China has a credit problem and it knows it

Added 29th February 2016

Anybody who says that China doesn’t have a credit problem is lying because when that much credit is pumped into the system there is no way that every single loan is a sound investment, according to Schroders’ head of Asian equities Singapore, Lee King Fuei.

China has a credit problem and it knows it

“I actually think that China has a huge credit problem and they actually know it as well. A lot of the measures that they’ve been putting through recently really tells you that they recognise that there is a problem,” Lee said at a roundtable event in London.  

“If they are going even down to the point that they’re restricting insurance money from leaving the country you know that capital is really restricted in the Chinese economy.”

Between 2006 and 2013 China’s debt as a percentage of GDP increased to 87%. Looking at other snapshots in history (pictured), all preceding financial downturns, Lee explained that when debt to GDP exceeds 40% a financial crisis is triggered.

Making payments

In a separate study Macquarie Bank looked at 780 bond issuers in China and asked them a single question: “This is the interest payment that you need to make on your bonds – how much of that is covered by your earnings?”

One quarter did not have sufficient earnings to cover their interest payments.

Lack of bankruptcy

What should be happening in China is that companies should be going bankrupt, “yet we haven’t seen any bankruptcies”, Lee said. “Why? Because banks continue to evergreen the loans, push out the duration of the loans, and lower the interest payments.”

“That cannot go on forever because at some point you have to recognise that that loans you made to these companies, the investment you’ve made, are not making any returns.”

Two solutions

For Lee, China has two options to resolve its credit problem. The first is to close the capital account and the second is to devalue the yuan.

“Closing the capital account defeats the whole purpose of joining the SDR basket. The other way they can do it is to devalue, because you actually devalue your debt. And that’s one of the ways you can actually get out of the whole spiral.” 

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