Dubbed “China’s new gold rush”, mounting bad debt has surprisingly become a sought-after investment for both foreign and Chinese investors.
Alibaba’s Taobao ecommerce platform has even been holding auctions of Chinese distressed assets, which you can buy alongside household products.
The paradox was displayed in the International Monetary Fund’s (IMF) warning to China, on August 17, that it needs to address its spiralling debt.
The Washington-based institution’s annual report on China also projects annual growth between 2017 and 2021 averaging 6.4% against a previous estimate of 6%. However, the IMF warns that growth fuelled by debt is a short-term solution and unsustainable over the longer-term unless the Chinese government addresses deeper structural issues.
“The growth outlook has been revised up reflecting strong momentum, a commitment to growth targets, and a recovering global economy,” the IMF says. “But this comes at the cost of further large and continuous increases in private and public debt, and thus increasing downside risks in the medium term.”
The Fund urges China’s leaders to use the opportunity presented by robust growth “to accelerate needed reforms and focus more on the quality and sustainability of growth.” The alternative “is further large increases in public and private debt.”
Vultures are circling
ShoreVest Capital Partners, a China-focused distress and special opportunity debt investor, is looking to raise $750m for a China distress fund. The size of the fund indicates growing interest in Chinese nonperforming loans (NPL).
The fund is expected to reach a first close this summer and will target non-performing loan (NPL) portfolios, distressed special situations and non-distressed situations in China, Private Debt Investor reported.
Some industry participants have said the banking industry’s NPL ratio is up to five times the official estimate of 1.7%.
In March, Andrew Brown, ShoreVest partner for macro and strategy, estimated that excess debt in the Chinese economy was roughly $3.1trn. Distress investor, Belos Capital Asia also recently claimed Chinese NPL prices had risen more than 30% this year.
But despite growing interest from investors to enter the NPL market in China, foreign firms have had trouble accessing the market because they lack local knowledge and relationships.
Foreign firms are struggling to get a piece of the pie
Last year, only five foreign investors managed to close deals, according to PricewaterhouseCoopers (PWC). Shoreline completed several portfolios, Lone Star Funds and Goldman Sachs acquired two portfolios, while PAG and Oaktree Capital closed one portfolio each, a PWC report states.
“Foreigners are attracted but largely absent, and local competitors have smaller funding pools with much shorter-duration profiles compared to ShoreVest,” says Brown.
Higher levels of corporate and household indebtedness are a continent-wide concern, according to Carlos Casanova, economist at Coface for the Asia Pacific region.
“From a macroeconomic perspective, higher levels of corporate and household indebtedness could become worrisome in the context of a slowing economy and rising rates,” explains Casanova.
“This could increase the cost of debt repayment, leading to an escalation of default risks and lower consumption in the case of households,” he tells GTNews.
There are two main implications to the spike in Chinese debt.
Firstly, this situation will be worse for economies with high levels of external debt, says Casanova. In Asia, the economies with the highest levels of foreign debt are Malaysia, Laos and Japan, also the financial centres Singapore and Hong Kong.
Secondly, those that are most exposed to China via trade may also see their revenues shrink in case the economy slows significantly in the second half of 2017, predicts Casanova.
“This is especially worrisome for countries that depend on incomes from exports, but have not done enough to build up their fiscal buffers over the years, as falling demand from China could escalate the risk of a full-fledged fiscal crisis taking place,” he says.
The IMF shares Casanova’s concerns, saying that “international experience suggests China’s current credit trajectory is dangerous with increasing risks of a disruptive adjustment and/or a marked growth slowdown.”
Don’t hold your breath
The Fund estimates that had credit expanded at a more “sustainable” pace between 2012 to 2016, China’s economy would have averaged growth of 5.5% annually, compared to the 7.25% recorded.
“The key policy imperative is to replace precise numerical growth targets with a commitment to reforms that achieve the fastest sustainable growth path,” the IMF states.
Despite the warnings, the Fund does not anticipate that China will manage to reduce its debt load any time soon.
The latest report predicts that total non-financial sector debt will increase from roughly 235% of gross domestic product (GDP) in 2016 to more than 290% by 2022. This compares to its previous prediction that debt would peak at 270% of GDP.
The IMF also expresses concerns over the rapid growth of the country’s banking sector: “China now has one of the largest banking sectors in the world,” it notes. “At 310% of GDP, China’s banking sector is above the advanced economy average and nearly three times the emerging market average.
“The sharp growth in recent years reflects both a rise in credit to the real economy and intra-financial sector claims. The increase in size, complexity and interconnectedness of these exposures have resulted in sharply rising risks.”
However, the IMF commends China’s efforts to boost oversight and regulation of financial sector risks, to control a run-up in corporate debt, to better manage capital outflows and to stabilise fluctuations in the yuan.
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