2015-10-28

Steel Industry May Finally Be Facing the End; Systemic Financial Crisis Looming?

Four years into a slowdown and Chinese steel mills may finally be forced to adjust.

Bloomberg: China Steel Head Says Demand Slumping at Unprecedented Speed
Demand is collapsing along with prices, banks are tightening lending and losses are stacking up, the deputy head of the China Iron & Steel Association said on Wednesday.

“Production cuts are slower than the contraction in demand, therefore oversupply is worsening,” said Zhu at a quarterly briefing in Beijing by the main producers’ group. “Although China has cut interest rates many times recently, steel mills said their funding costs have actually gone up.”
Many steel mills have mutual credit guarantees. Larger mills may have given credit guarantees to smaller mills or steel traders, who guarantee the debts of other traders. It may only take one or two bankruptcies to set off the daisy chains. Local governments have been good about defusing these bankruptcy risks to this point because losses have been limited is size and geography, but...

Reuters: Sinosteel's debt woes cast doubt on China's SOE reform programme
The prospect of China's state-owned metals trader Sinosteel defaulting on its debt leaves Beijing with a dilemma: stick with its pledge to let market forces operate in its sprawling state sector or step in to save jobs and keep the steel giant afloat.

Don't forget about Hebei Financing Investment Guarantee, the bankrupt state-owned credit guarantee firm.
Yesterday, we learned Hebei's nominal GDP contracted 7.3% in Q3. Not a surprise considering everything that's been going on and the fact that Hebei's economy (as of 2013)
is largely dominated by iron and steel manufacturing, as consolidation in the steel industry continues, this is likely to increase.
This has been a slow motion deflationary wave, with the government preventing a washout deflationary wave at every juncture. Support for industries such as steel has increased the risk, the bailouts created moral hazard, and allowed for a massive increase in debt as firms borrowed to stave off bankruptcy. The government could have solved the problem for a much smaller sum 4 years ago. Now it has far more production to cut, far more debt to write off, and far more interlocking credit guarantees that could serve as path to even wider economic impact than is already coming.

To give an idea of how big of a blow-up may be in front of us, Christopher Balding helps us by Sizing up NPL risk in China:
Let me put these financial costs in perspective.

A sample of most NYSE stocks finds that total interest expense as a percentage of total liabilities was 1.5 per cent with the median firm paying interest expense equal to 2 per cent of liabilities. The 2 per cent interest expense relative to liabilities is extremely common for NYSE listed firms. Walmart for instance, one of the largest listed consumer firms pays 2.1 per cent on interest expense relative to liabilities or the average of all Chinese firms. What makes this interest cost difference between Walmart and Chinese firms unbelievable is that Walmart incurred most liabilities where the official interest rate was 0.25 per cent while the official interest rate in China only recently dropped beneath 5 per cent. In other words, while Walmart was paying eight times the official interest rate on average for liabilities, Chinese firms were paying one-third the official interest rates. Put yet another way, relative to the national interest rate, US firms are paying twenty-four times more interest expenses than Chinese firms.
The article provides details for where these calculations come from. Chinese firms and banks don't want to default and have NPLs, so they find many ways to structure deals and give grace periods that put American-style "extend and pretend" to shame.

Balding also points to this: China Minsheng Bank reorganises loan ops as systemic risks seen rising
China Minsheng Banking Corp , the country's biggest private lender by assets, warned on Thursday of growing systemic risks in its home market and said it was reorganising its loan operations after suffering a sharp rise in bad debts.

Minsheng Bank's profit growth and business operations are facing "the biggest pressure in recent years," said Assistant President Shi Jie, responsible for the bank's credit assessment department, at a press conference on Thursday.

"The possibility for systemic, concentrated financial risk to happen in China is growing ... Next year Minsheng Bank will face an even worse environment and bigger challenges," Shi said.
There have been some big system crises locally due to credit guarantees, such as Xiaoshan last year: Rumored Mass Death of Companies in Xiaoshan District of Hangzhou If Banks Collect on Debts; Government Tells Banks to Sit Tight or Leave. China doesn't need a systemic financial crisis in the banking system to have a systemic crisis. Local economies are tied together by mutual credit guarantees. The failure of a major steel producer could set off systemic financial crises in multiple localities due to the triggering of credit guarantees. A city bank could go from a low NPL ratio to a massive NPL ratio seemingly overnight if the local government can't contain the problem and the mutual credit guarantees all blow up at once.

In the U.S., you'd expect some construction firms or auto dealers to default on their loans if the North Dakota shale oil producers go bust and take down the local economy. In China, instead of this taking months or even a year or more, everybody goes "bust" at once because the shale oil firm may have guaranteed loans to the construction firm, and the construction firm to the auto dealer. Everyone is immediately embroiled in a a financial crisis even if their core business is solid and their own debts are serviceable. Even if things don't blow up economically, it will be a total nightmare for the courts and banks for years to come as they try to sort out who owes what to whom.

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