Incoming President Xi Jinping may find China’s investment-driven economic recovery in the Year of the Snake jeopardized by mounting risks in the finance industry.
Gross domestic product is poised to expand 8.1 percent this year, up from 7.7 percent in 2012, according to the median estimate of economists surveyed last month by Bloomberg News. At the same time, an increase in lending fueled by trust companies and underground banks enhances the risk of loan defaults that would be “severely damaging” to the economy, Standard Chartered Plc says.
The danger is that an economic rebound lulls policy makers into complacency, delaying market-driven changes needed to reduce dependence on investment for growth. Xi needs to rev up consumption and services and ensure credit is diverted from inefficient state enterprises to growth-generating private companies, said David Loevinger, former senior coordinator for China affairs at the U.S. Treasury Department.
“If China tries to sustain growth by adding debt and investing it inefficiently it will be like cotton candy: a short-term high with no lasting value,” said Loevinger, now an Asia analyst in Los Angeles at TCW Group Inc., which oversees about $135 billion. “The U.S. got into trouble because institutions like Fannie Mae (FNMA) and Freddie Mac were too big to fail and had a toxic mix of private shareholders and implicit government guarantees. China’s financial system is full of Freddies and Fannies.”
Fannie Mae and Freddie Mac (FMCC) are the U.S. mortgage financiers that have been under U.S. government conservatorship since 2008, after losses on soured loans pushed them to the brink of insolvency.
Xi and his team are inheriting an economy more leveraged than the one President Hu Jintao took over in 2003. Government, corporate and consumer debt rose last year by 15 percentage points to an estimated 206 percent of GDP, Standard Chartered said in a November report. In March 2003 it stood at 150 percent.
Borrowers are using some new loans to “plaster over non-performing credits” while so-called shadow banking is growing too fast, said economists led by Stephen Green. They estimated that a bad-loan ratio of 12 percent would erase the banking industry’s 7.5 trillion yuan ($1.2 trillion) in capital.
Lending by so-called trust companies surged five times to 1.04 trillion yuan in the first 11 months compared with the whole of 2011. A “large part” of the sector’s lending is to higher-risk entities including local government investment vehicles and property developers that don’t have access to bank loans, the International Monetary Fund said in its Global Financial Stability Report in October.
“Lots and lots of projects have been approved to stimulate this economy,” said Patrick Chovanec, an associate professor at Tsinghua University in Beijing. “The banks are extremely reluctant to lend to them and that says a lot about what they really know about credit risk in this country.”
The trust sector was set to overtake insurance as the nation’s second-largest financial business after banks last year, KPMG LLP said in a July report. Trust assets have expanded more than 10-fold since 2007 and surged 54 percent to 6.3 trillion yuan in the first nine months of 2012 from a year earlier.
Trusts make up more than a quarter of the country’s estimated $3.4 trillion in non-bank lending, according to an Oct. 16 report by UBS AG chief China economist Wang Tao, equivalent to about 45 percent of gross domestic product. The share of non-bank finance in aggregate credit has surged to about 45 percent this year, from 30 percent in 2008, central bank data show.
The trusts typically offer better rates of return than banks, pooling deposits from businesses and households to invest in real estate, stocks, bonds, commodities, or other assets.
Bad debts of as much as 9 trillion yuan will impair banks’ ability to lend and begin choking off investment later this year, at a time when there are no alternative growth engines to drive the economy, said Adam Wolfe, senior Asia economist at Roubini Global Economics in London. Growth will slip below 7 percent in the final quarter and to about 5 percent in 2014 as debt drags on the economy, he said.
“Faster growth now only pushes China closer to the inevitable sharp slowdown that will come when its debt-fueled, investment-led growth model collapses,” Wolfe said.
For now, signs of an economic recovery are popping up in areas from housing to factories to markets. The value of home sales rose 18 percent in November from October and industrial production and retail sales both increased at the fastest clip since March. Service industries expanded in December at the fastest pace in four months.
GDP probably expanded 7.8 percent in the October-December period from a year earlier, up from 7.4 percent in the third quarter, according to the survey of economists. The government is scheduled to announce the figure on Jan. 18.
“The pickup in growth momentum we have been expecting for some time appears now to be occurring,” said Alicia Garcia-Herrero, chief economist for emerging markets at Banco Bilbao Vizcaya Argentaria SA in Hong Kong. It “is being spurred by the effects of previous monetary easing and an ongoing acceleration in infrastructure spending fueled by debt, as well as resilient consumer spending.”
Markets signal investors are wagering on a rebound. The Shanghai Composite Index (SHCOMP) has leapt 16 percent since Dec. 3, while the yuan has strengthened 2.5 percent against the dollar from a July 25 low.
Yields on 10-year government bonds reached 3.59 percent on Dec. 31, a 35-basis-point increase since a July 12 nadir, as demand shifted away from the safety of sovereign debt. Five-year credit-default swaps protecting China’s sovereign debt against non-payment fell 82 basis points in the past year to 60 in New York on Jan. 2, according to data provider CMA. It is owned by McGraw-Hill Cos. and compiles prices quoted by dealers in the privately negotiated market.
Confidence in China’s economy is at the highest in more than a year amid optimism that the new leadership headed by Xi will pursue policies that help boost growth, according to a quarterly global poll of 862 investors, analysts and traders who are Bloomberg subscribers. It was conducted on Nov. 27. Xi was named general secretary of the ruling Communist Party in November and is set to succeed Hu as president in March.
Power consumption rose in November by the most in nine months, passenger-car sales increased to the highest in almost two years and a survey of purchasing managers showed manufacturing expanded in December for a third month. Chinese corporate earnings are set to climb as much as 10 percent this year as the economy emerges from its slowdown, according to Seattle-based Russell Investments.
“The Cassandras have once again bet against China, and lost,” said Ken Courtis, founding chairman of Next Capital Partners LP in Tokyo and former vice chairman for Asia at Goldman Sachs Group Inc., referring to the prophet of doom in Greek mythology. “There is still in this economy the capacity for strong performance for some years into the future.”
Merk Investments LLC is betting the recovery will benefit the Chinese and Australian currencies. The yuan has the potential to rise 5 percent this year while the Australian dollar may strengthen to $1.10 from about $1.05 as China’s infrastructure spending supports the nation’s commodity exports, said founder and President Axel Merk. His Palo Alto, California-based firm oversees about $630 million.
“The Australian dollar is very much dependent on what happens in China, which is coming out of a slowdown,” said Merk, who started the Merk Asian Currency Fund in 2008. “It can surprise on the upside. We are buying the yuan, and we have the Australian dollar and we like it both on a strategic and tactical basis.”
Even so, policy makers including Xi reiterated last month that they want to reduce the economy’s reliance on investment spending in favor of domestic demand. China will seek a higher “quality and efficiency” of growth in 2013, the state-run Xinhua News Agency reported Dec. 16 after the annual central economic work conference, dropping the phrase “relatively fast” growth that has been in place for six years.
Focusing more on the quality of growth means a greater emphasis on avoiding excess industrial capacity, encouraging more private investment and innovation, giving markets a bigger role and ensuring “people share in the fruits of development,” Hou Yongzhi, a researcher with the State Council’s Development Research Center, said in a briefing.
Fitch Ratings says the liquidity that’s driving a rebound put China’s banking-industry assets on track to rise by almost $14 trillion from 2008 to 2012, more than the $13 trillion in assets of the entire U.S. commercial banking system.
The default of a savings vehicle offered by Huaxia Bank Co. (600015) of Beijing, a lender part-owned by Deutsche Bank AG, prompted an investigation by police and regulators that the company disclosed last month. The bank says the product was sold without its permission by a rogue employee.
Sales of similar so-called wealth management products, sold with few details about the assets backing them, surged about 48 percent last year to 13 trillion yuan and are raising concerns that banks will face losses, according to Fitch.
Some products like these sold by Chinese banks are “fundamentally a Ponzi scheme,” wrote Xiao Gang, chairman of Bank of China Ltd., the nation’s fourth-largest lender by assets, in a China Daily commentary in October.
“China’s shadow banking sector has become a potential source of systemic financial risk over the next few years,” wrote Xiao. “Particularly worrisome is the quality and transparency of wealth management products. Many assets underlying the products are dependent on some empty real estate property or long-term infrastructure, and are sometimes even linked to high-risk projects, which may find it impossible to generate sufficient cash flow to meet repayment obligations.”
China’s corporate debt rose to a 15-year high of 122 percent of GDP last year from 108 percent in 2011, putting it among the world’s top levels, according to estimates by Beijing-based research firm GK Dragonomics.
Solar-equipment companies in China including LDK Solar Co. (LDK), the world’s second-biggest maker of wafers for solar panels, are facing losses amid industry overcapacity and debt. LDK, which has more than $3.1 billion of debt, said Dec. 12 it hired Citigroup Inc. to help renegotiate its liabilities. The company received a bailout in July for part of the debt from the local authority in Xinyu, Jiangxi province, where LDK is based.
“Too often low-return companies have been propped up,” said Loevinger. “There are many companies in China whose business models are only viable with access to cheap credit and resources and land. As growth slows, many of these could become zombies.”
--Kevin Hamlin. With assistance from Dingmin Zhang, Zhou Xin and Scott Lanman in Beijing and Cynthia Li. Editors: Anne Swardson, Adam Majendie.
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