China Can't Go On Like This

The Economist: The coming debt bust

Its debt-to-GDP ratio has soared from 150% to nearly 260% over a decade, the kind of surge that is usually followed by a financial bust or an abrupt slowdown.

China will not be an exception to that rule. Problem loans have doubled in two years and, officially, are already 5.5% of banks’ total lending. The reality is grimmer. Roughly two-fifths of new debt is swallowed by interest on existing loans; in 2014, 16% of the 1,000 biggest Chinese firms owed more in interest than they earned before tax. China requires more and more credit to generate less and less growth: it now takes nearly four yuan of new borrowing to generate one yuan of additional GDP, up from just over one yuan of credit before the financial crisis.

Steve Keen published a simple excel sheet showing how Australia will have a recession if credit growth slows. Get ready for an Australian recession by 2017

Under the model, the debt-to-GDP ratio has to keep rising, and keep rising at a healthy clip if a debt crisis is to be avoided. If China increases credit growth to lift the economy, then it can't reduce the credit growth in the future. A slowdown will happen as soon as the credit growth slows. Distressed and defaulting borrowers restrains credit growth and the big reversals in credit over the past 18 months have created a stock market bubble, a bond bubble, a housing bubble and a commodities bubble. None of those are efficient allocations of capital. Debt defaults are already quietly piling up, but adding more bad debt will only increase the expected slowdown as defaults accelerate a credit slowdown.

The slowdown in M2 is cyclical on the calendar and there's clear downtrend over time. Eventually, credit growth will fall below the economic stall speed without a pickup in real GDP growth. Should credit growth accelerate out of trend and capital outflows continue, the currency market will react swiftly.

Meanwhile, China Opens Taps to Policy Banks in Bid to Sharpen Stimulus

China’s central bank is turning on the credit taps to its policy banks as it seeks to support the economy by channeling credit to designated areas of the government’s choosing.

The Pledged Supplementary Lending program used to fund its three policy banks for investment in areas such as shantytown development will now be allocated at the start of each month, the People’s Bank of China said late Tuesday. In the past, policy banks needed to seek roll overs from the central bank each month, imposing a form of lending restraint in case such funds weren’t forthcoming.

"The pledge shows the PBOC is determined to support credit expansion to stabilize economic growth," said Ming Ming, head of fixed income research at Citic Securities Co. in Beijing, who previously worked in the central bank’s monetary policy division. "It’s reassuring as the market is expecting a slowdown in loan growth in April."

And yet: Shadow Lending Crackdown Seen Forcing China Banks to Sell Bonds

New rules require lenders to make full provisions for loan rights they have transferred to other financial institutions, people familiar with the matter said last week. Banks will need to raise up to 1 trillion yuan ($154 billion) in capital over a number of years if the rules are applied to their total shadow lending exposure of about 12 trillion yuan, according to estimates from Sanford C. Bernstein & Co.

The great balancing act continues.

Update: The biggest problem with China’s latest credit boom, charted

The result of these clashing factors is exactly what we observe: On the one hand, the banking sector has been pushing out new lending aggressively, partly reflecting the government’s will to support growth, and partly driven by the needs to leverage up to offset narrowed profit margin and maintain returns. On the other side, many borrowers are reluctant to invest the credit from banks into real economy. Rather, they try to seek financial investment opportunities. With real returns coming down and the amount of financial assets chasing those returns going up, it should not be surprising if they turn to financial leverage to boost returns.