China faces debt crunch as property values fall

One Hong Kong based-hedge fund has accumulated the prospectuses of no fewer than 250 of the trust companies that sit at the heart of the Chinese shadow banking system. These contain virtually no disclosure except on the value of the real estate that backs loans whether committed or proposed.

In some ways, China today resembles Japan in the early to mid-nineties or the US in 2007 to 2008 on the eve of their respective financial crises, both triggered by overvalued property. It is not only that property companies are huge borrowers (in the case of China both domestically and in the offshore US dollar high yield bond market), it is that many other borrowers in China can only take out loans if they have property to serve as collateral.

Now the combination of a weak property market and record leverage among Chinese corporates has become one of the major concerns of investors in both Chinese shares and debt. Rising leverage, much of it involuntary as sales and cash flows weaken across a host of sectors, will at some point lead to rising non-performing loans at both banks and non-banks, limiting their ability to provide credit in future. And in the context of China, nobody knows whether that is even a good or bad thing, given the excess capacity in sectors from cement and coal to ships and steel.

Chinese domestic bank loans were just under 100 per cent of gross domestic product in 2008 but by August of this year, they had swelled to 139 per cent of GDP, growing at a 6.7 per cent rate per year - by far the fastest pace of any emerging market, according to data from David Hensley, an economist with JPMorgan in New York. By comparison, the figure for India is 1.2 per cent per year, or a mere 55.6 per cent of GDP. Add in the non-banks and the figure rises to about 200 per cent of GDP.

Moreover, the ability to repay that debt has deteriorated dramatically. The ratio of debt to operating cash flow for Chinese borrowers was 12 times at the end of 2013, according to boutique GMT Research in Hong Kong.

Meanwhile, interest rates are high. The average lending rate in September was 6.97 per cent, and the real, one-year interest rate is now 4.3 per cent, a five-year record. Moreover, the real burden of debt is becoming heavier because of deflation. Upstream producer prices have been in deflationary territory for 32 months now.

Foreign borrowings are also problematic. Chinese companies have become the largest issuers in the US dollar high yield market, having raised over $180bn in US dollar-denominated debt, according to research from Morgan Stanley.

The position of lower rated Chinese borrowers in sectors including property, mining, and materials is worse today than it was in 2008 as pricing power vanishes.

"Leverage is at an all-time high (7 times) while interest coverage is at an all-time low," these analysts conclude. Indeed, many developers who are seeking funds today are proposing structures that involve repaying their debts with more securities since they lack the means to repay in cash.

Chinese property companies such as Greentown China Holdings or Xinyuan Real Estate account for more than one-third of total outstanding Asian high yield issuance. Much of that leverage is involuntary, as earnings dwindle. Moreover, the burden of repaying foreign debt without foreign revenues is growing since few borrowers anticipated the relative strength of the dollar against the renminbi. Dismayingly, defaults from Chinese corporates closely correspond to the profile of issuers in the market, these analysts add.

It is not clear how Beijing proposes to deal with this mess. It is possible that reforms liberalising the capital account have been put on hold because this is no time to expose corporate China to the volatility involved in opening up. There is also disagreement between the People's Bank of China and the Chinese Banking Regulatory Commission on the best path forward.

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The uncertainty partly explains why China has not cut interest rates, as many economists suggest. Although such cuts would help bullish analysts with their buy recommendations on the introduction of the Shanghai-Hong Kong stock market connect.

At the moment wisdom suggests this is not the best time for bold investors any more than it is for bold bureaucrats.

henny.sender@ft.com

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