Signs of a China Credit and Real Asset Bubble Are Now Unmistakable!

By: Reggie Middleton | Tue, Mar 9, 2010
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Home grown credit risks look to come back home to roost. I am actually shocked the following development didn't get more traction in the mains stream media. The recent announcement by the Chinese finance ministry to nullify all guarantees for local governments for loans taken by their financing vehicles, and its plan to issue rules banning all future guarantees by local governments (see Bloomberg article), fuels (even further) our concerns about credit risks on such loans.

The primary concern is that most of these were non-recourse loans to provinces, municipalities and counties through shell companies, known as Urban Development Investment Corporations (UDIC). Some went to fund projects backed by assets, such as commercial real estate, others to projects with future cash flows such as subways and toll roads. Still others are social in nature and backed only by an implicit guarantee of the City/Provincial Investment Holding Corporation (CIHC).

This post should be taken in context of the discussion had regarding the prospects of the highly levered Russian energy company. Subscribers please see
Mechel (MTLR) 2010-02-26 18:32:58 366.23 Kb and
Mechel (MTLR) Overview, pt2 2010-02-28 06:09:51 532.89 Kb

The China Macro Discussion 2-4-10 is also quite relevant.

And the most concerning part of these loans primarily includes the estimated 3,000 billion Yuan ($450billion) of local infrastructure loans extended in 2009, which represents 30% of the record new bank lending last year.

According to Central bank governor Zhou Xiaochuan, during the National People's Congress, "while 'many' local financing vehicles have the ability to repay, two types cause concern. One uses land as collateral, while the other can't fully repay borrowing", which means that for such loans the local governments may become liable, leading to 'fiscal risks' for the government.

Similar concerns have been previously raised by Northwestern University's Professor Victor Shih, who estimates China's local- government outstanding debt at the end of 2009 at 11.429 trillion Yuan ($1.674 trillion)

and agreed credit lines with banks for an additional 12.767 trillion Yuan ($1.87 trillion). Additionally, and as per his estimates the total local government outstanding debt may result in bad loans of up to 3 trillion Yuan ($439 billion) as projects have been left without funding.

Further, Shih also stated that this rise in debt in "the worst case" could trigger a financial crisis around 2012.

China's local governments have been raising funds through investment vehicles to circumvent regulations that prevent them borrowing directly, (which is not counted in official calculations currently), inclusion of this debt could lead to debt rising to 96% of GDP ratio (total debt reaching 39.838 trillion Yuan or $5.8 trillion) next year, much higher compared to IMF's estimate of 22% which excludes local-government liabilities (

Harvard University's Professor Kenneth Rogoff has also highlighted fears of a debt bubble crisis in China. According to Rogoff "China's economic growth will plunge to as low as 2% following the collapse of a "debt- fueled bubble" within 10 years, sparking a regional recession. ...You're not going to go a decade without having a bump in the business cycle. ...We would learn just how important China is when that happens. It would cause a recession everywhere surrounding" the country, including Japan and South Korea, and be "horrible" for Latin American commodity exporters" (Bloomberg).

A February 2009 OECD report has also cautioned that China faces risks from bank lending surge. According to the report "While Chinese banks have so far weathered the global slowdown well, the acceleration in new lending since early 2009 raises the risk of a renewed surge in non-performing loans (NPLs) in the years ahead."

The probability of financial crisis is further supported by the Chinese state entities' poor record in preventing faulty provincial lending practices and low quality asset formation. During the 1990s Asian financial crisis, the Guangdong International Trust went bust, in spite of an implicit Guangdong state government guarantee (

The Consequence

The banning of local government guarantees will constrain the number of infrastructure projects that local governments launch in 2010, resulting in a smaller boost to the economy since the majority share of this 2nd year of stimulus consists of enormous lending by state banks and not of government funding (


Though there are risks of debt crisis if the government is unable to handle the current surge in local government borrowing and overall unprecedented lending, the country's high saving rate can help the country meet its liabilities if the government is unable to control the current lending outburst, in turn averting the crisis.

Counter-counter arguments

Never short a country with $2 trillion in reserves?

Michael Pettis, professor at Peking University's Guanghua School of Management specializing in Chinese financial markets, and a Senior Associate at the Carnegie Endowment for International Peace, draws very interesting parallels between China's massive foreign reserve build-up and the only other two countries that have managed to accomplish such a feat. This is an excerpt from his highly recommended blog linked above.

... Let us leave aside that the PBoC's reported reserves are a lot more than $2 trillion, and that if correctly accounted they would be pretty close to $3 trillion. China's foreign reserves are certainly huge. They add up to an amount equal to about 5-6 % of global gross domestic product.

But they are not unprecedented. Twice before in history a country has, under similar circumstances, run up foreign reserves of the same magnitude.

The first time occurred in the late 1920s when, after a decade of record-beating trade and capital account surpluses, the United States had accumulated what John Maynard Keynes worriedly described as "all the bullion in the world". At the time, total reserves accumulated by the US were more than 5-6% of global GDP. My back-of-the-envelope calculations suggest that this was probably the greatest hoard of central bank reserves ever accumulated as a share of global GDP, but please check before you accept this claim.

The second time occurred in the late 1980s, when it was Japan's turn to combine huge trade surpluses, along with more moderate surpluses on the capital account, to accumulate a stockpile of foreign reserves only a little less than the equivalent of 5-6% of global GDP. By the late 1980s, Japan's accumulation of reserves drew the sort of same breathless description - much of it incorrect, of course - that China's does today.

Needless to say, and in sharp rebuttal to Friedman, both previous cases turned out badly for long investors and brilliantly for anyone dumb enough to have gone short. During the early years of the Great Depression of the 1930s, US stock markets lost more than 80 per cent of their value, real estate prices collapsed, and the US economy contracted in real terms by an astonishing 30-40 per cent before recovering in the 1940s.

Japan's subsequent experience was economically less violent in the short term, but even costlier over the long term. During the period following its astonishing accumulation of central bank reserves, its stock market also lost more than 80 per cent of its value, real estate prices collapsed, and economic growth was virtually non-existent for two decades.

The idea that massive levels of reserves are a guarantor of economic stability is, in other words, based on a profound misunderstanding both of history and of the nature of reserves. Reserves of course are not useless as an enhancer of financial stability, but their use is for very specific forms of instability. Having large amounts of reserves relative to external claims protects countries from external debt crises and from currency crises.

Great, but neither Chanos, nor even the most pessimistic Sino-analyst, has ever said that these are the kinds of risks China faces today, any more than they were the risks faced by the US in the late 1920s or Japan in the late 1980s. The risks that China faces today (and the US in the late 1920s and Japan in the late 1980s) is of excessive domestic liquidity having fueled asset and capacity bubbles, the latter requiring the uninterrupted ability of foreign countries to absorb via large and growing trade deficits. These risks include an explosion in domestic government debt directly and contingently through the banking system.

These are, very typically, the kinds of risks that threaten rapidly developing large economies, unlike the external debt and currency risks that typically threaten small economies. And reserves are almost totally useless in protecting these economies from the risks they face (and, no, no, no, reserves cannot be used to recapitalize the banks - only domestic government borrowing or direct or hidden taxes on the household sector can be used to recapitalize the banks).

In fact, it was the very process of generating massive reserves that created the risks which subsequently devastated the US and Japan. Both countries had accumulated reserves over a decade during which they experienced sharply undervalued currencies, rapid urbanization, and rapid growth in worker productivity (sound familiar?). These three factors led to large and rising trade surpluses which, when combined with capital inflows seeking advantage of the rapid economic growth, forced a too-quick expansion of domestic money and credit.

It was this money and credit expansion that created the excess capacity that ultimately led to the lost decades for the US and Japan. High reserves in both cases were symptoms of terrible underlying imbalances, and they were consequently useless in protecting those countries from the risks those imbalances posed.

Whether the country will face a debt driven crisis remains dependent on how well China tackles the current situation, one certain outcome of unprecedented lending is a plunge in the current high economic growth rate of the country as infrastructure spending takes a hit from loan tightening.

Additional and relevant commentary on the bubble in China:

  1. It Doesn't Take a Genius to Figure Out How This Will End
  2. Can China Control the "Side-Effects" of its Stimulus-Led Growth? Let's Look at the Facts
  3. HSBC is Performing as Expected
  4. Part 2 of the Mechel Overview is Available
  5. Some Light Shown on My Developing China Thesis
  6. Follow Up to the China Short Thesis Debate
  7. China's Most Expensive Export: Price Inflation
  8. Believe Those China Growth Stories at Your Own Risk - Just Ask Google!
  9. He Who Bloweth the Bubble With Wet Lips Should Stand Back Lest Spittle and Saliva Spray Upon Ye Face
  10. Goldman Seems to Trust the Chinese Economic Reporting a Tad Bit More Than I Do!
  11. All of my warnings about China are starting to look rather prescient
  12. Now that the world is forced to agree with Reggie on China's growth propsects...



Reggie Middleton

Author: Reggie Middleton

Reggie Middleton

Reggie Middleton

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