My Blog

February 13, 2008

WED 13 FEB

China’s mystery value does NOT enhance its creditworthiness By Michael Pettis

Yesterday at an investor meeting someone made the point that the lack of transparency in Chinese accounting may actually act to reduce the riskiness of the system.  If this is true, it is pretty good news for investors banking on government credit. 

 

What’s the total amount of central government debt in China and how is it structured?  We don’t really know.  What is the amount of municipal and provincial obligations guaranteed by the central government?  We certainly don’t know.  How much did banks lend against real estate?  We have some figures but it is widely believed that an awful lot of real estate loans are not correctly classified as real estate loans.  What is the breakdown within the banking system of new loans, and what about old non-performing loans?  We have some information but not nearly enough to give us a real sense of how much bad debt there currently is and, perhaps more importantly, how vulnerable new loans are to a slowdown.  There is a lot of mystery embedded in the national balance sheet.

 

Asking about the creditworthiness of the central government is not a trivial question.  China is in a reasonably good fiscal position and government expenditures only barely exceed revenues.  In addition most estimates put total current debt of the government at around 30% of GDP, which everyone agrees is fairly low and should cause little concern to anyone looking at the government’s ability to service debt. 

 

More importantly from a financial stability point of view, most government obligations are very safe and optimally structured – they consist of medium- and long-term, fixed-rate, local currency bonds.  In my book on financial vulnerability in developing countries I make a point about stressing how important this kind of debt is in protecting countries from the threat of financial crisis because of the way they dissipate the impact of adverse shocks.  In a crisis anything that causes interest rates to rise substantially (say a burst of inflation) would automatically reduce the existing debt burden, thus acting to stabilize the financial system.

 

But still, that doesn’t mean that there is nothing to worry about.  Last March the Inter-American Development Bank published Living with Debt - How to Limit the Risks of Sovereign Finance by Eduardo Borensztein, Eduardo Levi, and Ugo Panizza, and one of the most interesting points the book makes is that the surge in debt that precedes a financial crisis rarely occurs because of the accumulation of massive fiscal deficits, as we are likely to assume, but rather because of a sudden conversion of contingent liabilities onto the government’s balance sheet. 

 

The two most likely sources of these contingent liabilities have typically been unhedged external debt, when a rapid depreciation of the currency suddenly causes the value of external debt to rise relative to the value of domestic assets, or a surge in non-performing loans on bank balance sheets that forces the government to intervene and assume the liabilities of the banking system.  China, which has been vigorously fighting the 1997-Asian-Crisis war, is almost immune to the former risk, but it doesn’t take an alarmist to see that the latter risk is a real possibility, especially given the explosion in bank lending during the best-of-times period of 2003 to the present.

 

Right now, my best guess is that if various contingent liabilities were correctly accounted, total liabilities of the government would exceed 50% of GDP, and could be much larger – some estimates put it at 80% of GDP, which is not implausible.  If there were a significant downturn the number would probably get worse – it is almost a certainty that non-performing loans in the banking system would rise in an economic downturn.  How much is anyone’s guess, but it is not implausible to assume the possibility of a sharp rise in non-performing loans. 

 

When these are combined with the non-performing loans still residing on the bank balance sheets (some correctly identified, but perhaps many of them still hidden) and the loans transferred onto the asset management companies created for that purpose, who are technically bankrupt but explicitly guaranteed by the MoF, total debt of the government may jump substantially, and this debt is not nearly as well structured as the existing bond obligations of the government.  In fact, as I explain in my book and elsewhere, these types of debt exacerbate external shocks and so can be as toxic for the government as external debt, or Mexico’s famous Tesobons, in case of a domestic crisis, because like external debt their value tends to expand just when the country can least afford it.

 

I brought this up yesterday at an investor meeting and received a comment, in the form of a question, that I have heard many, many times before – and from some fairly sophisticated sources.  Since the government has been able to hide the true extent of its liabilities quite well, why should we assume that in a contraction we will suddenly get access to this information and, if we don’t ever know, why should it matter?  The hole on a borrower’s balance sheet is only a problem if we know it is there.  China’s lack of transparency actually reduces the risk of bad information spooking investors.

 

It is always frustrating to get this kind of comment, especially now when the sub-prime crisis has made it very obvious that sometimes the lack of information is worse than unhappy information.  After all it wasn’t the extent of the potential sub-prime losses, even assuming the worst possible case, that scared the market but the fact that no one knew where these losses were hiding.

 

Information does matter, especially when we need it most.  Based on many years of trading, I can say one of the few rules of financial markets I know is that when markets are buoyant and liquidity plentiful, transparency and high-quality information is of little use – in fact since we tend to assume the best, no information just means no bad information, so buy, buy, buy.  However when things go badly, investors change tack suddenly and begin to assume the worst.  In this case no information means nothing but bad information.

 

It’s always dangerous to make predictions but one thing I will predict with great confidence is that when things turn badly in China – when economic or monetary conditions are contracting – the lack of information that emboldens investors today will force them into panic selling.  Lack of transparency is only a blessing in the irrational state of a bull market.  However it becomes a source of new irrationality in a declining market. 

 

This, by the way, is not a new observation at all.  On my flight to New York I was reading Russell Napier’s Anatomy of the Bear and came across this June 15, 1932 quote from the Wall Street Journal: “During the roaring days of the bull market, lack of full information about a company gave its securities a certain mystery value.  The long depression has done a good deal to eliminate mystery value from consideration of the worth of a security.”