Defensive credit creation and vicious circles in China | FT Alphaville

Defensive credit creation and vicious circles in China

Here are some things we imagine everyone knows by now: China’s credit growth since 2008/9 has been remarkably fast, the corporate sector has been the main driver, and the impact of that credit on growth rates and corporate profits has been getting ever weaker.

But for anyone who doesn’t know that, or just prefers pictures to words, here’s the story in three charts from a recent new IMF paper on China’s corporate debt problem:

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Not pictured: the shadow credit that may make the problem worse than currently estimated; the ever falling amount of low hanging fruit; the overhangs in property and infrastructure and the related overcapacity in construction related industries, which are a structural follow-through of the GFC stimulus; or the SOEs which are preferentially financed, more leveraged and less profitable than private industry and where reform has been sadly lacking.

But you get the idea?

Good, because the thing we want to talk about is how to get off what is a pretty circular situation.

As Goldman’s China team puts it in various bits of a new report, with our emphasis:

…our analysis suggests that the deterioration in China’s investment efficiency in recent years is unlikely only due to unfavorable cyclical factors. The economy seems to have increasingly struggled to put its vast investment to work in an efficient manner. This happens at the same time as the debt content of each unit of investment made tends to have become greater

…the function of credit in China has become more that of a substitute for shortfalls in corporate profits (and internal funds), serving to simply maintain broad stability in operations and investment.

…low profit leads to more credit required to fund investment, but given low investment efficiency the investment made may only generate sluggish profits in the future, which could then take us back to the difficult situation of more credit being needed to sustain investment.

Or, again, charted:

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Now one question here is simply: Where did the credit go to?

Goldman suggest a “trickle to personal wealth of borrowers who do not intend to repay, finance leveraged purchases of existing assets (e.g., property, bonds), facilitate ‘reverse’ RMB/FX carry trade (FX asset hoarding funded by RMB borrowing), etc.”

But the more important question is surely: This is a situation that ends how exactly?

If untreated, it obviously leads nowhere sustainable. But treating it is not easy — for example, you can’t really cut investment/credit if policy is aimed at keeping growth rates high via investment/credit. And that certainly seems to be the case at the moment.

The IMF, in the same report the graphs above come from, devotes pages to suggestions based on market reform, curbing overcapacity, debt restructuring, hardening of budget constraints, removing the state from the equation to the greatest degree possible and policy cushions to help with a painful adjustment.

It’s all very laudable stuff we’ve heard before and will again, we’re sure, even if logically just about everyone agrees this can’t go on. The model isn’t sustainable.

Goldman’s suggestions for breaking the cycle also read, in the absence of a deus ex machina boost to profitability, as a wish list of oft-repeated reforms that aren’t easy to follow through on since, tbf, they haven’t been up to this point.

Maybe more pertinent for now then is this from Reuters on October 4?

Profits at roughly a quarter of Chinese companies in a Reuters analysis were too low in the first half of this year to cover their debt servicing obligations, as earnings languish and loan burdens increase.

Corporate China sits on $18 trillion in debt, equivalent to about 169 percent of China’s GDP, but few firms reported feeling the heat.

Instead, lenders are heeding Beijing’s call to support the real economy and so are rolling over company debt or granting repayment waivers, sometimes for years, specialist lawyers and investors said.

Related links:
In search of China’s hidden credit – FT Alphaville
Document 82 and slapping down China’s shadow loan market – FT Alphaville