naked capitalism

Victor Shih has done some serious analytical work to try to get a handle on the magnitude of China’s local debt. His post, which included extracts from his op-ed in the Asian Wall Street Journal, shows that some of the narratives about China are woefully incomplete. The whole post is very much worth reading, but here are his main conclusions (hat tip Michael Panzner via Jim Chanos):

Did China accomplish the impossible? Did it generate almost 9% growth and maintain low debt to GDP ratio even as its export plummeted by 20%? What about claims that the torrent of investment in China has come without too much leveraging? After spending half a year looking into the debt level of local government investment entities– some 8000 of them– my conclusion is no. As in the past, the Chinese government just ordered banks to lend to investment companies set up by both central and local governments. Local governments have fully taken advantage of the green light in late 2008 and borrowed an enormous sums from banks and bond investors starting in late 2008 (well, a large amount even before that)….

So basically, in addition to the 20% of official debt-to-GDP ratio, one has to add an additional 30%. We also have to add other debt that the central government guarantees, such as the nearly 1 trillion RMB in Ministry of Railway bonds and bonds issued by the asset management companies. All of this gives China a high debt to GDP ratio. Also, there are some disturbing implications of this high debt. For one, local governments would have to sell lots and lots of land every year for many years to come to pay interest payment on this debt. Thus, to the extent that there is a real estate bubble today, it must continue for local governments to remain solvent. Regardless of what you believe about Chinese real estate, you have to think that this growth in real estate and land prices must slow or reverse at some point.

Yves here. This is consistent with what I heard at a lunch with Josh Rosner and Chris Whalen yesterday, who went on at some length about how awful the Chinese banks were, as in stuffed to the gills with bad loans. They think the idea that China is so well off by virtue of its massive FX reserves is oversold, given the black hole in its banking system.

Shih thinks the central government needs to stop leveraging by local investment companies, take over their debt, securitize it, and peddle it to local and foreign investors. Shih argues that foreign investors will take up this paper as a renminbi revaluation play.

I’m skeptical for several reasons. The act of selling this paper itself would push the RMB up. The early buyers can rely on momentum, but what about the later sales? Moreover, what will be the reporting on the performance on this debt? The US has had more than two decades to create the legal mechanisms and related reporting for securitization of debt to work (and it still wound up with considerable abuse and mispricing). Is anyone going to find the initial and ongoing reporting the underlying assets in this sort of program adequate? Highly doubtful, which means it would need a government guarantee.