A massive China sinkhole

Several major news outlets have reported on the problem of sinkholes in China.

Similar to the formations in the US and Central America, sinkholes often appear as a result of human activities - mining and construction or extraction of water for agriculture which alter the composition of below ground rock and soil which can then collapse.  As CNN reports these appearances can not only result in the occasional damage to pavements and roadways, but to vast swathes of often agricultural land in some areas which can end up sinking below the water level.  Relocations of infrastrucure and people can follow in what is a disturbing development for some localities such as Jining in Shandong Province.

Infrastructure revealed in China (c) AFP

Also disturbing and seemingly potentially catastrophic are emerging insights into the scale of capital shortfalls in China's banking system and economy. With the inner vaults of banks hollowed out by excessive lending, diversionary schemes and sources of risk concealed from regulators it is becoming a certainty that significant writedowns of bank assets will have to be made at some point.

It is with this in mind then that reports are emerging of steps being taken to put into operation the clean up of banking balance sheets by special "bad bank" vehicles - namely "asset management companies" (AMCs) which were set up in the late nineties to absorb bad loan portfolios from the largest Chinese "Big Four" banks - ICBC, BOC, Ag Bank and CCB (which became Cinda, Huarong, Orient and Great Wall, each taking on the bad loan portfolios of one bank).  

Fraser and Howie in their book Red Capitalism walk through the tainted origins of the AMC's which bought the bad loans at full face value and failed to achieve much running off of the portfolios (often recovering as little as 20 cents in the dollar, barely covering their costs and instead rolling over the bad loans).  Since then, apart from what the FT has investigated as seeming repayments from the central government and the AMCs taking on new debts and branching into active financing business, there has been nothing to quell serious doubts about whether the AMCs are fit for purpose (a historical perspective on the recovery process is here).   

While analysts debate the room for manoeuvre for AMCs, the scope of the task is substantial:

...In 1998, when these AMCs were formed, the first Rmb1.4tn batch of bad loans were bought at face value, or 100 cents on the dollar, which was great for the big four banks, but less good for the bad banks. They recovered only about 20 cents on the dollar. 

However, in the late 1990s, that Rmb1.4tn accounted for about 15 per cent of bank loans, according to CLSA. Ms Chu calculates that the Chinese banking system’s assets grew by $14tn between 2008 and 2013 – equivalent to adding the entire US banking system to its banks’ balance sheets. 

This illustrates why China needs more than merely a government bailout to tackle bad loans this time and that it will probably take a lot more than four privatised AMCs.

And with the application by Cinda to launch an IPO in Hong Kong, some are starting to question the viability of any such venture (given one as author contended, they have become "toxic waste dumps" of bad loan portfolios) :

...today China's four big asset management companies look on the surface like respectable universal financial services groups, with solid balance sheets and handsome earnings. In February, Cinda announced profits for last year of 14 billion yuan (HK$17.6 billion), while Huarong made 12 billion yuan. 

Sceptics claim these profits are illusory, produced by the companies trading assets among themselves at artificially inflated values....For potential investors, however, earnings quality should be only a minor concern compared with the enduring doubts that surround the strength of the asset management companies' balance sheets. 

Offsetting the liability of their bonds, their assets now consist largely of what amount to IOUs from the Ministry of Finance. These are not sovereign bonds, but merely a vague promise to pay at some point in the future....If these IOUs are comparable to similar IOUs held by state banks, then their eventual repayment is to be funded by recoveries from the bad assets injected into the "co-managed accounts". 

In short, it appears the recent restructuring of the asset management companies was nothing more than a cosmetic exercise, which still left them exposed to their original portfolios of worthless loans.  If so, their liabilities far outweigh the true value of their assets; they are insolvent. 

 And what could be the likely scale of losses in the banking sector? Goldman Sachs has come up with an estimate of $3 trillion (which presumably doesn't factor in any downward adjustment to rates of growth stemming from the fact that official Chinese GDP may be overstated by $1 trillion), which is about the size of China's coveted foreign reserves (which by the way may not be of any use in a domestic currency crisis, being held offshore and in another currency). And this may be the nail in the coffin - the backstop of every China watcher - the ability of the state to bail out any distressed entity may simply not be sufficient enough - as stated by Charlene Chu:

There is tremendous confidence in the ability and the willingness of the Chinese Communist party to bail everyone out....But as the system gets bigger and bigger, there are more questions about how feasible that is.”

Rather a large hole to fill.

In need of heroes

A motley crew of martial arts masters gathered in Xinjjiang last weekend for a martial arts conference involving training sessions, discussions and lots of photos being taken using smartphones which some Chinese internet users derided as "cosplay for the elderly".  Novelty photos aside the amount of conflicting messages now flooding out of China's economy and political management all points to authorities which are losing the initiative and are out of ideas.  Reform needs to occur, but can the recently installed team deliver?

The recession avengers?   (c) ChinaNews.com

It is telling that global markets have moved recently in a big and coordinated way on announcements of improving Chinese data - does anybody question the provenance of the official data? A few like Caixin do, but for the moment the theme is one China bringing support and stability to markets - quite absurd given the recent credit shutdown only back in June, when markets briefly went into a complete tailspin.  Expect more volatility, not less.

Policy feast

Perhaps more noteworthy than statistics were policy announcements.  A lot of them and conflicting as usual, but it seems that in pursuit of the great rebalancing, Xi and Li are ready to offer up the most sacrificial cows - could the authorities really be planning to ditch the one child policy, start radical agricultural land reforms, allow a privatisation of a major bank and ditching the hukou household registration system? These and other areas involve policies that have been established for decades and there are too many with vested interests and different objectives throughout the system to allow the process to be easy.  It must follow that there are two likely possibilities here:  (i) such announcements are pure puffery and the administration does not intend to follow through with any such reforms (this would explain bad habits like shadow financing and subsidising inefficient industries like solar are seemingly dying hard in the current administration) or (ii) the circumstances have got so desperate that officials are willing to consider anything (likely given the constraints).

One voice that is reasonably clear on this issue is Ambrose Evans-Pritchard in the Telegraph who recently commented that Chinese authorities had capitulated and given in to demands for more stimulus and to hold on reforms:

Mr Li’s implicit argument is that kicking the can down the road buys time to push through the market reforms needed as China abandons its obsolete, top-down, investment-driven, 1980s catch-up model, and switches instead to a grown-up economy. 

No doubt Mr Li genuinely hopes to push though these reforms, but he is up against an army of vested interests, and half the Standing Committee. 

As the IMF’s Article IV report makes clear, very few reforms have actually happened. Investment is still 48pc of GDP. The savings rate is still rising. China still has the most deformed economy of any major country in modern history.  

Reform under the microscope

Emerging litigation provides an excellent insight into the extent to which prior reforms have stuck and signs are not good.

The ongoing liquidation of former world leading solar cell maker Suntech in Wuxi is suggesting the recently introduced 2007 Enterprise Bankruptcy Law is not assisting an equitable distribution of assets or an efficient winding up of the bankrupt Suntech enterprise while the Wuxi government is seeming to have commandeered the process to the detriment of other creditors, including and especially foreign creditors.  

As has been noted for some time, foreign investors who use offshore structures to invest into Chinese entities (typically through holding companies in the British Virgin Islands and the Cayman Islands) often end up holding not shares but low priority claims to revenues of the onshore Chinese company, often without adequate security.  The result is several significant investors could end up with nothing:

Under Chinese law, foreign bondholders would be reimbursed only after domestic creditors, which means bondholders may end up with very little. Last week Suntech defaulted on a $541m bond issued in the Cayman Islands, which sparked a cross-default with other loans, including one from the International Finance Corporation, an arm of the World Bank.
“There are very, very few cases of defaults among offshore Chinese bonds and the recoveries have all been negotiated often with very unique circumstances, so there is no template to use to estimate the outcome in a case like Suntech,” says Kalai Pillay, Fitch Ratings’ head of industrials for Asia.
“But, no matter what, as an offshore creditor you are always structurally subordinated to onshore creditors. Any offshore bondholder has to assume that onshore creditors will get a full dollar before they get one cent.”

And in another dispute centred on the tropical island of Hainan, a British investor has been barred from leaving the island and fears for his safety while unsuccessfully pursuing claims corrupt officials with fellow local directors from his property development venture conspired to illegally transfer and strip from the project entity the key valuable asset.  It sounds more like post Soviet Russia than the great Chinese Dream Xi Jinping has been promoting of late (though the author is not quite sure exactly what that is!), leading to the question as to how many foreigners will be wiped out by an asset price collapse and general slowdown in China and how much money will they lose?