Financial Shock and Awe in China

CNBC’s John Carney points out that China’s official GDP is just short of $5,000bn, which means that a $463bn local government bailout is almost 10 per cent of the size of the country’s entire economy.

So this is a major market ‘shock and awe’ operation. The great Chinese clean-up, if you like.

In fact, the whole raft of measures reads like a direct response to some of the concerns expressed by people like Andy Xie and Victor Shih (and all covered, at one time or another, on FT Alphaville). China’s local governments have been quietly amassingbillions of iffy debt using bank loans that were part of China’s post financial-crisis stimulus package. Once those began running out, as China tightened, the banks (still unable to issue their own bonds) turned to dubious investment vehicles for financing.

Tracy Alloway, FT Alphaville

That’s a lot of bad debt, isn’t it? I have been saying for some time that this excess capital investment would come a cropper. And so it has. Shock and awe is overrated, as we know regarding ‘shock and awe’ in the Iraq War – and in the euro zone sovereign debt crisis. Time will always be the key factor.

Here’s what Andy Lees wrote this morning:

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The central government will pay off some of their loans and the state banks, including the Big Four, will be forced to take some of the hit. Part of the debt will be shifted to newly created companies that may be funded by the private sector although this has not yet been decided – (previously such asset management companies have been financed by borrowing from the banks themselves, ie rather than cleaning up the bad debt China has simply brushed it under the carpet). Beijing has determined that local governments have borrowed around CNY10trn and may default on around CNY2trn of that. Guo Tianyong, an economist at the Central University of Finance and Economics said that while the debt overhang exercise might take the bad debt off the local governments’ books, it won’t necessarily resolve the question of who will ultimately pay; “I feel it won’t fundamentally solve the problem by hiving off and selling the debt to other investors”– (again remember historically the asset management companies bought the debt at 100% nominal value).  Despite Fitch warning last month that China’s public finances may be strained by bad debt and putting it on negative outlook, the stash of local government debt is still growing and is expected to hit CNY12trn by year end according to the Economic Observer newspaper.

A friend sent me this excerpt and one from research by CLSA as well. The CLSA note says:

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We remain unconcerned about debt provisions for China banks. This is despite unconfirmed news overnight that Beijingwill shift US$300-465bn of debt off local governments by distributing the burden to the central government, and the Big Four banks. On first glance, the view from our chief economist and head ofChina banking research is that China can simply afford it. And on second glance, this news, if correct, reduces an overhang and should be good for China’s banking sector.

Clearing the board for local governments. News reports citing unnamed sources suggest China’s banking regulators plan to shift Rmb2-3tn in debt as part of Beijing’s overhaul of the finances of indebted local governments. The central government will reportedly pay off some of their loans and state banks including some of the "Big Four" will be forced to take some losses on the bad debt. Part of the debt will also be shifted to newly created companies, and Beijing will also allow provincial and municipal governments to issue bonds.

CSMB most exposed

To sum up:

  • Non-performing loans look to be a full 10% of Chinese GDP. That’s high.
  • The Chinese government is confronting this writedown problem head-on.
  • While a number of analysts have opinions on the measures just taken, it is far from clear what the effect will be on China and the global economy.

At any rate, the global economy is slowing – in the US, the euro zone and in places like China. At the same time, likely there will be less policy accommodation in fiscal or monetary policy in the US, Europe and Emerging Markets.

To me, this looks like a macro background which is unfavourable for increasing risk.

Update: Marshall Auerback says:

This looks like something functionally equivalent to revenue sharing with the states. It’s fiscal transfers. Of course the central government ‘pays’ for this, to the extent that it creates the RMB, but it’s tough to do indefinitely in a pegged rate regime, particularly if you want to keep your currency strong.

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