Sunday, June 14, 2009

China : The Biggest Bubble Of Them All

Around 2006, a public crescendo was reached about China's Non-Performing loan problem. Most famous was the withdrawn report of Ernst and Young, which estimated that China's Non-Performing Loan (NPL) exposure was nearly 1 trillion dollars.

Whatever happened to those NPL's ? China developed their own version of the "bad bank" scenario to discharge NPL's from their four major banks, Bank of China, China Construction Bank, Cinda Industrial and Commercial Bank, and Agricultural Bank of China. According to , NPL's declined from 31 % of total loans in 2001 to around 3 % in 2008 under this "bank bank" scenario.

The loans were transferred to new government-backed organizations called Asset Management Companies, while the banks received bonds worth the full value of the original loan, plus interest. (Good deal !) As with most "bad bank" scenarios, the NPL's were supposed to be sold off to the highest bidder, at their real market value. To a large extent this has not happened as well as planned, and the AMC's: Orient, Cinda, Haurong, and Great Wall, are stuck with a mountain of liabilities.

As the Financial Times reported :
Until three years ago the AMCs were reporting aggregate returns of about 20 to 22 fen on the renminbi – a 20-22 per cent return on the face value of the assets they received from the banks. However, they have since been much less forthcoming.

“These AMCs must by now be massively insolvent because all the better assets have been sold and they have used the proceeds to pay the interest on the bonds they issued,” says Lardy.

(note: Nicholas Lardy is a senior fellow at the Peterson Institute for International Economics).

AMC's are now reluctant to take on any more NPL's:
China Construction Bank Corporation (CCB) failed to sell its non-performing asset package due to low bid prices, sources reported. The asset package includes 626 loans from 390 consumers, with book value hitting CNY 9.31 billion. CCB planned to sell the package as a whole to China Huarong Asset Management Corp., China Great Wall Asset Management Corp., China Orient Asset Management Corporation and China Cinda Asset Management Corporation via public auction. But it failed to sell the package in an action held at the end of March 2009, as the four firms are much more rational amid the global financial crisis, a top executive of Cinda Asset said in an interview.

This, as China engages in a massive stimulus plan which has been predicted to create another surge of NPL's.

Through the last decade, China has been able to manage their NPL situation by riding a wave of export-led growth, enabling the stockpiling of enormous reserves, and the ability to inject capital wherever needed. Foreign and domestic investment has similarly ridden this wave, leading to a sharp increase in property values, which have become a significant portion of earnings for Chinese-based companies. According to the Financial Times (September 7, 2007) "While declared earnings growth is 75 per cent (for Chinese companies), growth in operating earnings, profit from actually running a business, is 33 per cent. Most of the rest comes from property and other investments."

Property values are poised to drop in China over the next few years, as a spate of articles have mentioned recently.
Cao Jianhai, professor at the Chinese Academy of Social Sciences, a leading government think tank, said an apparent rebound in the property market was unsustainable over the medium term and being driven by a flood of liquidity and fraudulent activity rather than real demand.

He told the Financial Times he expected average urban residential property prices to fall by 40 to 50 percent over the next two years from their levels at the end of 2008.
China's economy remains closely tied to its export sector, with an Export to GDP ratio of 40 %, and a trade surplus which represents around 10 % of GDP. But an export led recovery will be difficult to achieve in the face of a deleveraging U.S. and European consumer. There is good reason to believe that China's growth has stalled. Krugman notes that electricity consumption, is dropping, while reported growth figures are rising, breaking a long-term trend.
For most of the past decade, China’s industrial value-added growth (IVA) –industry output less input costs – has moved broadly in step with movements in electricity consumption. But the relationship’s broken down recently: electricity use is still seeing negative growth, while IVA is growing at a decent positive rate again...China’s association of electricity generators has a solution: it’s stopped publishing consumption data.

Large undeclared liabilities and debt in the state dominated financial sector, combined with the possibility of weakened export growth and deflated property values, make China's economic future far more precarious then commonly assumed.



Noted China watcher Michael Pettis makes similar points:
I have always argued that other not-yet-recognized liabilities, such as hidden municipal and government debt, the bankrupt AMCs, and other non-recognized debt, probably means that real government debt levels are higher than the official numbers by at least 15-25% of GDP, which suggests that, correctly counted, government debt levels may now be approaching 50-70% of GDP. If we throw in the possibility that the current bank-lending spree is also likely directly or indirectly to add to government debt burdens in the future (contingently, through a rise in NPLs), I would not be surprised if policy-makers are already starting to consider the possibility of a debt problem at the central government level.

Andy Xie, on China's property values (whose appreciation accounts for a substantial amount of the earnings growth for domestic Chinese companies):
China's property market holds even less value in the long run. Chinese properties are sitting on land leased for 70 years for residential properties and 50 years for commercial properties. Their residual values are zero at the end. The hope for perpetual appreciation is a joke. If you accept zero value at the end of 70 years, the property value should only be the use value during those 70 years. The use value is fully reflected in rental yield. The current rental yield is half the mortgage interest rate. How could properties not be overvalued ? The bulls want buyers to ignore rental yield and focus on appreciation. But appreciation in the long run isn't possible. Depreciation is, as the end value is zero.


1 Cracking China's Banking System

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