China can’t pay the loans, sells them to the US
Debt is big business.
It’s how banks turn a buck.
How Wall Street bets on the market.
How politicians keep countries running.
And productive debt is perfectly fine, when used for productive things.
However, when debt is used to prop things up, that’s when problems begin.
Debt is back
‘Debt is roaring back in China’, or so Bloomberg told me a couple of weeks ago.
It turns out that the past two years of Chinese officials reducing local banks’ lending ability is nearing the end.
Debt and the supply of money is back in vogue 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.’
Although, as you can see below, banks in China are the ones writing most of the loans…
Chinese lending increasing
Source: The Daily Shot
But there is a problem with this.
In spite of assurances from government officials that everything is under control, there’s still a massive US$34 trillion in total government and corporate debt already in the system.
Only last month, Jim Rickards explained to subscribers of Strategic Intelligence Australia that China is being hit by ‘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.
Defaults are bigger than ever
China is currently the default capital of major economies.
In 2018, more than 119.6 billion yuan (AU$24 billion) of Chinese corporate bonds were defaulted on. That’s four times the defaults value in 2017.
These defaults are coming from the corporate sector and include both US dollar-denominated and local currency bonds.
As large as these defaults are, we’re only getting started.
In March, Jim explained to subscribers that last year’s defaults were ‘just the tip of the iceberg’, saying:
‘China’s debt situation is structured as a massive Ponzi, where one company issues debt and then lends the money to another affiliated company, which lends the money to another affiliated company and so on in a daisy chain of related company debt.
‘This means that if any single company in the chain defaults, the entire group will default because the affiliates will be unable to pay back their loans to the parent company at the top of the food chain. China is between a rock and a hard place.
‘China also needs new debt to roll over old debt and to prop up asset values that depend on leverage.
‘If China tightens too much, it will cause a wave of defaults.
‘But if China does not tighten enough, it will let the asset bubbles in stocks and real estate expand to the point that market collapses are inevitable.
‘Given the size of the Chinese economy (second largest in the world, with about 15% of global GDP), a disaster in China would likely ripple around the world in a new global financial crisis.’
The problem, however, is that China won’t simply default and reset.
All those bad debts are looking for a home.
And it seems that ‘home’ is about 10,000 kilometres to the west.
Bad debts at fire-sale prices
This is where it comes back to how clever banks and politicians are.
They’ve amassed an incredible, possibly unrepayable loan tally and built their bridges.
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Like all debt-funded activities, eventually someone has to pay.
Who is that?
Well, there’s been billions of dollars’ worth of corporate defaults in China.
But the Chinese government can’t let all the debts fall at once.
Instead, China is doing what the West does, by creating a way to sell those bad debts.
Even though we are only four months into a new year, it seems China’s ‘distressed debt bond market’ is the market for lovers of high risk.
According to the Nikkei Asian Review, China currently has US$1.4 trillion (AU$1.9 trillion) in distressed debt looking for a home. All this debt can be picked up for cents on the dollar, too.
And that home just happens to be 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.
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.
And then those funds on the other side of the world are receiving an income payment on the value of the debt.
So the bad debts are basically being repackaged and spread throughout the financial system.
Bad debts aren’t kept in China. They are being sold to medium-sized hedge funds in the US and Europe. The sort of firms that are on the hunt for double-digit income.
If you had asked me a month ago, I would have said the rate of corporate bond defaults in China was the biggest issue.
However, today I have a different view.
That is, China is creating new loans at a faster rate than it can clear the old ones.
Furthermore, its bad debts are no longer ‘in-house’. Bad debts 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 I show you how to prepare for this level of risk right here.
Until next time,
Editor, The Daily Reckoning Australia