Thursday, 3 June 2021

 

The woes of China’s ‘bad bank’ point to deeper problems

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The fate of China’s giant “bad bank,” Huarong Asset Management, remains unresolved, underscoring the dilemma China’s authorities confront as they try to clean up an over-leveraged corporate sector riddled with bad and questionable lending.

Huarong triggered something of a panic in China’s debt markets earlier this year when it failed to issue its financial results.

Huarong has been meeting interest payments on its debts with the help of liquidity provided by state-owned banks as the central authorities try to decide how to deal with it.

Huarong has been meeting interest payments on its debts with the help of liquidity provided by state-owned banks as the central authorities try to decide how to deal with it.CREDIT:BLOOMBERG

The state-controlled vehicle for managing bad debts, established in the late 1990s along with three other similar vehicles to deal with the mountain of toxic debt China experienced after the Asian financial crisis, has been meeting interest payments on its debts with the help of liquidity provided by state-owned banks as the central authorities try to decide how to deal with it.

Their crackdown on leverage includes a state willingness to allow companies — even state-owned companies — to default in order to start lowering the level of moral hazard in their system, hence the dithering over the fate of a company, majority owned by China’s Ministry of Finance, with deep links into the financial system and economy.

Huarong isn’t an isolated case. The four companies set up to manage the 1990s bad debt legacy expanded beyond their charters into their own quasi-banking activities, with Huarong, at least, adding to its pile of bad debts with new ones of its own making.

Recent reports that China is considering establishing a new holding company to sit across the top of all four suggests that the problems within Huarong aren’t isolated.

Between them the bad debt managers have debts of more than $US450 billion ($581 billion), including tens of billions of dollars of bonds outstanding in local and offshore markets. Huarong alone has issued about $US40 billion of bonds, roughly half of them in dollar bonds issued offshore.

Spreads on the bonds have been blowing out and Huarong’s bonds are trading at discounts of 30 to 40 per cent from their face value as investors have digested the once-unthinkable possibility that the authorities won’t stand behind one of their bigger and most important state-owned enterprises.

If the problems within the bad debt managers were confined to them Beijing might have been able to deal with them more easily.

They aren’t, indeed they are reflective of a far wider issue of poor lending and too much debt within China’s corporate and local government sectors, a problem exacerbated by the pandemic.

China’s overall debt levels blew out during the pandemic as, like most governments, it injected massive doses of stimulus into its economy. In China’s case, as it traditionally has done, it responded to the outbreak of COVID-19 with an infrastructure investment-heavy program.

China’s authorities like to present an image of complete control and pre-destined success but, beneath the otherwise quite impressive progress and growth they have presided over there are some serious fault lines within the economy and financial system that, despite concerted effort, they have yet to come to terms with.

The overall debt-to-GDP ratio peaked at about 285 per cent in the third quarter of last year and has been subsiding since as the authorities, with the economy bouncing back, moved quickly to withdraw the stimulus and resume the longer term deleveraging campaign that the pandemic disrupted. It now sits at about 276 per cent.

The challenge for China doesn’t, however, lie in that overall ratio, which is lower than many advanced economies, including the US, where the Biden administration is still adding massively to the blowout in spending the pandemic triggered.

Its challenge relates to the composition of its debt. Government debt is low by international standards – total government debt is only about 45 per cent of GDP – but corporate debt is high and the credit quality low.

China’s authorities like to present an image of complete control and pre-destined success but, beneath the otherwise quite impressive progress and growth they have presided over there are some serious fault lines within the economy and financial system.

China’s authorities like to present an image of complete control and pre-destined success but, beneath the otherwise quite impressive progress and growth they have presided over there are some serious fault lines within the economy and financial system.CREDIT:AP

The non-financial corporate debt ratio of about 160 per cent of GDP is of some concern, given the degree of leverage and quality of assets in the sector and particularly within the state-owned entities.

Household debt has also been rising rapidly since the 2008 financial crisis, more than doubling to about 60 per cent of GDP. While that is also quite low by international standards it is of obvious concern for an economy attempting to pursue a switch from exports to domestic consumption.

Pre-pandemic and since its robust economic recovery China’s authorities had been, and are again, grappling with the leverage and quality of lending within the corporate sector and their state-owned enterprises (SOEs) in particular, as well as with the debt within local governments and their off-balance-sheet financing vehicles. They have also cracked down on peer-to-peer ending within the household sector.

SOE and local government borrowings blew out during the pandemic as they complied with Beijing’s stimulus directives, with a significant amount of unproductive investment in infrastructure and, in particular, property development.

The local governments face a particular problem that they have to follow Beijing’s commands but have limited revenue-raising capabilities of their own, hence the resort to debt.

A crisis earlier this year among China’s big property developers appears to have been averted, with borrowing by that sector falling in response to a tightening of bank lending rules and a central government edict that highly-leveraged developers aren’t allowed to increase their debt.

Nevertheless, SOEs entities have been defaulting on their loans at record levels and, with nearly $US4 trillion of bonds issued by these entities (about three-quarters of them onshore), the potential for contagion and panic and a crisis would concern the authorities.

For all the over-leveraged entities, including Huarong and its peers, growth would help alleviate their problems.

While China is targeting an economic growth rate above six per cent this year and may well come in well above that target, given the impacts of the pandemic last year, the era of double-digit growth is long gone and, with an ageing population and relatively modest productivity gains in a still-developing economy, it is unlikely that growth will resolve the challenges created by the combination of too much leverage and poor credit quality.

China’s State Council has adopted a policy of forcing local government financing vehicles to restructure or fail if they can’t service their debts, although a default by any significant local government vehicle would send shockwaves through debt markets that have long assumed they had implicit government backing.

Huarong and the other bad banks present an even more difficult problem because of their scale and their deep links into the wider financial system.

While the government will want to diminish the extent to which its response to their problems increases the level of moral hazard in its system, they may well be too big to fail.

At present, it appears the authorities are looking for ways to defer the issue, with some suggestions that, along with a possible merger of the four bad banks, some of Huarong’s bad assets might be transferred into a different state entity to keep it afloat without a direct bailout.

China’s authorities like to present an image of complete control and pre-destined success but, beneath the otherwise quite impressive progress and growth they have presided over there are some serious fault lines within the economy and financial system that, despite concerted effort, they have yet to come to terms with.

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