whether the Bank of Japan can maintain an ambitious policy to flood the economy with money and achieve 2 percent inflation.
      
As long ago as last summer, Mario Draghi, the European bank president, was publicly lamenting the limits of the central bank’s ability to address the broader problems of the European economy and calling upon political leaders to pursue structural solutions.
      
Jörg Asmussen, a member of the policy-making executive board of the central bank, reiterated that point in a speech on Sunday in Kiel, Germany. “The global reform agenda has lost momentum, as the sense of urgency imposed by the crisis has vanished,” he said.
      
But there did not seem to be any awareness of the limits of central bank forbearance among the 17 finance ministers in Luxembourg. The ministers pulled an all-nighter to complete their assignment — in this case, to establish a system to ensure that taxpayers never again have to pay so much for the mistakes of bankers.
      
The ministers have scheduled another meeting for Wednesday, a day before the leaders of the European Union’s 27 member states gather for a summit meeting in Brussels, their last scheduled meeting before the summer hiatus. The leaders have been expected to endorse the finance ministers’ decision — if there is one.
      
The 18-hour marathon was aimed at breaking the so-called doom loop, in which struggling governments go deeper into debt to save their banking systems, only to face sky-high borrowing costs. That vicious circle was largely the reason that Ireland and Cyprus required international bailouts, while Spain has struggled to avoid being sucked into a similar vortex.
      
But since agreeing in principle last year to centralize bank supervision in the euro zone and create a system to wind down terminally ill banks, the finance ministers have been snagged on various issues, including how to share the cost.
      
The ministers initially agreed in Luxembourg on Thursday night to let the euro zone’s emergency fund — the European Stability Mechanismpump money directly into failing banks, on a case-by-case basis in the latter part of 2014. But then, on Friday, the talks broke down on technical issues, such as whether countries would have the discretion to protect some classes of bank creditors in a crisis.

The failure to reach a deal could further unsettle investors who were already anxious about the lingering recession in the euro zone, turbulence on global markets, renewed political instability in Greece and hints that Cypriot leaders are balking at their bailout agreement.

The Bank for International Settlements acts as a financial clearinghouse for most large central banks, including the Fed and the E.C.B., and as a forum for central bankers to discuss policy issues. It uses its annual report to take stock of the global economy. 
      
While the organization has criticized politicians in the past, its verdict this year was unusually harsh, and implicitly aimed at Europe, where the central bank has already cut interest rates to a record 0.5 percent. Mr. Draghi, reiterated last week that the central bank for the euro zone remained “ready to act.”
      
The Bank for International Settlements also had some harsh words for commercial bankers, particularly in Europe, saying they had failed to make an honest accounting of bad loans and other problems. It urged bankers to sell off damaged assets and raise fresh capital, so that they are able to resume providing credit to businesses and consumers.
      
Continued low interest rates and unconventional policies have made it easy for the private sector to postpone deleveraging, easy for the government to finance deficits, and easy for the authorities to delay needed reforms in the real economy and in the financial system,” the organization said.
      
The organization also disputed claims made by some banks that they have become safer because they have increased the size of the capital they hold as a cushion against losses. Much of the improvement in the amount of capital that banks’ have reported recently was “window dressing,” achieved by manipulating the way that risk is measured, the organization said.
      
Uncertainty about asset quality remains a greater concern in Europe,” the organization said. On average, banks in Britain, France, Germany, Spain and Switzerland are barely profitable, according to its data, while banks in Italy are losing money. It is difficult for commercial banks to raise capital unless they are profitable, which suggested that some will either need government help or go out of business.
      
The Bank for International Settlements also weighed in on the debate about how quickly countries should cut debt, offering support to a pair of prominent American economists whose work linked excess debt to poor economic performance.
      
That research, by Kenneth S. Rogoff and Carmen M. Reinhart of Harvard, was used to justify policies that imposed harsh austerity in countries like Greece. But a study published in April by economists at the University of Massachusetts found flaws in the data that had been used to arrive at those conclusions.
      
The Bank for International Settlements said its own research supported the broad thesis that too much government debt is a brake on growth.
 
      
Jack Ewing reported from Frankfurt and James Kanter from Luxembourg. Mark Scott contributed reporting from London.