China Credit-Bubble Call Pits Fitch’s Chu Against S&P
Total lending from banks and other financial institutions in China was 198 percent of gross domestic product last year, compared with 125 percent four years earlier, according to calculations by Chu, the company’s Beijing-based head of China financial institutions. Fitch cut the nation’s long-term local-currency debt rating last month, in the first downgrade by one of the top three rating companies in 14 years.
“There is just no way to grow out of a debt problem when credit is already twice as large as GDP and growing nearly twice as fast,” Chu, 41, said in an interview.
Chu’s view puts her in a minority among those charting the future of the world’s biggest nation. She questions how long China can maintain the model of growth driven by bank lending that has allowed its economy to sidestep the global financial crisis. Fitch’s sovereign-debt downgrade to A+, the fifth-highest level has sparked a debate in which Chu’s calculations have been called “biased” by an Australia & New Zealand Banking Group Ltd. economist and a “misinterpretation” by Everbright Securities Co.
Her views have struck a nerve. “Everyone is talking about credit -- about the credit cycle, leverage and credit-quality problems,” said Stephen Green, head of Greater China research at Standard Chartered Plc in Hong Kong, adding that there’s not enough good data available. “It’s a big black box, and it’s quite scary.”
Amid the global credit crunch of 2008, China ramped up lending by state-controlled banks to prevent an economic slowdown. The assets of Chinese banks expanded by 71 trillion yuan ($11.2 trillion) in the four years through 2012, according to government data. They may increase by as much as 20 trillion yuan this year, Chu said April 23. That will exceed the $13.4 trillion of assets held by U.S. commercial banks at the end of last year, according to the Federal Deposit Insurance Corp.
Chu says companies’ ability to pay back what they owe is wearing away, as China gets less economic growth for every yuan of lending.
China’s expansion of credit hasn’t caused a surge in the proportion of bad loans, data from the banking regulator show.
While loans overdue for at least three months have grown for six straight quarters to reach 526.5 billion yuan at the end of March, the ratio of nonperforming loans declined to 0.96 percent as of March 31 from 2.42 percent at the end of 2008, according to the China Banking Regulatory Commission.
Chu, who has covered Chinese financial institutions at Fitch for seven years, says these figures are distorted. The ratio of nonperforming loans to total lending has declined mainly because credit has surged, she said. Moreover, the regulator’s data doesn’t reflect the real amount of debt because of the ways banks move loans off their books, Chu said.
Some loans, often for real estate, are bundled together and sold to savers as so-called wealth-management products, while other assets are sold to non-bank financial institutions, including trusts, to lower the lenders’ bad debt levels, according to Chu. Wealth management products and trusts are sold to investors eager to get more than the government-mandated benchmark of 3 percent annual interest on bank savings accounts.
“The data may be somewhat accurate for the on-balance-sheet loan portfolios of the banks, but banks have substantial off-balance-sheet positions for which there is no asset-quality information,” she said.
Chu has been one of the most vocal analysts to warn about regulatory loopholes and weaknesses in China’s banking system, saying they make official lending data unreliable. Fitch in 2011 started calculating its own measure of total credit in the economy.
Before joining Fitch in 2006, she analyzed China issues at the Federal Reserve Bank of New York’s emerging-markets group, serving as a point of contact for the U.S. government on China’s monetary policy and the nation’s attempt to restructure its financial system. Born and raised in Colorado, Chu holds an MBA and a master’s degree in international relations from Yale University.
Fitch rates the four biggest Chinese banks’ long-term debt at A, the same as Standard & Poor’s and one level lower than Moody’s. China’s local-currency debt is rated Aa3 at Moody’s Investors Service and AA- at S&P, both the fourth-highest level.
Estimates for off-balance-sheet lending in China, which together with non-bank credit has become collectively known as shadow banking, range from the Financial Stability Board’s about 2 trillion yuan, published in November, to JPMorgan Chase & Co.’s 36 trillion yuan based on data from the end of 2012.
Chu calculated China’s total credit at 198 percent of GDP last year by adding off-balance-sheet assets such as letters of credit, financing by non-bank institutions and offshore loans by foreign banks to figures for all forms of financing in the economy published by the central bank. The Chinese government doesn’t provide an estimate for total credit to GDP.
A jump in the ratio of credit to GDP preceded banking crises in Japan, where the measure surged 45 percentage points from 1985 to 1990, and South Korea, where it gained 47 percentage points from 1994 to 1998, Fitch said in July 2011. In China, it has increased 73 percentage points in four years, according to Fitch’s estimates.
“You just don’t see that magnitude of increase” in the ratio of credit to GDP, Chu said. “It’s usually one of the most reliable predictors for a financial crisis.”
The cost of credit-default swaps protecting holders of Chinese sovereign bonds for five years against nonpayment rose 10 basis points since Fitch’s downgrade on April 9 to a seven-month high of 81.5 on May 27, before trading at 78 yesterday, according to data provider CMA.
The yield on China’s three-year corporate bonds rated AA-jumped 18 basis points to 5.62 percent from a 28-month low on April 16. The three-year government bond yield added eight basis points this month to 3.06 percent, Chinabond data showed.
Other analysts have calculated similar levels of credit without concluding that crisis is on the horizon.
Francis Cheung, head of China and Hong Kong strategy at CLSA Asia-Pacific Markets, estimates total corporate, household and government debt at 205 percent of GDP. That’s less than levels of about 250 percent in the U.S. and almost 400 percent in Japan, though it’s high compared with other countries at similar levels of development, Cheung wrote in a May 9 report.
Liu Li-Gang, head of Greater China economics at ANZ in Hong Kong, echoed that view, saying China’s ratio of debt to GDP is lower than in any developed Western economy, without giving an estimate. Chu’s conclusion about the possibility of crisis in China also doesn’t take into account the “enormous assets” held by the government when assessing the ability to repay debt, said Liu.
China’s four largest banks, all majority-owned by the government, controlled about 43 percent of the nation’s 134 trillion yuan of banking assets at the end of last year. Industrial & Commercial Bank of China Ltd., China Construction Bank Corp. (939), Agricultural Bank of China Ltd. (601288) and Bank of China Ltd. are among the world’s 10 largest lenders by market value.
China faced a banking crisis in the late 1990s, when at least a quarter of the nation’s credit soured after years of state-directed lending. The state banks were transformed from almost insolvent institutions to the world’s most-profitable lenders with the help of more than $650 billion in bailouts.
The nation is in a better position now to tackle nonperforming loans, said Liao Qiang, a Beijing-based director at S&P. In the past decade, China’s economy has quadrupled, the number of urban residents surpassed those on farms and policy makers allowed freer flows of its currency in and out of the country. Its foreign-exchange reserves surged fivefold from 2004 to $3.3 trillion at the end of 2012.
“Given that China’s credit is mostly funded by its internally generated deposits, I don’t think a real financial crisis, which is normally manifested in a liquidity shortage, will happen anytime soon,” S&P’s Liao said by phone. Local-currency savings stood at 92 trillion yuan at the end of 2012, according to the National Bureau of Statistics.
There’s no basis for concluding that China’s debt is unsustainable, said Xu Gao, chief China economist at Beijing-based Everbright Securities, a unit of state-owned China Everbright Group. A public debt level of about 50 percent of GDP, including borrowing at the central and local levels and by policy banks, leaves room for the government to borrow more, he wrote in an April 16 note.
Chinese banks extended 2.8 trillion yuan of loans in the first quarter, 12 percent more than a year earlier and the second-largest quarterly total on record, government data show. Economic growth in the period slowed to 7.7 percent from 7.9 percent in the fourth quarter.
Only 29 percent of last year’s aggregate financing translated into economic growth, the lowest rate on record, as borrowers use more resources to finance outstanding debt and less for investment, Sanford C. Bernstein & Co. analyst Michael Werner wrote in January.
“Companies are taking on a lot of debt but not getting comparable returns,” Chu said. “If they’re not getting sufficient returns, at some point they will have problems repaying the debt.”
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