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Another Reason to Worry About China

by John Rubino on September 24, 2013 · 15 comments

It is generally accepted by Western analysts that China makes up most of its economic statistics — which is only reasonable when you consider what it would take to actually measure an economy of a billion people working for a mix of state-owned and private companies divided between chaotic mega-cities and distant rural farms.

But lately the fake number theme is showing up more often in the mainstream press, which is interesting. Consider this from Bloomberg on a segment of the Chinese economy that doesn’t generally get much attention:

China Corporates Not Making Debt Payments
Chinese corporate debt was 113% of gross domestic product at the end of last year according to the widely followed Louis Kuijs of Royal Bank of Scotland. That’s worse than the 86% in 2008.  J.P.Morgan thinks the 2012 figure was 124%, and BBVA, the Spanish bank, estimates almost 130%.

All these figures, in reality, are far too low.  They are based on official GDP statistics, which grossly overstate China’s output.  Make the proper adjustments to nominal GDP for inflation—this change by itself takes more than a trillion dollars off the 2012 results—and eliminate obvious fakery, and these percentages become astonishingly high, perhaps approaching 155%.

Will China’s corporate obligations trigger a nationwide crisis?  “The level of debt is not a good judgment of whether a country has a serious problem,” said UBS’s Wang Tao in July. “The issue is whether it can afford the debt, and so far China can.”

So far, Ms. Wang has been right.  Yet simple arithmetic indicates the country will suffer a wave of corporate defaults soon.  As Tom Holland of the South China Morning Post tells us, “China Inc.’s balance sheet is flashing danger signals.” Specifically, Holland reports that Gillem Tulloch of Forensic Asia, a research firm, notes that the 1,500 largest public Chinese companies by sales have debt that is nearly seven times their annual operating cash flow.  A healthy level is about three or four, he says, and the danger line is six.

Moreover, there has been a sharp deterioration in the condition of Chinese companies.  Net debt of the corporate sector was 30 times net earnings in 2012, up sharply from 10 times in 2011.

With profits falling and debt increasing, the ability of China’s corporates to meet obligations will deteriorate quickly.  Already free cash flow is severely negative, a “very rare” occurrence, seen in Asia only in the months preceding the 1997 financial crisis.

Analysts, focusing on “ghost cities,” believe China’s debt crisis will begin with the notorious LGFVs, the local government financing vehicles.  Now, however, there is a growing appreciation that Chinese companies, both gargantuan state-owned enterprises and smaller private firms, could be the trigger.

China’s steel sector is perhaps the country’s most troubled.  It has run up $490 billion of debt in building mills that now account for 66% of global production. Beijing, however, overbuilt.  The country currently has about 300 million metric tons of excess capacity, almost twice the output of the European Union.

Overcapacity, inevitably, has led to defaults, but only on the periphery of the industry. Steel traders, especially in Jiangsu province, have not been able to make payments, and in April Citic Trust Co. auctioned debt from a steel-related trust that failed to pay interest and principal.

At first glance, the failure of a major steel concern seems unlikely, in large part because of Beijing’s long-term support for the industry.  It is true that reformist Premier Li Keqiang wants to close marginal mills, but most observers believe his initiative will get nowhere beyond the shuttering of one or two small operations.  After all, attempts by his predecessors to eliminate capacity have been spectacularly unsuccessful due to local resistance.

In light of all this, even Li Xinchuang, president of the official China Metallurgical Industry Planning and Research Institute, believes there will be at least one default within a year because of the inability of companies to refinance.

Failures of major companies, some believe, could domino the sector.  That seems hard to believe, but the March bankruptcy filing of the main subsidiary of Suntech Power, the world’s largest maker of solar panels, looks like a sign of what can happen in the steel industry.  The filing is a warning because Suntech’s solar panels, like steel, enjoyed deep central government support that led to massive overcapacity.  The problems in steel and solar are evident across the heavy-industry landscape.  Coal and aluminum enterprises now look particularly vulnerable, for instance.

Analysts, therefore, are apprehensive. Christopher Lee of S&P in Hong Kong expects an increase in corporate defaults in the next six to twelve months. Zhu Haibin of J.P.Morgan notes corporate debt is the firm’s “No. 1 concern.” “Recession is inevitable,” says Forensic Asia’s Tulloch. “China has to have an economic contraction to cleanse the system.”

Chinese technocrats have been able to avoid system-cleansing contractions. The last one, according to the National Bureau of Statistics, occurred in the year Mao Zedong died, 1976.  In reality, the economy plunged at the end of 1990s, and it is on the verge of recession now, if it has not already tipped into one.

At the moment, Premier Li, in an attempt to avoid a contraction, has ordered the People’s Bank of China to flood the economy with cash.  The central bank began injecting liquidity on June 21—in secret—and has continued since then, both publicly and surreptitiously.

Liquidity injections seem unnecessary if official statistics are accurate.  But large industrial enterprises, the pride of Beijing, are running short of dough and are now paying their obligations in cash substitutes such as bankers’ acceptances, which are essentially promissory notes.  The Financial Timesreports that one car parts company in Shanghai receives payment for about two-thirds of its receivables in these instruments.  Therefore, the firm doesn’t have cash to pay its suppliers.  The FT was shown one acceptance, for a little more than a million yuan, which originated from a car company in Jilin province and which had been used twice for payment.

The practice has mushroomed—the amount of outstanding acceptances was just 3% of GDP in 2008 but reached 11% last year. In an environment where effective interest rates are skyrocketing—corporates are now paying an average of about 8%, up from 0% two years ago—all it takes is just one company in a payment chain to default in order to start a cascade from one province to another and one sector to the next.

Some thoughts
This article is even more apocalyptic than its title implies. To extract a few data points: China’s corporate debt has risen from 86% of GDP to 155% since 2008; “Net debt of the corporate sector was 30 times net earnings in 2012, up sharply from 10 times in 2011”; and “free cash flow is severely negative.” These are some serious trend reversals.

Using IOUs to pay bills is exactly the same thing as borrowing the money, in the sense that it creates an obligation that eventually has to be satisfied with cash. So “acceptances” rising from 3% to 11% of GDP is a helluva jump in private sector debt. It’s not clear whether the analysts quoted above are counting this in their other totals.

Given China’s opacity it’s hard to know how much faith to put in these numbers in any event, but the fact that they were compiled by analysts whose job it is to get at the truth (as opposed to government officials who have been ordered to report favorable numbers) means they’re probably somewhere in the ballpark.

  • Bill johns

    I don’t doubt for a moment the thoughts and estimates presented in this column, however…. Is the US inflation rate really around 1%? Is US unemployment really ~7%? Is Europe really getting its fiscal house in order? Is Greece really turning its debt picture around? Governments lie as a routine policy, the bigger the economic unit the bigger the lies. Why should China be any different? When was the last time anyone in the US who has been paying attention actually believed any key financial statistic offered by the government or the Fed? The global economy is balanced on a knife edge, lies keep it balance, but can only carry on for so long before reality bites, but when? Nobody knows. As far as collapse of a major Asian economy, I don’t doubt that it could happen big time and very possibly soon. Still I cannot forget that folks have been predicting an imminent collapse of Japan since the late 1990s.
    It’s all a matter of timing. Who said “When the tide goes out you can see who’s swimming naked, so keep your shorts on?”


  • Keith Cossairt

    the Harbinger is coming.

  • Dan

    When those factories start closing the riots will begin in the streets and the American corporations will start their trek back to the US, as already some of them are now. So too at the present some are in Mexico, although that country is feeling the effects of NAFTA and the resulting growth of drug cartels that have taken control of parts of the country.. China, Russia, and the US are in a currency war and the results are just beginning to come into view. They are attacking the dollar as we speak.

  • thomasaveryblairea

    What would happen if China chose or at least tried to pay off the debts of the private corporations with the billions of dollars China now holds as its reserve in U.S. Dollars?
    Wouldn’t that amount to driving down further the value and desire by others for the U.S. greenback “notes” and put China into a far better position to become a major player in the coming new world reserve currency as well?

    • Bill johns

      Good question. I personally don’t have a clue one way or the other. I do seem to recall a year+ ago this same question came up in a forum someplace and the answer was that you can’t do that. It is not possible to use a foreign currency to pay of internal debts. It would be sorta like the US being long in euros and using the money to bail out California — yeah, they have the euros in the bank, but there are certain restrictions on how it can be used. I’m not sure why but I bet the good and kind Mr. Rubino could explain.

    • pipefit9

      “….with the billions of dollars China now holds as its reserve in U.S. Dollars?”

      Not to quibble, but I think their dollar holdings are measured in trillions, not billions. I think the fed would have to launch a new, separate QE bond buying program just for this sale, should China decide to liquidate some of their foreign bond holdings.

      The problem with all these bonds, USA Treasury issued and others, is that there is no wealth backing them up. The original idea behind bonds was that the issuer would sell the bonds to raise capital in order to build something that generated revenue, like a factory, sewage treatment plant, etc. Now bonds are mainly issued to raise day to day operating funds. Not sustainable, I’m guessing, BWTFDIK

      • Bruce C.

        Agreed. China holds about 1.3 trillion dollars worth of US Treasuries, which is about 8% of all issuances.

    • Bruce C.

      China’s dollar reserves are in the form of US Treasuries. Cashing them in (i.e., selling them) would yield US dollars which would then need to be converted to yuan to pay of the corporate debt. That would strengthen the yuan and weaken the US dollar which would not help the Chinese companies that export. Furthermore, holding US Treasuries provides political leverage against the US. The threat of financial repercussions (i.e., dumping Treasuries) may have been behind the US backing down on Syria.

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  • Johnny Shiloh

    Question: Remember in the 1990’s (or was in the late ’80’s) when Japan’s economy was soaring and Time magazine’s cover featured “Japan INC” – well at that time Japan’s national debt ratio to GDP had to be so enormous like ours now, yet Japan’s economy was in the stratosphere – so why can’t the U.S. at some point do the same even with our massive economic problems?

    • Bruce C.

      It’s very possible that the US will follow in Japan’s footsteps. Remember, Japan’s economy collapsed in the late 90’s and has been in a deflationary funk ever since, mainly because the financial authorities chose to bail out the big banks and corporations instead of letting them go. Without that needed economic purging of mal-investments the Japanese economy has been mired in debt ever since. The latest effort to overwhelm the economy with “paper” via “Abenomics” should accelerate Japan’s decline even faster. So, yes, the US could do the same thing too.

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