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Bad debts in China might be starting to cave in [ClearOnMoney]
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Bad debts in China might be starting to cave in

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Commentary

Bad debts in China might be starting to cave in

9 Sep 2012 by Jim Fickett.

Industrial production in China continues to decelerate, despite stimulatory policy measures. Cash flows have slowed in many sectors, not just housing and infrastructure, suggesting a broad problem. Part of the explanation is probably that loans, both from banks and from local governments, are going bad, leading to a cash/credit crunch.

Today China reported industrial production growth through August. It is hard to know how seriously to take the actual number, but the trend of falling growth rates is very likely real:

Is there a real danger that the deceleration will continue? Yes.

There is evidence that the slowdown is occurring more broadly than just in infrastructure and housing, where overinvestment has been patently obvious:

The Financial Times analysed patterns in operational cash flows over the past six quarters for more than 1,700 companies in the database of S&P Capital IQ, which collates financial releases from listed businesses round the world and makes comparisons as close as possible.

The results showed that the pain is being much more broadly felt than in just the property, construction, steel and heavy machinery sectors most closely linked to government investment. …

the sector that threw up most results was the consumer and retail sector.

There are several hints that there is a cash/credit crunch on, making life difficult for businesses, probably driven ultimately by speculative loans/investments that are not performing.

Loan performance at banks is definitely declining (a core issue in many ways, given that the government stimulus programs are carried out via (not-really-) private sector lending). When banks reported quarterly results at the end of August,

While the details were different at every bank, virtually all of the leading institutions reported a small increase in bad loans – and a much larger increase in overdue loans.

At the country’s midsized banks, which are most exposed to struggling private entrepreneurs in coastal regions, the picture was worse. Ping An Bank reported a 51 per cent spike in non-performing loans. …

“The deterioration trend is just beginning,” warned Bin Hu, an analyst with rating agency Moody’s.

As the government encourages further lending to stop the economic slowdown, it is not clear the banks will continue to be able to respond.

Banks are not the only issue. Local governments set up investment corporations that made loans for infrastructure projects, many of which are not producing the revenue needed to pay back the loans. This debt is large:

local government finances are in tatters. Beijing estimates that their debts stand at Rmb11tn, or a quarter of China’s output. Moody’s thinks the debts could be Rmb3.5tn higher.

And there is evidence that local governments are now in trouble:

In a note about Chinese corporate earnings this week, analysts at CICC noted a new variable that was starting to catch investors’ attention: local authorities’ demands for more tax yuans. The analysts said that tax rates at a raft of companies had risen beyond expectations.

Managements explained that it is because some local subsidiary had been requested by the local government to pay full enterprise tax rate this year, rather than the preferential high-and-new-tech-enterprise tax rate they had been granted with.

Why? The Companies said they had been simply told that local government needed more money from enterprises this year.

Companies, hit by higher taxes, slowing exports, and delayed payments from overseas, have been seeking bridge funding. But with banks worried about loan quality, the funding provided has often been very short term:

As Mike Werner at Bernstein research wrote in a note:

July loan growth was once again skewed towards short-term loans as 29% of new loans were discounted bills (usually used to finance working capital and trade), well above the trailing 12-month average of 12%.

This of course makes the whole situation more brittle.

Footnote on inflation

Inflation data through August was also reported today. The inflation rate rose slightly in August from July, and many news articles speculated that the inflation rate has bottomed, making the policy choices of the government more limited. This may be, and in fact is more likely than not, but for now all we know is that in August there was a slight uptick, well within the noise range, and far from providing evidence of a change in trend.

(For data sources see the Reference pages China industrial production and China inflation.)