Last June, Goldman made a “surprising” finding when it calculated that China real debt load was far higher than it had represented.
In other words, whether due to using shadow banking strategies to cover the true debt load, or simply because Chinese corporations and the government were not booking all their obligations, China was covering up its true debt load. That strategy worked as long as China was flooding its ponzi debt system with far more debt than we maturing or being otherwise taken out.
However, now that Beijing once again appears intent on breaking China’s leverage addition – at least until overnight repo rates soar to 30% or higher as happened in the summer of 2013 when China tried this exercise for the first time – this is changing, but the real catalyst is China’s recent surge in defaults, a development which the local financial system had not had to deal with until as recently as two years ago, as virtually all defaults were settled privately, and usually involved a government bailout of some nature.
Now, with corporate bankruptcies soaring, we are finally getting first hand evidence that Goldman – and many other skeptics – were right, because as Bloomberg reports, “defaults in China are unearthing hidden debt at companies across the country.”
Think of it as nested debt: big companies, themselves reliant on debt, arbing interest expense by providing loans to smaller companies at higher rates, without declaring said loans, or as Bloomberg puts it, “small firms that can’t get loans by themselves have been winning banks over by getting other companies to guarantee their borrowings. The companies making those pledges exclude them from their balance sheets, leaving creditors in the dark. Borrowers often extend the guarantees for each other, raising the risk that failures could ricochet, at a time when increasing borrowing costs have already added to strains.”
Think of it as rehypothecated debt without an actual assets. This strategy worked as long as China’s regulators were willing to look away, but as we discussed last week, China’s banking regulator has ordered checks of such cross-guaranteed loans, Caixin reported Friday, prompting a sharp tumble in Chinese stocks, which have diverged significantly from the global equity rally.
Some notable examples have already emerged: a corn oil producer in the eastern province of Shandong said last month it had guaranteed debt of a neighboring aluminum product manufacturer which is now stuck in a cash crunch.
As detailed by Bloomberg, “investors dumped corporate bonds issued by borrowers in Zouping County in Shandong after the corn oil producer, Xiwang Group, said on March 29 that it has 2.9 billion yuan ($421.2 million) of outstanding guarantees, the equivalent of 17 percent of equity, for debts of Qixing Group Co.”:
While all this would be fine if the exposure was regularly disclosed, and thus could be quantified, it becomes a problem since almost none of this debt is disclosed and guarantors don’t mark the pledges on their balance sheets; it disclosed, it is only on an annual basis.
Such shadow debts pose rising risks after central bank tightening pushed up onshore corporate bond yields to two-year highs and defaults on local notes surged to a record.
Just days prior to the Xiwang surprise, a local government financing vehicle in China’s southwest had to repay an auto parts maker’s loans it had guaranteed after the latter defaulted.”
A Buried Mine
“Disclosure of such guarantees isn’t timely,” said Qiu Xinhong, a Shenzhen-based money manager at First State Cinda Fund Management Co. “Sometimes, it’s like a buried mine and you don’t know when the risks will explode.”
This debt minefield could be big, Bloomberg wryly observes. The amount of loan guarantees at privately held firms in China is equivalent to 11 percent of their equity, and at LGFVs is 18 percent, according to Citic Securities Co. The load is even heavier at weaker borrowers. About 44 percent of issuers rated lower than AA- have a ratio of more than 30 percent, according to Everbright Securities Co. The phenomenon is less common in the U.S. because banks don’t require such guarantees to offer loans, according Fitch Ratings.
Maybe a better analogy than a buried mine is an explosive butterfly effect: “If companies in the same region offer a huge amount of guarantees for each other’s debt, it would form a guarantee web and deepen interconnections among the companies,” said Gang Meng, director of rating at Golden Credit Rating International Co. in Beijing. “If one company has to repay debt for its guaranteed company, risks would quickly ripple to other companies in the web, which will result in a butterfly effect.”
So, as China scrambles to open up the world’s third-biggest bond market to foreign investors as it appears to be running out of greater fools domestically, the hidden debt is starting to present a challenge for international investors grappling with what bond legend Bill Gross dubbed the “mystery meat of emerging-market countries.” Moody’s Investors Service received more inquiries from global investors about such guarantees following the incident in Zouping, according to Ivan Chung, head of Greater China credit research.
Quoted by Bloomberg, Ivy Thung, head of credit research in Singapore at Nikko Asset Management Asia said that “the cross debt guarantees definitely raise concerns. Disclosure is definitely not in a timely manner and generally companies will not talk about this unless asked.”
Further digging reveals a stunning level of opacity:
China Chengxin International Credit Rating Co. sometimes has to resort to sources other than the company in question to obtain guarantee data.
“When we’ve done on-site due diligence on some rated firms, it was hard to get comprehensive and reliable information about their external guarantees,” said Kong Lingqiang, Beijing-based vice president at China Chengxin. The central bank should allow rating assessors access to the national financial credit system to get the latest information about companies’ pledges for loans, Kong said.
China Bond Rating Co. said guarantors should disclose guarantees in quarterly reports and also release information about the firms for which they provide the biggest pledges
“Cross guarantees for unrelated companies could lead to contagion and even systemic risk,” said Xia Le, Hong Kong-based economist at Banco Bilbao Vizcaya Argentaria SA. “Since the central bank has started tightening, more hidden cross guarantees may emerge.”
To be sure, this won’t be the first time China has seen credit turmoil: in 2012 similar pledges sparked a crisis in the eastern province of Zhejiang during a monetary tightening cycle, prompting 600 companies to ask for the provincial government’s help, according to 21st Century Business Herald at the time. Beijing and the PBOC promptly intervened, the tightening cycle was halted, and since then China has added another roughly 50% in debt to GDP.
“In China, this practice has stemmed from a structural deficiency of the banking system: since private companies have difficulties accessing credits from banks, they need to boost their financial profile by forming complex webs of relationship-based cross guarantees,” said Raymond Yeung, chief greater China economist at Australia & New Zealand Banking Group Ltd. “The toxin will surface when the monetary condition starts to tighten.”
An even simpler way of putting it: as long as the flood of easy money created out of thin air by the central bank keeps coming, the debt ponzi-funded system is viable; however once debt destruction begins via defaults, and is accelerated by tighter monetary conditions, all those who were swimming naked promptly end up the Chinese equivalent of Chapter 11 or 7. The process continues until enough workers lose their jobs to pose a systemic risk. At that point, Beijing has no choice but to step in and restart the process from scratch, unless of course China’s debt stock is so gargantuan that it no longer can. With debt/GDP now north of 300%, that moment is approaching fast.