1 Foreigners grow increasingly concerned about China’s debt risks
July 4
Bloomberg News reported that Chinese banks including the Industrial and Commercial Bank of China and China Construction Bank are issuing more loans that mature in 25 years instead of 10-year loans for most corporate lending, to qualified local government financing vehicles (LGFVs) with high creditworthiness in recent months, citing people familiar with the matter.
The people added that some of the 25-year loans came with waivers on interest or principal payments in the first four years, with the interest being accrued for later. The total size of the 25-year loans to LGFVs could not immediately be determined.
Bloomberg also reported that banks are continuing to lend to LGFVs at low interest rates because they believe that the PRC authorities will not let them fail. The report added that while none of the LGFVs have defaulted on a public bond, “a recent last-minute payoff of a note raised fresh concerns about the sector’s debt-servicing abilities,” referencing the case of Zunyi Road and Bridge Construction Group in Guizhou.
July 5
Goldman Sachs said in a report that it had downgraded the ratings of some major Chinese banks, including changing the Agricultural Bank of China from “Neutral” to “Sell” and the Industrial and Commercial Bank of China from “Buy” to “Sell.” Goldman said in the report that investors are concerned about the exposure of Chinese banks to local government debt, earning risks stemming from such debt, and diverging fortunes among individual banks.
The shares of Chinese banks in Hong Kong fell after the Goldman report was released. The Hang Seng Composite Index closed down 1.57 percent, the Hang Seng Tech Index fell 1.42 percent, and shares of Alibaba and Tencent dropped by more than a percentage point.
Meanwhile, the Hang Seng Mainland Banks Index dropped by as much as 3.6 percent, the lowest point in nearly four months and the worst day for the index in nearly eight months. Shares of the Industrial and Commercial Bank of China and China Construction Bank fell by almost two percentage points, shares of the Agricultural Bank of China declined by about three percentage points, and China Merchants Bank shares fell by 3.56 percent.
Background
The International Monetary Fund estimated in February 2023 that the total debt of China’s LGFVs hit a record 66 trillion yuan ($9.5 trillion), up from 57 trillion in 2022. According to Bloomberg, the quick increase in the amount highlighted how local governments increased off-book borrowing and spending during the pandemic years.
According to a Tianfeng Securities report published on May 6, the amount of interest-bearing debt of LGFVs likely exceeded 70 trillion yuan in 2022.
According to Zhongtai Securities, the national land transfer fee decreased 14.46 percent year-on-year from January to May 2023 to 1.132617 trillion yuan. In May, the national land transfer fee fell by 1.06 percent year-on-year and increased 18.36 percent month-on-month to 320.516 billion yuan. Concurrently, the proportion of land acquired by urban investment (i.e. LGFVs) dropped; land acquired by urban investment accounted for 20.4 percent of the total in May, a year-on-year decrease of 18.37 percent.
Our take
1. China’s dismal economic data in the first half of 2023, local governments publicly signaling their financial and debt woes, continued property sector weakness, and other factors appear to have sapped foreign optimism of rapid economic recovery in China while increasing scrutiny of debt and financial risks in the PRC.
We believe such trends will become more visible in the second half of the year as China’s economic and financial problems increasingly bubble to the surface.
2. Investor concerns about Chinese bank risks, including those of major state-owned banks, are warranted in considering the situation with LGFVs.
The minutes of a meeting by financial experts on the state of LGFVs in Kunming City that emerged in May 2023 hint at what sort of risks Chinese banks are exposed to. For instance, LGFV considered to be “creditworthy” were found to have not been able to make wage payments for three to four months and had defaulted on payments to suppliers, yet the banks chose to roll over their loans with payments on interest and principal to be made only in 2024 or 2025. Banks also did not count extended loans to Kunming LGFVs as non-performing. Assuming the Kunming problem is widespread, then the scale of non-performing LGFV loans, which corresponds to the scale of non-performing loans being obscured by the Chinese banking system, could be staggering.
Also, what was not said in the Goldman Sachs report on Chinese banks makes the banking sector risk situation look much worse than it already is. The Goldman report focused on the local government bond risks of 12 large Chinese banks, but the local government bonds held by the major Chinese banks are relatively more creditworthy than those held by small and medium-sized banks. For instance, the Kunming LGFV minutes note that all national-level commercial banks (with the exception of state-owned banks) had instructed their Yunnan branches not to invest in local LGFV bonds while only local commercial banks in Yunnan were allowed to hold those bonds; this implies that the bonds issued by local LGFVs in Yunnan have poor creditworthiness and are very risky. And if the large Chinese banks’ exposure to relatively more creditworthy local government debt has convinced Goldman Sachs to downgrade some of their ratings, then the debt risks of small and medium-sized banks is likely to be substantially worse.
Another worrisome detail about the LGFV situation appeared in the State Council’s audit of the implementation of the central government budget and other financial revenues and expenditures in 2022 published near the end of June. The audit found that 70 regions inflated fiscal revenue by 86.13 billion yuan through “self-selling and buying” state-owned assets and fictitious land transactions. A lot of the “self-selling and buying” would have been conducted through troubled LGFVs, and those LGFVs would have undoubtedly taken bank loans to partake in the fraudulent transactions.
3. The Bloomberg report about large state-owned banks in China providing 25-year loans to LGFVs indirectly affirms what we have observed and analyzed to date about the financial and debt difficulties of local governments. Assuming the information is accurate, then the central government is indeed very concerned about debt risks in the regime in the wake of local governments going public about their respective problems, but lacks the means to properly resolve the issue or does not want local governments taking advantage of a “bailout” by the higher authorities to borrow indiscriminately and pad their political achievements. As a partial workaround, the central government appears to have allowed some big Chinese banks to issue longer term loans to “qualified” LGFVs with “high creditworthiness” (note that even “creditworthy” LGFVs in Kunming are really in trouble) to avoid triggering the debt bubble.
However, larger Chinese banks providing LGFVs with longer-term loans and exempting them from interest or principal payments in the first four years is akin to the Zunyi Road arrangement. As we wrote at the time, the CCP authorities would have “merely transfer(red) the debt risks to financial institutions and have not actually resolved the regime’s broader financial troubles.” While the banks will likely obscure the risks by not classifying those loans as non-performing, their debt risks are nonetheless increasing and compounding the CCP regime’s financial difficulties.
The central government is likely looking to delay the triggering of debt risks in the hopes that the Chinese economy will eventually see recovery and the regime’s financial problems will gradually be resolved over the long haul. Many Chinese economists, however, are less optimistic about the state of the economy; some urged Beijing to introduce policies to turn things around quickly lest deflationary conditions see China enter a prolonged slowdown like Japan.
2 CCP pretends that ‘all’s well’ as more signs of deflation and economic malaise emerge
Economic rescue
June 11 – June 27
Liu Yuhui, director of the China Chief Economist Forum, delivered a speech titled, “From Recession to Recovery” at three recent economic forums (Sina Finance and Funding Carnival Summit, 2023 20th Zhejiang Business (Investment and Financing) Conference, and the Caijing Annual Dialogue Forum).
In brief, Liu pointed out in his speech that the Chinese economy faces the risk of deflation; that enterprises, residents, and local governments are unable to take on more leverage; and urged the central government to quickly issue special treasury bonds to boost credit and buy assets to rescue the markets.
Noteworthy details in Liu Yuhui’s speech include:
China’s economy is slipping into deflation
1. According to Liu, the Chinese market is contracting and there is a growing risk of deflation. The investor community and the fund industry have begun to accept this reality, especially since March.
In a nutshell, the Chinese economy coming out of three years of epidemic prevention and control suddenly found that people were not buying houses, cars were not selling, the household sector started deleveraging, the people were saving money faster than it was being printed, and the corporate sectors and local governments showed a pronounced tendency to minimize debt.
2. China’s decision makers initiated high-intensity monetary and credit stimulus in the past year, and especially in the first quarter of 2023. Liu believes that the authorities have printed a lot of money, but the increase of China’s M2 money supply to 28 trillion yuan in 2022 only led to a measly 6 trillion yuan in new GDP growth, and the 15 trillion yuan M2 increase in the first quarter of 2023 only led to about 1.35 trillion yuan in new GDP growth. Liu said that this phenomenon is what Keynes referred to as a liquidity trap, and the collapse of the money multiplier would theoretically cause a break in the normal economic cycle.
On the central government issuing special treasury bonds and undertaking debt relief
1. Given the experiences of the United States and Japan, Liu believes that the PRC authorities should come up with economic rescue policies that “break from convention.” For instance, the central government should initiate credit support, i.e. through the establishment of systemic special treasury bonds to help “systematically repair the balance sheets” (i.e. undertake debt relief) of enterprises, residents, and local governments. (Explainer: Liu is implying here that the U.S. and Japan fought off deflation through stimulus and Beijing should learn from this experience. Also, Liu is suggesting that the Xi leadership should take bolder economic action [“break from convention”] to rescue the economy and not be afraid of creating debt bubbles.)
The operations of Japan and the U.S. over the past 30 years can be summed up as follows: 1) set an interest rate of zero, 2) carry out quantitative easing, 3) implement modern monetary theory (which supposes that the government can finance its own spending by issuing money without having to rely on tax revenues or debt).
Liu Yuhui’s economic recovery proposal
Liu proposed the following five-point plan for the Chinese economy:
1. Help enterprises bear the burden of making “five social insurances and housing fund” (五險一金, or endowment insurance, medical insurance, unemployment insurance, employment injury insurance, maternity insurance, and housing provident fund) contributions to their employees, which would ease their difficulties.
2. Reduce the cost of rolling over local government through central government credit support (i.e. have the central government assume some of the local debt).
Liu estimated that the explicit local government debt is currently about 60 trillion yuan and implicit debt is about three to four times greater than the explicit debt. Meanwhile, the turnover cost of local government debt is as high as 4 percent. If the cost of this debt is not not significantly reduced, then local governments will gradually lose credibility and liquidity. The resulting impasse will brew systemic financial risks.
3. Establish a real estate national storage fund to transform the immense real estate sector pressure into public utility benefits such as building housing for “talents,” public rental housing, recreational assets, etc. However, there is currently 6 billion square meters of real estate inventory of houses for sale and houses already under construction in today’s China. Further, the household sector’s debt ratio has climbed to 140 percent and can no longer bear the pressure of increased leverage.
4. Establish a childcare fund to fully bear the cost of childbearing for young families and encourage young families to have children.
5. Replenish the securities market stabilization fund to ensure that when the market goes down, the central government can enter the market to supply sufficient capital, purchase core assets, and create a long-term trend of a “rising bottom” in the securities markets in a timely fashion.
July 6
PRC premier Li Qiang presided over a symposium on the economic situation where he listened to the opinions and suggestions of experts and scholars on China’s economy and economic work.
The experts and scholars in attendance were:
- Liu Shangxi, president of the Chinese Academy of Fiscal Sciences.
- Luo Zhiheng, chief economist and dean of the Yuekai Securities Research Institute.
- Tian Xuan, associate dean of Tsinghua University PBC School of Finance.
- Huang Xianhui, vice president of Zhejiang University.
- Yuan Haixia, deputy director of the China Chengxin Credit Rating Group Research Institute.
- Qin Hailin, chief engineer of the China Electronics Information Industry Development Research Institute.
- Lu Ming, executive dean of Shanghai Jiaotong University’s China Development Research Institute.
- Zhao Wei, chief economist of Sinolink Securities.
According to state media reports, the experts and scholars acknowledged that the “complex” international political and economic situation this year has left the Chinese economy facing “many difficult challenges” and “many impacts on China’s development.” They also noted that China is in a “critical period of economic recovery and industrial upgrading, with structural problems and cyclical contradictions intertwined and overlapping.” However, the experts and scholars still believe that China’s economy is “recovering and improving” under the “strong leadership of Party Central with Comrade Xi Jinping at the core.”
Li Qiang said at the symposium that China’s “sound economic fundamentals for long-term growth remain unchanged” and that the regime has the conditions to promote sustained growth “as long as it keeps strategic composure and enhances development confidence.”
Renmin University macroeconomic report
June 25
The China Macroeconomic Forum of Renmin University published its 2023 mid-term report. Titled “China’s Macroeconomy Has a Solid Foundation for Recovery” (夯實復甦基礎的中國宏觀經濟), the report forecasted that under a “baseline scenario,” the actual growth rate of the Chinese economy in each of the quarters would be 4.5 percent, 7.7 percent, 4.5 percent, and 5.9 percent respectively. The report also anticipated China’s GDP growth at 6.2 percent in the first half of the year and 5.7 percent for the whole year.
The report claimed that China’s macroeconomic recovery growth trend is “obvious” and the economy shows the “operating characteristics” of “bottoming out.” However, China is also seeing the characteristics of “macro hotness and micro coldness” (宏觀熱、微觀冷), that is, there are “obvious time lags and obstacles” in the transmission of the current macroeconomic rebound in the employment and income situation of residents, in the performance of enterprises, and in the transmission of market confidence.
The report noted that the pain points and difficulties of China’s economic recovery are concentrated in the “five 20 percents,” or the surveyed youth unemployment rate exceeding 20 percent, the total profit of industrial enterprises having decreased by 20 percent year-on-year, the revenue from local land transfers having decreased by 20 percent year-on-year, the area of new real estate construction having fallen by 20 percent year-on-year, and the gap in the consumer confidence index being as high as 20 percent. These “five 20 percents” indicate that the pressures in the relevant areas have exceeded the areas’ ability to self-heal.
The report also issued a warning about youth unemployment, noting that it was not just a cyclical problem but a systemic and trending problem. The report said that high youth unemployment will probably continue for the next decade and will keep growing in the short term. If not handled properly, youth unemployment will lead to other social problems beyond the economic sphere and even become a fuse for political problems.
The report proposed several policy recommendations covering 13 aspects, including implementing a more proactive fiscal policy and accommodative monetary policy; having some policy combinations that go beyond the convention; further tapping the space for tax cuts and fee reductions; guarding against an unanticipated outbreak of credit risks; being aware of extreme scenarios that may occur this year or in the next; people’s livelihood policies must be supported; and China’s position in the global industrial chain and supply chain should be consolidated.
Our take
1. Liu Yuhui’s “From Recession to Recovery” speech and the China Macroeconomic Forum of Renmin University’s 2023 mid-term report both indirectly acknowledge our earlier observation (for examples, see here and here) that China is experiencing deflation.
The deflation references, which were relatively cryptic given the sensitive economic and political nature of admitting the fact in the PRC, include:
- Liu observed that there is a growing risk of deflation in China. He also noted that money printing is not working and could cause a break in the normal economic cycle.
- The Renmin University report listed the “five 20 percents” and warned about the endemic nature of the youth unemployment problem.
Both the report and Liu’s speech also obliquely affirm our long-time observation of rapid economic deterioration in China and our general pessimism about the Chinese economy’s prospects. In particular, Liu’s five proposals and the report’s acknowledgment that youth unemployment could become a fuse for political problems underscore the CCP’s concern that social problems will build up to an intolerable point under continued and strengthening economic pressure.
The Renmin University report, Liu Yuhui, various Chinese economic experts and scholars, and even foreign investors are all anticipating aggressive economic rescue policies from Beijing, including a “more proactive fiscal policy and accommodative monetary policy.” Yet the central government is limited in what it can do to turn things around given that China appears to have entered a “balance-sheet recession” according to the economist who coined the term. Richard Koo, chief economist at the Nomura Research Institute, noted that “people are no longer borrowing money” over concerns about asset prices and economic growth prospects, and are instead “trying to reduce their debt.” Koo believes that “the government should not waste time on monetary easing, or structural reform policies that economists love to talk about,” and should instead put in “speedy, sufficient, and sustained fiscal stimulus” while making it their top priority to ensure that developers complete unfinished projects.
2. Those looking at the CCP authorities to roll out strong economic stimulus could be disappointed. Hints that Beijing will more likely be moderate in its economic rescue can be found in the July 6 symposium that premier Li Qiang attended. Li’s assessment that China’s “sound economic fundamentals for long-term growth remain unchanged” and that the regime has the conditions to promote sustained growth “as long as it keeps strategic composure and enhances development confidence” signals Beijing does not want to rock the boat too much. The experts and scholars at the symposium also assessed that the Chinese economy is “recovering and improving” under the “strong leadership of Party Central with Comrade Xi Jinping at the core”; this political statement suggests that Beijing is unwilling to move too aggressively with economic stimulus since doing do is an indirect admission of the Xi leadership’s failure.
Politics aside, Beijing cannot introduce strong stimulus policies without incurring various economic and financial troubles.
For one, lowering interest rates would further widen the spread between the U.S. and Chinese 10-year Treasuries, putting pressure on the renminbi to depreciate. Already, the renminbi is partly under pressure as the Federal Reserve continually raises rates to fight inflation. On June 30, the offshore renminbi rate fell above the 7.28 mark against the U.S. dollar, a new high since November 2022; the yield spread also inverted by 115.1 basis points that day. In the first half of this year, the onshore renminbi rate also fell by 3.6 percent. The widening interest rate spread between the U.S. and China will likely lead to more capital outflows from the mainland, worsening China’s economic situation.
Greater currency depreciation will also unlikely help China’s export situation by much given shrinking demand in the U.S. and Europe. In May 2023, China’s exports denominated in U.S. dollars fell by 7.5 percent year-on-year, imports dropped by 4.5 percent, and total imports and exports declined by 6.2 percent. Declining exports, arguably the main leg of China’s “troika” of growth drivers (exports, investment, consumption), in turn affects economic growth and recovery prospects.
Meanwhile, the People’s Bank of China lowering its loan prime rate by only 10 basis points on June 20 indicates that Beijing dares not take on more leverage now unlike what it did in the past given the current debt situation in China. Data from the Bank for International Settlements showed that China’s total debt-to-GDP ratio reached 295 percent in September 2022, surpassing that of the U.S. and the eurozone. The central government could be concerned that ramping up stimulus and taking on more leverage would end up triggering the systemic financial risks of Chinese banks.
We believe that Beijing will likely rely on propaganda to cover up China’s economic and social difficulties so that the CCP regime can muddle through its complex financial and economic situation while it “delays and waits for change.” The central government’s economic rescue limitations foreshadow the development of even more severe economic and financial difficulties for the PRC in the second half of 2023. The emergence of concentrated economic, financial, debt, and social problems will not only trigger systemic risks in the financial system but will lead to serious political problems for Xi and the CCP.
