China is about to go to war with price.
The country just closed the annual session of its legislative body, and one economic concern loomed larger over the proceedings than any other — what to do with the country’s growing pile of non-performing loans (NPLs).
NPLs on Chinese bank balance sheets now total about $200 billion.
Out of that session, two plans surfaced — one through the media, and one through the government itself. Neither of them (even combined) will be enough to deal with the problem entirely and both are incredibly risky.
What’s more, both plans need China to work against the basic principles of supply and demand and control the price of assets. That’s something this government has experience with, of course, but it’s still risky and it’s a move that completely contradicts what China has said it means to do with its economy.
Because the government says so
We’ll talk about the newest plan first. It was announced by the head of the People’s Bank of China, Gov. Zhou Xiaochuan, as he addressed the National People’s Congress in Beijing on Saturday.
Zhou said that the government would allow six banks to securitize about $7.7 billion in NPLs and sell them to investors. He was also careful to explain that there’s “
no need to exaggerate” about the plan, and that this was just a starting place. The market for these asset backed securities might not even be that big anyway.
Additionally, and most importantly, he said that the market would be allowed to price these assets.
Cool. Nothing to see here. Just going to chop up and some really horrible debt and sell it as asset backed securities to whoever wants them — maybe retail investors in the country, maybe investors around the world.
No big deal?
As Societe Generale analyst Wei Yao pointed out, if the market is really going to set the price of this literal junk, then we have “a risk-ridden debt deleveraging process” on our hands, “given the uncertainty with market’s pricing of non-performing assets.”
In other words, the government is going to be working hard against where the market wants to price this stuff. These are, after all, assets reflecting the value of shrinking industries — loans that Chinese corporates have already given up on paying back.
The government may very well have to prop these assets up as it does the currency, which under the pressure of a slowing economy has been declining in value since August.
Just a little bit
The question is, why even create such a risky asset if it’s going to make such little impact on your debt problem?
Because in China’s desperate search for ways to free up cash for unproductive, highly indebted companies, officials have had to get as creative as possible. The country is trying to manage its way through an economic transition from an investment based economy to one based on domestic consumption. Until sluggish corporations from the old economy stop sucking up cash and resources, that will never happen, and economic growth will continued to grind down to a snail’s pace.
Meanwhile, debt in the country’s banking system is mounting. It would take 2.5 years worth of full economic output to pay it all back as things stand right now. China has been easing its economy to stimulate some growth for almost a year now, but the government knows there are limits to that. It can’t engage in all-out stimulus because the credit situation is tenuous.
From Societe Generale analyst Wei Yao, emphasis ours:
Truth be told, the PBoC cannot afford to let credit growth run wild again. Chinese banks are going through the most severe NPL cycle they have ever managed by themselves — at least so far this is the case, with no explicit government support announced yet. As the capacity reduction is likely to make a meaningful start soon, NPLs of state-owned enterprises, which have been implicitly guaranteed by the government and are much more sizeable than private sector’s NPLs, will finally emerge… The bad debt problem may finally come to fore.
Invisible iron hand, velvet glove
That brings us to China second plan, which was not mentioned by Zhou in his speech, but was reported by news outlets last week. The government will allow some banks to convert their NPLs into equities. This is usually something that happens to a company when it’s on the brink of bankruptcy, and some on Wall Street raised an eyebrow considering what it could do to the economy at large.
“This is using liquidity to paper over solvency issue in our view,” wrote analysts at Bank of American Merrill Lynch. “As a result, we consider this unconfirmed new policy, if it comes to pass, to be a long term negative for the market, and particularly for banks and the Asset Management Companies (AMCs), aka the bad banks (due to reduced business scope). In the long term, we are also concerned about the potential forming of a banking-industrial complex in China.”
Liu said that, under his watch, the government would continue to support the stock market with buybacks whenever it’s necessary. His office was about to reintroduce a new free market framework for the stock market this spring, but that can has been kicked down the road. Instead, the government will continue to manage the stock market — or maintain the illusion that it’s managing it.
This means it will essentially protect banks that are about put a bunch of shares of struggling companies onto their balance sheets.
Here’s the pricing issue again. If the market knows that the companies who get these swaps are on the verge of disaster, wouldn’t that work as a signal to the market that their stock price should be lower?
And remember: It’s going to take a lot more than writing off the debt to turn these companies around — if that’s even possible. In the meantime, this is a horrible deal for banks.
The again, maybe you believe the government can totally handle the stock market — that it can rule price (in this case, and in the case of asset backed securities made of NPLs).
Chinese government vs. Price — this is going to be a crazy tug of war.
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