The Chinese Credit Bubble
The confrontations between the U.S. and China on trade, currencies and geopolitics will begin immediately at a rhetorical level, but may take a year or two to play out at a policy level. Supply chains, long-term contracts, and reserve positions don’t turn on a dime even when new administrations are sworn in.
Yet, one issue that will not wait and is a ticking time bomb is the Chinese credit bubble. That bubble is primed to explode with or without new policies from Trump. When it happens and how it happens will have profound implications for your portfolio.
The dimensions of the problem are vast. China’s growth has become captive to what economists call Goodhart’s Law. This law says that when an economic metric becomes the goal of policy, it loses meaning as a metric. Goodhart’s Law applies in the case of Chinese GDP.
Once the Chinese government decided to “target” GDP growth of 8 percent, or 7 percent, or 6.5 percent more recently, GDP growth lost its meaning as a reliable guide to Chinese economic performance. Instead the Chinese hit the economic target by non-economic means merely to say they hit the target.
For instance, my trip from Shanghai to Nanjing was on one of the new high-speed rail lines being built under direction from the central government in Beijing.
The train is the best in the world. It travels at 200 mph and is almost silent as it speeds down specially welded high-speed rails. I had a business class seat that was nicer than most airline business-class seats. The train stations in both cities are spacious, clean, and efficient and put American train stations to shame. In fact, they’re even nicer than some of the newest major airports around the world.
Best of all the ticket was cheap! Just ¥429.50 (about $62.00) round-trip. A comparable trip on Amtrak’s Acela would have cost $400 and the service would have been far inferior (not to mention having to endure the cramped confines of New York’s Pennsylvania Station).
While I enjoyed the ride, a thought crossed my mind: How do you pay for billion-dollar train stations, and billion-dollar railroads by charging $62.00 for a 350-mile round-trip?
The answer is, you can’t. The entire enterprise in being financed with unpayable debt. The state-run China Railway Corporation is losing over $1 billion per year and various other state owned enterprises (SOEs) are losing billions more in construction and equipment manufacturing.
If you have a 6.5 percent GDP growth target, it is easy to achieve just by building infrastructure, which counts in the “investment” category of a standard GDP definition. Billion dollar train stations and rail lines count as investment and therefore GDP whether the railroads ever make money or not. The same is true for highways, pipelines, even entire cities.
On various visits to China I’ve seen so-called “ghost cities” stretching to the horizon entirely empty of residents and businesses. Yet the construction costs are added to GDP even though there are few or no paying tenants. (I’ve spoken with some business owners who do occupy offices in ghost cities. They pay no rent and are there just to make the buildings look partially occupied and help the sales office attract others).
The problem is that the rail transportation infrastructure I found so impressive, and most of the other infrastructure in China, was built with debt. The debt was financed by the mega-Chinese banks on government orders.
Since the ghost city buildings don’t have tenants and the train tickets are heavily subsidized, there’s no way that debt can be repaid. Instead new loans are made to pay interest on the old, or the debt is refinanced or rolled-over in a never-ending stream of zombie lending.
The banks finance their lending with customer deposits or sales of wealth management products (WMPs, something like the CDOs that brought down Lehman Brothers). WMP’s have been described by the former Chairman of the Bank of China as the greatest Ponzi scheme in history. Banks rely on sales of new WMPs to redeem the old ones at maturity. The projects financed by the original WMPs cannot repay them.
How big is this mountain of debt? Total Chinese debt at all levels (household, corporate, bank and government) is now more than 250% of GDP as shown in the chart below:
However, this 250% figure understates the problem. It does not include the WMPs, which are technically investments kept off the balance sheets of the book. It also does not include provincial obligations that take the form of guarantees. Those will have to be bailed out by Beijing.
The real debt-to-GDP figure is easily 500%. It’s like owing $100,000 on a MasterCard when your salary is $20,000 per year. That’s a sure recipe for bankruptcy.
You can see from the graph that most of the debt is coming from the corporate sector. But, these are not normal corporations as understood in the U.S. These are mostly SOEs, controlled by the government. That means they may have to be bailed-out by the government when the system finally crumbles.
Much of this debt is denominated in U.S. dollars so the situation is made even worse by the strong dollar and the global dollar shortage. Both of those factors make dollar-denominated debt much harder to repay.
The debt system is propped up — for now — by more debt and dishonest accounting. If the banks were forced to write-down bad loans, the system would have collapsed a long time ago.
But one dysfunction that cannot be finessed is cash-flow. As every entrepreneur and small businessperson knows, cash never lies. You either have it or you don’t. Because of excessive debt and inability to pay, cash flow problems are now reaching epidemic proportions in China.
China observer Valentin Schmid, writing in the Epoch Times in late 2016, reports:
“If firms can’t borrow more or squeeze their suppliers, they will go bankrupt. According to research by Goldman Sachs surveying companies in China, four have defaulted on $3 billion worth of bonds since the middle of November. These defaults are a break with the record in the previous five months from June to October, when only three of the companies surveyed didn’t meet their payments.
Given that China’s companies are drowning in debt, this squeeze on cash flow does not bode well for stability in 2017.”
Of course, China could try to grow its way out of the debt problem. This is like the person in the above example suddenly getting a $50,000 raise so he can manage the payments on his $100,000 in MasterCard debt.
This is where the Trump administration seems set to throw a monkey-wrench in China’s already dubious growth plans. Trump’s plans for tariffs, taxes, and a strong yuan will slow China’s growth at exactly the moment it needs to grow faster. Geopolitical analysts at Stratfor summarize the situation as follows:
“Clearly there are no easy answers to China’s debt problem, which is looking grimmer by the day. The only painless escape would be on a wave of economic growth, but at this point that seems unlikely. Achieving growth rates of more than 10 percent is much more difficult for an economy that is already the second-largest in the world, and the global economic environment is not half as favorable to China as it was 15 years ago because the developed world is struggling to manage debt problems of its own.
At home, Chinese wages are considerably higher than they were in 1991, and the economy is less competitive. Because China’s working-age population will soon begin shrinking, ending the productivity gains from the decades long “demographic dividend,” these wage hikes will make it harder for the country to achieve prodigious growth.”
China is faced with a mountain of unpayable debt, weaker growth, and a stronger dollar that will make the debt even harder to repay. The Chinese credit bubble has only one feasible solution, China must use its hard currency reserves to bail-out the entire banking and SOE sector and try to start over with a relatively clean balance sheet.
The problem is that the reserves needed for a bail-out are evaporating and liquid reserves may hit zero by the end of 2017.