- I think sometimes we overcomplicate our analysis of issues. I am just as guilty as anyone and not looking at anyone in particular here, but it can be tempting to over complicate an analysis when the reality is much more straight forward and simple.
- There has been some good news reporting on the problems and skepticism even with the Chinese financial and economic world about how well these debt for equity swaps will work. The problems have highlighted such issues as the lack of public capital injection. Persuading existing companies to essentially fund the bailout, the absurdity of having a bank create a WMP to fund purchasing a loan off its balance sheet, or how a bank can receive a debt for equity swap with no discounting of the debt price by the bank when the loan is classified as normal among some of the problems.
- These are all entirely valid concerns but I see a high probability of failure of the debt for equity swap for a much simpler and fundamental reason as compared to previous iteration in China: the gap between growth and debt. Prior to, let’s say 2008 for a simple dividing line, nominal GDP growth and cash flows were higher than debt growth in China. Since 2008 however, debt growth has been about twice as fast as nominal GDP growth and that ratio continues to worsen.
- I do not care how perfect the incentives work, how ideal the financial engineering, or immaculate the restructuring and organization plans: if debt continues to grow at twice the rate of cash flow or nominal GDP growth the debt restructuring will fail and fail spectacularly. We can write a length about a variety of issues about who absorbs the cost of the debt, the difficulty of restructuring, subsidized debt costs, the employment burden, and so many other issues that need to be considered but at the end of the day if debt continues to grow at two times nominal GDP and 3-4 times cash flow growth, there is absolutely no chance solving this debt problem.
- It is also important to note that while some may point to developed countries debt growth and their weak economic growth but these are very different levels. Take a simple scenario, not drawn from any specific country. Assume a country has 2% nominal GDP growth and 4% debt growth. After five years their debt level has risen 22% and GDP expanded 10.4%. Hardly a crippling blow. However, in China assume that debt goes up 15% and nominal GDP expands 7.5% also for 5 years. The debt level has more than doubled by 101% while nominal GDP is only up 44%. Even if a developed country faces the same ratio, debt growth twice as fast as nominal GDP, the scale and speed of the numbers is radically different compared to China.
- This debt swap, whether it is perfectly designed and executed or whether it is a disaster, has absolutely no hope of working absent credit restraint.
- Let’s project this out slightly. To make the fundamentals of the debt restructuring work, we have to either rapidly accelerate growth in China or we have to rapidly cut lending. Right now, for many reasons, it is extremely difficult to see any type of catalyst or driver to significantly accelerate nominal GDP growth in China. Official nominal GDP YTD through Q3 is up 7.4%, leave aside the validity, and I see no obvious indicator of what would push this up above 10% even within the next few years. Some may disagree with my pessimism here, but I don’t know anyone that believes the contrary and simply strains credibility to posit that as reasonable alternative.
- What happens to the Chinese economy if there is any type of significant deceleration of credit growth? Total loans are up 13% and aggregate financing to the real economy is up 12.5%, I have heard some argue that deleveraging is starting and while there may be narrow examples, by firm for instance, there is simply zero evidence of any widespread deleveraging. If you look beneath headline data, the only thing keeping the Chinese economy from likely entering an actual recession is fiscal and quasi fiscal stimulus. What happens if this credit growth is restrained going forward by any significant degree? For instance, if nominal growth continues around 7% and debt growth falls to say 4-6%, what happens to Chinese growth? I don’t think it is unfair to say that absent continued large scale credit growth, the Chinese economy would suffer from a significant slowdown in growth.
- Though I am frequently cynical of Chinese “reforms”, I actually believe Beijing wants to delever. However, and this is an enormous caveat, they do not want to make the trade off that comes with deleveraging of lower economic growth and asset prices. I always tell me students that there is a stunning amount we do not know about economic processes and where reasonable people can have reasonable differences. However, there are a couple of universal laws. One of them is economics is the study of trade offs. What trade offs are we willing to make. I believe China wants to delever but that they do not want to make the trade off involved.
So recently a lot of ink has been spilled on the rapid growth in Chinese mortgages. On the face of it the increase is certainly worrying. New mortgage lending in 2016 is up 111% and the total stock of mortgages is up 31%. Even if we take a broader measure of household lending that likely captures a not insignificant amount of real estate related debt, medium and long term loans to households is up 31%. The numbers on their face appear large with medium and long term loans to household registering 22 trillion RMB and personal mortgages clocking in at 16.5 trillion RMB.
These sound like big number and in some ways they are, but in reality these numbers are if anything suspiciously too low. Most get caught up on the size of the numbers but never place these total numbers in any type of context. In fact, if you place these numbers in context, these numbers are absurdly low. Let me explain.
For conservatism, data, and simplicity sake, I am going to limit the analysis to urban housing units. In other words, let us assume that all mortgage and medium to long term household debt is owed only by urban households. This does not change the outcome in anyway and if anything make it much more conservative than it would be otherwise.
The primary thing we want to do is adjust for the number of households in urban China. Without going into all the underlying calculations, which come from all official data, there are approximately 272 million urban households in China and according to official data, only a very small number of households do not own their housing. Again, this is all relying and strictly using official data.
If we then estimate urban residential real estate wealth using the 100 City Index price per square meter as our high value and the Third Tier City Price per square meter as our low value, we have both a high and low value for our estimate of urban residential real estate wealth. This gives us an estimated upper bound of 330 trillion RMB and a lower range of 189 trillion RMB.
Here is where it gets interesting. If we translate this into a broad loan to value number, this means that urban China has an estimate loan to value ratio on its real estate holdings of 5-9%. In other words, almost all of urban Chinese real estate is owned almost entirely free and clear according to official statistics.
If we apply this analysis backwards, the numbers are even more nonsensical. In 2011, the urban loan to value ratio ranged from 3.3-4.5%. If we use absolute numbers, the appear even more absurd. When the average housing unit in 2011 cost 665,000 RMB using the third tier city price and 910,067 using the the 100 City National Index, mortgage debt totaled only 29,675 RMB per urban housing unit.
If we focus just on the new mortgages and new urban units, the numbers look decidedly problematic. For instance, if we use the 100 City Index housing price, this would give us an implied equity share for new housing units from new mortgages of 71%. In other words, if we assume that only newly constructed units are purchased with new mortgage debt, owners would be providing a down payment equal to about 71%.
Now while I use the slightly more restrictive mortgage debt, even if we include the broader label of medium and long term this would barely dent the number. If we use the medium and long term household debt number instead which is only about 4-5 trillion RMB more, again using only urban households, this would still barely move the per unit or value debt number. To bring Chinese urban housing wealth up to a 20% LTV, would require about a 41 trillion RMB increase in mortgage debt. Put another way, outstanding mortgage debt would need to go from about 16.5 trillion RMB to 58 trillion RMB. Including the obvious candidates that some have nominated simply does not come close to making these numbers plausible.
We are left with a conundrum: either believe the data at these levels or find a better candidate when no good obvious source of debt under counting exists. I’ll be honest in saying I’m not sure whether to accept them as vaguely reasonable representation or believe that they are not even close.
If we consider the possibility that these debt numbers are relatively accurate, while there are positives, there are also very real risks. First, it raises the scope that Beijing could further increase urbanization and home ownership rates by loosening credit. However, there is evidence that rural households migrating to urban areas are already debt budget constrained and that Beijing is uncomfortable with the level of debt even at these levels. Additionally, this raises the possibility that real estate prices have a long way further to appreciate which seems implausible given already elevated price to income levels.
Second, this would imply that households have put very high level of savings into their homes and may have less liquidity available than understood. By some recent estimates, Chinese households had 70% of their wealth in real estate. Liquidity constraints may exacerbate any real estate or broader economic down turn placing additional pressure on prices.
Third, this would seem to place enormous pressure on public officials to maintain housing prices at elevated levels. If Chinese households have placed the vast majority of their wealth into their home, though lack of leverage will not magnify the financial returns, it will place enormous pressure on the government to prevent price declines.
There is one possible scenario, though we do not have the data to say for sure this happening that would explain the discrepancies we see. Given the mismatch of the mortgage data and required down payment this raises the possibility of the leverage upon leverage scenario. For instance, a home is owned with no mortgage debt. The owner then pledges the real estate as collateral to borrow money for the equity share and borrows money in the form of a mortgage to purchase additional real estate. In this instance, only one mortgage appears outstanding where, if we assume the second property is financed with a 50/50 debt/equity split at the same value of the first property, then we have a mortgage per unit value of 25%. However, in reality the risk level is much higher as both properties have debt against them and depend on stretched cash flow valuations or capital appreciation.
There are many possibilities but the only thing we can say for sure at the moment, once we break down mortgage data into per housing unit basis, the numbers seem implausibly low.
So I wanted to write a few more technical issues on China’s CDS market as a follow up to my Bloomberg View piece. As usual start there and come here.
- I hate to sound so negative, I really do, but this is another incredibly poorly thought through idea that seeks dress up symbolism as some type of real reform. There are so many technical problems that simply have not been thought through.
- Though it is not the same type of instrument it is a very close parallel, credit or loan guarantee firms already exist to manage this focusing on SME. Though there is not good data on these firms and their pricing schemes, evidence seems to indicate that there is little price discrimination on credit quality. This implies that either existing firms do not or are not allowed to change the price based upon the risk of the borrower. Given the lack of price dispersion in the bank loan market based upon credit quality this seems to indicate that the pricing mechanism is simply not being used in the credit market.
- The reason that the lack of price movement in the credit risk market matters is why if it is not moving from the major banks in China in these other major financial institutions do we think that it would move significantly with the introduction of a CDS market? One of the primary purposes of the CDS market is to provide a clear, transparent regular price for the default risk of a specific firm. However, there is little evidence in any market that China would allow the market to accurately price the risk given the prevalence of intervention in asset price markets to set a price preferred by the government. If the market cannot set price for default risk, the government is better off leaving this market absent.
- There is also the lack of market reform that makes this even more of a concerning move. Assume ICBC has a 100m RMB loan to a coal company and Bank of China has a 100m RMB loan to a different coal company. They both want to hedge their default risk so they buy a CDS that covers their potential losses so ICBC buys a CDS from BoC and vice versa. Now both are worse off because there has been no net change to the total risk level but both think they are better off and potentially become even riskier after purchasing the CDS. Unless there are large outside investors selling to people wishing to hedge potential losses nothing has changed and people believe they have hedged their risk potentially allowing them to absorb more risk believing they are covered.
- There is also an important psychological point here that has been overlooked. When China is controlling the price it is normally through more opaque methods and markets. For instance, we do not know exactly when the PBOC intervenes in currency markets or how much. Furthermore, the risk is much more macro oriented or focused. However, in a CDS market it focuses the attention on a weak firm and has an important psychological impact. Even if the government intervenes, it will only be calling to attention to the state of a weak firm. This has the ability to concentrate attention much more on the weakness of a firm or industry that it might other wise be able to obscure.
It seems a lot more like a symbolic reform of sound and fury signifying nothing that has not been thought through.
So I have been travelling to much and am currently enjoy a strenuous regimen of two a day umbrella drinks and naps on a south-east Asian beach. The battery is getting recharged and looking forward to writing more.
I wanted to put out something someone sent me about the rapidly shrinking payments gap. As you can see below, the difference between bank payments for imports and the customs reported imports has shrunk rapidly and dramatically.
Since the recent peak discrepancy number, of $58 billion in January and writing about it here in February when the discrepancy dropped slightly to $47 billion, the difference between bank payment for imports and customs reported imports have fallen dramatically. In August, this discrepancy was just above $10 billion USD.
The fall off in this discrepancy has been nothing short of stunning. The last time there was a single month this small was in September 2013 with periods of 2012 and 2013 matching some type of moving average. SAFE is clearly cracking down on moving money out of China this way.
Placed in larger context it gets even more interesting. First, this drop is responsible for essentially all of the supposed slow down in outflows from China. If this number returns to the pre-crack down average, outflows from China would be approaching $100 billion per month. Second, there is a game going on here which we can call whack a mole. Shutting this avenue down will only drive the money out other channels which we already see evidence of as other channels become more prominent. Third, this movement represents a structural outflow of capital. As I have noted before, this is not due to 25 bps in New York but rather a structural and likely quasi-permanent shift in the demand for foreign assets by Chinese citizens.
Interesting stuff now back to my pina colada.