To explain, the eurozone crisis was a combined banking and sovereign crisis. Before crisis, banks raced to lend to peripheral countries because of the perception of that there was little or no credit risk. It's all one eurozone, right? They are all sovereigns in the eurozone and sovereigns don't default, right?
What could possibly go wrong?
Banks gorged themselves with lower credit eurozone country debt, and, in particular, the bonds of their own countries. Yield spreads between peripheral country bonds and Bunds narrowed to microscopic levels. When the crisis hit, national governments were handcuffed from bailing out their own banking system because their banks were stuffed full of their own governments' debt. So how do you bail out yourself?
It's all guaranteed, right?
As I read Kate Mackenzie's analysis of the Chinese banking system in FT Alphaville, I get an eerie sense of deja vu. China's banks are gorging themselves on SOE and local government debt because there is a sense that the central government wouldn't allow (fill in the blank) to default. A credit bubble formed and, as a result, the cost of growth was too much investment spending in infrastructure (see my recent post Who pays for China's excesses?). Sober Look also highlighted this chart from CS showing how China's recent infrastructure growth has been credit driven and how much of a credit bubble has formed:
Mackenzie quoted Anne Stevenson-Yang of J Capital Research writing about this exact problem:
In fact, Anne Stevenson-Yang of J Capital Research wrote in March that the early aspirations that the Chinese bad banks would facilitate more responsible lending has given way to a consolidation of the big banks’ financing of the powerful state-owned entities:I don't know how this all ends up, nor do I know the timing, but this won't end well.
The AMCs were to assume debt from fundamentally viable companies and swap it for equity. This was part of the massive SOE restructuring plan of the time: the AMCs were expected to act like private equities—stern and dispassionate board directors motivated by profit. It was thought that this would help create SOEs that thought and acted like commercial companies. To the contrary, the result was an implicit guarantee to SOEs that they would not go bankrupt, which in turn supported the general disregard for debt-equity ratios and any calculation related to servicing debt.
The SOEs’ are widely acknowledged to be one of the biggest hurdles to China reforming its economic strategy, due to a combination of their poor performance, easy access to credit, and significant political power.
At worst, it ends with a banking crisis that spills over beyond China's borders and sparks a global financial panic. At best, bailing out SOEs and local government authorities amounts to financial repression of the household sector and impedes the government's stated policy of re-balancing growth to the consumer and household sectors of the economy, which would create long-term headwinds for China's growth path.
Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”
None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.