360° Analysis

The Dragon Miracle’s Curtain Call: China Approaches its Great Deleveraging (Part 1)


September 05, 2012 02:52 EDT

Chinese banks and firms are starved of liquidity as a consequence, respectively, of reckless loaning and unsustainable industry bubbles. The first of a two-part article.

To understand just how bad the health of China’s economy has become, look at the People’s Bank of China’s (PBOC) behavior. Recently, their actions appear frustrated and aggressive. On July 5th the PBOC cut their benchmark interest rate; its second cut in less than a month. The Central Bank has also cut the reserve requirement ratio (RRR) three times since December 2011. The last cut was in May. Today the RRR is 20%, down from 21.5% last December.

That week the PBOC also introduced its biggest injection into the money market in nearly six months. They injected 225bn yuan ($34.5bn) through reverse-repurchase operations (repo). This follows a combined injection in the four preceding weeks of 291bn yuan ($45.6bn).

What’s the Rush?

Why is the PBOC rushing to open up the floodgates of liquidity? It is desperate to apply a monetary band-aid to a bleeding economy. These aggressive measures however will not fix the problem. At best they will sustain an over-leveraged economy and avoid a systemic shortfall in debt financing.

The primary drivers of China’s debt financing are China’s cash starved state-owned banks. According to Citigroup, in 2011 seven of China’s biggest banks raised 323.8bn yuan ($51.4bn). Several other financial firms are expected to raise another 113bn yuan ($17.7bn). Of this, China’s fifth-biggest lender, the Bank of Communications, is expected to account for 57.4bn yuan ($9bn).

A wave of unprecedented lending is being encouraged by the central government’s requirements for regulatory capital in addition to the need to maintain the payment of jumbo dividends that are required for their largest shareholders – the state. These actions are leaving China’s banks, the world’s most profitable, in a precarious position. According to GaveKal, in 2010 China’s five biggest banks, the Big Four (the Industrial and Commercial Bank of China, the Bank of China, China Construction Bank and Agricultural Bank of China) and the Bank of Communications, paid out more than 144bn yuan ($22.6bn) in dividends. They also raised more than 199bn yuan ($31.3bn) in the capital markets. Ballooning balance sheets driven by a loan frenzy and strict capital requirements have made China’s banks crave cash. In March China’s Big Four increased their total assets by 14% to 51.3tr yuan ($8tr). This is about the size of the German, French, and British economies combined.

To accommodate a new set of rules, the country’s biggest banks have to increase their capital levels to 11.5% of assets by the end of 2013. Their core Tier 1 capital ratio will need to be at least 9.5%. These requirements are more stringent than those applied through the Basel III Accord, which requires a Tier 1 capital ratio of 6%, up from 4% in Basel II. To meet these requirements the PBOC has had to come to the rescue.

The Central Bank though cannot conjure up miracles. At this point all they can do is administer monetary band-aids to a broken economy. The problem with this is that the load of debt/credit in the Chinese economy has become excessive and it cannot be corrected with monetary band-aids.

Fermenting Bubbles

According to Fitch the ratio of total financing to GDP in China between 2007 and 2010 rose from 124% to 174%. In 2011 it rose again to 179%. In 2012 the growth of broad credit is expected to decelerate slightly but it is still expected to outpace GDP. Also according to Fitch, in 2012, each yuan in new financing will yield 0.39 yuan in new GDP. Pre-crisis this yield was 0.73 yuan. Returns have to rise above 0.5 yuan for domestic credit/GDP to stabilize at the 2011 level of 179%. Clearly, China’s problem is not liquidity. It is a diminishing return on credit.

Achieving this will be very difficult. This is because businesses today need more and more credit to achieve the same net economic result. To do this they would need to take on more and more leverage. But this puts them in a position of being less and less able to service the debt and more and more prone to insolvency and bankruptcy. Eventually the number of insolvencies and bankruptcies will become so great they initiate a rapid downward spiral for the underlying asset values and this will drive up the non-performing loan ratio for the banks. At some point an over-stretched banking system implodes and this ignites a full-blown economic crisis.

This outcome is inevitable because the PBOC, rather than tackling the root causes of China’s economic ills-those unsustainable economic bubbles and diminished demand-is adding fuel to the fire. The only question is when will China reach this PBOC-inspired turning point?


Bubbles in Construction

China’s construction industry presents a good example of one of China’s economic bubbles. The consumption of cement is used as a primary indicator of a nation’s level of new construction. In 2010, China’s consumption surpassed 1,800 metric tons (mt), which was about 56% of global consumption. India had the second highest consumption at 212 mt. US consumption was 69 mt, which is 1/25th that of China. With an average per capita consumption of 1,400kg, China’s consumption is nearly five times that of the world’s average. In other countries, these levels of consumption have been a bellwether for a construction crisis. In the Spanish property/construction bubble the peak-per-capita consumption of cement was 1,300kg. Four years later per capita consumption is 500kg.

According to Société Générale, China spent more than 6.4tr yuan ($1tr) on construction in 2010. This includes: residential and non-residential real estate and infrastructure. This represented about 20% of nominal GDP, which is about twice the world average. (According to Tao Wang, head of China economic research at UBS Securities, real estate, including materials and appliances now represents 30% of China’s GDP.) In 2010 China accounted for 15% of global construction, surpassing the US to become the world’s largest construction market.

In 2010, China built about 1.8bn square meters of new residential floor space. This is equivalent to Spain’s entire residential floor space. China’s construction has already provided accommodations for 60m people in urban areas, but the urban population has only increased by 20m. If China kept this pace of construction for five more years it would provide 9bn square meters of new housing, which would accommodate 300m additional people. According to the IMF this amount of floor space would accommodate a Chinese urbanization rate of 65-70%. But the IMF doesn’t predict this level until 2030. If the IMF prediction is right, China is on a path to have more and more cities like Ordos, a modern Chinese Ghost Town that was depicted in Time Magazine.

China’s construction binge has pushed its fixed investment/GDP ratio in 2010 to 48.5%. This is 16.5bp higher than Indonesia, the G20 country with the next highest ratio. The ratio of fixed investment to GDP in China sets a record that is unprecedented in the recent history of China or any other major economy. China’s economy is not just investment led, it is construction led.

Even though second quarter GDP 2012 data met expectations for 7.6% growth, anecdotal evidence from cuts in steel prices by Baosteel, the country’s biggest steelmaker, and falling electricity output suggest the economy may be decelerating more than realized.

Bubbles, Meet Ponzi Schemes

Economic bubbles work like Ponzi schemes. It begins with central bank policies focusing on loosening liquidity. Cheap funds drive demand that drives asset prices. Higher asset prices now drive demand. (This is the phenomenon George Ackerloff and Robert Schiller labeled Animal Spirits.). These animal spirits now drive up asset prices further and further. Then reality strikes, the Ponzi scheme collapses and there is a stampede for the exit as prices plummet. The over leveraged asset purchasers are now in for a great deleveraging. China’s investment-fueled growth has all the appearances of a giant in-process Ponzi scheme.

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.


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