Conclusion: Reports out of China concerning the potential for a high degree of non-performing loans used to finance local government infrastructure projects appear alarmist and should not be given substantial credence at this time, which is confirmed by the CDS and equity markets.
In the past few days, there has been a great deal of news flow coming out of China regarding the potential for local government financing vehicles to struggle to service 23% of the 7.7 trillion yuan ($1.1 trillion) of outstanding loans which had been lent to finance local government infrastructure projects (highways, airports, etc.) – according to a person with knowledge of data collected by the nation’s regulator. With supposed at-risk debt near $261 billion (nearly five times the amount ($53.5 bil.) the nation’s five largest banks are raising to replenish capital) there is concern that the government may need to accelerate efforts to shore up its banks.
What cannot be overlooked here, however, is that Chinese government bailouts have helped bring the industry’s non-performing loan (NPL) ratio to 1.3% by the end of June – down 28bps since the end of 2009. Efforts to mitigate any potential buildup in NPL’s brought on by last year’s $1.4 trillion of credit expansion have been particularly successful (slowing loan growth, raising capital requirements, etc.). The Chinese government targeted a maximum of 7.5 trillion yuan ($1.1 trillion) of new loans this year – down from last year’s record 9.59 trillion yuan of credit expansion – and the central bank recently affirmed that, at the current pace of lending (which has decelerated each month since April), that goal will be met. Furthermore, last month, the China ordered its local governments to ensure repayment, concentrate on completing projects already under way, and stop spending within financing units that rely solely on the fiscal income of local governments. We expect these efforts to achieve a similar desired effect as the curbs on the Chinese banking system at large.
Still, any rapid expansion in credit always brings about a repayment risk, particularly when confounded by the complexity of China’s local government financing. Because of their inability to directly borrow money, local government set up financing vehicles to fund projects. These vehicles issue bonds in China’s exchange traded and interbank markets, which are then bought by commercial banks, asset managers, securities firms and other institutional investors – based largely on false pretenses, at least according to Dagong Global Credit Rating Co. They claim that because most companies can’t issue junk bonds, they have to be rated at least AA to apply for debt issuance, which causes local government-backed borrowers to “shop around” for the best rankings, giving business to whomever gives them the highest rating (sounds familiar? See: U.S. MBS market 2005-2008). According to China Lianhe Credit Rating Co., 43 construction companies affiliated with such financing vehicles issued 72 corporate bonds totaling 59.2 billion yuan ($8.7 billion) in 1H10. Of that total, 70 were rated AA or above.
Potentially faulty ratings, coupled with the repacking of such loans into investment products and shifting off-balance sheet by Chinese banks, does indeed mask the repayment risk of such ventures. Currently, China has more than 1,000 county-level governments and hundreds of city and municipal councils that get revenue from local taxes, land sales, and central-government transfers. Of those three, revenues from slumping land sales brought on by China’s efforts to cool its property market is most at risk.
When it’s all said and done, servicing loans has always been about the generation of aggregate cash flow – which is precisely why we like the health of China’s banking industry a great deal more than the its U.S. and European counterparts. In China, you have a consumer whose purchasing power is growing (wage inflation, currency strengthening) and has a history of thrift brought on by decades of minimal social services; that same thrift allows China’s banks to keep mortgage down payments north of 40-50%. Contrast that with the Western consumer, whose purchasing power is eroding due to austerity measures and currency debasement, is mired in stagnating-to-worsening high unemployment, and is in the early stages of a secular deleveraging. Moreover, China, on an aggregate level, has the ability to grow into its ability to service loans.
All told, let’s just say that if China’s banking system is in a precarious scenario based on these recent reports of potential non-performing loans, domestically speaking, we better start heading for the hills.