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>>> China Prepares Big Bang Financial Reforms


Sep 26 2013


http://seekingalpha.com/article/1714992-china-prepares-big-bang-financial-reforms?source=yahoo



•The nub of the problem
•What China proposes to do about it
•What's missing?
•Relevant precedents
•Risks involved

There's growing speculation that China will soon undertake substantial reforms to its financial system to address growing risks from escalating debt. First, the central government will take over some local government spending functions, such as social security and part of healthcare. Second, it'll allow local governments to issue bonds to replace the so-called local government financing vehicles (LGFVs). The changes are expected to be announced at a key meeting of Communist Party leaders in November.

If true, they'll represent the biggest reforms in China since 1998. They'll have enormous ramifications, including: i) the intention of reducing risks in the financial system but whether it does so remains to be seen ii) it'll slow bank loan growth, which was due to slow anyway iii) most importantly, it'll reduce infrastructure spending and put further pressure on commodity inputs which principally rely on Chinese demand (such as steel, copper, aluminium and iron ore).

The overall aim will be to cut corporate and local government debt, while also reducing investment. The problem is that other parts of the economy will need to pick up the slack if GDP is to stabilise at current levels. Namely, central government spending and household consumption. Also, China will need currency depreciation for exports to cushion the adjustment from corporate deleveraging. That's why you can probably expect cuts in interest rates and currency depreciation in the not-too-distant future. Without these two things, there'll be greater short-term economic pain than the new leadership would like.

Today's post will look at the likely policy changes in detail because they'll have a huge impact not only on China, but on Asia as well as developed world. We'll also investigate some of the risks involved with the proposed reforms.

The nub of the problem

To understand why China may announce these significant reforms over the next few months, it's important to recognise some of the serious issues that the country faces.

Put crudely, and as is widely reported, China has a debt problem. But those who compare this debt issue to the U.S. subprime crisis - a very common comparison - don't know what they're talking about. For whereas the U.S. problems originated form excessive household debt, China's debt problems are at the local government and particularly corporate sector levels. Household leverage remains low while central government leverage is also reasonable.

China's debt issues are more similar to those of Japan in 1990 and South Korea in 1997-1998. Both of these countries also had serious corporate indebtedness. One succeeded in addressing the problems quickly (South Korea) while the other didn't (Japan).

There are other differences between the Chinese issues of today and those of the U.S. pre-crisis. Chinese debt exploded from 2009 due to a 4 trillion yuan stimulus package designed to prevent the country from sliding into a recession/depression as much of the developed world did at that time.

The stimulus was principally debt-funded. State-owned banks lent money to state-owned companies (SOEs) which were deemed less risky than privately-owned businesses. Also, local governments financed public infrastructure works via off- balance sheet borrowing (LGFVs).

As you can imagine, the spending wasn't very productive and led to overcapacity in numerous sectors. The situation was made worse by:

1) The government keeping rates too low for far too long.

2) The explosion in lending to the so-called less risky SOEs turned out to be a serious mistake. It turned out many of them were risky, particularly when they earned negative returns on their investments. More significantly, it crowded out lending to small businesses, which led to significant strains in this sector.

3) A lack of proper funding channels for local governments. Local governments can't issue bonds. This means they relied on off-balance sheet vehicles, offering higher rates, to fund long-term infrastructure projects.

4) Financial innovation via wealth products became the go-to for loans to small business. These products had zero transparency and made financial guarantees which were subsequently shown to be highly dubious.

Because of all this, China now has a debt issue. Ratings agency Fitch puts total credit to GDP at almost 220%. More importantly, credit now accounts for more than a third of GDP. That means the economy is heavily reliant on increasing credit for GDP to remain at current levels.

Where China does bear similarity to the U.S. and other countries who've experienced financial distress is with its rapid accumulation of debt. Credit to GDP will have risen by almost 90 percentage points for the five years ending 2013, nearly twice that of other countries prior to financial crises.




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