The Reserve Bank of India (RBI) presented its last monetary policy statement for this financial year, yesterday. It decided not to cut the repo rate which continues to be at 7.75%. The repo rate is the interest rate at which the RBI lends to banks and is expected to act as a sort of a benchmark to the interest rates at which banks carry out their business.
The RBI deciding not to cut the repo rate was largely around expected lines. I had said so clearly in my column dated January 16, 2015. The RBI had cut the repo rate by 25 basis points (one basis point is one hundredth of a percentage) a day earlier, on January 15, 2015.
There was a straightforward reason for this—the RBI had said in the statement released on January 15, that: “Key to further easing are data that confirm continuing disinflationary pressures.” Between January 15 and February 3 no new inflation data has come out. Hence, there was no way that the RBI could figure out whether the fall in inflation (or what it calls disinflation) has continued. Given this, there was no way it could cut the repo rate, unless it chose to go against its own guidance.
The more important issue here is that despite the RBI cutting the repo rate on January 15, 2015, very few banks have acted on it and passed on the rate cut to their consumers. Reuters reports that only three out of India’s 45 commecial banks have cut their base lending rates since the RBI cut the repo rate last month. The base rate is the minimum interest rate a bank is allowed to charge to its customers.
This has happened in an environment where growth in bank loans has slowed down substantially. Every week the RBI puts out data regarding the total amount of loans given out by banks. As on January 9, 2015 (the latest such data available), the total lending by scheduled commercial banks had grown by 10.7% over a one year period. For the one year period ending January 10, 2014, the total lending by banks had grown by 14.8%. This clearly shows that the bank lending has slowed down considerably over the last one year.
In this scenario theoretically it would make sense for banks to cut their interest rate so that more people borrow. As Rajan put it while addressing a press conference yesterday: “To get that lending they will have to be more competitive, which means they will have to cut base rate. I am hopeful it is a matter of time before banks judge that they should pass it on.”
But as I have often explained in the past cutting interest rates does not always lead to more people borrowing because the fall in EMIs is almost negligible in most cases.
As John Kenneth Galbraith writes in The Affluent Society: “Consumer credit is ordinarily repaid in instalments, and one of the mathematical tricks of this type of repayment is that a very large increase in interest brings a very small increase in monthly payment.” And vice versa—a large cut in interest rate decreases the monthly payment by a very small amount. So interest rate cuts do not always lead to people borrowing more.
Hence, the banks run the risk of cutting the base rate and charging their existing customers a lower rate of interest and at the same time not gaining new customers. This will be a loss-making proposition for banks and given that only 3 out of the 45 scheduled commercial banks have cut their base rates since January 15, 2015.
Banks increase their lending rates very fast when the RBI raises the repo rate. But they take time to cut their lending rates particularly in a situation where the RBI has reversed its monetary policy stance and cut the repo rate after a long time.
As Crisil Research points out in a research note released yesterday: “Lending rates show upward flexibility during monetary tightening but downward rigidity during easing. Between 2002 and 2004, while the policy rate declined by 200 basis points, lending rates dropped by just 90-100 basis points. Conversely, in 2011-12, when the policy rate rose by 170 basis points, lending rates surged 150 basis points.”
So when the RBI is increasing the repo rate, banks typically tend to match that increase, but the vice versa is not true. “Lending and deposit rates also move in tandem in times of policy rate hikes, while the gap between them widens when rates fall. Base rates of banks have been steady around 10-10.25% over the last 18 months, while deposit rates started coming down in October 2014 by about 20- 25 basis points because of ample liquidity.,” points out Crisil Research.
This is something that Rajan also talked about yesterday, when he said: “Many [banks] have been relatively quick to cut their deposit rates, but not so quick to cut their lending rates, I presume some are hoping they can get the spread for a little more time to repair banks’ balance sheets.”
When a bank cuts the interest rate it pays on its fixed deposits and at the same time does not cut its lending rate, it earns what bankers call a greater spread. This essentially means more profit for the bank.
Rajan in his statement also talks about banks repairing their balance sheets. This is particularly in r reference to the bad loans of public sector banks. As the latest financial stability report released by the RBI in December 2014 points out: “PSBs[public sector banks] continued to record the highest level of stressed advances at 12.9 per cent of their total advances in September 2014 followed by private sector banks at 4.4 per cent.” The situation hasn’t really changed since then, if the latest quarterly results of public sector banks for the period October to December 2014 are anything to go by.
The stressed asset ratio is the sum of gross non performing assets plus restructured loans divided by the total assets held by the Indian banking system. The borrower has either stopped to repay this loan or the loan has been restructured, where the borrower has been allowed easier terms to repay the loan (which also entails some loss for the bank) by increasing the tenure of the loan or lowering the interest rate.
What this means in simple English is that for every Rs 100 given by Indian banks as a loan(a loan is an asset for a bank) nearly Rs 10.7 is in shaky territory. For public sector banks this number is even higher at Rs 12.9.
The public sector banks are hoping to recover some of these losses by cutting their deposit rates but staying put on their lending rates. And this leads to a situation where even though the RBI has cut the repo rate once, it hasn’t had much impact on the lending rates of banks. “High non performing assets curb the pace at which benefits of lower policy rate are passed on to borrowers. Data shows periods of high NPAs – such as between 2002 and 2004 (when NPAs were at 8.8% of gross advances) – are accompanied by weaker transmission of policy rate cuts. This time around, NPA levels are not as high as witnessed back then, but still remain in the zone of discomfort,” Crisil Research points out.
In this situation, banks will cut lending rates at a much slower pace than the pace at which the RBI cuts the repo rate.
SpiceJet has approached the government for financial help. The top officials of the airline met the Minister of State for Civil Aviation Mahesh Sharma, a couple of days back.
“We have given no assurance to SpiceJet. We will take a final decision keeping wider interest of passengers in mind,” Sharma told the press after the meeting. He also said that the request for financial help would be put before the petroleum and the finance ministries, as well as the prime minister’s office.
A newsreport in The Times of India suggests that the officials of SpiceJet told Sharma that the airline had an immediate cash requirement of Rs 1,400 crore and an overall requirement of Rs 2,000 crore.
The airline, like Kingfisher before it, owes money to employees, airports and oil companies. Over and above this there are statutory dues that remain unpaid. The airline has provided a guarantee that it would clear the dues worth Rs 200 crore that it owes the Airports Authority of India (AAI),
which operates most airports in the country.
Yesterday the government allowed SpiceJet to book tickets up to March 31, 2015. Earlier, the airline wasn’t allowed to book tickets beyond thirty days.
This will help the airline in two ways. First, it can honour the bookings that it had made earlier and will not have to cancel these bookings. Cancelling the bookings would have meant paying back the customers who had booked tickets, and this would mean outflow of cash for the airline. The airline is currently running short on cash.
Secondly, the airline can make fresh bookings and in the process raise some money. It will be interesting to see if the airline uses this opportunity to announce flash sales. This is how the company has been operating this year.
A report in The Hindustan Times quotes an unnamed expert as saying: ““In a bid to raise working capital, the airline started frequently coming up with flash sales. It was their desperation to raise working capital as they waited for an investor.” In a bid to shore up its working capital the airline has announced over 25 sales this year.
It will be interesting to see if consumers book seats on SpiceJet given that in the last few months the airline has used what aviation industry insiders term as the “Christmas tree” option. This essentially means that the airline is taking out spare parts from its aeroplanes and using them for other planes in its fleet. Long story short: it doesn’t even have the money to pay for spare parts. So, the question will consumers feel comfortable travelling in such an airline?
Further, the government also allowed the airline to operate for another 15 days without paying up the Rs 200 crore that it owes AAI and Rs 80 crore that it owes to other companies operating airports in the country. The company also owes Rs 14 crore to oil marketing companies.
The Times of India report quoted earlier goes on to suggest that the government may be working out a “’revival package’ for SpiceJet as it fears shut down of yet another big airline after Kingfisher — both poor companies of rich promoters — ‘will send a bad signal globally’.”
Another PTI report suggests that the government may request banks to give loans of up to Rs 600 crore to SpiceJet, so that it has enough money to keep operating.
If the government does anything like that it will be setting a bad precedent by building in moral hazard into the system. As economist Alan Blinder puts it in After the Music Stopped : “ [the]central idea behind moral hazard is that people who are well insured against some risk are less likely to take pains (and incur costs) to avoid it.”
A very good example of this in an Indian context is Air India. Its employees know that the government will not shutdown the airline and keep pumping money into it, and given that they have very little incentive in turning it around.
While this is not the only reason for the disastrous performance of Air India, it remains one of the major reasons. Its employees know that the government will not shut-down the airline because the politicians need their free airline rides at the end of the day and that is only possible with Air India around.
The airline made a loss of Rs 5,400 crore in 2013-2014. During this year the airline will see a total capital infusion of Rs 6,000 crore from the government. Such capital infusions have become a regular feature of Air India’s survival kit. The airline also has a total debt of close to Rs 40,000 crore.
One look at these numbers tells us that SpiceJet’s requirement of Rs 2,000 crore is rather small in comparison. Nevertheless, it is important to point out here that once bailouts start they can’t be scaled back, as central banks all over the world realized in the aftermath of the financial crisis.
Further, if the government chooses to rescue SpiceJet, after this every airline in trouble will expect to be rescued by the government and so might other companies as well. And this is exactly what moral hazard is all about.
Other than encouraging the insiders to take on increased risk, it gives them the impression of the world being a safer place to do business in than it actually is. This is because the firms assume that in case of a crisis, the government will come to their rescue. And this is not good for the system as a whole.
Also, as I have often pointed out in the past, the government isn’t exactly overflowing with money. The tax collections this year have been nowhere as expected. The disinvestment programme is yet to take off. And the fiscal deficit for the first seven months(April to October 2014) of the financial year has already burgeoned to 89.6% of the annual target.
Further, as I had pointed out in a previous piece on SpiceJet, it is worth remembering that the commercial aviation business is a huge cash guzzler and has led many a capitalist to his ruin. This is not only an Indian phenomenon, it seems to be the case globally. A February 2014, article in The Economist suggests that profits margins of airlines have been less than 1% on average over the last 60 years.
In this scenario, it doesn’t make any sense for the government to rescue SpiceJet. Further if they choose to rescue SpiceJet, they will essentially be rescuing a crony capitalist, who built his main “media” business with the blessings of a political party. This will not be a good thing to project for the government.
It is important to remember here what Raghuram Rajan and Luigi Zingales write in Saving Capitalism from the Capitalists: “Since a person may be powerful because of his past accomplishments or inheritance rather than his current abilities, the powerful have a reason to fear markets…Those in power – the incumbents – prefer to stay in power.” Even if it means begging the government for a rescue.
Rajan and Zingales further elucidate on this point: “Throughout its history, the free market system has been held back, not so much by its own economic deficiencies as Marxists would have it, but because of its reliance on political goodwill for its infrastructure. The threat primarily comes from…incumbents, those who already have an established position in the marketplace…The identity of the most dangerous incumbents depends on the country and the time period, but the part has been played at various times by the landed aristocracy, the owners and managers of large corporations, their financiers, and organised labour.”
Keeping these points in mind, if the government does decide to rescue SpiceJet, it will be helping another crony capitalist survive without having to face the consequences of his actions. This can’t be good for the government which anyway gives an impression of being close to big business.
To conclude, it is important to remember what the American economist Allan Meltzer once said: “Capitalism without failure is like religion without sin. It doesn’t work.”
Borrowing money to run or expand a business is standard operating procedure. The only thing is that the money that has been borrowed needs to be repaid. But sometimes the business does not make enough to repay the borrowed money or debt as it is referred to as.
And some other times, the business does not make enough money even to repay the interest on the debt, that it has taken on. Indian businesses are going through that phase right now. A significant number of them are not making enough money to even repay the interest on the debt that they taken on.
In a report dated November 19, 2013, Ashish Gupta, Prashant Kumar and Kush Shah of Credit Suisse make this point. As they write “Of our sample of listed companies(around 3,700 listed companies), the share of loans with corporates having interest coverage (IC1) <1 went up to 34% (versus 31% in 1Q14). Of these, 80% (78% in 1Q) of loans were with companies which had IC<1 for at least four quarters in the past two years and 26% of them have not covered interest in eight consecutive quarters.”
Now what does this mean in simple English? Around 34% of the listed companies that Credit Suisse follows have an interest coverage ratio of less than one. Interest coverage ratio is essentially the earnings before interest and taxes of a company divided by its interest expense. If the interest coverage ratio is less than one what it means is that the company is not making enough money to pay the interest on its outstanding debt.
Hence, more than one third of the listed companies in the Credit Suisse sample are not making enough money to pay the interest on their debt. Of this lot nearly 80% have had an interest coverage ratio of less than one in at least four quarters in the past two years. And 26% have not made enough money to cover their interest for eight consecutive quarters.
The only conclusion that one can draw from this is that India Inc is sitting on a debt time bomb. “Large corporates continue to be under significant stress as out of the top-50 companies by debt with interest coverage<1 in the second quarter, 23 companies haven’t covered interest in seven or more quarters in past two years and 38 companies were loss making at a profit after tax level,” write the analysts.
A lot of this borrowing was carried out during the easy money years of 2003-2008, when banks were falling over one another to lend money. But now the chickens are coming home to roost. When corporates do not have enough money to repay the interest on their outstanding debt, banks can’t be in the best of shape.
The non performing assets of banks have been on their way up. As economist Madan Sabnavis wrote in a recent column in The Financial Express “Ever since the economy started slipping, companies have found it difficult to service their loans leading to NPAs’ volume increasing from 2.4% in FY11 to 3.0% in FY12 and around 3.6% in FY13. In absolute numbers, they stood at around Rs 1.9 lakh crore in March 2013.”
But what is even more worrying is the rate at which the total amount of restructured loans have been growing. Under restructuring, companies are allowed a certain moratorium on repayment of the outstanding debt. The interest rates to be paid on the outstanding debt are eased at the same time.
In a note dated November 7, 2013, Gupta and Kumar of Credit Suisse had pointed out that “Indian Bank restructured loans were at Rs3.3 trillion (Rs 3,30,000 crore) of which 55% has come through the corporate debt restructuring route.” The total amount of restructured loans are now at 6% of the total loans that banks have given(around 47% of networth of the banks).
And this continues to grow at a huge speed. In October 2013, the corporate debt restructuring cell received new references of Rs 170 billion (Rs 17,000 crore).
Economist Madan Sabnavis throws some more numbers. “The CDR website shows that the volume of restructured debt has increased continuously, touching Rs 2.72 lakh crore as of September 2013 from Rs 0.9 lakh crore in FY09, and was at Rs 2.29 lakh crore by March 2013. In terms of a ratio as a percentage of total advances, CDR was higher at 4.4%, and even traditionally this ratio has been higher than the declared gross NPA ratio...Adding the NPAs to CDRs, the total would stand at 8% for FY13, which is quite scary,” he wrote in The Financial Express.
The reasoning given for corporate debt restructuring is that often a project that the business has borrowed for, does not take off due to external circumstances. This can vary from the environmental clearance not coming in to the land required for the project not being acquired in time.
But with the amount of loans being restructured rising at such a rapid rate leads one to wonder whether the banks genuinely feel that these loans will be repaid or as they just postponing the problem? Take the case of October 2013. New references of Rs 17,000 crore were made to the CDR cell. In comparison for the period of July 1 to September 30, 2013, references to the CDR cell had stood at Rs 24,900 crore.
The Reserve Bank of India(RBI) is clearly worried about this. “You can put lipstick on a pig but it doesn’t become a princess. So dressing up a loan and showing it as restructured and not provisioning for it when it stops paying, is an issue. Anything which postpones a problem than recognising it is to be avoided,” Raghuram Rajan, the RBI governor said a few days back.
But just being worried will not help.
The article originally appeared on www.firstpost.com on November 22, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)
On October 3, 2013, the finance ministry headed by P Chidambaram put out a rather nondescript press release, in which it said “The Central Government has decided in principle to enhance the amount of capital to be infused into Public Sector Banks (PSBs). It may be recalled that in the Budget for 2013-14, a sum of Rs. 14,000 crore was provided for capital infusion. This amount will be enhanced sufficiently. The additional amount of capital will be provided to banks to enable them to lend to borrowers in selected sectors such as two wheelers, consumer durables etc, at lower rates n order to stimulate demand.”
In other words, the government of India will provide public sector banks more money than what it had budgeted for, so that they can lend it to borrowers to buy two wheelers and consumer durables. And this would revive consumer demand and in turn economic growth.
Now only if economics worked in such a linear sequence, even I could be the RBI governor. The first question is where is the government going to get this ‘extra’ money from? As Deputy Governor of the Reserve Bank of India K C Chakrabarty put it on Saturday “How much (will the government put in)? If the government has so much money, then no problem.”
The government of India (like most governments in the world) spends more than it earns. Hence, it runs a fiscal deficit. This deficit is financed by selling government bonds. Who buys these bonds? Banks and other financial institutions.
Latest data released by RBI shows that as on September 20, 2013, the banks had a credit deposit ratio of 78.2%. This means that for every Rs 100 that banks had borrowed as a deposit, they had lent out Rs 78.2.
The banks need to maintain a cash reserve ratio of 4% i.e. for every Rs 100 they borrow as a deposit, they need to maintain a reserve of Rs 4 with the RBI. Other than this banks need to maintain a statutory liquidity ratio of 23% i.e. Rs 23 out of every Rs 100 borrowed as a deposit, needs to be invested in government bonds.
Hence, Rs 27 (Rs 23 + Rs 4) out of every Rs 100 borrowed as a deposit goes out of the equation straight away. This means only Rs 73 out of every Rs 100 borrowed as a deposit can be given out as a loan. But as we saw a little earlier the Indian banks have lent Rs 78.2 for every Rs 100 they have borrowed as a deposit.
This means is that banks are borrowing from other sources in the market to lend money. Why would they do that ? They are doing that because they aren’t able to raise enough enough deposits. Lets look at data over the last one year (i.e. between Sep 21, 2012 and Sep 20, 2013). Deposits have grown at a pace 11.9%. Loans have grown at a much faster 15.4%. The incremental credit deposit ratio is at 101.4%. What this means is that for every Rs 100 raised as deposit, banks have given out Rs 101.4 as loans. Ideally, for every Rs 100 raised as a deposit, banks shouldn’t be lending more than Rs 73.
Hence, banks have a paucity of funds going around. In this situation, if the government chooses to hand over extra capital to public sector banks, it will have to finance this transaction by selling government bonds. Banks and other financial institutions will buy these bonds. As we saw, banks are already stretched when it comes to deposits. In order to buy these bonds, banks will have to raise extra deposits by offering a higher rate of interest. Or they will have to raise money from sources other than deposits, and that will mean paying a higher rate of interest. And when they do that how can they be expected to lend at lower interest rates?
The finance minister has been pretty vocal about the fact that the government won’t let the fiscal deficit cross the level of 4.8% of the GDP, that it had projected in the annual budget. The trouble is that in the first five months of the financial year (i.e. between April-August 2013), the fiscal deficit has already touched 74.6% of its annual target. If the government wants to provide extra capital to public sector banks then it would lead to more expenditure, making it more difficult for the government to stick to the fiscal deficit target.
Given this, the government may look to finance this transaction by cutting other expenditure. In this scenario, it is more likely to cut planned expenditure than non planned expenditure. Planned expenditure is essentially money that goes towards creation of productive assets through schemes and programmes sponsored by the central government. Non- plan expenditure is an outcome of planned expenditure. For example, the government constructs a highway using money categorised as a planned expenditure. But the money that goes towards the maintenance of that highway is non-planned expenditure. Interest payments, pensions, salaries, subsidies and maintenance expenditure are all non-plan expenditure.
As is obvious a lot of non plan expenditure is largely regular expenditure that cannot be done away with. Hence, when expenditure needs to be cut, it is the asset creating planned expenditure which typically faces the axe and that is not good for the overall economy.
It also needs to be pointed out that currently the market for two wheeler and consumer durable loans is dominated by private players and not public sector banks. People stay away from public sector banks because of the high level of documentation required. As a senior executive of Bajaj Auto told DNA recently “Currently, NBFCs and private banks dominate the two-wheeler finance market. So, I don’t think the move will have any major impact.” Hence, just offering lower interest rates on loans is not enough to get people to borrow from public sector banks.
Further, trying to get public sector banks to lend at lower interest rates is “inconsistency in public policy approach.” As Sonal Varma of Nomura put it in a note dated October 3, 2013, “The government is prodding public sector banks to lend at a subsidised rate at a time when the RBI has just hiked the repo rate – a signal to banks to hike their lending rate. We do not see this as a sustainable strategy to kickstart consumption.” The RBI had also recently asked banks not to offer 0% EMI plans for the purchase of consumer goods. And now the government is telling the banks that we want you to lend at lower interest rates.
Also, some little bit of basic maths can show us why interest rates do not have much of an impact, when it comes to people taking loans to buy consumer goods and two wheelers. Lets us say an individual takes on a two year loan of Rs 25,000, at an interest of 17%. The EMI for this works out at around Rs 1236. For every 100 basis point (one basis point is one hundredth of a percentage) fall in interest rate, the EMI comes down by Rs 12. Yes, you read it right.
So, if the rate of interest falls to 16%, the EMI will come to around Rs 1224 from Rs 1236 earlier. At 15% it would come to Rs 1212 and so on. Hence, even if interest rates crash by 700 basis points and come down to 10%, the EMI will come down by only Rs 84 per month.
Considering this no one is going to go ahead and buy a consumer good or a two-wheeler because the EMIs fall by Rs 12, for every 100 basis points cut in interest rates. As Chakrabarty rightly put it “You cannot lure the people (to buy goods) by lowering interest rates.”
People are not buying because they do not feel confident enough of their job prospects in the days to come. As Varma puts it “The job market and income growth – the key drivers of consumption – remain lacklustre.” And that’s the main problem. Lower interest rates alone can’t just address that.
The article originally appeared on www.firstpost.com on October 7, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)
A famous Central Intelligence Agency (CIA) paper on China is titled “The Art of China Watching”. In this paper the author Gail Solin concedes that “The art of China-watching is imprecise at best…The explanation, or blame, for this often frustratingly lies mainly with the way the Chinese conduct their affairs. To say the Chinese have a penchant for secrecy is almost an understatement.”
Edward Chancellor and Mike Monnelly of the global investment management firm GMO writing in a white paper titled Feeding the Dragon: Why China’s Credit System Looks Vulnerablesuggest that the CIA paper was written sometime in the 1970s.
When it comes to those from the outside watching the Chinese financial system, things haven’t changed nearly four decades later. China watching is still imprecise at best. Or as Stephen Green, head of Greater China research at Standard Chartered Plc in Hong Kong recently told Bloomberg “It’s a big black box, and it’s quite scary.”
And a few things coming out of the black box now seem to suggest that things are not as hunky dory as they are being made out to be. The loans given by banks and other financial institutions have reached very high levels. As Chancellor and Monnelly point out in their research paper “Between 2007 and 2012, the ratio of credit(i.e. loans) to GDP climbed to more than 190%, an increase of 60 percentage points. China’s recent expansion of credit relative to GDP is considerably larger than the credit booms experienced by either Japan in the late 1980s or the United States in the years before the Lehman bust.” As of the end of 2012, the total lending by banks and other financial institutions as a proportion of the GDP ratio stood at 198%.
So China has a debt problem, given that the total loans given by its banks and other financial institutions have risen at a very rapid rate. “There is just no way to grow out of a debt problem when credit is already twice as large as GDP and growing nearly twice as fast,” Charlene Chu Senior Director in the Financial Institutions Group at Fitch Ratings based out of Beijing, told Bloomberg.
What is interesting is that the loan boom in China has been faster than many other countries which have faced severe banking and financial crises in the past. As the Bloomberg story points out “A jump in the ratio of credit to GDP preceded banking crises in Japan, where the measure surged 45 percentage points from 1985 to 1990, and South Korea, where it gained 47 percentage points from 1994 to 1998, Fitch said in July 2011. In China, it has increased 73 percentage points in four years, according to Fitch’s estimates.”
And this loan growth continues unabated. In the period January-March 2013 total loans grew by 20% in comparison to the same period last year. There are two main problems that arise with excessive loan growth.
As Wei Yao of Societe Generale writes in a report titled China’s missing money and the Minsky moment “a fast rising debt load of an economy suggests either deteriorating growth efficiency or high and rising debt service cost, or in many cases both. There is clear evidence that China is suffering from both of these.”
What this means is that China now needs more and more debt to create the same unit of growth. Meanwhile the debt service ratio keeps growing. Debt service ratio is essentially the sum of interest to be paid on all the outstanding loans along with the maturing loans that need to be repaid expressed as a percentage of GDP. Wei Yao estimates that China has “a shockingly high debt service ratio of 29.9% of GDP, of which 11.1% goes to interest payment and the rest principal.”
“At such a level, no wonder that credit growth is accelerating without contributing much to real growth!,” she writes.
A lot of the excessive loan growth in China has gone into buying and building property, where no one lives. “Miles upon miles of half-completed apartment blocks encircle many cities across the country. Official data suggest that the value of the unfinished housing stock is equivalent to 20% of GDP and rising..Developments in the infamous “ghost city” of Ordos, in Inner Mongolia, reveal the vulnerability of China’s credit system to an overblown housing market. The Kangbashi district of Ordos is a totem for China’s property excesses. Kangbashi has enough apartments to shelter a million persons, roughly four times its current population,” write the GMO authors.
This basically means that builders who built these homes are not in a position to repay the loans they had taken on, given that the homes are not selling and have been more or less abandoned. This excessive building of homes was driven primarily by demand from speculators. The government has taken various steps to kill ‘speculation’ from time to time but hasn’t done enough and it keeps coming back.
Andy Xie, a former Morgan Stanley analyst, who closely tracks China made a fairly interesting point in a column he wrote in late March 2013. As he wrote “The government has introduced tightening measures against property speculation from time to time. These measures have never been serious enough to stamp out speculation. They merely slowed and extended it. The ineffectiveness of the measures keeps up the dream that prices could surge when the government either loosens up or is overwhelmed. That dream keeps speculators in the game. The latest measure – a 20 percent capital gains tax, yet to be fleshed out in detail – is the latest example. In the short term it sparked a frenzy because speculators are rushing to buy before the tax comes into effect.”
This has led to a situation where banks and other financial institutions have ended with a lot of real estate as a collateral against the loans they have given out. “It’s probably fair to say that at least one-third of bank credit exposures are real estate related,” write Chancellor and Monnelly.
Banks have also given a huge amount of loans to local governments and taken on land as a collateral. The trouble is that a lot of this land has been dubiously overvalued by local governments to take on higher amount of loans. “The quality of the collateral held by the banks against their loans has been questioned. Collateral often comes in the form of land, which in some cases has been valued by local officials at a premium to actual market values…Loudi, a little-known city in Hunan province, serves as the poster child for local government funding vehicles excesses. According to Bloomberg, Loudi’s local government borrowed RMB 1.2 billion to finance the construction of a 30,000-seat faux Olympic stadium, gymnasium, and swimming complex. The land collateral for Loudi’s loan was valued at around four times the value of nearby plots zoned for commercial use,” Chancellor and Monnelly point out. So if the banks try to sell the land they have as collateral in case of defaults, they are not going to recover a large portion of the loans they have made.
Also, a lot of local governments have taken on a large amount of loans to spend on trophy projects which are not going to generate returns any time soon. One such project is the famous maglev (magnetic levitation) train that goes from Longyan Road in Shanghai to Pudong International Airport in eight minutes.
Ruchir Sharma, head of Emerging Markets and Global Macro at Morgan Stanley Investment Management, describes his experience of taking the train in Breakout Nations. While the experience was fantastic, there were hardly any passengers around. He points out that locals say that the train is usually only half full because it starts in the middle of nowhere and the ticket is very expensively priced.
Such projects are not expected to generate returns anytime soon, making the repayment of loans even more difficult. As Chu of Fitch told Bloomberg “Companies are taking on a lot of debt but not getting comparable returns… If they’re not getting sufficient returns, at some point they will have problems repaying the debt.”
So the situation is tight but this hasn’t started reflecting in loans defaults as yet. The formal banking system has a non performing loan ratio of around 1%. There are several reasons why this ratio is not higher. One simple reason is that the banks have been allowed to roll-over loans, in case the local government bodies which have taken on the loans are not able to pay up. This basically means that when a loan falls due and the borrower needs to repay it, the bank does not demand repayment of the loan and continues to accept interest on it from the borrower.
What has also happened is that banks are selling bonds bundled into wealth management products to their clients. These bonds are supposed to be raising money to finance infrastructure projects. But that is really not the case. As the GMO authors write “Caixin (a Beijing based media group) quotes a source at a major bank claiming that many bonds, which purported to finance new infrastructure projects, were actually being used to pay off old bank debts. While this has allowed banks to reduce their reported exposure to local governments, it is possible they will have to make good any future losses suffered by investors on future bond defaults.” So basically future bad loans of banks have been passed onto bond investors.
Of course such things cannot go for eternity. As Wei Hao of Societe Generale puts it “a number of economies had similar or moderately lower debt service ratios (DSRs) when they were headed towards serious financial and economic crises. Examples include Finland (early 1990s), Korea (1997), the UK (2009), and the US (2009). This is one more data point in China that evokes the troubling thought of a hard landing.”
But not everyone is willing to buy this argument. Those who don’t buy feel that China is in the midst of a ‘credit bubble’ like to point out that most of the outstanding Chinese debt is domestic. And given that there can be no crisis. They just need to look at Japan. Domestic savings fuelled a stock market and real estate bubble in the late 1980s. The bubble started to burst in 1989, and the Japanese economy has never recovered since then.
The other point that China supporters like to point out is that China has a very low government debt to GDP ratio. As Chancellor and Monnelly point out “Many commentators also take comfort from the fact that China’s public debt (another term of government debt) is less than 30% of GDP. The trouble is that the official numbers are misleading…In order to get a proper picture of China’s sovereign liabilities we must add back the loans to local government infrastructure projects, policy bank debt (issued by the likes of the China Development Bank), borrowings by the asset management companies (which acquire non-performing loans from banks and others), and debt issued by the Ministry of Railways to fund the roll-out of the expensive high-speed rail network.” After this is done, China’s government debt to GDP ratio comes close to 90%, which is not small by any stretch of imagination.
So while there might be many out there who would like to believe that all is well in China, the evidence is clearly to the contrary. Chu of Fitch put it best when she told Bloomberg “You just don’t see that magnitude of increase in the ratio of credit to GDP…It’s usually one of the most reliable predictors for a financial crisis.”
The article originally appeared on www.firstpost.com on June 11, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)