The Chinese Economy

 

WEEKLY COMMENT 28-04-2016

By Barry Edwards

The Chinese Economy

The IMF has published a short paper about how to manage the enormous debt problem in China and especially the non-performing loans (NPL) in the banks. Many economists are advising that this could be a major threat to the world economy if it is left unchecked and grows even larger. Although China is a controlled economy with some foreign investment which is still a small proportion of the economy, it has a big impact on trade and finance throughout the world.

The paper is headed ‘Debt-Equity Conversion and NPL Securitization in China: Some Initial Considerations.’ If you click on the link below you can read the paper, it is 7 pages long and easy to read;

http://www.imf.org/external/pubs/ft/tnm/2016/tnm1605.pdf

The banks in China have started preparing to sort out the mass of NPL’s on their balance sheets and the government is encouraging resolution. At the turn of the century there was a big clean-up of NPL’s which were placed in special purpose vehicle companies (SPV’s) and funded by issuing 30 year government bonds at full loan value.  Most of these loans are from state owned enterprises (SOE’s) and are still on the books of those SPV’s. The Chinese economy has tripled in size since then which has substantially reduced the percentage of their original proportion of the economy.

SOE’s play a big role in the social care of their workforce and fulfil the function of the welfare system normally handled by government in other countries. Until the services are established by government which is underway, these companies have to carry the burden and cost. Hence this makes many of them unprofitable businesses for those reasons. The banks keep them going and another large sum of NPL’s has accumulated in the process.

The IMF paper states; “Corporate debt is high and increasingly under stress, which is mirrored in banks’ asset quality. Corporate debt is some 160 percent of GDP and continuing to rise quickly. An increasing share of corporates show signs of being at risk, for example, the latest Global Financial 2 Stability Report (GFSR) suggests that corporate loans potentially at risk (ie owed by firms with an interest coverage ratio less than one) amount to 15.5 percent of total commercial banks’ loans to corporates, or $1.3 trillion (12 percent of GDP). This compares with about $1.7 trillion in bank Tier 1 capital (11.3 percent of risk-weighted assets), and $356 billion in reserves. Reported problem bank loans, including “special mention loans,” amount to 5.5 percent of bank corporate and household loans ($641 billion, or 6 percent of GDP), up from 4.4 percent at the end of 2014.”

As you can see the figures are very large and many economists believe the actual figures are much larger threatening the solvency of the banking system. The fact that all the big banks are majority owned by the government makes the possibility of failure remote providing the problem is resolved in the near future. The IMF paper states; “In the last few weeks, some contours of an emerging strategy to deal with banks’ NPLs have emerged. The two main ones seem to be: (1) converting NPLs into equity and (2) securitizing NPLs and selling them. The securitization program is reportedly being piloted by a handful of large banks, instruments can only be sold to institutional (presumably domestic) investors, and the program is reported to be capped at RMB 50bn (a tiny fraction of current NPLs).”

The IMF believes a much larger programme is required but on its own it will not solve the problem. They are proposing that banks adopt strategies experienced in developed countries which have proved successful and improvement in administration, legal process and management. Fortunately, the reserves held by China are large enough to allow the time to implement the proper planning of this process. However, the amount of corporate and government loans cannot increase much more as a proportion of GDP (currently 240%) without a serious problem arising which would eventually have an enormous impact on the world economy with serious consequences.

China has been very successful at manging the rapid growth so far and most economists believe they will get through this NPL and loans to GDP concerns but there is a risk if it is not handled well and reasonably quickly. The IMF keep reducing their forecasts for growth in the world economy making many investors nervous of potential problems arising somewhere in the world. The EU, Brexit and the Emerging Markets are other candidates as well as China making long-term investment planning difficult to predict.

The Chinese economy is set to become the largest in the world over the next fifteen to twenty years and the managing of the progress will become as important as the USA is today. The influence it will have will be very relevant to every aspect of economic activity worldwide making it even more important those excesses caused by the rapid growth are controlled to allow the economy to become more consumer orientated and balanced. It is possible there will be some upsets along the way and they will reverberate around the world, let’s hope they can be managed effectively.

That’s all for this week, more observations next week.