Whether you noticed it or not, 2015 has been an eventful year for China's frequently debated and well-documented debt problem. The 2015 changes have not come in the form of a lower debt load. China's total debt is still growing; not as fast as in the late 2000s, but debt is still accumulating faster than the economy is expanding. However, two major changes have taken place in 2015 that may significantly reduce structural problems within China's debt markets: Increased transparency and the introduction of risk into credit markets.
Transparency into opaque areas of China's debt burden has been improved through Beijing's local debt swap and the declining popularity of shadow banking. At this point, it appears that two favorite topics of China hard landing doomsayers - opaque local government debt schemes and the growth of shadow banking - are successfully being diffused.
Risk is slowly being introduced to credit markets as Beijing has allowed more and more firms to default this year, removing the notion of Beijing's implicit guarantee of all debt.
China's debt problem is a long way from being fixed for good, but risk calculations associated with the debt load and banking system should considered lower than the last few years.
Local Gov Debt Swaps: Closing the "back door" and opening the "front door".
Perhaps the biggest change of the year, and a potential game-changer for transparency, is the introduction and recent expansion of the local government debt swap plan. In March, Beijing introduced a plan to convert 1 trillion RMB worth of opaque local government debt into low-interest municipal bonds. Last week the debt swap program was expanded by another 1 trillion RMB. The 2 trillion RMB total swap plan so far represents only 9.5% of total local government debt, but the expansion last week shows that the swap plan will continue to expand. Local government debt is roughly 33% (see chart below). But the risk from the debt comes from the complex inter linkages with the banking system, the opaque nature of the debt, and the frequent use of proceeds to fund malinvestment. Here are key points of the debt swap:
- Fitch expects the debt swap to lower financing costs for local governments and to extend maturities, which will improve liquidity and allow time for Beijing to reform its fiscal policies.
- The main beneficiary of the debt swaps are likely to be the complex and opaque local government financing vehicles (LGVF). LGVFs have been used for years to skirt Beijing's ban on local government debt in order to fund a surge of local investment projects and in many cases malinvestment.
- The 2 trillion RMB swap amount is roughly 112% of LGVF debt maturing in 2015, relieving some liquidity risks and insuring 2015 infrastructure projects will face fewer delays.
- In May, China allowed banks to use local government bonds as collateral for PBOC borrowing. This step has helped drive demand for the local bond new issues.
- The conversion of opaque debt instruments into bonds should, in theory, add more effective risk pricing and more market discipline to local government borrowing.
- One question going forward is whether or not these bonds will end up owned by a broad group of investors in order to spread the risks, or whether they will be concentrated among banks. The latter would reduce the effectiveness of the plan.
Debt as a % of GDP by Source
Old fashioned bank loans are in, shadow banking is out.
For years bank loans have lost ground on other forms of credit in China (see the charts). Over the last year, and accelerating in 2015, that trend has reversed. Non-bank loan forms of credit have slowed considerably. In May, the much feared trust loans grew around 2% from last year, a full 6% lower than nominal GDP growth, and quickly heading to negative. Shadow banking in May grew roughly 6% vs. traditional loan growth of over 14%. Much of the acceleration of the bank loan revival this year has been driven by the PBOC easing, but easing often drives all forms of credit. After the 2008 easing measures, non-bank loan credit grew at 40-50% over the prior year.
Chinese banks do not have a stellar track record of diligent lending practices. But, lending practices by banks are much more prudent than the complex, opaque practices of shadow banking, or the low quality that often arises when pooled lenders are totally removed from the lending decision altogether (such as trusts), or when non-financial firms lend money as a side revenue stream.
In May, outstanding non-financial bonds grew 19% from last year. The bond market expansion will add more transparency to China's debt load as well. The reduction of the more shadowy elements of China's debt relative to more transparent forms of debt is positive for China's prospects.
Corporate debt and defaults: Thinning the herd.
China had its first default last year. In all, three firms defaulted on debt and went through some form of restructuring last year. In 2015 there have already been more defaults than last year, and we are not yet halfway through the year. Defaulting firms include a state held firm, a property developer and an electrical equipment firm. Defaults will accelerate due to lower growth and Beijing's newfound decision to let firms fail.
Beijing has prepared the ground for defaults, shoring up the financial system, including: Bank deposit insurance for 99.6% of deposits started in May, and lending facilities that have been rolled-out over the last few years to help banks through turmoil. I wrote in more detail about this subject here: "Be vigilant over indebted Chinese firms, but don't freak out about China's debt load.". Defaults should be viewed as a positive for China's prospects.
The acceleration in defaults will help break the perceived Beijing implicit bail-out guarantee, which has led some investors to ignore credit fundamentals. Letting weak inefficienct firms finally fail will also allow Beijing to thin the herd and, allowing losers to perish instead of having to pick winners within industries. Thinning the herd is an important step in the Asian industrial policy model. In the short-term, defaults will impact bank profits, but in the long-term defaults will clean up the books.
Make no mistake, these developments will improve China's overall debt structure, but much work needs to be done to fix China's main debt problem: The corporate debt load of 125% of GDP. 2015 has seen positive changes for banking and financial system risks, but the massive corporate debt load is still expanding. Firms needing to divert resources towards debt maintenance will continue as a significant economic headwind. But so far, 2015 is a big step in the right direction for fixing well documented structural risks.