China does not have a foreign debt problem – but its creditors may have. Quite how bad that becomes depends on how far China will go to let market forces prevail rather than allowing its own financial institutions to protect defaulters indefinitely and put in more money to prop up unviable entities.
China’s foreign debt, estimated at around US$1.1 trillion is often contrasted with its embarrassingly large foreign exchange reserves – now US$3.8 trillion. But recent events have been a reminder that the quality of China’s official foreign holdings is much higher on average than that of its foreign creditors.
Indeed, apart from government-guaranteed loans from the likes of the World Bank, there is limited information about much of the debt beyond the location of the financial institutions to which it is owed as provided to the Bank for International Settlements. And even that may well have large gaps due to loans via Caribbean and other offshore entities. Not all the lessons of the 1998 Asian crisis have been learned.
The biggest concern must be for Hong Kong where last year the Monetary Authority issued a caution about the very rapid growth in loans to the mainland. Now credit and bond markets are worried in the wake of the failure of property developer Kaisa Group Holdings to meet obligations on HK$400 million in loans from HSBC and also missed a deadline to pay a US$26 million coupon on a US$500 million bond issue.
Doubtless other loans to Kaisa including from mainland banks in Shenzhen are now also in default and there is likely to be a scramble to lay claim to Kaisa assets. Foreign lenders seldom do well in such asset scrambles.
Prices of foreign bonds issued by other property developers have fallen in the wake of the Kaisa default. The market is worried not just about the extent of over-leveraging among developers generally at a time when the stabilization of property prices and perhaps cuts in interest rates is probably the best that can be expected.
Fears abound of boardroom disputes and the spin-off from Beijing’s anti-corruption campaign. Politics, property development and massive wealth accumulation are too closely related for outside investor comfort.
But concerns go beyond the property sector, where the big companies are, by local standards, fairly transparent and the industrial enterprises are struggling with over-capacity and commodity companies with falling prices.. Most of the foreign currency bank debt is short-term and trade-related. In theory that should make it relatively safe. But in that case why did the amounts borrowed rise so dramatically in 2013-14 when trade was growing quite modestly? The main answer appears to lie in speculation by mainland companies.
First, for much of that period the dollar was weak and expected to get weaker. Thus there appeared to be a profitable “carry trade” in borrowing dollars to fund higher yielding yuan lending. Much of this may well have gone into the opaque off-balance sheet trusts and financing vehicles being used to get around bank lending restrictions or fund investments by cash-strapped local governments. Some would have been outright speculation in commodity prices.
But now the dollar has turned around, so far rising about 3 percent from its low against the yuan, Chinese interest rates are more likely to go down than up while the opposite is the case in the US. And commodity prices have collapsed – to the benefit of China as a whole but not of the many companies which used them as collateral for borrowings.
China’s overall balance sheet remains very healthy. Most of its liabilities are foreign direct investment (FDI) of about US$2.5 trillion, which cannot easily exit. Its trade balance remains in large surplus with lower oil, coal and iron ore prices more than offsetting any pressure on manufactured exports from competition from weaker foreign currencies.
Foreign reserves appear to have peaked as capital inflows reverse as speculation is unwound – a process which itself calls for easing of domestic monetary policy.
China could well benefit now from lower interest rates and further currency weakening in the light of the sharp falls of the yen, euro and many emerging market currencies. But what would be good news for many would be very bad for those on the wrong side of currency trades, which just might include many who had borrowed heavily from foreign banks to finance them.
The strength of the dollar has discomfited many borrowers, especially among commodity-dependent countries that have seen the local currency value of debt soar as revenues have plunged. Herein may lie the seeds of another financial crisis as years of ultra low interest rates are shown to have resulted not in a borrowing binge in the US but of one of dollars overseas. Foreign bank lenders will mostly have more difficult problems than China as a result. But those banks who saw China as an Eldorado but failed to see the disconnect between China’s economic performance and the quality of its financial system could have an anxious 2015.
What remains to be seen is how far Beijing is prepared to go in letting the chips fall where they may regardless of the short term implications for both economic growth and the borrowing costs of mainland companies.