Wednesday, June 30, 2010
While we may be kicking off a bounce day elsewhere in the world (TMM are dashing off to the plastic surgeons to get new Kevlar fingers fitted for renewed knife-catching), yesterday China started to resemble a car hit by a semitrailer. Equity markets are down again following another huge sell off yesterday and some of the non-Asia-based members of TMM are asking the all important question: how much worse can it get?Perhaps what is most disturbing about this sell-off is that it comes without a significant re-rating of the profitability of most Chinese companies - the forward PE of the A Share Index is not a pretty sight:This is all grist for those believers in the Chanos/Pettis framework which sees China's "recovery" as a credit bubble that has done little except for goosing Chinese property and bulk commodity prices. The problem TMM have always had with this thesis is that is very heavily dependent upon assuming something notoriously hard to observe: the credit quality of Chinese banks' loan books and the future willingness or ability of China's government to fund the banks just lending on to a bunch of rubbish. One of the first things we learned to do as credit tadpoles was due diligence on loans being auctioned out of some of China's bad banks like Cinda and Huarong. This was a complete waste of time because, after one or two initial deals, all the bidders worked out that these loans were worth 15c on a good day - far shy of the par-ish levels they were marked at or where the bad banks were willing to sell. Since these auctions, very few people in the industry have ever really assumed that marks and provisions at Chinese banks have anything to do with the mundane realities of paying interest and principal on time.
For the most part, then, analysis of Chinese financial institutions seems to have a lot more in common with Kremlinology and the big picture than anything else. China pushing out a lot of equity placements in banks? They probably need the cash pronto. Bank of Communications' loan books mostly property? Prices up, so who cares? This may seem disgusting to Western analysts of financial institutions but when the data is rubbish, why both wasting reams of paper on one Garbage-In Garbage-Oit exercise after another? There is some halfway decent anecdotal evidence of waste in local government investment vehicles, but the national accounting for local governments is similarly opaque. It's definitely bad, just how bad is anyone's guess.
If you assumed all US banks lie about their marks (no comment... ahem...), you could do worse than look at a financial conditions index which normally has a few things in it - TED spreads, equity volatility, credit indices, mortgage rates and some credit growth metrics. On almost any of these metrics, China isn't looking great. The Shanghai 3month lending rate (SHIBOR) minus the 3month deposit rate is ramping aggressively. And whilst there is debate as to how much influence the Ag Bank IPO is having on SHIBOR, the response has been bigger than is usually the case when there is a large IPO:Credit growth is coming off...
And while property data for China is only marginally more reliable than for loan quality, the indicators are all pretty bad. Add increases in reserve ratios at banks and China looks pretty stressed out with only a moderate amount of tightening. Take a look at the CSI 300 excluding financial and the index doesn't look too leveraged, at ~33% debt/market cap. Take a look at EBITDA/Interest cover assuming rates rise 200bps - as they have in SIBOR - and about 20% of the index has EBITDA/Interest of >2.5x. Make no mistake, this is a leveraged economy: not because everyone is borrowing at 95% LTV, Interest Only, but because so much of the economy that actually gets loans has wafer-thin margins, produces more than the country can use and can barely make a buck. Remember, these are "central" SOEs that are listed and represent the more solvent government owned enterprises.
With a lot of the government shareholdings having their backs against the wall and banks heavily leveraged to them, what is a quasi-capitalist state to do? One option would be to privatise more, kick out the bad loans and do all that good 1990s Washington Consensus-type stuff (unlike, what the Brussels Consensus has decided to do in Europe...). TMM have their doubts - last time a serious reformer came up in China, called Zhu Rongji, his reformist plans ran into the need to keep steel and aluminium workers employed, ensuring that in the good times, the orgy of capital spending continued, while in the bad times, not much got cut back. TMM does not see any reason why anything has changed in terms of the political pull of central SOEs and their management.
China has clearly got some tough choices to make - either keep up the tightening to rein in a bigger bubble later, or let it rip and hope you can reform corporates while aggravating a property bubble. TMM is of the view that while the longer-run picture of having sectors go from 9-10% ROAs to less than 1% is all bad, there is no reason to bet that China is not capable of turning on the taps, printing the money and stuffing it into the banking system in order to let good times roll.
Who would have thought the Chinese may have to join the global QE program? Who says they aren't team players?