The following is a guest post from Jonathan Rochford, CFA Portfolio Manager of Narrow Road Capital Pty Ltd.
China debt situation gets worse and other EMs start to struggle
One article this month pretty much summed up the overbuilding issue in China. In aggregate, Chinese cities are planning for 3.4 billion people in 2030. That’s three times the existing population and forecast population growth is minimal. Peak urbanisation may have arrived for China, the substantial slowdown in wage inflation is a strong indicator that the demand for labour is flat at best. This aligns with recent reports of a substantial increase in the unemployment rate. The city of Tieling is one example of what happens when a construction and manufacturing bubble pops.
Remember that local governments earn most of their revenues from property development activities, which would fall flat if urbanisation stops. A collapse in revenue would make debt servicing problematic, which is particularly concerning as local governments have seen an enormous increase in their debt issuance in 2015 and 2016. This includes continuing to build coal fired power plants when the existing plants are running at low capacity. Local governments are blocking lenders from withdrawing credit in order to protect jobs at zombie companies. 7.5% of companies in China are believed to be economically unviable, with medium and large state owned entities the worst.
Last month I wrote about the first non-performing loan securitisations in China and it looks like this process is ramping up. The Agricultural Bank of China is planning to sell a US$1.6b securitisation of non-performing loans which includes the underlying loans being marked down to 29% of face value. The other big way that banks are planning to clean up their loan books is debt to equity swaps, which are expected to start soon.
There’s plenty to worry about with peer to peer lending and a crackdown is coming for wealth management products. In order to reduce fraud in these areas executives are being given tours of prisons, as a reminder of what might happen to them when investors lose money. Given the concerns with these sectors, investors are increasingly investing overseas or putting their savings in a bank. In a reminder that Chinese investors are still learning the ropes, one article highlighted their love affair with stock splits and stock dividends. If a company is issuing more stock they assume it must be good.
The Chinese regulators are planning to reduce the maximum leverage within managed funds from 70% to 50%. In what might be a sign that the Minsky moment is near, corporate bonds sales are falling as default rates are increasing. Perhaps investors are starting to realise that Chinese ratings agencies can’t be trusted with 56% of AAA rated bonds having sub-investment grade metrics. Chinese asset management firms will have to continue raising capital in order to deal with the expected wave of defaults. Bankruptcy and recovery processes are still problematic with Dongbei Steel going about its business as if nothing has happened three months after it skipped debt repayments.
I suspect iron prices can’t remain at current levels for too much longer as Chinese stocks piles are soaring once again. Chinese iron ore producers are claiming that Australia and Brazil are dumping iron ore into China, the clearest indication yet that they are suffering. The higher prices for iron ore are driven by credit growth that remains strong and investment by state owned entities that has skyrocketed this year, neither of which can last forever. Chinese state owned entities are being loyal to their masters, helping to prop up both the yuan and share prices.
Venezuela keeps getting worse as gold reserves are still being sold off to postpone an inevitable default. Big repayments are due in October and November and that’s when a default might occur. McDonalds and Kimberly Clark are the latest businesses to halt production after being unable to obtain key supplies.
Mozambique is set to default soon, with the story of how it fell from Africa’s most promising economy to its current situation an interesting one. Puerto Rico paid $1.1 billion and defaulted on $977 million of repayments in early July.
The Puerto Rican water utility wants to raise $900m in new debt and give existing debtors a 15% haircut. The President of Angola has warned that his country will struggle to pay its debts. Argentina hasn’t defaulted, but with inflation running at 50% per annum and with interest rates at 30% the average citizen might think it has.
Turkey, Russia, China and Brazil all have issues with private sector debt levels. Turkey’s political issues are well known, creating a risk for its banks who rely heavily on external funding. Russia is raiding its sovereign wealth fund to maintain government spending, retail sales are down 5.9% and about 10% of loans at banks are thought to be non-performing. But don’t worry about any of that, emerging market debt is all the rage. Investment refugees from negative interest rate countries need somewhere to put their money. The P/E ratio for emerging market equities is well above long term averages. India’s high yield bonds are also currently sought after. That seems a little odd given its banks are dealing with a mountain of non-performing loans and credit rating downgrades. Indian state banks are set for a $3.4 billion taxpayer recapitalisation but some are saying it won’t be enough.