Here's Why US Equity Investors Should Care About China's Bad Loan Problem
With all eyes on Brexit, the market seems to have temporarily forgotten about the biggest risk factor of all: China.
Understanding the country’s capital markets, FX regime, and banking system can be a daunting task, but it’s worth the time to do a bit of research because it truly is important to comprehend what’s going over there.
As we saw last summer, what happens in China no longer stays in China. The country’s epic equity market meltdown put the rest of the world on edge and then, following the August 11 transition to a new currency regime, all hell broke loose once it became apparent that Beijing would need to begin burning its reserves to keep the yuan devaluation from spinning out of control. If you need proof of how much China matters, look no further than Black Monday when the Dow fell 1,000 points out of the gate on August 24.
Things stabilized after September (sort of) but January was rocky and were it not for the weak dollar accord agreed in Shanghai in February, the capital outflows might have picked up pace again.
In any event, China’s banking system has long been on the minds of market professionals but the narrative went mainstream this year after Kyle Bass made a show of his intentions to place bearish bets against the yuan. According to Bass, Beijing will need to spend trillions to recapitalize the system once banks are forced to realize bad loans. We talked a bit about this here.
Undoubtedly, this all sounds rather esoteric to anyone who is solely interested in trading US stocks and options but think of it like this: if a ~3% devaluation of the yuan was enough to trigger a Black Monday for Wall Street last August, just think what might happen if Bass is right and China is forced to devalue by 30-40%.
It’s with that in mind that we highlight a Bloomberg piece out last week which describes the situation at China’s local banks as a “smoldering bonfire.”
We won’t delve into the painful details of wealth management products and trusts (which are two of the vehicles that have helped to embed an enormous amount of risk into the Chinese banking system) because honestly, the entire problem can be summed up rather succinctly without a deep-dive.
Officially, non-performing loans (NPLs) at Chinese commercial lenders have risen for 18 straight quarters and now sit at about 1.75% of total lending. Not to put too fine a point on it, but that number is laughable by almost anyone’s estimates. Think about it: these banks are lending to the country’s industrial sector which is struggling mightily as China transitions away from a smokestack economy and as global demand remains soft. They simply can’t service their debt. In fact, Chinese companies issued a trillion dollars in new debt last year just to pay interest on their existing debt. The Chinese government doesn’t like bankruptcies and they especially don’t like bankruptcies at state owned enterprises (SOEs) which is why in many cases, banks are “encouraged” to roll over loans rather than classify them as non-performing.
Ok, simple enough right? So the thing is this: there’s only so long this charade can go on, especially when China desperately needs to extend more credit to the economy to keep up that other charade: the one about the country growing at 6.5%.
So instead of extending more traditional loans (which have to be carried on the balance sheet as such), Chinese banks use a variety of “alternative” vehicles to lend money to borrowers who will likely default. That credit is carried as “investments” on banks’ books and it serves as a kind of proxy for how precarious things are getting.
That’s pretty much the long and the short of it.
Now let’s get back to the Bloomberg piece mentioned above. Here are some key excerpts:
“The city banks -- which together hold 15 percent, or $3.6 trillion, of the nation’s commercial banking assets -- have jumped into the financial engineering that lets Chinese banks disguise lending by buying ‘investments’ from intermediaries such as securities firms, trust companies or other banks. Assets showing up on banks’ balance sheets as financial investments are often backed by loans.
“The 10 city commercial banks listed in Hong Kong and the mainland boosted their financial investments by 56 percent to 2.4 trillion yuan ($365 billion) in 2015, according to their annual reports. That’s almost triple the pace of increases at the four biggest state-owned banks. By the end of last year, after a two-year spree, the bulk of Bank of Jinzhou Co.’s assets were classified as financial investments rather than loans.”
So basically here’s the problem: lenders are being pressured to both keep the economy alive by extending credit and exercise caution in lending to sectors that suffer from overcapacity (i.e. commodities sectors) at the same time. Well, you can’t have it both ways. The city commercial banks are just the most exposed, but make no mistake, the so-called “Big Five” are right there as well.
The question then, is what happens if one of the smaller lenders collapses? What will the contagion look like? Well, it won’t be pretty. Have a look, for instance, at the following graphic from Deutsche Bank which shows what percentage of the country’s current debt burden is corporate and SOE debt:
Source: Deutsche Bank
So if total debt-to-GDP is 254%, 142% of that is debt that could potentially go bad (and by the way, the local government debt burden is a story in and of itself). Here’s what the IMF had to say this month:
“By IMF calculations, state-owned enterprises account for about 55 percent of corporate debt. That is far greater than their 22 percent share of economic output. These corporates are also far less profitable than private enterprises. In a setting of slower economic growth, the combination of declining earnings and rising indebtedness is undermining the ability of companies to pay suppliers or service their debts. Banks are holding more and more nonperforming loans, or NPLs. The past year’s credit boom is just extending the problem. Already many SOEs are essentially on life support.
“The Fund’s most recent Global Financial Stability Report estimated that the potential losses for Chinese banks’ corporate loan portfolios could be equal to about 7 percent of GDP. This is a conservative estimate based on certain assumptions about bad-loan recoveries and excluding potential problem exposures in the ‘shadow banking’ sector.”
The takeaway here is that this isn’t something you can ignore, although it - like German bunds and the yen - isn’t something most US equity investors are used to tracking.
Does that mean you have to become an expert on shadow banking in China? Well, no. Of course not. What you should watch for though, is news of SOE defaults and/or trouble at small Chinese banks. If you see a small Chinese bank get into trouble, you should consider all of the above when it comes to deciding on risk appetite.
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