“While this is surely good news for the very short run, as it allows the worst of the worst in China’s insolvent corporate sector to issue even more debt, in the longer run it means that China’s total debt to GDP, which is already at 350% is about to surpass Japan’s gargantuan 400% within a year if not sooner.”
In what may be the biggest news of the day, and certainly with far greater implications than whatever Mario Draghi will announce in a few hours when we will again witness the ECB doing not “whatever it takes” but “whatever it can do”, moments ago Reuters reported that China is preparing for an unprecedented overhaul in how it treats it trillions in non-performing loans.
Recall that as we first wrote last summer, and as subsequently Kyle Bass made it the centerpiece of his “short Yuan” investment thesis, the “neutron bomb” in the heart of China’s impaired financial system is the trillions – officially at $614 billion but realistically anywhere between 8% and 20% of China’s total $35 trillion in bank assets – in non-performing loans. It is the unknown treatment of these NPLs that has been the greatest threat to China’s just as vast deposit base amounting to well over $20 trillion, which has been the fundamental catalyst behind China’s record capital flight as depositors have been eager to move their savings as far from China’s domestic banks as possible.
As a result, conventional thinking such as that proposed by Bass, Ray Dalio, KKR and many others, speculated that China will have to devalue its currency in order to inflate away what is fundamentally an excess debt problem as the alternative is unleashing a massive debt default tsunami and “admitting” to the world just how insolvent China’s state-owned banks truly are, not to mention leading to the layoffs of tens of millions of workers by these zombie companies.
However, China now appears to be taking a surprisingly different track, and according to a Reuters report China’s central bank is preparing regulations that would allow commercial banks to swap non-performing loans of companies for stakes in those firms. Reuters sources said the release of a new document explaining the regulatory change was imminent.
According to Reuters, the move would represent, “on paper, a way for indebted corporates to reduce their leverage, reducing the cost of servicing debt and making them more worthy of fresh credit.”
It gets better.
It would also reduce NPL ratios at commercial banks, reducing the cash they would need to set aside to cover losses incurred by bad loans. These funds could then be freed up for fresh lending for investment in the new wave of infrastructure products and factory upgrades the government hopes will rejuvenate the Chinese economy.
It is certainly possible that this is merely a trial balloon, one which as was the case repeatedly during Europe’s crisis uses Reuters as a sounding board to gauge the market’s reaction, however the reality is that China may truly be desperate enough to pursue this option.
Because what is lacking in the Reuters explanation is that this proposal entails nothing short of a nationalization on a grand scale, one which gives China’s impaired commercial banks – all of which are implicitly state controlled – the “equity keys” to the companies to which they have given secured loans, loans which are no longer performing because the underlying assets are clearly impaired, and where the cash flow generated can’t even cover the interest payments.
In effect, the PBOC is proposing the biggest debt-for-equity swap ever seen. What it also means is that since the secured lender, which is at the top of the capital structure will drop all the way down, it wipes out the existing equity and unsecured debt, and make the banks the new equity owners, and as such China’s commercial banks will no longer be entitled to interest payments or security collateral on their now-equity investment.
Finally, while this move does free up loss reserves, it essentially strips banks of their security and asset protection which they enjoyed as secured lenders.
So why is China doing this?
As Reuters correctly noted, by equitizing trillions in bad loans, it frees up the corporate balance sheets to layer on fresh trillions in bad debt, the same debt that pushed these zombie companies into insolvency to begin with.
What this grand equitization does not do, is make the underlying business any more profitable or viable: after all the loans are bad because the companies no longer can generate even the required cash interest payment – as a result of China’s unprecedented excess capacity and low commodity prices which prevent corporate viability. It has little to do with their current balance sheet.
That, however, is irrelevant to the PBOC which is hoping that by taking this step it can magically eliminate trilliions in NPL from commercial bank balance sheets in what is not only the biggest equitization in history, but also the biggest diversion since David Copperfield made the statue of liberty disappear, as instead of keeping the bad loans on the asset side as NPLs, thus assuring at least some recoveries, the banks are crammed down and when the next NPL wave hits, their exposure will be fully wiped out as mere equity stakeholders.
So why are banks agreeing to this? Because they know that as quasi (and not so quasi) state-owned enterprises, China’s commercial banks are wards of the state and when the ultimate impairment wave hits and banks have to write down trillions in “equity investments”, Beijiing will promptly bail them out.
Essentially, in one simple move, Beijing is about to “guarantee” trillions in insolvent Chinese debt.
In short, as pointed out earlier, what the PBOC has proposed is the biggest “shadow nationalization” in history, one which will convert trillions in bad loans in insolvent enterprises into trillions in equity investments in the same enterprises, however without any new money actually coming in! Which means it will be up to new credit investors to prop up these failing businesses for a few more quarters before the reorganized equity also has to be wiped out.
Going back to the Reuters, it reports, that “the new regulations would be promulgated with special approval from the State Council, China’s cabinet-equivalent body, thus skirting the need to revise the current commercial bank law, which prohibits banks from investing in non-financial institutions.”
Of course the reason why commercial bank law prohibited banks from investing in non-financial institutions is precisely because it is a form of nationalization; only this time it will be worse – China will be nationalizing its most insolvent, biggest zombie companies currently in existence.
Reuters also observes that in the past Chinese commercial banks usually dealt with NPLs by selling them off at a discount to state-designated asset management companies. “The AMCs would turn around and attempt to recover the debt or resell it at a profit to distressed debt investors.” That China has given up on this approach confirms that there is just too much NPL supply and not nearly enough potential demand to offload these trillions in bad loans, hence explaining what may be the biggest nationalization in history.
Finally, Reuters concludes that “the sources did not have further detail about how the banks would value the new stakes, which would represent assets on their balance sheets, or what ratio or amount of NPLs they would be able to convert using this method.” Which is to be expected: in this grand diversion the last thing China would want is to reveal the proper math which would show how both China’s commercial banks, and the government itself, are about to guarantee trillions in insolvent assets.
While this is surely good news for the very short run, as it allows the worst of the worst in China’s insolvent corporate sector to issue even more debt, in the longer run it means that China’s total debt to GDP, which is already at 350% is about to surpass Japan’s gargantuan 400% within a year if not sooner.
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