China careering towards a credit crisis, panellists warn

China has to address its exorbitant levels of local government debt if it is to avoid a 2008-type credit crisis onshore, panelists warned at a conference last week.

Fitch Ratings has estimated that local government debt in China surpassed Rmb20 trillion ($3.3 trillion) this April.

Mainland corporations need to cut their investments by 75% and generate free cash flow in order to repair their balance sheets, said Gillem Tulloch, founder of Forensic Asia.

“If they do not, they will be in danger in three-to-five years’ time," he told the audience at Asia’s Independent Research Summit last Thursday, on a panel provocatively entitled "China’s debt time bomb".

“It’s the worst I have ever seen,” agreed Paul Schulte, chairman of Schulte Research, adding that deflation could make the situation especially ugly. “Deflation will destroy everything. If you have deflation, your wages go down, your profits go down, and it becomes impossible to repay [your] debt.”

Schulte noted that China’s foreign bank reserves still stand at 3%, which could act as a buffer to help the mainland fund its banking system via the interbank market.

Despite its huge levels of local government debt, he reasons that China’s banking system is still healthier than Spain’s was in 2007.

Tim Summers, principal of XTE China, was more upbeat. He said the country’s vast foreign exchange reserves – which stood at $3.66 trillion in the third quarter, according to media reports – are sufficient to bail out its banks, if necessary.

On the topic of local debt, Summers suggested it may not be as serious as some make out. There is great diversity among corporates in China, plus the economy is still growing strongly.

But how officials plan to tackle these issues is still unclear, and some worry about a potential conflict of interest between local and central government officials.

China’s largest banks are all state-controlled and receive state funding, yet the local branches make the decisions (i.e., who to offer loans to.) Much of the loan growth came post-2008, helping China to rebound through infrastructure projects but loading local governments with debt.

While local governments and bank branches hand out loans to boost growth, ultimately Beijing will bear the brunt of the costs in the event of a default.

Such a contrast in incentives will make it difficult to address the debt problem in a coordinated fashion, argued Benjamin Schmittzehe, CEO at Schmittzehe & Partners.

Provincial debt reform will likely be a topic discussed at the 18th CPC Central Committee’s third plenary session next month, and Schulte expects “radical revolutionary stuff” to come out of this meeting.

But nothing moves quickly in China. If land reform and interest-rate liberalisation initiatives are anything to go by, Tulloch doesn’t expect the country to sort out the debt problem any time soon. “I have heard it so many times [before], but it doesn’t seem to come true,” Tulloch said.

Summers noted that president Xi Jinping had reinforced his views on reform many times over the past six months. He believes the country will take a gradual, experimental approach to reform.

Looking ahead, Schulte suggested that China would introduce securitisation as part of its five-year plan, and expects provincial and property debt securitisation to become a reality by 2017.