The red dragon’s fire breath was already dying out before the Coronavirus pandemic had slain the beast. After more than 20 years of exponential growth, the paper tiger’s roar became a whimper thanks to the housing collapse, trade war, and public health crisis. The fragility of China’s economy is on full display as the world learns of the financial troubles brewing in Beijing. China is on life support, and it may be too late to resuscitate the nation whose situation is a lot worse than global financial markets are anticipating. President Donald Trump or his successor could approach the monster and only be scratched in a battle between two powerhouse states.
Abandon Hope All Ye Who Enter
China, which is typically a proud country, conceded defeat to 2020. Premier Li Keqiang announced in a letter to the National People’s Congress (NPC) that the government has made the rare decision to avoid establishing an economic growth rate target for the year due to the uncertainties surrounding COVID-19. You cannot fault the Communist Party for attaining this defeatist attitude since the early indicators suggest that President Xi Jinping would fail to meet his initial economic objectives in the aftermath of the pandemic, according to forecasts from independent economists.
The Kitchen Sink: Made in China
This year, the central government and the People’s Bank of China (PBoC) have deployed a diverse array of fiscal and monetary measures to shore up the world’s second-largest economy. But these stimulus and rescue packages have been nothing more than surviving until tomorrow instead of staying alive a decade from now. Any outsider could conclude that Beijing adhered to the Keynesian principle of “in the long run, we are all dead.” Keqiang has waxed poetically that officials are “providing water so that the fish can survive.” But what happens when that water becomes toxic?
On the fiscal side, President Xi and his Communists have utilized a concoction of tax cuts, public spending, and direct cash payments. On the monetary side, the central bank has implemented interest rate cuts, reserve requirement ratio declines, small business lending, and a myriad of other market interventions. PBoC Governor Yi Gang confirmed that the institution is prepared to accelerate monetary policy in the second half of 2020 to facilitate growth, including expansions to rediscounts, re-lending, deferred loan repayments, and targeted lending support.
What should be noted is that both the government and the central bank had already imposed a wide range of fiscal and monetary support mechanisms before the financial crisis. China tried to weather the economic storm from the U.S.-China trade war, as well as the downturn in the fallout of the housing collapse. Plus, Beijing was still trying to recoup the cost of its astronomical $564 billion prescription in the wake of the Great Recession.
By now, China should have something to show for its incredible stimulus efforts. It is a mixed bag. Manufacturing activity, for example, has rebounded, but the purchasing managers’ index (PMI) readings have signaled a sluggish recovery. Industrial production has expanded, but retail sales have yet to improve. Unemployment remains to be a thorn in the side of the Xi administration with joblessness at its highest level on record.
Put simply, the paper tiger’s roar is bigger than its bite.
Debt on Debt
According to the Institute of International Finance (IIF), China’s debt-to-GDP ratio topped 310% last year. It is unclear just how much debt China took on to tackle the COVID-19 forces, but conservative estimates say that the ratio likely picked up an additional 18 percentage points so far this year. Considering that it overstates its GDP, the ratio is probably a lot higher than official statistics dictate.
But while all the focus is at the federal level, it is at the municipal level where there should be the most concern. Beijing recently granted permission to local governments to issue more bonds and with longer maturities (from ten to 20 years). The idea behind this newest embrace of the long-term bond is to avoid financial risks and provide the central government with some leeway until policymakers find solutions to resolve its mounting debt challenges.
However, local governments’ accumulation of debt has been a major problem for several years. It was officially revealed in 2014 that municipal debt levels totaled $2.42 trillion, in addition to another $1.12 trillion in unfunded liabilities and expenditures. Cities tried to mask the red ink by pouring a few hundred billion dollars into bonds, but this resulted in two headaches. The first migraine was that these bonds had maturities of just three years, which required them to be rolled over. The second was that the overleveraged PBoC and state-owned financial institutions have been continually acquiring these debt instruments to stave off a fiscal debacle for these jurisdictions.
Municipal governments are expected to sell more bonds this year. The caveat is that they will need to price them according to what the market is signaling if they wish to entice investors – at home and abroad. There is a lot of talk about zombie companies, but what about zombie governments? If these municipalities can only get by on debt, then how is it any different than the undead that walk the marketplace?
Corporate debt has been elevated to critical status after years of privately- and state-owned businesses taking on unprecedented levels of debt. Over the last 18 months, many foreign banks sounded the doomsday alarm about a tidal wave of defaults. It looked like red ink was going to swallow the quasi-private sector amid the pandemic, but it failed to materialize. Why? Financial regulators relaxed regulations to permit corporations to change the way they fundraise. Still, there have been fewer than 100 defaults year-to-date, and the value of missed payments on corporate bonds increased by 40% to $9 billion. Many companies have mirrored the efforts by local governments by employing bond swaps that replace old notes with new ones that offer a higher yield. It also helps when the central bank is pumping obscene amounts of liquidity into the financial system.
But private firms will not be let off scot-free unless the government intervenes, according to warnings from Fitch and S&P. The rating agencies recently stated that the 50% spike in the value of maturing bonds ($108 billion) in the second half of 2020 could raise the risk of default. Why is there a higher chance of default? About half of the issued bonds were from those rated AA+ or lower, which means a greater likelihood of failing to meet their obligations.
Because China has exhausted its domestic options, it may need a foreign solution. Authorities are reportedly attempting to appeal to overseas investors by pushing outside banks to underwrite their bonds and encourage retail investors to purchase them at their local branches. But Iris Pang, chief economist for Greater China at ING, shot down those aspirations by stating that foreign interest is quite low.
Slaying the Dragon
Be it a trade war or an outbreak of the highly infectious respiratory illness, China’s decay was inevitable. The piling up of debt, the malinvestment toxicity, and the expensive perpetual bailing out of state-owned enterprises were always going to lead to its demise. The only difference for the red dragon was time. If everything remained the same, Beijing could have kept its Ponzi scheme alive for a few more years. But these unforeseen circumstances are merely accelerating the inevitable downfall.
Read more from Andrew Moran.