I wanted to make some brief follow up points that will be a little more technical than what appears in my BloombergViews piece. As usual start there and finish up here.
- I am decidedly pessimistic about the state of the Chinese economy and finances, but I really do not see a near term risk of what we would think of as a financial crisis. China is saddled with enormous sums of bad debt, people are taking their money out of China, surplus capacity is simply astounding, and cash flow growth through the economy is hovering around zero. There is very little to be positive about, but I see little risk this year of some type of crisis.
- I do not believe we have reached or are even at a near term inflection point, barring some exogenous shock, where financial conditions so escape policy and bankers control that the path is set.
- Maybe my biggest concern is the inability of bankers and regulators to face the problem. I actually should just say regulators as they are clearly the driving force at play. As one simple example, after all the talk about deleveraging in December, debt growth has pretty much exploded. Not only are they not deleveraging, they are adding fuel to the fire.
- The supposed 1 trillion RMB debt for equity swap does not even begin to address the size of the problem. Caixin highlights one steel producer, let me say it again one steel producer, with 192 billion RMB in loans in cannot pay with its largest subsidiary not having paid interest since 2011. Let’s make a simple assumption that you wanted to keep this steel company in business and complete a 100% debt for equity swap. You would immediately use up 20% of the 1 trillion in capital on one company. Even the Xinhua has noted the larger problem of unprofitable steel firms which made only a small profit in 2014 and a large loss in 2015. Accounting for the debt and overstatement of financial health, 1 trillion in capital will not even begin to address the problems in one industry.
- There are so many problems associated with some of proposals I have heard floated but one of them what happens to the firms and industries after completing the debt for equity swap. For instance, if all firms stay in business with lower debt burdens the only thing that will happen is an even more heated round of cost cutting. That is not a real solution.
- Furthermore, many are counting on shutting down a firm and selling the assets at the price they are booked for on the company’s balance sheets. History tells us in these situations corporate assets on sale in a bankruptcy type situation even when bought free and clear simply are not worth anywhere near their booked valued. Then add in the massive surplus capacity and there would likely be little secondary market for these assets. Anecdotally, from people I have talked to the going recovery rate seems to be about 20-25 cents on the dollar. This would imply sales, to use a round number, at 10-15 cents on the dollar to investors. The steel company in the Caixin article supposedly has 290 billion in assets. Let’s suppose these are all real assets, which as the story notes does have some very real questions, this would imply a sales rate of 30-40 billion RMB, an enormous haircut.
- The basic strategy I think of Chinese policy makers is to try and replicate their 2003 strategy of growing their way out of the problem. As I wrote in a paper, there were banks going public in December 2014 with long term bad debt obligations that they used IPO proceeds to payoff. Economic growth post 2000 was such an ahistorical event that I think it is a highly risky expectation to grow your way out of a mountain of bad loans two times in a row. Even just think of the strategy of accomplishing this. Will these bad loans on steel companies be paid off in 5-10 years just putting them off to the side? Unlikely.
- The ones that get mentioned the most are coal, steel, and real estate but this same concept holds for virtually any industry in China. Shopping malls, chemicals, and energy suffer from high debt and over capacity. Even assuming asset prices underpinning assets remains high, which is highly unlikely if there is a significant push to reduce over capacity or reign in lending, large amounts of the Chinese economy need to address the NPL problem.
- One of the biggest issues that no one has addressed is what do Chinese banks do with the equity? What secondary market would they sell the equity into? If they are swapping debt for equity at par, will they be required to mark to market? What requirements will there be on lending as the equity owner? This seems like a bad alternative as much of the equity will be near worthless and require haircuts of 90%. Why then go through the debt to equity swap process if the likely outcome for either the loans or business is large write downs? This implies that the intention is to try and salvage the value of these assets which would depend on large amounts of new lending.