Looking for debt
By Michael Pettis
Quite a lot of data came in last week as I was recovering from the jet lag generated by last week’s trip to the US, and for good measure, the PBoC then raised minimum reserve requirements Thursday evening. I discuss the numbers extensively in my newsletter, and of course there has been a lot of discussion in the press, but for this blog entry I want to discuss once again (and perhaps for the last time) the subject of copper imports. I know I have written many times about goings-on in the copper markets in China, and I don’t want overdo it, but so many people I met with during my trip to the US continued to be interested in the story that I thought I would cite what one of my smartest students reported to me recently.
Michael Liang, who heads my trading seminar, wrote me about a recent conversation he had with a commodity trader he had invited to speak later this week at the seminar. According to him, this conversation confirmed the story we have put together over the past five months.
He [the trader] said that on March, clothes makers, food manufacturers, and others who have never bought copper before were massively buying copper from the tariff-protected warehouses, in Guangdong for example. The warehouses are in China, but tariffs on the goods there haven’t been paid yet, and any purchase from one of these warehouses is regarded as an import.
These enterprises purchased copper just to get L/C financing, in which banks finance the purchase of the imports for 90 days. This costs the buyer 30 bps. If they defer repayment to 180 days, they pay an additional 40 bps. The import is settled in dollars, which means that the buyer has a dollar liability due in 180 days, but can sell copper today for RMB. The interest cost for the L/C is around 1.4% annualized, so that even when LME copper trades at a premium to Shanghai copper, the all-in borrowing cost is greatly mitigated by the low cost of L/C and any RMB appreciation.
The reason that banks love to do this business – and markets have become so competitive and rates so low – is that 1)the transaction is off the balance sheet, and 2)bank clerks get paid a direct commission on the L/C. The more they do, the more they earn personally.
This process stopped a month ago because the PBoC intervened to prevent more copper-based financing. This was the start of the bearish sentiment in copper – the massive demand in China is gone. As to the role of my friend and his trading house, they do the physical and paper arbitrage between Shanghai, LME and the tariff-protected warehouses. Their role is to import copper from LME to the tariff-protected warehouses and sell them at a premium.
I think that in his account my student has not included all the financing costs implicit in the L/C – I am pretty sure the L/C was issued at a discount. At any rate I hope to talk to the trader later this week and if I hear anything different or interesting, I will follow up. I suspect, however, that this particular form of leverage may have come to an end now that the PBoC has discovered it and Intervened.
This doesn’t mean however that we can relax. It probably just means that the financial sector will continue to find ways to “innovate” around attempts to rein in credit growth. It also means, I would guess, that total imports in the past few months were artificially high, and we should expect lower than “normal” copper imports over the rest of the year. Of course this will put upward pressure on the trade surplus.
While we are on the subject of innovative financing, I thought I would relay three interesting things I saw this week. First off was a report by Market Watch on struggles of real estate developers:
The debt carried by China’s real-estate developers jumped 41% in the March-ended year from the same period 12 months earlier, according to a report by Chinese state media. Debt carried by the nation’s developers was 1.05 trillion yuan ($162 billion), the Xinhua News Agency reported on Monday, citing figures compiled by the Shanghai-based data provider, Wind Information.
The figures were based on the 113 mainland-listed developers and their first-quarter filings. The value of unsold houses was up 40.2% to CNY903.5 billion, the Xinhua report said. Average profit was down 4.9% to CNY54.65 billion yuan.
None of us are terribly confident about the validity of the numbers, but what matters here is likely to be the trend. Needless to say it would not be at all surprising to see a strong correlation between declining sales and rising debt. This just suggests that as developers have trouble selling projects they have already financed, they need to roll the debt over rather than repay it.
The second interesting piece was from the current issue of the always hard-hitting Caixin:
Angry institutional bond investors holding a Sichuan Province highway construction company’s debt are stirring a hornet’s nest over a financial practice that’s apparently commonly used by local government financing platforms across China. The practice is called internal asset transfer, and investors who purchased bonds backing Sichuan Expressway Construction & Development Corp recently learned the hard way that it can be used by local governments to burn corporate debt holders.
…Investors say they were forced to accept higher default risks for their Sichuan Expressway mid-term notes because the transfer involved the construction company’s most valuable asset – a stake in the Chengyu toll road between Chengdu and Chongqing worth about 3.85 billion yuan.
I don’t want to read too much into this one incident, but of course as the GFC and the European crises remind us (especially some recent moves in Ireland to abrogate the bank subordinated-debt contracts), in overly liquid markets with rapid credit expansion, lenders tend to overlook mechanisms that weaken their ability to protect themselves – generally on the assumption that protection is unnecessary. This issue of internal asset transfers is something about which I have heard a lot over the years, but I always resolve to learn more about it at some later date and so have never dug too deeply into it.
Also in the same edition of Caixin is an article on total banking assets:
As of 2010, the total assets of China’s banking industry have grown to 2.39 times the amount of national GDP, breaking records once again at nearly 100 trillion yuan. In comparison, according to OECD data, Japan’s banking assets in 2008 stood at US$ 9.81 trillion, 2.27 times the amount of its GDP, which was US$ 4.32 trillion. Germany, another country representative of economies that rely on banks for financing, had 6.6 trillion euros for banking assets and 2.48 trillion euros for GDP in 2008. Its 2008 banking-assets versus GDP ratio was 2.66, almost the same as it had been in previous years.
The surge in China’s banking assets, which took off in 2009, was attributed to political directives rather than monetary policies. In 2009, huge amounts of loans were made at the order of government. The central bank did not cut interest rates; in fact, it conducted a net absorption of liquidity from the market through its open market operations. Meanwhile, the market capitalization of domestic stock exchanges more than doubled from a year earlier, an indication of too much capital flowing around.
I guess I don’t need to comment much beyond what Caixin says. I have many times argued that historically one of the key indicators that the high-growth investment-driven model has reached its limits as a wealth creator (i.e. is no longer allocating capital efficiently) is when we see an unsustainable increase in debt. Of course whether or not we have reached this point is still much debated, but I would argue that we started to see this at least five years ago. The surge in banking assets doesn’t give much comfort.
Finally, for the last thing I want to bring up, my Shenyin Wanguo colleague Chen Long sent me a piece on the recent 2011 First Quarter monetary policy report issued by the PBoC this week.
The 2011Q1 monetary policy report reiterates that controlling inflation remains the PBoC’s top priority, and it will continue to raise interest rates and reserve requirements when necessary. It is unusual for the central bank to address its policy targets in such a straightforward fashion, which led to concerns in the market about more tightening measures.
The report also revealed that actual lending rates are much higher than the minimum levels set by the PBoC. The weighted-average lending rate was 6.91% in March (72bps higher than at the end of last year) while the 1-year benchmark lending rate was only raised by 50bps from the end of last year. In March, 56% of new bank loans were lent out at a premium to benchmark rates and only 14% of new loans went lent out at a discount. Last year only 40% of these loans were lent at a premium while nearly 30% were lent at a discount to benchmark interest rates. The major causes of this change are the recent property regulation measures and tighter credit quotas.
An unsustainable rise in debt is, for me, one of the key indicators that the investment-driven model has passed its useful life and is generating negative growth while posting positive growth numbers. This is why I spend so much time trying to understand debt levels and the structure of balance sheets. I plan to discuss this a lot more in my next blog entry.