Aussies suffer from China’s ‘debt iceberg’
There are some things you just don’t say out loud in Australia.
You don’t criticise John Farnham.
You never admit you don’t like Vegemite.
You never ask for VB beer at a bar (but you drink it secretly at home).
And you never talk about how your wealth is entirely reliant on what the Chinese do next…
Distressed loans are rising
‘Debt is roaring back in China’, or so Bloomberg told me back in February.
It turns out that the past two years of Chinese officials reducing local banks’ lending ability was coming to an end.
Debt and the supply of money was back on the agenda in China, with Bloomberg writing, ‘From bank loans to trust-product issuance to margin-trading accounts at stock brokerages, leverage in China is rising nearly everywhere you look.’
And Chinese banks were the ones writing the loans.
But there’s a problem with freshly issued bank debt.
That is, the banks need to get rid of the debts they’ve got.
In May this year, the South China Morning Post reported that China’s financing had grown to 8.18 trillion yuan (AU$1.7 trillion) in 12 months.
That’s an astounding 40% jump for new credit when compared to the previous year.
The majority of that went into Chinese stocks and property development.
It didn’t translate into economic growth, which is what the government was looking for.
China is being hit with the law of diminishing marginal returns.
In other words, more and more debt equals less and less growth.
That isn’t stopping the Middle Kingdom writing rubber cheques.
Except now, China may be approaching the point where excessive debt levels send the economy backwards.
It’s different this time
China is currently the default capital of major economies.
In 2018, more than 122 billion yuan (AU$25 billion) of Chinese corporate bonds were defaulted on. That’s four times the defaults value in 2017.
And for the first half of 2019, already 55 billion yuan (AU$11 billion) worth of loans have defaulted.
These defaults are coming from the corporate sector and include both US dollar-denominated and local currency bonds.
However, the default over the last 18 months differs from those in the years preceding it.
Bloomberg noted that in 2016, the majority of Chinese distressed loans were from firms like steel and coal.
This time around, the defaults are spread amongst a wide variety of industries.
Private investment firm China Minsheng Investment Group, which has exposure to the aviation, property and health sectors, sank with 54 billion yuan (AU$11 billion) in debts. Not long after, a coal miner and an oil firm went under too.
The variety of the distressed loans remind us that these defaults aren’t cyclical or tied to commodity performance.
Instead, they show us just how much debt was used for speculation.
To boot, the amount of ‘non-performing loans’ is as high as 40% in the smaller Chinese banks.
Until recently, the smaller Chinese banks were allowed to call distressed loans ‘special mention loans’.
This clever disguise meant investors saw a relative low number of ‘non-performing loans’ when looking at a bank’s risk.
Special mention loans accounted for roughly 20% of the smaller banks’ books, and the number of non-performing loans was minimal.
Once banks were forced to call a spade a spade, a sudden influx of 1.75 trillion yuan (AU$36 billion) in more distressed loans became visible.
And all those bad loans just had to go somewhere.
China’s ‘debt iceberg’
The real worry lies in what some economists are calling China’s ‘debt iceberg’.
According to some estimates there is as much as AU$50 trillion in public and private debt floating around the Middle Kingdom.
But given the masking and clever accounting we’ve already witnessed, no one is actually certain what the real number is.
What we do know is that these unrepayable loans have to go somewhere.
Mirroring how the West does business, Chinese corporate defaults are being flogged for cents on the dollar.
And these loans are finding their way into hedge funds in the US and Europe.
Apparently, Chinese distressed debt corporate bonds are being bought up for 20-30% of their original value…and returning around 10% in interest payments so far this year.
So billions of dollars of distressed loan sales have been forced into China’s nascent distressed debt market.
Let me put it another way.
Almost $2 trillion of loans — roughly one third of their original value — are being sold to the other side of the world.
We should most definitely be concerned about the repackaging of distressed debt as high-yielding assets to unsuspecting investors.
The distressed loans are basically being repackaged and spread throughout the financial system, meaning they are no longer ‘in-house’.
Distressed loans are being sold to others as a way to make money, spreading the risk to all corners of the financial system.
That is the very definition of systemic risk.
And more than anyone, Aussies have been riding on China’s debt-fuelled growth for a long time.
Until next time,
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