China Debt- Opportunity or Contagion

By Rob McCreary

Remember when a Japanese investment group bought Pebble Beach Golf Blub September 1990? It seemed like every important asset was being gobbled up by an ascendant Japanese economy. Soon thereafter in 1992 the Japanese real estate market crashed and then, in a great imitation of a kamikaze, the Nikeii followed suit  Now, more than 25 years later, the Japanese economy is just starting to shake off the chains of asset deflation.

In the rearview mirror,the miracle of Japan was really a debt financed bubble and Bank of Japan’s monetary policy of keeping bad investments alive and preserving “zombie” banks spawned 4 decades of decay.

Murky As The Yangtzee

No one knows for sure how much debt is now supporting the China miracle? In his book on the subject, “China’s Great Wall of Debt” Dinny McMahon, a financial journalist with the Wall Street Journal specializing in China, will not speculate about the debt burden (government, banks, shadow banks and private debt). Other sources like Wikipedia speculate the debt burden (on and off-balance sheet) could be $11 Trillion or about 90% of China’s GDP. This may not capture the funding for China’s Belt and Road infrastructure initiatives for which there is virtually no reported financial information.

Shadow Banking Products Are The Wild Card

Mr. Mc Mahon is especially concerned about the shadow banking system where banks sell their own “wealth management products” (WMPs) to customers where the holder is completely unsecured and bears the complete risk of loss. The US analogy might be a special purpose off balance sheet investment vehicle that is selling annuities (promises to pay) but has no assets. The difference in China is the state has always made good on bad debts, especially if generated by the banking system, and citizens trust the state’s implicit guarantee. But according to McMahon the enormity of WMPs is staggering:

“ In 2008, the future pillars of China’s shadow banking barely existed. At the end of 2014, the amount of credit that had been generated by the shadow banking system was about 40% of China’s GDP. By mid 2016, that had doubled to about 80%.

A recent factoid from Wall Street Journal’s “The Daily Shot” was also pretty alarming. Apparently, business owners have been pledging listed shares for personal loans, and defaults are accelerating. The analogous situation is 1929 in the US. Once there is a default on the bank loan, the value of the collateral disappears quickly because there is no orderly downside market for stocks being liquidated in distress. If the securities cannot be liquidated, the banks will try to make a distressed sale of the underlying companies. The deflationary spiral is hard to stop. Just ask the Bank of Japan. Here is the information. The blue line is the percentage of listed firms where more than 50% of a company’s shares are pledged.

The Shanghai Stock Exchange has lost almost 30% of its value since the beginning of the year which puts even more strain on the credit system which is increasingly secured by pledges of stock collateral in material decline.

 


 

Luckily most of China’s creditors are its own banks and citizens.  As long as they have confidence that China will provide, the moment of financial truth may never arrive. Unfortunately, recent experience suggests that all financial bubbles eventually burst and miracles turn to contagion overnight.

Rob McCrearyChina Debt- Opportunity or Contagion

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