Monday, August 15, 2011

Michael Pettis on Hidden Debt in China

In Michael Pettis' private newsletter received July 31st, I covered the first half on why china needs to buy U.S. bonds here and the second half of his July 31 private newsletter began with "Thinking about balance sheets".  Since July 31st, Pettis has also published in the Wall Street Journal an article on why China's export economy cannot continue and will slow down.

Since all four scenarios under which China can sell U.S. government bonds is unlikely (see link above for the first half of the newsletter), the purchase of U.S. government bonds is going to continue until there is a dramatic change in global imbalances.  Despite rumors every six months that they will stop buying U.S. Treasuries, they cannot until they have rebalanced their economy  and eliminated their large trade surplus.  this will take a long time and PBoC domestic debt is going to rise dramatically.  The rise in PBoC domestic debt is going to become an increasing problem for China, which most economists writing about China do not understand, according to Pettis, "...the root causes of Chinese imbalances and the vulnerabilities in the growth model. They do not see the relationship between rising debt, financial repression, and low consumption. What is worse, too many analysts see the problem of local government debt as specific to local governments and caused by misguided polices on their part, whereas in reality it is a systemic problem."

Pettis believes his approach to understanding the Chinese balance sheet is quite different as he tries to understand the development of the system as a whole and then tries to figure out how it will "...logically evolve within balance-of-payments, balance sheet, and monetary constraints."  He admits to being addicted to reading about finance and economic history, with understanding historical precedents key to his approach.  "Furthermore the work of economists like Hyman Minsky, Charles Kindleberger and Irving Fischer drives my sense of balance sheets and how changes in the structure of balance sheets affect economic outcomes. Among other things it leaves me very skeptical about prospects for financial systems, like China’s, that are engineered to maintain stability at all costs.

"Not only do these kinds of financial systems typically sacrifice efficiency for stability but, as any good Minskyite could tell you, regulatory regimes that force stability onto the financial system always result in increasingly destabilizing behavior by the agents within the system. Instability, in other words, is simply repressed and pushed forward, and the financial system must become increasingly inefficient in order to suppress the increasingly irrational behavior of agents within the system. In any financial system, as Minsky famously said, stability is itself destabilizing."
In Pettis' view, it was apparent in 2004-5 that using the balance sheet approach, the rise in Chinese debt argued that within a few years there would be real questions about debt sustainability, because "...there was no logical way for the growth model to continue functioning without an unsustainable rise in debt, and it was already pretty clear that without reform and liberalization in the Chinese financial system we were eventually going to run into another banking crisis. And ignore what you may have heard from other analysts – there has been absolutely no meaningful financial sector reform in the past decade."  He then credits Charlene Chu and her team at Fitch with best analysis of the Chinese banking system and creativity in discovering and counting debt as well as Victor Shih at Northwestern  and Logan Wright at Medley Advisors. 
Pettis specifically cites the Fitch report, "Growth of leverage still outpacing GDP growth" as an example.

Earlier this year, the PBoC unveiled the concept of "Total Social Financing" in an attempt to measure real growth in bank related credit by including various type of important loan growth which had not been included in older measurements.  For many years the key measure of credit growth was the new Renminbi denominated loans made by Chinese banks.  "By setting annual, quarterly or monthly quotas for the maximum amount of new RMB-denominated loans, the PBoC hoped to maintain some control of credit expansion in China."  But it does not work that way, because as the PBoC limited the growth of that kind of credit, the banks found innovative ways around the constraints and pushed new lending into other forms of lending.

When the PBoC produced Total Social Financing numbers earlier this year, the data showed that RMB loans were 92% of total TSF, but by 2010, new RMB loans had dropped to 56% of TSF.  "Clearly loan growth, correctly measured, far exceeded the already-very-high numbers that we had all been looking at. Among other things this meant that M2 was even less useful as a measure of monetary growth than in most other economies because much of the growth in deposits had been disintermediated. The real growth in the form of money for which M2 is a proxy was much higher than actual M2 growth."
Pettis hypothesizes that the intention of the PBoC in releasing the TSF data was 1) it needed a way to demonstrate how amazing the expansion of credit has been to the pro-growth faction in the State Council and 2) "...they wanted to reassert control over credit expansion by widening the scope of credit instruments they were monitoring."  Pettis immediately made what he believes was an obvious prediction, given his belief "...that growth is determined mainly by increases in investment, which are themselves determined mainly by increases in credit", the the TSF would quickly lose its usefulness by September of this year.  However, Fitch has already found additional credit instruments other than those included in TSF which have been expanding quickly and he quotes Fitch:  "The main portions of this uncaptured financing include letters of credit (LoCs), credit from domestic trust companies, lending by other non-bank financial institutions (NBFIs) and loans from Hong Kong banks."
The adjusted Fitch TSF numbers are interesting, because they show "RMB loans are down for the first half of the year, with new renminbi bank lending declining by 9.7%, from RMB 4.6 trillion in the first half of 2010 to RMB 4.2 trillion in the first half of 2011.  

"TSF is also down for the first half of the year, but of course by a lot less than new RMB loans. It declined by 4.7%, from RMB 8.1 trillion in the first half of 2010 to RMB 7.8 trillion in the first half of 2011.

"So overall credit growth is down, right? Perhaps not. It looks like Fitch’s adjusted TSF is actually up, and this doesn’t even include private lending pools and non-bank sources of lending, which anecdotal evidence suggests is way up."  Pettis then relates a communication from a PhD student who had been doing research in Ordos Municipality in Inner Mongolia relating finding a tremendous amount of informal financing schemes with some have monthly interest rates as high as 4%.  Pettis is not surprised by this as "The relationship between credit expansion, investment growth and GDP growth means that as long as GDP growth rates are high, credit growth is going to be accelerating."  He challenges if you do not see this you are not looking at the right numbers.

One last point he wanted to make was the the LGVF bonds issued by local government financing vehicles are getting hammered in the market, declining in the last month from 2-10% depending on maturities.  Pettis believes that less than 10% of LGVF debt is in bonds and roughly 80% in the form of bank loans.  He believes this will have implications for debt going forward, because, if one is a newly appointed mayor and how you perform over the next five years will determine future promotions within the political machine and you realize you have inherited a crushing debt burden and few revenues with which to cover the debt, what do you do. Soldier on and hope something turns up within 5 years and you do not get blamed for the revenue shortfalls?  Or do you make a big stink about debt immediately to establish it was not on your watch?  Could a noise be expected by mid 2012 to have arisen?  

Pettis also says it is not clear how many of the LGVFs can meet debt servicing costs and some of their land collateral may have already been pledged more than once.

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