Monday, May 19, 2014

China's Ponzi Trifecta

As concerns mount about debt overhang in the Chinese economy, FT has a nice blog that points to three ticking time bombs - property developers with meagre cashflow; big cities relying on land sales to repay debts; and some industrial firms facing debt repayment crisis.

Another way to think of them is as the unravelling of a trifecta of massive Ponzi schemes - bubbles financed by leveraging debt in the expectation of never-ending growth - all of which were sustained for long and in such scale through the demand created by the country's spectacular economic growth over the past two decades.

Property developers built up a massive debt-financed portfolio of properties whose valuations kept rising as if there would be no end. Land was purchased at inflated prices and constructions done using cheap and readily available short-term capital, in the firm expectation that the investment could be easily recouped and the debt repaid from sales. But once sales tanked, strains have started to quickly cascade through the system.

City governments borrowed heavily to invest in grandiose infrastructure projects. They relied on land sales revenues to finance these investments. The soaring property prices encouraged them to borrow recklessly and invest in projects. So much so that all major cities rely on revenues from land sales to finance more than half their debts. Again, as property market cool and housing sales decline, demand for land among property developers have been falling sharply. This has in turn squeezed cities off the cash flow required to repay their debts.

Finally, large industrial firms supplied inputs that kept the massive construction boom inflated. Like developers and local governments, in the belief that the investment boom would never end, they too splurged on the massive cheap and easy short-term credit supplied by public sector banks. Since 2009, non-financial corporate debt has more than doubled to 147% of GDP in 2013, far higher than with other major pre-crisis economies of the recent past. Now as demand for their goods tapers off on the back of slowing construction, their reduced cash-flow is threatening to keep not keep up with their debt repayment requirements.

In all three cases, there is a common counter-party to their debts - public sector banks or the shadow banks. Property values are another underlying asset which is leveraged to raised the debts. The argument that the government could ask the creditors to take a hit or roll-over the loans over-looks the second-stage effects of such write-offs on the balance sheets of banks. It would seriously constrain the credit available for capital investments that are necessary to sustain a reasonable rate of economic growth. This is not to even talk of the serious systemic shocks, with unforeseen consequences, that are likely to accompany such credit squeezes.

A perfect storm looms large. What magic tricks are up the sleeve of the rulers in Beijing to avert this?

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