The coming China corporate debt crisis and its effects on the Australian economy
- Christopher Prince
- Jun 27, 2016
- 6 min read
Dr Sukudhew Singh, Bank Negara deputy governor, considered on the sidelines of the Financial Times Asia Banking Forum in June that China’s corporate debt load, standing at 145% of gross domestic product, could be dealt with “if policymakers react pre-emptively and forcefully”.
However, the IMF issued a fresh warning on 14 June that Chinese corporate debt was “very high by any measure” at the Fund’s latest review of the Chinese economy. David Lipton, IMF’s number two and leader of its latest mission in China, admitted that “systemic debt problems can lead to much lower economic growth, or a banking crisis. Or both.”
Indeed all major world institutions, think tanks and rating agencies have been raising alarms at the rate and level of Chinese corporate debt piling up and many signs in the Chinese economy are reminiscent of the lead-up to the GFC. And if China undergoes a much lower economic growth, or a banking crisis, or both, Australia could suffer also as it is the second favoured country for accumulated Chinese investment and these investments are vital for many sectors of the Australian economy.
I. All major world financial institutions, economic think tanks and rating agencies have been raising alarms at the rate and level of Chinese corporate debt piling up
Non-performing loans have officially doubled in the last two years in China at 5.5% of banks’ total lending, and this are only the official numbers. The reality is actually much grimmer as about 40% of new debt is made to pay back interest on existing loans. And in 2014, 16% of the 1,000 biggest Chinese firms owed more in interest than they earned before tax.
China requires more and more credit to generate less and less growth. Official numbers show that the GDP is declining from a peak of 10.6% in 2010 to 6.2% in 2016 (forecast from the OECD). And this growth is mainly made on credit as it takes nearly four yuan of new borrowing to generate one yuan of additional GDP, that is one yuan more than just before the GFC.
Some pundits say that the mighty Chinese government can control this, but can they for ever? China might be affected by a “scissor effect” with debt climbing at the same time as economic growth falls, and no fix from the government will be able to help it out. And both scissors blades could actually be sharper than expected.
1.Chinese GDP numbers might be faked and the level of shadow lending underestimated
On one side, most economists agree that the real Chinese growth is actually well below the official rate of 6.7% for 2016. Chinese officials themselves admit that they fake their economic figures, so the question is how serious are these China’s exaggerations.
China n°2 leader Li Keqiang admitted in 2007 in a diplomatic cable released by Wikileaks that his country GDP figures were “man-made” and therefore unreliable. It is better to look at electric consumption and freight to get a more reliable idea of how the Chinese economy is faring. Capital Economics calculates China GDP based on cargo freight volumes and estimates it between 4 to 4.5%, but some analysts estimate it as little as 1 to 2%. The difference is important as if China is overstating its GDP growth just a bit, it means the world economy will be a bit weaker in coming years than expected, but if it is overstating it a lot, it could mean the government is really worried about a hard landing with serious implications for the global economy.
On the other side, the scale of shadow lending could be underestimated. Shadow lending was introduced in China after the Global Crisis to help stabilise output growth and fuelled by stimulus package, but it has kept growing since and increased by 69% in 2015 alone according to Wigram Capital Advisors, and that represents 16.5% of the formal loan book.
Also, Chinese banks are very enthusiast about off-balance sheet products that boost their profits and Chinese investors like them as they offer better returns than bank deposits.
More seriously even, Chinese banks are disguising risky loans as “investments” and employ financial engineering to evade regulations designed to limit risk. This sounds reminiscent of the miscategorisation of subprime mortgage loans as AAA by rating agencies in the US in years leading up to the 2008 GFC.
2. Many signs in the Chinese economy are reminiscent of the lead-up to the GFC
Indeed many signs in China today remind us of what happened in the US a decade ago, as note influential investors George Soros and Kyle Bass. George Soros has outlined the similarities he finds in the economic situation in China now with the situation leading up to the GFC in the US, while Kyle Bass is noting the presence of “ticking time bomb” in China’s banking system.
3. Several solutions are considered but it is uncertain how they can work
Financial experts have suggested two solutions to tackle the excessive corporate debt using financial tools. One would be to convert non-performing loans (NPLs) into equity, hence lowering the debt level and increasing the size of the stock market at the same time. Another one would be to securitise these NPLs, that is repackage them into marketable securities and sell them, as mortgage lenders did in the US with subprime loans.
The IMF considered these conversion techniques in a study in April 2016
but concluded that they needed to be part of a more “comprehensive, system-wide” plan to be effective, otherwise they could actually worsen the problem by allowing “zombie” firms (non-viable firms that are still operating) to keep going.
4. How long will the Chinese government be able to control the situation?
Some observers argue that the Chinese government is very powerful and that they can pressure lenders to accept debt restructuring in a way not possible in Western countries. However, OECD, IMF and most economists agree that in the absence of fundamental market reforms to the financial system and to state-owned enterprises, productivity will continue to fall, the debt will balloon and the situation will be out of the hands even of the mighty Chinese government, with wide implications for its trade partners.
II. Australia is the second most favoured country for accumulated Chinese investment so could be severely impacted by a Chinese financial crisis
Chinese investment in Australia is still rising and is transitioning from secondary to tertiary industries and still strong in real estate
According to KPMG, Australia is the second largest global trade partner of China, after the US, and their investments increased by 32.9% in 2015. They are actually transitioning from the mining, manufacturing and construction sectors where investments have declined by 33% to 22% year-on-year to consumer and services industries. In these sectors, the largest increases are reported in health with a 800% increase year-on-year, management of water and environment facilities with a 280% increase and hotels and catering services with a jump of 198% compared to 2014. In volume, real estate is still attracting the largest proportion of Chinese investment, with 45%. The rest is in energy (23%), healthcare (17%), mining (9%), infrastructure (3%) and agribusiness (3%).
In term of regional distribution, Chinese favoured the states of New South Wales for 49% of their direct investments in 2015, Victoria for 34% and Queensland for 9%, the other states making the remaining 8% all together. Looking at the sizes of the deals, 86% of deal volumes were done in real estate in NSW, respectively 88% and 87% in mining in Queensland and Western Australia, respectively 93% and 59% in energy in South Australia and Victoria, and 90% in infrastructure in Northern Territory.
2. A Chinese debt bust will have high impact on Australian property market and corporate investments
With these figures in mind, a Chinese investment contraction of its foreign investment due to lower growth or a crisis at home will undoubtedly have an impact on NSW property market, mining in Queensland and Western Australia, energy in Victoria and South Australia and infrastructure in Northern Territory.
One should also consider demand. Australia has benefited a lot from Chinese demand in resources during the mining boom years and is benefiting less now. The risk is that these sectors will know a severe contraction, as well as property, tourism and other sectors affected by Chinese demand.
3. The downturn could be bigger but also different to the Japan-led recession of the early 1990s
Some parallel the China coming bust to the Japan-led recession of the 1990s. One must remember that this last recession in Australia (as Australia was not really directly affected by the GFC) was triggered by a raise in interest rates in Japan and then its financial crisis that triggered the burst of its bubble and massive sell-offs. A Chinese crisis could have the same effects. However, Japan downfall into stagnation and deflation was slow and orderly. Chinese financial system and economy are more chaotic. Therefore, a Chinese crisis is likely to be more sudden and acute with stronger effects on Australian jobs and wealth.
To prevent these effects, Australia on one hand should accelerate the transition of its economy from mining and resources to a wider range of service industries so that sharp cuts in investments or even sudden drops in demands in these sectors do not impact it so much. On the other hand, it should diversify its investments and demand markets to all regions of the globe, so that a crisis in one of these regions does not affect it so much.
