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.

The audacity of hope

Bears rally
A couple of provocative headlines hit the newsfeeds this week as some notably bearish Chinese analysts digested the recent stimulus announcements.  Gordon Chang's article "China is running out of money"  certainly grabbed attention and while much of the discussion about the country's central bank, the People's Bank of China (and its ability to maintain the system of foreign exchange inflows) has been covered before, details of how short some local authorities are of money right now is rather new (and emerging).

In contrast, investors' optimism about the extent of the current stimulus is well illustrated by a slide from a recent Rio Tinto investor presentation (below).  Frequent readers will recognise one of the project leaders - the National Development Development and Reform Commission (NDRC) which Victor Shih and others have identified as being at times a very effective rubber stamp executing little scrutiny of projects it approves (including earlier in the year a project to influence the weather).

Michael Pascoe of the Sydney Morning Herald is one China bull who saw only a soft landing from the stimulus and in pro-reform comments of a Bank of China official.  Similarly doveish comments from Jiang Chaoliang, chairman of pillar bank AgBank (Agricultural Bank of China) suggested a benign situation of measured reform.  However it is questionable how much the necessary reforms and consumption increases will proceed during a stimulus given fairly little progress made on such things during the last round of stimulus in 2008-9.

Meanwhile at respected magazine Caixin, Andy Xie sought to put recent conditions into perspective, with some dire forecasts for the property and finance sectors:

China's land market will experience a dramatic adjustment ahead. In most cities, land prices may fall by 80 percent. The financial consequences will be severe. Most bank loans are backed up directly or indirectly by land. If land prices fall so much, the banking system would suffer a crippling level of bad loans. Local governments increased their spending appetite during the heyday of land sales. They will have a difficult time adjusting to the new reality. Their struggle to source new revenues will be the main reason for social instability ahead.

And adding difficulty the FT's Beyond Brics blog noted, was that the fact that many statistics releases which drive the China news cycle seem to increasingly split analyst opinion (pointing to more or less future growth in equal measure).  Similar to the debates as to whether key Chinese statistics are falsified - a recent report examined opposing interpretations of rising non-performing loans data by Reuters and Bloomberg. Reuters' conclusion, that it was a positive sign (looking at the overall ratios provided by the China Banking Regulatory Commission), was favoured.

Chinese property, it's a long way down...

Reluctant consolidations
While questions remain over the long term outcomes from the new stimulus, other commentators have noted falling profits across a number of sectors and in some cases a run of bankruptcies is looking likely.  Three industries which have been observed to be at risk of widespread bankruptcies are the solar panel makers, shipbuilders and automakers.

For manufacturers of photo-voltaic cells there have been plenty of headlines for Chinese companies, themselves struggling against a backdrop of oversupply and falling prices. Suntech, the largest solar panel maker in the world, announced it had been defrauded by an Italian co-investor (who offered fake German bonds as security for a payment guarantee) and just recently obtained a worldwide freezing order against its Italian partner's assets.  Even without this, the company is struggling under a weight of debt.  LDK Solar, based in Xinyu was bailed out by the local authority last month, although some commentators doubted whether even this would be sufficient to restore the companies' prospects.

Chinese shipbuilders meanwhile are continuing to tread water through the worst conditions in a decade.  Major builders including Rongsheng and Cosco have recently been hit by profit concerns amongst falling orders and shrinking backlogs, while there have been several bankruptcies including Dalian Oriental Precision & Engineering and a major shipbuilder in Zheijiang province.

And local car manufacturers (who have been flooding dealers with unsold inventories) face the prospect of being forced into bankruptcy by local authorities due to widespread anticipation of failures.  As this report from Ken Rapoza in Forbes explained:

The Ministry said in a note published on Tuesday that it is considering the introduction of a withdrawal mechanism to force near-bankrupt automakers out of the bloated automotive industry.  China has around 1,300 automobile makers, including 171 car, truck and bus makers and more than 900 specialty vehicle manufacturers, according to the government.
Nearly a quarter of these manufacturers are on the verge of bankruptcy, barely producing anything despite obtaining production approvals from supervising authorities, the statement said.

Restructuring with Chinese characteristics
The announcement of forced restructuring of the automotive sector is interesting because it shows the role of the state in dictating the policy direction for much of the industry.  State involvement has been a feature of industry restructuring throughout China's history, and most notably during the aftermath of the Asian crisis, when  many International Trading and Investment Corporations (ITICs) - forerunners of current Local Government Financing Vehicles and investment trusts, collapsed and when the banking system was restructured.

At the time, there was no advanced nor comprehensive bankruptcy law governing the restructuring of state-owned entities and private entities.  As William Gamble, an investor with experience in that period has noted, the bankruptcy legislation applicable in 1998, when GITIC collapsed, did not recognise security interests or allow for restructuring (nor could foreigners' investments into ITICS even be registered with Chinese regulators).

A new bankruptcy regime, which is more sophisticated and borrows elements from US legislation and other jurisdictions was implemented in 2007, but its effectiveness remains to be seen as courts and other officials establish a practice of using and enforcing the new regime.  Also in a new trend, Simon Rabinovitch in an FT article this week, noted that more parties seem to be using local courts to resolve contractual and debt claims across a number of Chinese regions.  

It seems there is much more than just a simple increase in litigation volumes - generally speaking local and regional state authorities, with their close ties to businesses seem to play a very dominant role in either leading arrangements to stave off bankruptcy (causing a lighter caseload and a slimmer practice of dealing with bankruptcies) or as in the case of the automotive industry - taking a dominant role in which foreign investors may be marginalised and/or unfamiliar.  Reports of the pending bankruptcy of the Zhongdan Guarantee company (which was exposed by the collapse of the Tianyu Construction Company and 600 companies which were connected to it by a network of guarantees) indicate that the Beijing city government is directing the restructuring response which is expected to get underway later this month.  And Zhongdan apparently was also involved in selling WMPs (below).  Should there be more businesses like Zhongdan to be bankrupted, this could lead to a deterioration of market sentiment and intensification of any crisis, should it arise in China.

"No touch" regulation
Watchers of Chinese bank finances noticed a shrinking of deposits and increase in interbank liabilities in bank capital reports which many commentators are blaming on the rise of WMPs - wealth management products, unregulated speculative investments which Chinese banks have been using to source new loan capital and which are popular with bank customers as they offer interest rates far above regulated deposits.

Nothing wrong with little or no regulation in the short term (in China) you might think, however it has emerged that many of the products do not have recourse to specific assets and are increasingly appearing to have the characteristics of a pyramid or ponzi scheme (with there not being enough assets to cover redemption requests or meet all obligations), the collapse of which could trigger financial contagion.  An excellent Reuters piece uncovered one product which it likened to an American subprime mortgage (of dubious quality), being marketed to the public under the name "Golden Elephant" and whose source of income derived from property assets which were yet to be built.

While Chinese regulated banks themselves have questions to answer regarding their NPLs (which may challenge their solvency) the growth of WMPs and so-called "shadow banks" could threaten a significant crisis in the Chinese financial system.  Recent discussions on various blogs this week reminded that there are a number of precedents of this sort of scheme which could equally apply to China.  For both Russia and Albania in the 1990s (and Poland in the last few years), pyramid and ponzi schemes were able to flourish escaping weak and slow moving regulators in a changing environment and, upon collapse, causing great damage to the economy.  A great paper on the Albanian pyramid scheme phenomenon is here, while in Russia, the famous MMM and GKO scandals (the latter of which contributed to the collapse of the Russian government and precipitated the 1998 Asian crisis) have been well written about (Sergei Mavrodi restarted a new MMM-style scheme online last year).

How it all plays out in China will remain to be seen.