2015-01-28

China's Albatross of Debt

A great piece on Chinese debt.
WSJ: Debt That Once Boosted Its Cities Now Burdens China (Alternate Link)

A little over a year ago, a Chinese credit agency downgraded a government-owned financing company in this dusty industrial city. Default—nearly unheard-of in China on government bonds—was a possibility, it said.

But during discussions with lenders, city officials made sure Wuhan Urban Construction Investment & Development Corp. could keep borrowing...

...Wuhan Urban, whose debt jumped 20% in 2013, has borrowed big. A listed unit raised 650 million yuan ($103.9 million) in November from bond sales to underwrite a construction blitz that earned Wuhan’s mayor, Tang Liangzhi, the nickname Mr. Dig Dig...

...“When it comes to raising funds for the purpose of developing the city, we leave no stone unturned,” Wuhan Urban said in a July report...

...“The guys running local government financing operations won’t roll over and die,” says Fraser Howie, co-author of “Red Capitalism,” a study of China’s financial system. “These companies take on a life of their own.”

...Roughly 8,000 local-government-financing firms across China are responsible for the rapid development of cities but also the glut of housing, industrial parks and other projects economists and officials say threaten China’s economic health. “If you’re building projects that can’t cover their cost, you’re spending money on keeping them going,” says Mr. Howie. “Some hospital somewhere isn’t being built; some small company isn’t getting money.”
The punchline is that China is adding debt faster than Japan and Korea prior to their recessions.

Also, land sales had fueled a lot of this development, but as Deutsche Bank pointed out, land sale finance will hit this year: Deutsche Bank Says Land Sales Slowdown Only Started Hitting in Q4
There is a common misperception that land revenue has already dropped sharply in 2014. The market appears well aware of the slowdown of property sales and land auctions in 2014. It likely overlooked the lag between land auctions cooling off and the decline of fiscal revenue. The reality is, land market started to cool down sharply in March 2014, but land sale from a fiscal revenue perspective in yoy terms remained positive until Q3 2014. We believe the fiscal shock to local government revenue only started in Q4. The full impact will likely be seen in H1 2015.

What happened to real estate investment in December 2014? It went negative for the first time in at least a decade and probably much longer.

Any guesses where Jan-Feb will land, short of a massive increase in credit?

Background on how a real estate recession is a Threat to China's Development Model
China International Finance Limited, chief economist Peng Wensheng sees three effects from weak land sales. The first is reduced local government investment, reduced fixed asset investment. [There's your economic rebalancing away from investment.] The second is increased debt risk for local governments. The third is restrained credit growth. Peng also makes the important point that real estate price decline expectations are still forming. As I've pointed out here in previous posts, the situation was worse from a price standpoint in 2011. Peng goes on to note that developers haven't started to reduce land purchases yet, but that could be coming in the next few months, in which case land revenue growth for many cities will decline and even turn negative.

To recap the situation: Chinese local governments sell land to developers who build homes and commercial centers. The revenue from land sales pays for development of supporting infrastructure, everything from roads and subways to schools and parks. Land sales also finance local government debt which exploded after 2008. In the post-2008 economy, developers rushed to build property amidst a real estate bubble and when the government moved to restrict activity in first- and second-tier cities, developers poured into third- and fourth-tier cities and repeated the model. However, developers have run ahead of many local governments. In areas where there are true ghost cities, support infrastructure such as schools and hospitals have not been built. If the real estate bubble bursts and land sales fall, local governments will need to find another revenue source or they may be unable to finance the infrastructure that generates GDP growth and supports the local real estate market, and they may even face a debt crisis in some of the worst hit areas. This ignores all the potential issues with indebted developers, plus overproduction and bad debts in other sectors of the economy.

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