Sunday, June 26, 2011

notes of 'another leg to the Chinese story laid bare!!!'

Andrew Lee from UBS wrote an excellent article last month and made a number of key points explaining why he thinks China's growth story is fundamentally unsustainable.And here is some of my notes.

1.China are encountering a number of vital resource depletions right now. Fuel, oil and Top soil are all critical concerns to the stability of Chinese economy.

China has to employ 40% more capital to obtain similar growth) - and how it is rapidly exhausting those factors of production. The demographic dependency ratio is now starting to soar reducing its available workforce. This in turn will reduce free capital and therefore its capital to labor ratio, lowering productivity still further. The lack of productivity growth in agriculture means the rural economy has exhausted its supply of labor such that the continued industrialization has to be met with increased agricultural imports resulting in a swing in the terms of trade away from manufactured goods. 

Top soil is collapsing to dangerous levels and its fertility is being destroyed by acidification. Water is being consumed way beyond sustainable levels, aquifers are being exhausted and the stated policy of no water reaching the sea is getting nearer to reality as China’s latest 5 year plan aims to capture 95% of potential hydro capacity. Finally, and most importantly, China is exhausting its own fuel supplies extremely rapidly. 

2. Heavy government intervention lead to huge misallocation of capital. As the government always try to enforce businesses to meet certain social targets,hence price control, and artificially direct massive credit to SOEs, the unintended consequence of which is both the dropping of profitability of SOEs as the debt piled up and liquidity squeeze of SMEs.

We have heard the recent stories about companies using letters of credit to import copper or soybeans and then using the proceeds to support other debt, but this is just the tip of the iceberg. You may recall back in 2006 Ernst & Young issued a report that China’s bad debts may be as high as USD900bn, outstripping the country’s massive foreign exchange reserves at the time.

According to government data, about 40% of industrial State owned enterprises (SOEs) make losses, with the bulk of profits coming from relatively few firms. “Evidently, the longer these resource misallocations are allowed to continue, the greater the eventual fallout”. The BIS said that the SOE’s easy access to bank credit has lowered the marginal return on capital to the point that productivity levels are 30% lower than in private firms. “High rates of investment were also observed in East Asia in the 1980’s and early 1990s, culminating in the 1997 – 98 crisis”.

3. The story of the robustness of Chinese bank is a fairytale, Chinese banks have already been bailout two times in the past 20 years or so. Each time NPL ratio had hit 40% north. Some of these NPLs are still hidden in banks' asset today leeching depositors.

In 1999 the 4 asset management firms bought CNY1.4trn of bad assets at face value and issued bonds to the same banks in exchange. 

Rolling over the bonds is the easiest way to keep from realizing the actual hit. The CNY247bn of bonds accounted for 3% of China Construction Bank’s total assets. Eventually the state may have to buy out these asset management companies, but extending the debt for another 10 years buys them time.

Government has already warned us that many of the projects will be negative cash flow in the short term although the projects will eventually be good for the country. The fact is that the borrowing has been by the same SOE’s that have not been able to finance their debt in the past so, given the scale of loan growth in 2009 and the rapidly put-together projects, why should now be any different?

The NPL’s accumulated represented about 20% of GDP from the period 1988 to 1993 which were allowed to sit unnoticed on the banks balance sheets for another 5 years, and then off-balance sheet for another 10 years, and still are no closer to being written off. 

4. And this time, the rampant credit growth initiated in early 2009 for the sake of 'helping global economy' could be worse than previous crisis, for never did one country have so much hidden debt.It could last for a while, but the eventual collapse is inevitable.

Last year it was reported that a township government in Shanghai borrowed CNY2bn in 2008 under the cover of a national high speed railway project to repay debt. 

The financial arms of local governments have borrowed some 6 trillion yuan although you will recall that Victor Shih, a researcher with Northwestern University in the United States, estimated that China's total local government borrowing from 2004 to 2009 was around 12 trillion.

Red Capitalism calculates that these off-balance sheet liabilities means that China’s public-debt obligations will be 77.3% GDP at the end of this year, using what it suggests are extremely conservative measures.

The more you dig, the more China appears like a sovereign version of Enron, which as you recall was also the darling of the stock market for many years enjoying spectacular growth.

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