Author Archives: Andrew Collier

Debt-Equity Swaps – Slow Progress is Good for the Banks

The leadership in Beijing has made debt-for-equity swaps an important part of restructuring of the state firms. However, opposition from other groups, including the banks, has slowed the program. We estimate only Rmb322 billion of swaps is under discussion, far less than the Rmb1 trillion targeted. As a result, it is unlikely the banks will incur significant losses in the near term due to political constraints.

 

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CNBC Interview on Asia and Fed Rates

http://video.cnbc.com/gallery/?video=3000550536

CNBC Asia
Global confidence in U.S. markets is shaky, while the Fed is concerned about corporate spending, says Andrew Collier, MD at Orient Capital Research.

China’s “New Normal” – Quiet Policies for Slower Growth

China’s New Normal

Summary. In 2015, Premier Li Keqiang broke new ground when he said China is preparing for a “new normal” as the result of slower economic growth. However, he focused his speech on the shining glory of new industries – rather than a realistic appraisal of the nuts and bolts of deleveraging. This has given rise to a debate about what China’s policies will be as GDP growth winds down. Will stimulus continue? Will there be reduced growth in bank loans and the money supply?

We believe that China is acknowledging the “new normal” in a series of policies that are designed to adjust the economy to slower growth, a kind of unofficial reform.  Chinese policymakers have been busy designing and implementing significant changes in China’s economy – but they have not been announcing these as part of a major change in policy. There are two reasons for this. First, there is significant opposition to any retrenchment from pro-growth stimulus among senior leaders, including Premier Li Keqiang himself. And second, senior leaders do not want to hint at a slowdown for fear of losing political support among the Chinese people.

We believe, however, there is a significant change underway. These policies could help pave the way for a manageable decline in growth – although it’s too early to tell how effective they will be. They could also offer opportunities for foreign investors to acquire distressed assets.

China’s New Normal

Notes from Beijing

Notes from Beijing

 I just returned from a week in Beijing meeting my local contacts. Several interesting points emerged:

 

New Loan Limits Imposed by the Banks

State firms have been the favorite borrowers for most banks in China for the obvious reason that they are a reliable credit. That may be changing. According to bankers in Beijing, a series of defaults have exposed the banks to the weakness of state firms, particularly local state firms. There are 103 centrally, Beijing state firms, and more than 100,000 local state firms. Most recently, the National Salt Company, the monopoly provider, defaulted on loans to five banks.  One bank was exposed to the Beijing branch of National Salt for 60 million renminbi. The defaults actually occurred on a letter of credit to the salt processor in Guangdong Province. “China Salt is a grain company. It’s more like a government agency.  Maybe used the capital for other investments,” said an official at the NDRC.

Surprisingly, National Salt, with 45,000 employees, is controlled directly by Beijing. But this time around, Beijing hasn’t stepped in to bail out the company. In fact, usually the Beijing holding company would provide credit to an operating unit in trouble, but this hasn’t happened. Instead, the dispute is being fought in the courts. 

 As a result of this and several other defaults, state banks have begun imposing internal quotas on lending to state firms – the first time this has happened in recent memory. An official formerly with the China Banking Regulatory Commission (CBRC), told me that this quota system would not have been dictated by the CBRC but would have come from the banks themselves.

What does this mean? State banks supply roughly half of total loans. Roughly half of all loans are made to SOEs. (We’re omitting Shadow loans). A widespread quota on SOE loans would severely curtail their ability to operate effectively. We’ll see how widespread this becomes.

In addition, apart from the SOE quotas, a banker with a large Chinese bank in Beijing said they are now restricting lending to property developers outside of the city. They are concerned with the property downturn in smaller, tier 3-4 cities. This is in line with my expectation that credit increasingly will flow to what Chinese call  Beishanguang – Beijing, Shanghai and Guangzhou, the most important, wealthiest and politically powerful cities. 

 

Rise of Private Banks

Private, non-listed banks officially haven’t existed in China. There are state banks, shareholding banks (listed), and city banks. But privately owned regulated financial institutions (outside of the non-regulated shadow banks) have not been permitted. That is changing. In the past year, Beijing has allowed the creation of five private banks and is on the cusp of approving three more. The five have capital each of around 4 billion renminbi. The officials I spoke with are grappling with the problems of regulating a bank where the financial fiduciary is a private citizen, as opposed to a state entity, shareholders, or a number of corporations. The logic behind this is twofold: allow the expansion of private credit, and shift Shadow Banking credit flows into more normalized, transparent channels. I asked whether this was a threat to the existing state banks that are central to China’s economy. The answer was they are yet too small in market share to do much damage but they are the wave of the future.

 

Xi Jinping and Policy Confusion

There’s been a great deal of debate about the current state of China’s policymaking. Does China have an understanding of its debt, inefficient state industries, and slowing economy? The confusion among western analysts/investors reflects division within the leadership, particularly of Xi Jinping and Premier Li Keqiant.  Xi and Li  themselves have contrasting views of how to proceed. Li Keqianq views himself as a kind of a liberal reformer. He believes the state system should be reformed to eliminate inefficient industries. But in the meantime, he is in favor of continued stimulus to maintain growth. These clearly are contradictory goals.

In contrast, many here see Xi Jinping as genuinely concerned with the excesses of the state system. But his method of attack involves a rapid curtailment of excess capacity in older industries. This would reduce the waste of capital and — in his view — lead to the creation of  “new economy” type firms. This is a more rapid and more abrupt reform of the economy than that envisaged by Li Keqiang and explains Xi’s increasingly hard-line political stance. Political tightening would be a bulwark against the likely protests due to closure of state firms caused by this abrupt reform. However, in the end, Xi would slim down the state sector, but maintain it in the hands of the Party. There would  be little change in the underlying dynamic of Party control of the economy. In that sense, he is a classic leader in the Stalinist mode. 

 

Problems with One Belt

I had several discussions regarding Xi Jinping’s much heralded program to invest in infrastructure in Asia under the “One Belt One Road” program. However, clearly the government aims are being thwarted. According to an official with the NDRC planning board in charge of the program, the goal is to provide jobs and business for state firms, along with improving trade flows in Southeast and Southwest Asia. The capital for key rail projects is coming from low-interest bank loans from the China Development Bank. Other projects that may be profitable are funded through commercial loans from Chinese banks. However, bankers I spoke to are increasingly leery about OBOR because they expect many of these loans to default. One banker said her bank, owned by the Beijing government, has specifically mandated a reduction in loans to the various state owned railway companies that are building many of these rail networks abroad. “We are reducing exposure to national rail due to exposure to western projects in places like Baluchistan,” the banker said. The OBOR theme is very much a policy driven investment and likely to be a significant headache for years to come.

Meanwhile, the government is pushing the banks to make loans and contribute a portion of aid in renminbi. This would help prop up the currency and facilitate purchase of Chinese equipment by removing currency risk for Chinese firms. 

Coming Clean on China’s “Hidden” Bank Debt

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By Andrew Collier

Caption: Borrowing, which has fueled many infrastructure and housing projects like this one in Shanghai, may be much higher than reported. (Qilai Shen/Bloomberg)
Borrowing, which has fueled many infrastructure and housing projects like this one in Shanghai, may be much higher than reported. (Qilai Shen/Bloomberg)

 

The IMF’s new “Global Financial Stability Report,” with a comprehensive overview of China’s credit outlook, suggests that 5.5 percent of all loans, or $641 billion, are nonperforming. Using companies’ ability to at least pay interest on loans, the IMF writes, the amount of corporate loans at risk more than doubles to $1.3 trillion. But the report, which focuses on official credit through the banking system, fails to take into account implicit debtthat is likely to become part of official credit in the future. What’s more, several recent policy initiatives—debt-equity swaps and debt-bond swaps—are likely to exacerbate the problem.

The report gives China credit for several recent policy moves, from liberalized deposit rates to a new exchange rate system and the elimination of rules for outbound investment. It also highlights growing concerns about China’s rising corporate debt: the percentage of firms that cannot even cover interest payments on debt has ballooned over the last five years to 14 percent from 4 percent, and more than 40 percent of all firms have “excess payables,” or more than 45 days’ sales outstanding. Nonetheless, according to the report, this level of nonperforming loans is “manageable given existing bank and policy buffers and the continued strong underlying growth in the economy.”

That assessment may be overly optimistic, because it doesn’t capture future borrowing trends. Even some Chinese economists think the IMF estimates are too low. The value of all loans owed by the nation’s non-financial companies equaled more than 160 percent of GDP as of May 2015, according to Yu Yongding, research fellow at the Chinese Academy of Social Sciences.

What is interesting is what the IMF does not include in its analysis of Chinese debt. Much of China’s real debt is implicit—technically not bank debt, but loans that probably will become bank debt fairly soon. In addition, several policies are likely to boost debt even more. What would we throw into this pile?

Local debt. The official 2014 National Audit Office survey puts the total local debt at RMB 24 trillion, and local bankers suggest it could be as high as RMB 30 trillion. About half was loaned by China’s banks, while the rest came from private sources through shadow banking channels. Much of this bank debt would already be included in the totals for corporate loans. However, some private debt, because it was given to state-supported local companies, is likely to end up on bank balance sheets, too.

Implicit debt from shadow banks. Lending from the shadow banks, which includes the government-owned trusts, wealth management products sold by the banks, and other sources like online peer to peer lending, is basically private loans to corporate borrowers. According to Moody’s, the total is more than 44 trillion, and upon examination, that figure seems low. Technically, this isn’t bank debt. But it will become that soon.

Debt for bonds swaps. In addition, the new program that allows banks to swap local debt for bonds as a way to reduce interest rates has backfired, becoming a way for local governments to borrow even more. Instead of eliminating debt, the program has simply added bonds to existing debt. The swaps started out at RMB 3 trillion but could double or trip this year, adding substantially to bank nonperforming loans once local investments start to default—which is already starting to happen.

Debt for equity swaps. To save financially distressed state-owned enterprises (SOEs), Beijing has offered to permit certain firms to exchange their outstanding loans to the banks for equity stakes. In a meeting in March, top officials agreed that the first batch would total RMB 1 trillion. While some argue that this will give banks a voice on SOE reform, more likely it will just allow indebted state firms to increase their debt to replace the swapped debt. As a result, that RMB 1 trillion is likely to balloon within a short period of time – and it, too, will be added to bank balance sheets.

Why? First, many of the loans were sold through banks, and so lenders assume the banks are behind them. Second, many of the borrowers, such as local government companies, have state backing, and it’s going to be tough for state leaders to separate private from government borrowers. Third, lenders who are politically connected, such as wealthy people in the cities and workers with big state firms, can threaten to demonstrate and force the government to recapitalize the loans.

There are a number of steps Beijing can take to help improve China’s debt position. First, the government can increase the central government bond market. Local bonds are just another form of bank debt without much transparency. However, central government bonds are larger in size and are the explicit liabilities of the central bank. Beijing has an aversion to increasing the country’s official debt-to-GDP ratio, now around 42 percent. But acknowledging debt as a central government responsibility would increase transparency.Second, Beijing should abandon the debt-for-equity swap program. Such swaps just leave investors in the dark about the true debt picture for firms and are unlikely to result in any greater control over corporates by the banks. Increased transparency about China’s real debt burden could go a long way to calming skittish investors.