China – The potential financial meltdown (an extract from GEAB No 95 – May 2015)

China meltdown

Many of the funds advanced and loans issued by Chinese commercial banks and other lenders to the LGFVs are deemed to fail.
(LGFV = local government financing vehicles).

If people start doubting the LGFVs’ credibility, we would see a cascading financial crisis in China, comparable to the 2008 financial crisis in the US, as investors started withdrawing their money from these organizations and the value of their bonds, loans and stocks would crumble. Loans issued by banks are an important part of their assets and their solvability is, in part, determined by the quality of their loan book; if the LGFVs’ credibility collapses, China’s State-owned commercial banks would be severely hit and the result could be a bank crisis.

However, China is a State-led command economy and all State-owned financial institutions, including the People’s Bank of China, are responsible to the CPC which decides on investments and defaults with the Chinese financial authorities taking care of  bad loans to solve the debt problem. There is no political reason why China’s current debt problem should unravel as chaotically as we saw in the US and Europe, it will be resolved according to the CPC’s wishes. China is in the position that it can solve its debt crisis without harming its future ambitions.

Though it’s not yet clear what the upcoming 13th Five-Year plan will contain[1], it’s most likely that it will extend the goals defined in the current one, but it can only be perceived as credible if there is funding for it. It would be pointless introducing a plan that would be impossible to fund due to an ongoing debt crisis, thus the Chinese government will resolve it before 2016.

Our anticipation is that the PBC and China’s financial authorities will do whatever it takes to resolve the problem this year. The latter doesn’t have to invent the tools itself to avert a crisis, it would simply copy the Fed and ECB playbooks.

QE, buying problem assets

The simplest strategy would be a QE programme as we have seen in the US, Japan and Europe, with the PBC buying the loans held by the Chinese commercial banks and the LGFVs, who are paid with freshly printed Yuan, a strategy which will inject the fresh capital needed for the upcoming Five-Year plan into the Chinese financial markets.

The bad loans will literally disappear from the market since the PBC will never force the borrowers to restructure their loans or force them into bankruptcy.It simply doesn’t care as long as the lenders don’t enforce their loans. The PBC can indefinitely maintain that the loans will be fully repaid one day, as does the Fed and the ECB, and whilst we don’t think China will opt for this solution just yet, in the end it will be inevitable.

Extend and pretend

The PBC can also follow the cul-de-sac chosen by the ECB in 2012, by introducing a new type of loan to save the banks, which could take three-year loans from the PBC using their bad loans as collateral. The problem is that, after three years, these loans would have to be repaid and the bad loans used as security, returned to the commercial banks and LGFVs. Ultimately, nothing is solved, it’s a temporary solution and it shouldn’t have surprised anyone that European QE kicked in as soon as the 2012 loan programme (called LTRO[2]) came to an end.

Debt for debt, the bail-out

The most likely scenario that the PBC will follow is a so-called debt-swap, a term which sounds more complex than it is.

It could be done by guaranteeing LGFV debt, since China needs to allow the LGFVs to issue state guaranteed loans, the guarantee provided by the local and regional authorities and its taxpayers. This solution is similar to the 2008-2012 European and US bailout programmes, whose governments produced all sorts of measures to guarantee their banks’ debt; EU and US taxpayers paid for the banks’ losses and are still liable for future losses.

A similar but slightly different alternative would be a direct swap programme: commercial banks and LGFVs exchange the loans they are holding for a state guaranteed loan[3]. Here again, the PBC doesn’t care about fulfillment of the loan obligations.

If China chooses this solution, no new printed money would be injected into the financial system, investors would inject credit into China’s financial system, knowing that it is secured by the Chinese State and its people. As no new printed money would be needed, these would not be viewed as QE programmes and China could maintain its stance that it doesn’t need to print new money to finance its ambitions.

In all these scenarios, the Chinese State and the PBC will have to pay for all the losses – as is also the case for the US and European bailout programmes… (Log in to read the GEAB no 95 or subscribe now )

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[1] Source: China Business Review, 12/02/2015

[2] Source: ECB

[3] Source: South China Morning Post, 21/04/2015