China on the Verge of Major Financial Crisis

Thus summer I wrote Get caught up on Chinese local debt levels and join the bears and The Strictest Audit in History Will Open Local Government's Black Box of Debt

At that time, a strict audit of Chinese local government debt was expected to be completed by the end of October. I linked to one piece that noted the following estimates:
That local government debt totalled 12 trillion by 2012 simply looks too good to be true. Even the auditors themselves won't believe it. Dong Dasheng, deputy minister of the National Audit Office, said in May the latest debt scale for governments at all levels was between 15 to 18 trillion yuan, while Xiang Huaicheng, a former finance minister, said in April China's local governments might have already borrowed more than 20 trillion yuan.

For investors, I noted that the first major audit was completed around the time the Chinese real estate market first cracked in 2011. The second audit was completed this past June, when China's cash crunch emerged and global assets tumbled. The third and most complete audit still hasn't been announced......but there are solid estimates.

Debt doubles at local govt level in 2 years
China's local government debt may have doubled to almost 20 trillion yuan ($3.3 trillion) by the end of 2012 from 2010, a report released by a government think tank showed Monday.

The country's local government debt rose to 19.94 trillion yuan by the end of 2012, a report released by the Chinese Academy of Social Sciences (CASS) showed Monday. An audit into local government debt by the National Audit Office (NAO) showed the figure stood at 10.7 trillion yuan by the end of 2010.
So the bears were right and China's debt levels are at the high end of the estimates, assuming this government think tank has access to some of the latest audit numbers.

Over this period the Chinese economy grew by $2.3 trillion; local government debt alone increased by $1.6 trillion.

The reports downplayed China's total government debt, which is about 53% of GDP, but the threat here isn't a collapse in Chinese government bonds. The threat to the economy comes from a slowdown in credit growth. In 2008, U.S. government debt also was not very high, by the huge private market credit bubble led to an economic depression and a subsequent rise in government debt. China's local government finances are tied to real estate prices and the local economy, which was goosed by local government debt binges.

China Pledges to Tackle Local Government Debt Amid Reform
This year’s goal for GDP growth is 7.5 percent, the same as in 2012. An annual target of 8 percent was in place from 2005 to 2011 and it was 7 percent in 2004. Premier Li said in October that China needs annual expansion of 7.2 percent to keep unemployment stable, after indicating in July his “bottom line” for expansion was 7 percent.

The State Information Center, a government research institute, said China may set next year’s target at 7 percent, the Economic Information Daily reported Dec. 3, citing an annual report from the organization. The state-run Chinese Academy of Social Sciences also believes the goal will be set at 7 percent, the newspaper said.
I will take the under on these estimates, assuming the government is serious about tackling local government debt. If Lie Keqiang's figure is correct, unemployment will go up in 2014.

China Changes Stance on Growth-Hampering Local Government Debt
"The implied scenario here is to first tackle the increment. If the debt stops ballooning, China's debt level will decrease as its GDP grows," Ding added.
Short of some positive growth shock, China will also have a recession. The market is priced for rapid credit growth, which very simply means a lot of debt is Ponzi finance, where the ability to repay is contingent on rising asset prices that are fueled by rising debt. Slow credit growth and asset prices will stop inflating, leading to debt failures and then falling asset prices, more debt failures, etc. In other words, the bust.

China's local governments borrowed heavily to fund their construction and other investments as part of a stimulus in 2008 that was announced to buffer against the global financial crisis.

Officials controlling local governments were competing with each other to launch heavy infrastructure and industrial projects, as they expected faster promotion on the back of high economic growth provided by the projects. They had borrowed aggressively to finance their projects.

Many analysts found the situation to be highly risky, as local government borrowing kept ballooning. Subsequently, the regulators banned banks from directly providing loans to local governments.

Nevertheless, the local governments were able to get loans from the highly-active shadow banking in the country. They used shadow banking products like trust loans and other wealth management products to fund their projects.
Even if the local governments are 100% solvent and make whole on their debts (which is not the case in at least a few cases), the debts themselves are often tied to economic projects that will prove to be malinvestments. Marginally viable investment projects in the private sector that rely on high GDP growth rates financed by local government debt binges will be the first to fail. These failures will hit the high yield trusts offered by banks, which themselves have no deposit insurance whatsoever. What impact that has on the confidence of Chinese investors and savers is unknown, but it won't be good.

Chinese economic conference warns of downturn
A four-day Central Economic Works Conference convened by the Chinese leadership, which concluded on December 13, warned that the world’s second largest economy is facing downward pressure, with industries confronting serious overcapacity, and huge local government debts threatening financial stability.
......According to a Chinese Academy of Social Sciences report yesterday, total government debts reached 28 trillion yuan, or 53 percent of gross domestic product (GDP), in 2012, while non-financial corporate debt totalled 113 percent of GDP—higher than the average levels of 90 percent for the developed economies of the OECD. Moreover, the report identified a huge gap of $US1.24 trillion between net increased assets and GDP, as an indication of “ineffective investment” that accounted for 18.7 percent of GDP, mainly due to large overcapacities built into the economy.
And not a small amount of that corporate debt was money essentially given to Chinese state owned enterprises, since there was very little due diligence. Not a small amount of that founding eventually made its way into real estate projects.

Do Chinese state owned enterprises count as government debt? If so, China's government debt levels could easily surpass those of the United States in the event of a downturn in the economy, assuming the government did not tap its currency reserves. Tapping those reserves, however, would lead to a rapid devaluation in the renminbi.
At a forum last week, central bank governor Zhou Xiaochuan said borrowing costs could rise once interest rate controls were lifted. This could provoke unforeseen financial turmoil. A clear sign came last weekend as banks struggled to meet their short-term financing needs after inter-bank lending rates doubled in just five days. The seven-day repurchase rate soared to a level similar to the last credit shortage in June, when China’s money markets almost froze up.

The danger of a credit crunch in a country awash with credit appears paradoxical. In fact, the banks have made huge loans to real estate companies and local governments, leading to rampant speculation, while those desperate for credit, especially small and medium firms, found it difficult to obtain loans. They turned to the underground bankers who charge extortionate interest rates and in turn borrow from the major banks. As a result, despite unleashing massive amounts of credit, the banking system has repeatedly faced a credit crunch, as financial institutions are deeply suspicious of each other’s large and murky debt exposure. The deregulation of the state banking system will only generate further uncertainty and crises.
That's from the World Socialist Website, where they naturally oppose privatization. They aren't incorrect though; their only mistake is blaming the market reforms for creating the crisis. The crisis has already been created by massive malinvestment due to a centrally planned economy fueled by a partially privatized banking sector. Reform of the banking sector will reveal the truth: China is very short on capital because it has been destroying capital at an epic rate in one of history's largest credit bubbles.

Here are two posts by Ye Tan
失信、欺诈是债务危机根源 (Dishonesty, fraud is the root cause of the debt crisis )
叶檀:信用体制不建立 金融市场化将是庞氏骗局 (Credit System Not Built Financial Market Is A Ponzi Scheme)
On the surface, the local government land, coal, nonferrous metals and other assets pledged, when the economy into a downward cycle, local real estate and private lending chain collapse together, such as land and coal asset prices plummeted synchronization. In fact, asset prices are the result of the release of money, or is the result of economic development, if the government will continue to release a burst of inflation monetary crisis, low investment efficiency if the government led to the damage of wealth, the reputation of the government's credit will be discredited, worthless . When injected large banks listed on the government's credit crisis has occurred, by economic development, development of securities market to solve the problem, but the market did not therefore solve the crux of credit, up to today not unexpected.
Google translate isn't great, but she's talking about how all of China's balance sheet assets are going to collapse along with real estate prices and GDP growth.

Michael Pettis has dubbed this the volatility machine. Revisiting my 2011 predictions
I don’t want to sound in this issue of the newsletter as if I am on a book-peddling mission, but I discuss all of these waves of financing followed by crises in one of my earlier books, The Volatility Machine: Emerging Economies and the Threat of Financial Collapse (Oxford University Press, 2001).

In the first three or four chapters of my book I examine the history of each of these periods, and try to show that it was not just, or even primarily, fundamental changes in the recipient economies that drove economic growth (or the political process of economic reform) but rather that exogenous changes in global liquidity determined the timing of the process. Among other things, I argued, this suggests that in order to predict the performance of individual countries, including the direction and pace of economic reform, it may be at least as important to understand external liquidity conditions as it is to evaluate domestic economic polices – something the much-discussed Fed tapering may be about to remind us again.
In another recent post by Ye Tan, she argues that the taper won't cause a crisis in China, bad debt will be the cause of a crisis. However, tighter liquidity conditions may well be the trigger.

Related news: China city governments may issue municipal bonds
China may allow city governments to issue municipal bonds as early as next March, the state-run China Daily newspaper reported on Tuesday citing unnamed sources.

The Ministry of Finance and the People's Bank of China have been studying a plan which could relieve the debt burden of local governments and provide an engine for China's urbanization plan.

Currently only six local governments are allowed to issue bonds directly. They are provisional governments of Zhejiang, Guangdong, Jiangsu and Shandong as well as city governments of Shanghai and Shenzhen.
Chinese local governments will need to issue municipal bonds in order to bail out their failed investments. There will be a transfer of debt onto the local government's balance sheet.

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