The debate has well and truly started over whether China has a credit bubble. The few commentators who are forecasting potential problems, such as Charlene Chu from Fitch, are outnumbered by bulls who argue that there isn’t a problem or that the Chinese government is able to fix it. The investment community as a whole is therefore able to be comfortable in taking no action. The safety of numbers allows people to believe that everything is satisfactory and even if it is not they will be far from alone when problems arise. For those who prefer independent and detailed analysis, with a view to being an early mover and avoiding potential problems, a review of the indicators of previous credit bubbles should be of interest.
Credit as an asset class can be quite cyclical, with extended boom times when loans are available to almost anyone followed by very sharp pullbacks when only the highest quality borrowers can obtain finance at reasonable rates. In reviewing various credit crises over the past few decades, six indicators emerge that point to a forthcoming sharp reduction in the availability of credit and a subsequent economic contraction as debt-fuelled investment bubbles deflated. These six indicators are:
- A rapid increase in the level of credit in the economy
- Credit being used for speculative and uneconomic investments
- Maturity mismatches between loans and investment activities
- The presence of hot money that is aggressively searching for a home
- Limited price differentiation on credit quality
- A belief that “this time is different”
A Rapid Increase in the Level of Credit in the Economy
Following the onset of the global credit crisis in 2008, Chinese leaders began encouraging their banks to increase their lending in order to stimulate economic growth. The encouragement was well heeded with the amount of credit outstanding estimated to have increased from 125% to 200% of GDP in the last five years. This level of credit growth is extraordinary with Chu from Fitch going as far as saying, “This is beyond anything we have ever seen before. We don’t know how this will play out.”1
Some will argue that compared to first world economies China is actually not that bad, with Japan and the UK running at 500% debt to GDP. The key differences are that China is an emerging market not a fully developed economy and that the rate of growth has been so fast that credit is unlikely to have been allocated and invested wisely.
Credit Being Used for Speculative and Uneconomic Investments
In the Asian financial crisis and the US subprime crisis, speculative lending became normal with projects undertaken that had virtually no chance of making a decent return, and with a very high likelihood of not being able to repay lenders. The US subprime crisis saw as much as 20% of all residential lending directed to borrowers unable to meet even minimal credit standards. The infamous ninja loans (no income, no job, no assets) personified the absolute ignorance of any rudimentary credit assessment.
In the case of China, stories abound of empty office and apartment blocks, roads to nowhere, empty shopping complexes and functional bridges being destroyed so that new ones can be built in their place. In isolation anecdotal stories can be deceptive, but hard data has emerged that more than half of China’s steel mills and aluminium smelters are currently operating at a loss. The close relationships between the banks and governments mean that uneconomic projects can remain funded and apparently solvent for many years. However, losses must eventually surface and even the State Council is now publicly saying that the time has come to let uneconomic businesses be closed down or restructured.2 The increasing dependence upon short term funding from wealth management and shadow loan markets also means that problems are unlikely to be able to be hidden for much longer.
Maturity Mismatches Between Loans and Investment Activities
Banks and lending markets perform a key service to the economy when they turn short term deposits into long term loans. The financial crisis showed that this process is far from risk free, with Northern Rock probably the best example of the consequences of an overreliance on short term funding. The new Basel III regulations particularly target this issue, with banks required to hold both more equity to cushion potential losses and more long term funding to deal with a potential liquidity crisis.
In China, financing terms of 7 to 90 days are common amongst the wealth management and shadow lending sectors. When loans reach maturity, they are typically rolled over into a new loan of a similarly short maturity. Funds are being lent for all sorts of business purposes including property, infrastructure, small business loans and funding for large corporations, often with limited due diligence. With the exception of trade and invoice financing facilities, commercial activities should be funded by long term loans that reflect the ability of the business to generate profit and amortise the loan over time. A market built on short term loans has the potential to collapse at any time from a wholesale withdrawal of willing lenders, with the trigger often the default or rumoured impending default of a few borrowers.
The Presence of Hot Money that is Aggressively Searching for a Home
In the Asian financial crisis the term “hot money” came to symbolise the rapid inflows and outflows of overseas capital particularly into Thailand, Indonesia and South Korea. Hot money usually flows to sectors offering higher than normal growth rates or interest rates, and flows out of sectors or jurisdictions with lower expected rates of return. Hot money is often associated with foreign investors targeting emerging markets, but the excessive increases in equity and property prices in Japan in the 1980s shows that it can also be internally generated by an economy with high growth and savings rates.
The artificially low interest rates available at banks in China, deliberately held below the rate of inflation, have increased the impetus for Chinese investors to find alternatives. An underdeveloped equity market, restrictions on purchases of residential property and difficulties in sending capital out of the country to invest elsewhere have left few alternatives. Wealth management products sold by major banks and shadow lending through non-bank intermediaries offering returns of 5-25% are one of the few avenues available to Chinese investors that hold out the prospect of earning a decent return.
One of the hindsight lessons of the financial crisis for the Federal Reserve was that holding interest rates too low for too long from 2001 to 2005 created credit and asset bubbles. When both first world and emerging market investors have historically made bad investment decisions in the face of negative real returns, what chance do Chinese investors have of being unique? A recent Bloomberg article written by a shadow lender commented “traditional banks have steadily lowered their lending standards, from prime loans to subprime and then to simply silly loans.”3
Limited Price Differentiation on Credit Quality
One of the signs in developed nations that credit has become too cheap is that the spread available relative to the base rate barely increases as investors move down the risk spectrum. In 2005 and 2006 the hot money chasing yield meant that first world investors were paid very little additional return for owning a BBB rated bond relative to owning a AAA rated bond. The gap between sectors also narrowed substantially with the spread gap between a simple AAA rated corporate and a complex AAA rated CDO also falling. Differentiation issues can also occur on the basis of perceived guarantees. Many lenders to investment companies in Dubai wrongly assumed that because the government owned or controlled the investment companies those loans were of equivalent risk to loans made to the Dubai government.
In emerging markets with less developed financial infrastructure, easily quantifiable measures often don’t exist. Problems with differentiation of quality may be more easily seen with the project sponsor or the seller of the product. As an alternative to vanilla bank deposits Chinese banks have been increasingly offering wealth management products to their yield hungry customers. These are investments whose returns can be determined by the price of listed equities, gold or the ability of a poorly analysed borrower to repay their loan.
Many Chinese investors are seeing these products as of equivalent risk to a bank deposit, wrongly assuming that since they are sold by a bank they must be guaranteed or insured by the bank. The publicly reported failure of a few such products, with losses subsequently reimbursed by the banks, has only heightened the misplaced trust in these vehicles. Should China suffer a credit crunch, the failure of many wealth management products backed by loans to borrowers of speculative credit quality is likely. Investors may find that banks are unwilling or unable to reimburse customer losses, perhaps due to a bank’s desire to limit losses to its shareholders, or perhaps due to a government edict that investors wear the loss and not the banks whose solvency may by then be dependent upon the government.
A Belief that “this Time is Different”
For a bubble to develop in a broadly held asset class there needs to be a majority of people who believe that the return potential in the asset class is reasonable. Reinhart & Rogoff in their exceptionally detailed book laid out how country after country was able to increase their debt levels until at some point trust evaporated, default of some variety occurred and a crisis resulted. Often times, the run up in debt beyond reasonable levels was acknowledged by many, but was considered acceptable as that particular situation was deemed to be unique from other pre-crisis situations.
For China, often the defence given for why everything will work out is that the Chinese government is in control and is not willing to allow economic growth to slow below an arbitrary level, commonly thought to be 7%. Whilst this can seem logical, the Chinese government is not omnipotent and will eventually be subject to the same economic forces as other emerging economies. One government official recently commented “We need to find ways to let the bubble burst and write off the losses we already have as soon as possible to avoid an even bigger crisis. Deep adjustment means economic growth slows as costs are paid, it means hard days, it means the bankruptcy of some companies and financial institutions and it means reform.”4
The high savings rate is also cited as a potential handbrake to any slowdown in growth with the common perception that China has developed a great stock of efficient infrastructure and manufacturing capacity to fall back on. However, the failure to wisely invest the capital saved in the last decade means that China is not like Germany in having a high level of efficient and productive assets and the accompanying skilled and creative workforce to fall back on. Rather, the two decade long growth hibernation in Japan should be seen as a parallel. Japan also had a government with high levels of influence over the economy and high levels of savings yet it has been unable to cleanse the economy of a credit system that was highly exposed to speculative and uneconomic investments.
China is currently exhibiting all six of the indicators that have previously indicated the presence of a credit bubble in other countries. Whilst this doesn’t guarantee a credit crisis and economic downturn, it does warn that the probability of such a scenario is high. Predicting the exact timing of a bubble deflating is extremely difficult and some have lost much by betting too much too early on a potential decline. However, unlike equity investing, credit investing typically offers limited upside so the cost of being uninvested for the medium term, even if no such bubble exists, is low relative to the losses that may occur if the credit system breaks down. Investors in China, particularly those with concentrated investments in banks, wealth management products and shadow lending should strongly consider reducing their risk appetite or allocating capital away altogether from these segments.
Written by Jonathan Rochford for Narrow Road Capital on July 18, 2013. Comments and criticisms are welcomed and can be sent to [email protected].
This article has been prepared for educational purposes and is in no way meant to be a substitute for professional and tailored financial advice. It contains information derived and sourced from a broad list of third parties, and has been prepared on the basis that this third party information is accurate. This article expresses the views of the author at a point in time, and such views may change in the future with no obligation on Narrow Road Capital or the author to publicly update these views. Narrow Road Capital advises on and invests in a wide range of securities, including securities linked to the performance of various banks and financial institutions.