Bad debts galore?

A slew of Chinese banks are reporting half year results, and most have reported lower bad debts ratios. Good news? Wait. Due to an explosion of property related loans in the H1, total bad debts had actually gone up.

China has a prudent down-payment policy, in the range of 20% to 60% (!). As such mortgages are actually prime assets of the banks. The weak link is loans to the property developers. Huaxia Bank, listed in Shanghai and known ninja loan maker, reported a 14.5% increase in bad debts to the developers. Citic Bank’s bad debts to property developers were up 10%. China Minsheng Banking Corp., one of the better managed ones (and perhaps more transparent?), actually surged by 78%!

In terms of bad debts ratios, all banks are still within the comfort zone. But with the tightening policies only kicking in mid-April, one has to wonder whether the bad debts situation will deteriorate, perhaps dramatically, in H2.

How bubbly is the Chinese property market?

This is the million dollar question and I’ve decided to give it a try. Where do I start? How about the developers inventory?

The National Bureau of Statistics just announced yesterday that developer’s inventory for residential housing by the end of June at 106mn sqm, or roughly 1.5mn homes assuming an average of 70 sqm (753sf) per home. This amounts to a mere 1.5 months of new home supply on last year’s sales. Now, 2009 was a brisk year. But even if I use 2008 figure, when sales dived 20% due to the financial crisis, it equates to 1.8 months of supply, far from horrendous if you consider that the US new homes supply seldom dip below 4 months even in the best of times.

Why is this focus on new homes supply important? Due to the requirement for 30% down payment for homeowners, the weakest link for a Chinese bank is actually lending to the developers, the conduit in which the bursting of a property bubble may morph into a full-fledged financial crisis.

Of course, the tightening measures on the property market only kicked in mid-April and the data is only from end of June. Given time, it’s definitely plausible that inventory may build up further and prices may plummet (so far it has barely budged). Which is why the Chinese banking regulator is performing a stress test on the assumption of 60% pricing fall in the worst case scenario. But should this be taken as an admission that Chinese property market will indeed collapse? I think not.

According to the National Bureau of Statistics, housing price index rose 14% year-on-year by June this year. Before you scream communist propaganda, I should add that this index is compiled with data from 70 Chinese cities, with huge variance among them. Beijing registered 22% rise during the period, while Sanya of Hainan (think Florida in terms of climate, location, and economy) rocketed by 59%! Private economists, like Stephen Green of Standard Chartered, have also noted the geographical concentration of the housing bubble.

So all in, I think the coming bursting, while painful, will not be catastrophic. The froth is concentrated in a few key cities and the banking system is insulated to a degree by the down payments. The US financial crisis had its root in leverage, rather than the fall of housing prices.

Just how much debt does China have?

The general perception is that China has very low debt burden, estimated at roughly 18% GDP, especially when compared to the sea of red ink that other nations swim in. However, this figure counts only central government debt (not that other nations are more forthright in debt accounting though). How much debt has the local governments borrowed over the years?

China’s powerful Banking Regulatory Commission had previously ordered an audit on all local government financing vehicles, and initial reports have come in. The 21st Century Herald reported that 2009 total local government debt amounted to RMB7.4 trillion (USD1.1 trillion). So by this estimate, total debt-to-GDP ratio is at 40%. While not quite the catastrophic level suggested by Victor Shih (USD1.6trillion), it’s still rather worrisome, especially given the local governments’ propensity to waste and corruption.

So how much of this USD1.1trillion might become bad debt? Full report isn’t in yet. But  the parts that have completed the audit aren’t very promising. 90% of local government debts are bank borrowings and 60% of which are illegal guarantees. If we simply do a back of the envelope calculation and extrapolate from the data that we already have, than local bad debts amount to 12% of 2009 GDP. Well, so much for the savior of world economy.

Credit card bad debts soar in China

The focus of Chinese NPLs is on its overheating property market and the related bad debts incurred by developers and local governments. Consumers, unlike those in the US, are largely seen as prudent and safe. To a large extent this is still true. Consumption is still mostly paid with cash. Mortgages require 20%-30% down payment. However, there’s a sub-sector within the consumer market that is seeing increasing risk of NPLs, that of credit cards.

Credit cards as an industry is still new in a country that traditionally issued only debit cards. But credit card issuance has been exploding in recent years. Couple this with stone age risk management practices in Chinese banks and the new consumption habit of the post-reform generation, the result is catastrophic. According to a spokesman from Shenzhen Development Bank, 2009 credit card NPLs totaled RMB7.7bn (USD1.1bn) nationwide which may sound peanuts, but in fact was 226% (!) that of 2008.

No the Chinese banking system will not collapse, one of the tiny winy benefits of having real savings instead of just printing press. But a major banking crisis is looming and China’s formidable foreign reserve has already been earmarked for the eventual cleanup.

How’s China going to pay for its bad loans?

Micheal Pettis has an interesting post on China’s expected NPLs and the related cleanup costs. In short, he expects a collapse in Chinese consumption in the future as households are being squeezed to pay for the bad loans that the over-heating economy is racking up right now. And I don’t quite agree with him.

A decade ago China had a huge surge in NPLs, the cleaning up of which was to cost China 40% of GDP and a possible banking collapse, and yet, they claim, nothing bad happened.  The doomsayers were wrong, the last banking crisis was easily managed, and Chinese growth surged.
…… In fact China paid a very high price for its banking crisis.  The cost didn’t come in the form of a banking collapse but rather in the form of a collapse in consumption growth as households were forced to pay for the enormous cleanup bill.

Pettis is giving a bit of background info here regarding the last Chinese banking crisis and its cleanup. While I agree with him that the cleanup was costly (hey, there’s no free lunch after all),  his conclusion is erroneous.

There are 2 reasons why many uninformed people thought the cleanup was painless. First was rapid economic growth during the time period reduce its proportion to GDP and made the effort more bearable. Second was the fact that recapitalization was paid with China’s reserve. One could argue that the reserve was built up by pinching from household consumption, but cleaning up bad loans certainly was not the reason why it was built up. The reserve was a RESULT of China’s economic policy of preferring investment over consumption.

Why am I nick-picking over such a technicality? Because this means there was no connection between China’s historic lean consumption and the last banking cleanup. As such, the forecast collapse in Chinese consumption to pay for this recent one isn’t likely either.

Does this mean that the upcoming cleanup would indeed by painless? Not unless you believe in alchemy. But it will come in the form of running down China’s reserve, vaporizing a substantial portion of it. One can argue that this indirectly hurts consumption as the money could have been spent on things more productive like building up China’s social security network. But I don’t think anyone has a clear vision of how the reserve will be used and factors it in when making consumption forecast. As such, I doubt running down reserve to pay for banking cleanup will have much impact on future consumption, the level of which will depend on other economic incentives. In a way one can argue that the price has already been paid. China’s consumption may or may not collapse in the future, but cleaning up loans gone sour is not the cause either way.