Musings on Chinese Debt Concerns

The Financial Times at Alphaville has a great piece on how recent policy changes surrounding the nascent provincial bond market are being interpreted covering a range of thinking, even if I am labeled the resident crank a role I accept with relish.  They do raise some very valid issues which deserve attention.

Anything Deutsche Bank says about China should be read skeptically as it acts as little more than a public relations arm and recruiting ground for the PBOC.  However, more specifically, DB makes two illogical arguments about Chinese debt and the economy.  First, it argues that the slowdown in the Chinese economy is attributable flat government spending.  Considering DB was overestimating Chinese growth by more than 1-2% recently, the fact they even say slowdown is remarkable.  Second, DB believes that even more provincial led investment through additional debt, either by LGFV or bond sales, will continue to drive the Chinese economy.

Even mathematically it is difficult to reconcile the DB claims.  LGFV investment, which is responsible for 20% of the national total according to DB, has contracted so enormously to cause the national slowdown.  With  YOY fiscal spending, again according to DB, essentially flat at -0.2% it is difficult to see how this would cause the national slowdown when it was up only 6% last year.

Additionally, the flat spending conveniently overlooks the fact that local government revenue is falling.  Nationally land revenue to local governments is down 30% and given that on average about 50% of government revenue comes from land sales, this significantly impacts spending ability.  This tracks with something else in the FT piece that estimated growth, by one calculation 5.3%, is significantly lower than official estimates.  Finally, provincial borrowing is only implicitly allowed for LGFV and not operational spending of governments.  Lending guidelines should have minimal impact, according to Chinese law, on general spending.

If Deutsche Bank research economists believe this is such good policy and the financial risks are low, then may I suggest using DB capital to purchase some of the newly issued provincial bonds?

There are two larger points however that are somewhat acknowledged.  First, in China there is an enormous difference between lip service to addressing a problem and enduring the pain (structural reform) required to addressing a problem.   As GaveKal rightly notes about the nascent bond market, “opening the front door and closing the back door”  was intended to introduce transparent financing and market risk to local government debt.  However, what we have witnessed has been the complete opposite of this.  Banks being ordered to continue lending leaves the back door wide open.  The price on the bonds is not commensurate with the risk, which is why the bankers held out so long.  There is no transparency on the financing as it is all private placement offerings.  Then the PBOC is essentially buying any debt the banks decide not to hold.

Economically this means asset prices need to decline and surplus capacity needs to be reduced.  Given Beijing tacit encouragement of the stock and housing market, it appears they have little interest in reigning in asset prices.  The drive to encourage more infrastructure investment and lending to favored companies or SOE’s indicates they have little interest in addressing the capacity issue.  The rising asset prices and declining producer prices, and the policies driving these trends, will only create additional problems later on.  The fundamental take away here is that there remains an enormous gulf between the press releases and the actions.  The policy itself is fundamentally sound but if there is never an adherence to the policy and the restructuring involved, it is worthless.

Second, there remains no plan to address these problems.  The entire plan, and the only reason the banks are not in outright revolt, is that the PBOC is allowing the banks to use the bonds as collateral to prompt further lending to favored industries and firms.  This isn’t addressing the problem, this is doubling down on the strategy that created the problems in the first place.  Citi, in the FT piece, addresses the issue quite delicately writing that “…if there is no efficiency gain in coming years, some local governments may become insolvent….”.  GaveKal notes the lack of a strategy writing “Beijing will not admit there is a big solvency problem and cut lending to entities who have trouble.  Instead Beijing wants banks to keep lending in the hope that one day the borrowers may get better.”

As I have noted, Chinese banks were able to outgrow some of the bad debt problems a decade ago, however, hoping for the same a second time is an incredibly risky proposition.  As of yet, there has been no plan even floated to reduce the debt burden or impose the type of discipline required to delever.  In fact, it has been just the opposite.  The plan so far has been to increase lending and investment even more and hope that things work themselves out.

In closing, I want to make two final points.  First, I should note that the PBOC and CBRC by forcing the debt restructure have used standard strategies with distressed borrowers whether they be firms or governments.  They are to be commended for taking decisive action.  However, the very real concern is that they won’t take the necessary follow up steps.  Think of a patient that undergoes heart surgery to prevent a heart attack but returns to  a diet of sweets and red meat with no exercise.  The surgery prevented a heart attack but only put off the reckoning without real changes.

Second, I think a financial crisis scenario is much less likely than a zombie scenario.  I have heard from some that I am predicting a financial crisis and I want to make clear that is not what I am predicting for many reasons.  From the political risks Beijing sees in a financial crisis to the willingness to bailout everyone by Chinese policy makers, I believe a financial crisis is not the most likely scenario.  High debt levels with ongoing problems for many parts of the economy is the bigger problem.

The Chinese Bailout is Starting to Bail Fast

After the PBOC and CBRC announced a unilateral change in debt policy that allowed indebted Chinese provinces to swap their high interest short term debt for long term low interest bonds which banks would then present to the PBOC as collateral for cash to use for additional lending, it seemed like the forced restructuring would ease the pressure on local governments for a while.

However, Friday night the Chinese central government through the Ministry of Finance, along with the PBOC and CBRC, jointly announced a policy intended to further aid local governments.  In the words of the Financial Times, the regulation:

“…told financial institutions to keep lending to local government projects even if borrowers are unable to make principal or interest payments on existing loans….(the regulation) explicitly banned financial institutions from cutting off or delaying funding to any local government projects started before the end of last year and said that any projects that are unable to repay existing loans should have their debt renegotiated and extended.”

Let me say that again just so it sinks in: banks were told to keep lending money even if the borrowers are unable to make principal or interest payments on existing loans and banks are forbidden from cutting, denying, or delaying loans.  While country policy makers around the world have unofficially encouraged excessively loose credit policies and lenders may take such policies in individual cases, I have never heard of a similar countrywide or bank wide policy anywhere.  (If anyone knows of a comparable case please let me know).

Though they are mostly speculative, there are many inferences that can be drawn from this latest announcement.

  1. The local government debt problems surrounding the $3.5 trillion USD are much more widespread and profound than is currently recognized by people outside the Chinese government, the banks, PBOC and CBRC. For comparison sake, imagine Barack Obama and Janet Yellen announcing a similar policy for all local governments and banks in the United States.  If the bad debt was limited to even a handful of provinces or loan types, we would not be seeing these types of policies.
  2. The bankers must really be resisting the new policies. For the last month as news began to trickle out about this policy shift,  we saw how the bankers didn’t want to buy the new bonds, didn’t like the pricing, the duration, and now the regulation tells them to keep lending even current borrowers are unable to service existing debt.  This can only be interpreted as a public and strict ordering of bankers to walk the line set by government.
  3. If debt problems were more limited and bankers were complying this policy would never have been made public in China.
  4. If the bankers are telling you what they think of the debt problems in China by resisting even the early forced restructuring, what is the government telling you by announcing ability to service debt is not a requirement for more lending and forcing banks to lend?  Given the information asymmetries in Chinese financial markets, it helps to judge how those that should know behave.  This policy appears extremely desperate by the government indicating their level of concern.
  5. 7% GDP growth and 1% non-performing loan ratios are both figments of a CCP statisticians imagination. Even in a world where an NPL is only counted after a firm is bankrupt and non-operational for a year, the GDP and NPL numbers are simply fairy tales.
  6. China through a combination of policy and luck grew its way out of the last bad loan build a little more than a decade ago. There are banks that still carry the bad loans from a decade ago and some very large companies have been started out of these assets.  However, even without a significant growth slowdown much less what even the Chinese government touts as “the new normal”, it will be extremely difficult to replicate the debt swallowing growth of the previous decade.  China cannot count on outgrowing its debts again.
  7. Beijing and Shanghai do not represent China. Declaring the health of the Chinese economy based upon trips to these two cities is like visiting New York City and Washington DC and saying the economy looks great.  It is also worth noting that Beijing and Shanghai are two of the most indebted subnational provinces in all of China.
  8. Expect to see a significant portion of the bad debt end up at the PBOC with no recourse back to the bank if the debt goes bad. The PBOC printed enormous amounts of money to keep the exchange rate low and the money supply rising in the past decade.  Their new strategy seems to be to print money to lend out via low credit quality collateral.
  9. The private sector is being forced to bail out the government.
  10. I wonder what bank shareholders will think about their capital being forced to be lent without an obvious path to repayment. No wonder the market was pricing in bad news during the recent stock market runup.
  11. China remains an economy completely dominated by the state. As one economist who argued that the true state share of the Chinese economy was closer to 80% of GDP, just because it is a listed company does not mean it is a private company.  With the exception of Alibaba, there is virtually no major Chinese company where the state does not have, frequently through Cayman shell corps in true capitalist fashion, a major holding in most every company.  Banks as extensions of the state are following the orders of their major shareholders.
  12. While I would definitely be categorized as someone who has significant concern about the risks in the Chinese economy, and I respect many economists who are more sanguine about these risks, at this point I struggle to understand how anyone can see these signals from the Chinese government and not be very concerned about the buildup of financial risk.

I hope I am wrong about what I see as the financial risks as signaled by the Chinese government are extremely large.

The Giant Debt Restructure

Let’s run a simple thought experiment.  Assume a government is drowning in debt.  They can’t raise the money to pay off the debt coming due.  The interest rates are too high and the maturities too short.  Revenues are falling and the banks are reluctant to continue extending credit to the government.  The situation looks dim.

The government and central bank, however, come up with an idea to solve the problem.  The government imposes a debt swap on the banks where they unilaterally turn short term high interest debt into low interest long term debt.  Though there is no write down in the face value of the debt, there would be a reasonable case given the coercion and change of terms, to ask whether this was a debt default.  There has been no change in asset or borrower quality but rather a unilateral rewriting of the debt contract using coercion.  Not wanting to miss out, the central bank offers to accept this troubled debt as collateral should the banks want cash instead, effectively monetizing the bad debt.

This scenario isn’t about Greece but about the debt swap imposed by the Chinese government in partnership with the PBOC on lenders holding local government debt.  While no one is saying this is a default, if this same scenario played out in Greece, there would be arguments over whether this constituted a default.  Furthermore, less anyone forget the magnitude of debt, the debt swap constituted only about $160 billion of the estimated $3 trillion.  To put this in comparison, this is a similar absolute number as is being discussed in Greece and still only about 5% of publicly acknowledged local government debt.

There are a number of important points to note about the overall debt swap.  First, the bankers are going along with this not because they think it’s a good deal but because Beijing is threatening them and the PBOC is buying them off.  As with most countries, if the central government tells you to do something you do it.  If the central bank essentially offers to take some risky debt off your hands at face value, you accept and don’t look back.

Second, the bankers are telling you a lot about what they think of the state of local government finances in China.  They wanted nothing to do with refinancing the debt and definitely not at the prices being offered.  Given their knowledge of debt repayment capacity of their clients, this tells us a lot about the state of local government finances.  Especially with land revenue falling by more than 30% annually when it typically constitutes more than 50% of government revenue, the provinces ability to repay is highly suspect.

Third, Beijing did not ask nicely but rather imposed regulations about the interest rate tying it closely to the central government cost of funds.  The interest rate on the debt will drop from typically above 7% to about 3.5% with maturities moved from 1-3 year to at least 5.  The PBOC accepting bonds that the banks can’t wait to unload should also call into question the prudence of accepting such widely acknowledged low credit quality instruments.  It seems unlikely that the PBOC would try to collect capital from banks if the underlying borrower defaults, essentially turning the PBOC into a bad debt asset manager.  This could the Chinese method of tapping the PBOC balance sheet by swallowing bad debts.

Fourth, the banks, after getting cash for the bonds as collateral from the PBOC, are being encouraged to lend out this cash to firms in favored industries.  Given the drop in risk weighted capital from holding government bonds as an additional benefit, this means that banks will have significant new capital to lend.  The rapid rise in Chinese debt, which has even officially surpassed most developed countries, seems bound to rise even more.  I can’t help but think that this seems like trying to sober up an alcoholic by buying him a beer.

While this certainly heads off larger financial problems in the near term, it seems at best designed to put off dealing with the problems and at worst exacerbating the credit bubble.  Most China watchers have been focused on debating whether the PBOC is running QE with Chinese characteristics, but missed the importance of the debt restructuring.

Here is hoping that deposit insurance will never be needed.

Reading Between the Financial Tea Leaves

The big news in Chinese financial markets is that the local government bond offerings designed to refinance off-balance sheet high interest short term borrowing into market based low interest long term products have hit a snag.

Chinese banks are refusing to buy local government bonds at the price on offer.  As the Financial Times noted, the trouble with market based financing is that it doesn’t always do what you want it to do.

There are a number of important issues however, that are largely being overlooked.  First, despite all the sooth saying of Chinese and international pundits that the government is not debt burdened, that is really only partially true.  While the Chinese central government has a relatively low debt load, the real burden is held by the provinces.  Seven provinces have debt to GDP ratios above 80% with Beijing coming in at 100%.  According to the FT, Standard and Poors estimated that half of all Chinese provinces would receive a junk rating.  Just because the official national government debt load is low, doesn’t mean government debt is low.

Second, from the banks perspective, the bond program makes no sense.  Let’s take a simple scenario of what the banks are being asked to do.  The bank has a loan that is paying probably 6-10% (as it is an off-balance sheet project with only implicit government support) with a 1-3 year duration.  They are being told to transform that into a bond with a 5 year duration paying 3.6-4%.  This is a losing proposition for the bank.

Third, there is a major information asymmetry involved between China financial analysts and banks.  Chinese banks which are being asked to purchase the bonds from the same underlying borrower with the same underlying asset as existing loans, presumably have much more information than anything a journalist or professor has access to.  Their level of reluctance reveals their concern about the debt quality from largely existing assets.

Fourth, despite some arguing this represents normal financial development, this quite potentially represents something much more ominous.  During the Greece debt crisis that continues to drag on, a key question has been whether a forced duration extension and lower interest on original debt qualifies as a default.  For some the important question here focuses on the level of coercion involved in exchanging liabilities with the same underlying borrower.  The key point here is that there appears to be a fair amount of coercion involved to force banks to renegotiate existing debts from short term high interest into long term and low interest.  The Financial Times sums it up perfectly quoting one analyst saying  “This isn’t really about adding liquidity.  It’s aimed at alleviating debt pressures on local governments and reducing financial risks.”  If we changed the names from Chinese provinces to Greece, we would be discussing whether this constitutes a default.

Fifth, as I have noted, the Chinese response worryingly seems to be to try and sober up a drunk with more Baiju.  The Financial Times writes “China’s central bank is considering extraordinary measures to boost credit flows to heavily indebted local governments…”.  Reuters writes “China’s Ministry of Finance has warned of slowing tax revenue growth and told local authorities to hasten issuance of newly-approved municipal bond debt.”  China’s problem is not lack of credit but firms and provinces with unsustainable debt loads.  This explains the push into long term low interest bonds.

Taken in isolation, this might be seen as standard growing pains.  However, the recapitalization of policy banks, recent defaults, and semi-coerced refinancing paint a grim picture of Chinese finances.

Looking Back at Chinese Finances

The Chinese economy is entering an interesting state.  Producer prices are falling relatively rapidly due to lack of external demand and a supply glut with producer output falling moderately.  A major real estate developer defaulted this past week (though this more likely owes to corruption scandals than financial problems though no one is quite sure) and maybe the biggest news of all a Chinese SOE with a mainland bond defaulted.  Add in the 1% cut in the RRR by the PBOC and while Beijing may not be pushing the panic button but they appear to be making sure it is working properly.

The Chinese economy is under an enormous amount of stress and there are no easy answers.  There are a number of problems.  First, banks and bond markets have tilted heavily to short term lending.  This means that the amount that has to continually be either repaid or rolled over is high.  According to the Asian Development Bank, nearly 60% of corporate bonds are under 5 years with large amounts falling due within the next two years.  Banks have shortened maturity periods with some banks having more than 65% in lending under 1 year.  While it may give some comfort that relatively little external finance exists in China, it should cause high levels of concern over the significantly shortened maturities.

Second, despite the self congratulations be handed out that China has significant scope ease monetarily, this over estimates the economies ability to absorb additional stimulus.  Many industries in China already suffer from surplus capacity,  infrastructure white elephants litter the country, and major firms with access to credit are already over levered (PDF).  Easing monetary conditions is right out of the Macroeconomic I textbook but here it is like trying to sober up a drunk by buying him a beer.

Third, there is very little appreciation for just how fragile Chinese banks are and how poor their history of lending has been.  I have a forthcoming paper in the Journal of Financial Perspectives which details some of the problems.  From banks that only list a loan as doubtful until after the borrower has declared bankruptcy, ceased operations, and been out of business for at least one year to banks that declare losing loan paperwork as a risk to being repaid, there is little appreciation for their perilous state.  Bad loan numbers are, even while amazingly generous in the definition, spiking rapidly and expected to climb.  China has also started recapitalizing policy banks this past week by converting existing loans into equity.  While the official reason is to boost investment in the Silk Road projects, given the conversion of method of existing loans and in the very unknown projects well off in the future, I remain skeptical towards the official reasons.

There are very real risks to the Chinese economy and financial sector and there should be a lot of attention paid to those risks as repayments come due.

Chinese Foreign Exchange Movements

Concern has been raised over the deterioration of the Chinese economy even though growth is officially only set to slow by a few tenths of a percentage point.  The signals coming from Beijing indicate a greater level of worry than the shift from 7.4% to 7%, officially speaking of course.

As I have noted in other writings, despite its reputation as prudent money manager, China and the PBOC have overseen one of the fastest expansions of the money supply in the world in the past decade. Excluding countries suffering from serious or hyper inflation, even after controlling for real economic growth, China has witnessed one of the highest rates of growth in money supply in the world.

According to State Administration of Foreign Exchange (SAFE) data, net purchases of foreign exchange averaged nearly $300 billion USD annually since 2001.  As recently as 2013, total net purchases of FX in USD terms equaled nearly $400 billion USD.  However, since peaking in late 2013 early 2014, net foreign exchange purchases have deteriorated rapidly on both a monthly and annual basis.

There are a number of interesting conclusions to draw from all this.  First, monthly net foreign exchange purchases as recorded by SAFE have not witnessed such a sustained period of net sales (outflows) since January 2001.  There was a brief period in the middle of 2012 when net monthly purchases turned briefly negative during a couple months.  However, it was smaller, inconsistent, and shorter in duration.  Net monthly purchases are prone to relative volatility, but the overall trend and size are important to note.

Second, if we consider annual purchases on a rolling basis, there is a brief period in late 2012 when the net annual FX purchases by SAFE drop beneath $100 billion.  However, as was noted with the annual purchases, this trend quickly reversed and by February 2013 rolling 12 month purchases were back up above $200 billion USD.

Third, if we consider annual purchases around fixed dates either after Chinese or calendar years, to adjust for potential seasonal issues, we see clearly the magnitude and speed of the change.  2002 was the last calendar year China had net FX purchases under $100 billion USD with a similar result if we adjust the calendar to account for Chinese New Year differences.  From March 2013 through February 2014, China enjoyed net FX purchases of $387 billion USD.  From March 2014 through February 2015, China saw net FX purchases of just $12.6 billion USD a decline of 97%.

Fourth, if we focus on FX purchases since January 2009, the pattern indicates that since about late 2012, gross purchases have grown more slowly while gross sales have continued to grow rapidly.  The net result is that net purchases have declined dramatically.  In July 2010, gross purchases of FX by Chinese banks reached a new monthly high of $114 billion USD.  In February 2015, the latest month with available data, gross purchases totaled $115.6 billion USD.  Conversely, gross sales in the same months grew from $88 billion USD to $126 billion USD.  In other words, while inflows into China have essentially gone flat, outflows have continued on trend.

Fifth, while China is in no danger of a run on the currency or exhausting its FX reserves this does appear to portend a much broader and severe slow down in the Chinese economy.  If gross purchases are essentially flat, this means that both investment in China and Chinese exports are not growing or tepidly.  Given the concern expressed by foreign companies in China over the capricious regulatory environment, anti-foreigner sentiment, and costs, to name just a few worries, this appears to be hitting inflows.

Though too soon to tell if it is a longer term trend, this does appear to be a longer trend than the 2012 phase.  It does however appear to signal much greater weakness in the overall Chinese economy.

China Notes for March 31

China with the diplomatic coup of the Asian Infrastructure Investment Bank appears on a hot streak.  However, the economic and financial problems appear bigger and bigger everyday.

Hainan has admitted to major debt problems.  Haikou, the capital of Hainan, estimates total revenue of 21b rmb with 15b rmb of debt maturing this year.

The McKinsey Global Institute notes that total Chinese debt is 282% of GDP while the debt laden Americans and Germans come in at a more frugal 269% and 258% respectively.  With credit growth continuing to expand rapidly and a loosening of requirements for second homes, there is little evidence of deleveraging.

Now China seems intent on exporting its problems.  The enormous glut of Chinese steel with iron ore prices a long term lows, has prompted some Chinese steel makers to export surplus capacity abroad with scant evidence of demand of size.  Even crazier is that the Chinese government seems intent on supporting this strategy with various forms of financial capital.

Three quick economics lessons for China.  First, if there is surplus capacity globally, moving that surplus capacity from one country to another still leaves surplus capacity.  Second, Chinese subsidies to move loss making Chinese steel producers abroad subsidizes foreign consumers.  Third, steel and iron ore are global commodities.  Chinese steel producers producing in foreign countries still have to compete in a global market.  If the market price is below their break even, they still lose money and the foreign country can buy on the world market.

It seems destined to get worse before it gets better.

China: Be Careful What You Wish for About the AIIB

Diplomatic circles have been have been fluttering with intrigue over which countries would join the Asian Infrastructure Investment Bank as founding members.  The United States has been leaning on allies to refrain for what it claims are environmental and financial governance standards though geopolitics is undoubtedly the driving reason.  The Obama Administration has been as successful in convincing allies not to join as they were in convincing the world Yemen was a success for US foreign policy.  US foreign policy on the AIIB appears small minded and working very hard to defend an incredibly weak position.

Little thought however, has been given to the other side of the equation: the role of China at the AIIB.  To China may I caution: be careful what you wish for.

The Chinese creation of the AIIB is designed to extend both its hard power via financial capital and its soft power via its influence and institutional leadership.  However, in neither case does China have a positive track record of success to build upon.

As has increasingly been noted, China went on a enormous lending spree to other emerging markets over the past few years.  This was done in an effort to both secure access to commodities and gain influence.  The result of this financial largesse is a wave of impending defaults, write downs, or restructuring.  Nor are domestic Chinese banks exactly a model of prudent lending.  In other words, the Chinese record of state sponsored lending leaves something to be desired.

However, Chinese interest in the AIIB is driven as much soft power influence building as hard power.  The Chinese record isn’t much better here.  Whether it is their constant drum beat of xenophobic saber rattling aimed at Japan or its south China Sea neighbors, the current Chinese government has little understanding of or ability to exercise soft power influence.  The minister of education railing against the threatening influence of western values fails to demonstrate any understanding of the concept of soft power.

The New Zealand Prime Minister has already stated their desire to influence bank policy and it is likely other founding members like the environmentally conscious Danes are going to seek similar input.  Critiques of US influence at the World Bank overlook its relatively minimal 15% shareholding, compared to the 50% holding of China in the AIIB.   This has the potential to create soft power diplomatic headaches for many years for Chinese bankers and diplomats.  Other countries, especially developed and democratic countries, do not respond well to rule by fear.

Given the Chinese inability to project hard or soft power: be careful what you wish for.

S&P Looks at Temasek Part II

The S&P criteria for evaluating investment holding companies (IHC’s) has the potential to move Temasek from a AAA rated credit firm to Greece as the headlines have noted.  While this headline does accurately capture the potential impact, too many have focused on the outcome and a misreading of the its implication and not enough effort focusing on how the proposed methodology arrives at the new rating.  In fact, the potential outcome of the S&P proposal rests on much more technical reasons than a sudden belief that Temasek is a low credit quality firm.

The biggest proposed change is the importance S&P gives to liquidity in their risk assessment of IHC’s noting that “we propose to give a greater weight to our assessment of asset liquidity than to our assessments of asset diversity and asset credit quality.”   S&P stresses the importance of liquidity “…because the ability to sell assets quickly is the ultimate source of debt repayment if an IHC cannot refinance maturing debt.  Our assessment reflects how quickly we expect the entity can liquidate assets at a reasonable price.”

There are solid financial reasons, especially for a firm like Temasek, to accept higher liquidity risk by holding lower liquidity assets.  Studies have found that asset liquidity is valued so that financial firms, such as hedge funds, willing to hold lower liquidity assets receive a premium for bearing that risk.  University endowments have targeted lower liquidity investments given longer investment time horizons and the ability to sell at their discretion.

The second major proposal is to use “spot prices” rather than some “average price over n trading days – to value listed assets.”  Related to but also distinctly different from liquidity, this focuses on what price could assets be sold to cover debt payments.  This debate has raged for how banks should value their loan portfolios in what is typically called “mark to market” by valuing a bond or loan at the market price the bank could expect to sell it at or at some other less potentially volatile rate such as a long term average or expected stream of cash flow basis.

There is reasonable and straightforward logic as to why spot prices should not be used.  Let’s use a simple scenario to illustrate why.  Assume the market price of an asset declines and a financial institution reaches a level where they have to sell the asset to cover their debt payment.  When they sell an asset this further depresses the market price potentially causing other firms to be forced to sell.  It is also possible to recreate this scenario in reverse when prices are going up.  Fundamentally, there is a solid argument that using market prices can increase volatility.  It should be strongly emphasized that reasonable people have reasonable disagreements on this very tricky issue.

While these two concepts need to be considered separately, they also need to be considered jointly.   S&P is proposing that we ask the following about credit risk as it pertains to IHC’s: if an IHC needs to sell assets to repay a debt, how easily can it sell its financial assets and at what price?

How do these concepts apply to Temasek specifically?  Temasek can reasonably be considered a somewhat less liquid IHC for two reasons.  First, Temasek asset holdings are relatively concentrated.  Temasek holdings are concentrated with significant stakes in key firms like Singapore Telecom, DBS, Standard and Chartered, and China Construction Bank.  As one article noted, approximately 50% of Temasek assets are concentrated in ten firms.  If Temasek needed to sell some of these stakes, given the large size of the holdings, this would reduce the liquidity by pushing down the price if Temasek needed to sell a significant amount or if the market found out Temasek was selling a sizable block.  Also, if Temasek ever needed to sell its entire stake in a major holding, this would significantly reduce companies with the ability to finance large acquisitions.

Compare this to Norges Bank Investment Management (NBIM) which manages the Norwegian sovereign wealth fund.  They have limited themselves to 2% of outstanding equity of any company they hold.  While this essentially turns them into an index fund as they hold 1-2% of most every listed company, this also means that they remain very liquid.  NBIM is able to easily sell stakes in entire companies in relatively short periods of time or in many companies when needed.  In short, there is elevated liquidity risk due to the concentration of Temasek’s portfolio.

Second, there is what I will term political liquidity risk.  Look at the major holdings in Temasek’s portfolio and you will see politically strategic firms like Singapore Telecom, DBS, and Singapore Airlines.  Those are for all practical purposes completely illiquid investments where Temasek depends on dividend cash flow for debt repayment.  Removing firms from the Temasek portfolio that are for all practical purposes illiquid, reduces Temasek liquidity to cover debt repayment even further.  The S&P concern over liquidity risk has a significant impact when focusing on Temasek.

Turning to the question of what price Temasek might be able to secure for its assets under different market conditions returns us to the issue of asset concentration and political risk.  Not only is the Temasek portfolio concentrated within its portfolio, it is concentrated by industry and geography with an increasing allocation to higher risk assets like financial and natural resource firms.  For example, three of the top four holdings are in financial firms and Temasek remains closely linked to Singapore and surrounding countries.  This implies a high degree of correlation among their holdings.  If the market is declining, then Temasek would need to price any significant asset sale at an even larger discount.  Conversely, in a rising market Temasek might be able to extract a sizable premium for one of its strategic stakes.  However, given the concern about debt coverage from asset sales, we should focus on down markets and again there is cause for concern.  There would be significant pricing pressures on any significant asset sales by Temasek.

There would also be pricing pressure due to potential political risk.  Let’s assume for one moment that Temasek decides to sell a significant stake Singapore Telecom, DBS, or Singapore Airlines.  Given the long historical record, key personnel through each firm, and political significance, any buyer would be enormously concerned about undue influence exercised after the sale.  The same could also be said about most Asian holdings for instance in China Construction Bank or Bank of China.  The Chinese government would most likely have a strong opinion about Temasek selling its holding to anyone else.  Political risk is likely to impact the final sales price and not positively.

The primary risks the S&P is proposing to increase in its credit model for IHC’s are the ability to sell and the price it will receive for selling.  I believe there is a fair and reasonable case to be made that when Temasek is narrowly analyzed against these two criteria, it does have an elevated risk level.  There is good reason to have some concern over liquidity and asset pricing risk should it need to sell assets to cover debt repayment.

As noted at the beginning of this article, while the S&P frameworks does raise the risk profile of Temasek, it is important to note the reasons why.  Their reasoning focus on specific and technical issues and not due to a new belief in the underlying quality of Temasek assets.

Note:  Part III will cover the Temasek response, whether they should be considered as risky as Greece, and other bigger picture issues.

S&P Looks at Temasek and Sovereign Wealth Funds Part I

Somehow I missed the November release of the credit ratings agency S&P asking for comments on its proposal for updating standards of investment holding companies (IHC) and government related entities (GRE).  This is both a somewhat technical exercise and discussion by credit ratings agencies that takes place to reassess their standards for evaluating credit risk but also has very tangible impact on Singaporeans and can be explained in ways that make sense.

Before beginning to analyze the proposed S&P standards and Temasek’s response, let me try and provide some background to better understand the overall situation.

  1. S&P is one of the three major global credit ratings agencies along with Moody’s and Fitch.  Their market dominance stems primarily from their oligopolist position conferred by the US government within the American market.  Less than 10 credit rating agencies in the United States are recognized as “nationally recognized statistical reporting agency” which allows a privileged position for instance in rating investment grade debt held by a large variety of institutions.  The big three are estimated to control approximately 95% of the credit rating market in the United States which they leverage into dominant positions throughout the world.
  2. S&P, in putting forth generalized standards, is trying to create a clear, transparent, framework that they can use to compare different companies rather than make every analysis unique.  To take a simple scenario, they might state that companies with a debt to equity ratio of greater than 3:1 will receive a B rating while a company under than will receive an A.  Framework standard sacrifice detail and uniqueness, which individual analysts will provide later when researching companies, for broad standards than can be applied throughout the world.
  3. The broad framework standards used by every credit ratings agency can be used to disguise the true risk.  Frameworks to assess credit risk are generally solid guidelines but like all rules can be used to manipulate the overall system.  During the global financial crisis, many mortgage linked products met the technical guidelines to receive a high rating even if it clearly masked the true level of risk for that financial instrument.  Guidelines laid forth by ratings agencies should be considered fallible frameworks that attempt to capture common risk factors but they absolutely should not be considered final and perfect assessments of individual risk.
  4. Credit rating agencies are riddled with group think and conflicts of interests, but at the same time historical data reveals a very clear relationship between defaults and ratings.  The riskier the rating the higher the probability of default (PDF).  Credit ratings are imperfect by any measure with a systematic downward risk bias, but they should be ignored at your peril.  There is a strong relationship between both initial rating and adjusted rating and default probability.
  5. Credit ratings rarely change so consequently, there is a lot more interest in the framework or the rules that allow firms to receive top credit ratings.  Unlike credit default swaps (CDS) which trade daily and can be used to predict default probability, bond ratings typically go years without a ratings change so the initial rules of the game matter a lot more.  According to S&P, the last time it changed its IHC framework was May 2004 when it was entitled “Rating Methodology For European Investment Holding And Operating Holding Companies.”  The “European” in the title should giveaway how outdated the S&P framework is.
  6. Every firm that does not receive the rating they feel they deserve will loudly protest that there are factors unique to their situation that the ratings body is not accurately weighing.  Most of the time, but definitely not always, firms arguments that the ratings agencies fail to accurately understand their industry or firm are poor attempts to gain a better ratings.  Credit ratings by the large agencies on average accurately assess the credit risk associated with firm issued debt.  If anything, credit ratings agencies on average understate rather than overstating the risk associated with debt products.
  7. S&P in its framework creation rarely deals with the type of issues I raise such as accounting or corporate governance problems but rather on much narrower concerns focused on whether debt can be repaid and potential stress concerns.  For instance, two issue which S&P raises which may seem technical are liquidity and mark to market vs. trailing average over some period.  Again, these are broader framework issues narrowly focused on repayment rather than the specific corporate concerns.

So as not to turn this into an excessively lengthy post, I am going to limit this post to the broader framework and background surrounding this issue.  This is a very important issue that has very real ramifications for Temasek, Singapore, and everyday Singaporeans.  I want to make sure the background and broader issues are understood so that when I turn to analyzing S&P’s proposal and the Temasek argument, everyone is aware of what is unfolding.

This may seem somewhat technical and boring but let me assure you it is vitally important and will be very important.