China is defaulting on its debts – how can it save the world?

September 20, 2011

Global Macro

Did you know that about 85% of Lliaoning province’s finance companies default last year? I didn’t either but here is an intriguing article from Forbes contributor Gordon G Chang that I picked up on Twitter. I have heard rumblings to this effect over the past few months but I hadn’t actually read anything that steps it out like this.

It seems that even though local governments and provinces were prohibited to take on debt by the Central Government they managed to get around this via finance houses called “local government financing vehicles”, LGFV’s. They have, using this method, managed to build up massive debts. Chang says,

The central government’s National Audit Office said these companies, at the end of last year, had taken on 10.7 trillion yuan of debt.  No one, however, knows the true amount of LGFV indebtedness, and some have calculated the real amount to be more than double the official figure.

Why the disagreement as to the amount of debt?  Local governments have gone out of their way to hide borrowings, perhaps in part because of their doubtful legality.  As famed economic journalist Hu Shuli points out, new local officials sometimes do not know the extent of obligations left by their predecessors.  There have been a number of stratagems employed, from the issuance of illegal government guarantees to the transfer of funds in roundabout routes.

The case of China Zhongwang Holdings, a giant aluminum producer, illustrates how Liaoning province effectively went into debt in a roundabout manner—and concealed the borrowing.  As disclosed in a footnote in its 2009 financial statements, Zhongwang had borrowed 2.3 billion yuan from two Liaoning banks and, as reported by Naomi Rovnick of the South China Morning Post, had “given the money” to a government-owned entity.  Zhongwang, based in Liaoning, kept the loan on its books but disclaimed any responsibility for repayment.  Apparently, the series of money transfers among Liaoning’s government-owned entities through Zhongwang was intended to facilitate development of the local economy.

Chang reports that Liaoning is in the “rust belt” of China (did you know China had a rust belt?) but,

LGFVs in other parts of the country are also beginning to experience difficulties.  Yunnan Investment Group, the largest financing vehicle of southwestern Yunnan province, has just put restructuring plans on hold after China’s most widely followed rating agency warned of a downgrade in July.  Most LGFVs, however, are not rated and so there is virtually no public scrutiny of their activity.

LGFVs can continue to meet existing debt obligations as long as they can borrow new funds.  “If the government doesn’t tighten its policy too much, there shouldn’t be any problem,” said Tianjin Vice-Mayor Cui Jindu on Friday.  “But if we end up not getting a single new loan, there could be problems.”   

Sounds like a Ponzi scheme to me if that is the case and so like a Ponzi scheme is on extremely tenuous ground as it runs out of new members, in this case lenders.

Now I’m an unabashed China bull but that does not mean that I don’t believe that they will be immune from the cycles of business. I’m not sure any country has industrialised without some sort of intense recession or depression in the economic history of the world and I don’t think China is going to be any different. There is always a point where supply exceeds demand for a period or borrowing gets to a level where it can’t be sustained.

Perhaps China is closer to that point than I thought – I don’t really know. But as the rest of the world slows and the pressure on China and the rest of the developing world to provide an engine for developed world markets in terms of internally generated demand intensifies it may just be too much to ask.

Time will tell but the outcome is crucial for Australia and our economy.

greg@lighthousesecurities.com.au

www.twitter.com/gregorymckenna

This blog is for information only and does not constitute advice. Neither Greg McKenna nor Lighthouse Securities has taken your personal circumstances, objectives or financial situation into account. Because of this you should, before acting on this information, consider its appropriateness, having regard to your objectives, financial situation or needs.

If you do need economic, investment or financial advice we are happy to help.

Please Email the team at Lighthouse at info@lighthousesecurities.com.au or Greg directly on greg@lighthousesecurities.com.au

 
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