Bridges to nowhere – China’s debt problems

Welcome to Finance and Fury. In this episode we are going to look at the debt problems that China has – at the moment, economic news globally is going from bad to worse, with talks of recessions, high inflation, declining financial markets – but with all of this noise, one area that hasn’t received as much attention is China’s debt problems

1. There are signs that this major economy has really been a paper tiger – where we are starting to see cracks appear due to malinvestment – both internally in property and infrastructure, but also externally as part of their Belt and Road imitative

In this episode – we will be looking at this further and the potential fallout from these loans going bad

When it comes to economic growth – capital flows and productivity really matter – and this is true across all economies

1. the flow of capital in or out of an economy plus the productivity of that capital are what determines economic growth –
   1. If lots of capital – which in the modern era is in the form of additional debts, flow into a project that has high productivity – i.e. a high ROE – then economic growth can be expected
      1. This is where debt based investments can generate prosperity – as the repayment of the debt are negated by the positive wealth that is generated
      2. This is where companies have an IRR for projects – what is the expected return versus the cost – if say you borrow and it will cost you 4% and return you 8% p.a. – then this project may have legs to it – but if you borrow at 4% and the project provides you 0% return – you are going to just end up with compounding losses
   2. This is where if capital is squandered on unproductive speculation – this generates bubbles of phantom wealth that eventually pop – destroying not only the illusion of wealth but the very money backing these projects
      1. These types of investments could be considered bridges to nowhere – imagine that a country borrowed $1bn to build a bridge out into the middle of the ocean that was a U-turn at the end – would this be a wise use of capital – or simply put this country into a $1bn deficit on which interest costs would be incurred – leading to a loss by not only the initial borrowings but also a compounding cost due to the interest accruing and the cost of maintaining this bridge – this is an extreme example
   3. Initially though – this bride to nowhere can seem to be boosting economic growth through an increase in GDP through government spending, but if this doesn’t actually boost the productivity of a country, through increases in the inputs such as capital, technology or labour – then these are mal-investments that bleed the economy dry over the long term – this could be considered phantom wealth where you get positive GDP growth initially, but declining growth long term
2. Beyond this – Everyone wants become wealthier, and investors will follow whatever trails are open to them to do so – but if the economy is structured to funnel most of the majority’s wealth into one asset class through say banning international investments and limiting domestic investments – well that economy becomes highly dependent on the stability of that asset class for its financial, social and political stability – through also creating mal-investments
   1. Say for example that investors only really had one choice to invest their wealth into real estate to the degree that owning empty flats is considered a form of secure savings – then that economy is extremely vulnerable
   2. If an asset class was only owned by the super-wealthy collapses – such as a Banksy painting going from $100m to $50m – then the damage to the economy is limited  
   3. But when an asset class collapses that is the primary foundation of the nation’s wealth collapses – that has widespread effects – decreasing confidence

Keep these points in mind as we go through the rest of the episode – Before we look at the state of the Chinese internal economy – its important to consider the belt and road initiative –

1. This is a global infrastructure development strategy adopted by the Chinese government in 2013 to invest in nearly 70 countries – through lending to these countries and building key infrastructure such as ports, railways and roads
   1. The naming is a little confusing – as the belt part of the name refers to overland infrastructure and the road part refers to the seas – this aside
   2. China identified key countries and projects – then lent money to these countries in bi-lateral agreements to complete the infrastructure required
2. The aim was to create a modern Silk Road through building trade infrastructure across both developed countries in Europe and other resource rich developing countries through Asia, the pacific and Africa –
   1. The original Silk Road was neither an actual road nor a single route, as the term referred to a network of routes used by traders for more than 1,500 years from 130 BC that spanned from the Han dynasty in modern day China into Europe
3. Modernising and expanding on these trade networks aimed to help boost trade flows and cut costs of global trade – helping to increase global GDP
4. But this is not the first time a major world power has done something like this –
   1. The US had the Marshall Plan after WW2 where they were providing aid for the reconstruction of western EU cities and infrastructure which were destroyed in WW2 – it aimed to remove trade barriers and increase commerce and reliance on the US
      1. By the end of WW2 – the US was a world leader in its industrial capacity. But once the war was over – there was a saturation of the domestic market and there was an inability to export the excess capacity of goods – due to there no longer being a demand for planes, tanks and weapons – so economic growth started to slow
      2. The terms of the Marshall plan stated that countries receiving American aid for infrastructure would need to accept American investment and import American goods
   2. But this was as much a political project as an economic one – as one of the goals was to halt communism and created greater ties between the US and Europe, over their previous allies in the war being the USSR
   3. So, this plan was not completely altruistic – as it was beneficial to the US as it provided a huge export market and closer political ties to EU countries over their new found rivals in the USSR
5. China found itself in a similar position by around 2010 after the GFC – due to the global recession, they couldn’t simply rely on export led growth due to not having the same demand for their exports
   1. So establishing the Belt and Road initiative was a way of sending Chinese goods and workers all over the world to build infrastructure – then increase the reliance on China both economically but also politically
   2. Compared to the Marshall plan however, the BRI is around 12 times larger – but there was actually high demand for the projects being built post WW2 – as the infrastructure being build was previously destroyed – and then rebuilt – rather than trying to stimulate additional trade and economic growth by building ports and other projects where there may be no demand
6. Now – there have been plenty of criticisms of this initiative
   1. One major one is that this does not add any economic growth to the host nations – as China is shipping in their own labour for the projects, they have even been shipping in food and goods for these workers – not benefiting local countries where projects are built through stimulating employment or consumption – there even accusations of modern slavery being used for the workforce on these projects
      1. Also – many projects have been mired in corruption in emerging market countries – like the telecommunication tower in Sri Lanka
   2. But one of the major criticisms comes down to the terms and agreements on which funds are lent – where these projects are being funded by loans from China to the country that they are developing in – which are often at high repayment rates – so if these projects fail to generate any economic returns, the host country is left footing a bill that they cannot afford – both on the debt repayments but also maintenance costs on the infrastructure
      1. This has been referred to as a form of neo-colonialism using a tactic referred to as debt-trapping – where loans are given to poor countries which have little chance of being repaid, who can then be held captive to the lenders demand and wishes
      2. This form of lending becomes even worse if there is no economic growth from the projects – and the maturity terms on the loans are also much shorter than conventional loans given by say the World Bank – leading to quicker defaults
   3. As previously mentioned, projects in Shri Lanka and other nations like Malaysia have become white elephants with no economic benefit to the host nation – so with no economic return, now these nations have an accompanying debt as a burden and have to pay back the interest on these loans – as well as carrying the costs of maintaining the infrastructure – such as stadiums, tourist towers, ports and bridges
   4. I should note that this criticism shouldn’t be purely isolated to China – as other Western countries and entities like the world bank and IMF could also be criticized for doing the same thing
      1. Many developing countries are in huge infrastructure deficits – and are in need of infrastructure projects for which China isn’t the only lender
   5. But one major difference is that when these countries default on their debt – rather than austerity measures being placed on a nation – asset seizures can occur –
      1. China has in the past has written off loans that were going to default in countries like Ethiopia, Cuba and Zimbabwe,
         1. There is also the middle ground like in Sri Lanka – where a Chinese company took over one of their major ports for 99-years on a lease due to debt defaults
         2. On the other hand, countries that boarder China directly have not been as lucky – as these have had to sign over land and mineral rights to China in order to settle their debt obligations
      2. But this debt issue is something that could come back to haunt China –
         1. These huge projects not only could end up entangling China in other nations issues as well as leaving Chinese state companies on the wrong side of a national default – But the malinvestment is the real issue here – as can China afford to lend so much money to countries that may provide little benefit to the nation’s economy but also China’s?
         2. The Financial Times did an investigation on the Road and Belt initiative and found that almost all of the loans have gone to high-risk countries and have been non-performing – and many of these loans are going bad in the current economic climate
      3. Remember that borrowing for infrastructure projects can only be justified if it is going to increase productivity beyond the invested level – i.e. benefits greater than costs
         1. But with China offering funds to build many white elephant projects has created major malinvestment – the debt ends up constricting economic growth further – this gets worse in corrupt countries where the project funding has been embezzled and handed out through contracts of nepotism
         2. To explain malinvestment – say you are starting a business as a brick layer and you get a $100k loan to buy a truck, cement mixer and to help finance your initial start up and potential labour costs – then if you do your job well you will be able to pay this loan back and then reap additional benefits over time – but if you take this loan and buy a boat instead, you will be left with the debt and have no form of income to pay the loan back – this is malinvestment

Coming back to today – where does China stand domestically –

1. Starting to see civil unrest – 2022 was unkind to most nations – but cracks are starting to being seen in their economy due to decades of malinvestment – most of which has been done to hit government GDP targets –
   1. The idea was to borrow to spend on infrastructure projects and property development to help boost GDP growth – but now this is starting to fall apart due to the amount of debt that has been incurred
2. GDP – growth has been revised to 4.3% – almost 1% less than what was forecasted in December 2021
   1. It is important to note that China’s initial growth via debt was real – from their move from a communist economic system back in the early 80s to more free market – borrowings went to finance projects that had a real need – all the way up until the 2000s this was the case – but from the mid-2000s the real demand for infrastructure that was productive started to dry up – I don’t know their motives – but rather than reassessing – this practice continued
   2. However – when a countries debt increases at a greater rate than their GDP = this means the additional debt was greater than the returns achieved on new investments
3. This is where multiple pillars of the Chinese economy are starting to fall apart – all at the same time – which have been built around debt – we have gone through their external debt problems
   1. But one of the major problems domestically is the Property market – developers last year started to default due to the red line policies by the CCP: Three major read lines: Liability to asset ratios of less than 70%, Net gearing ratios less than 100%, Cash to short term debt ratios of more than 1X
4. This was a problem as home development projects are responsible for almost 30% of China’s GDP growth
   1. So, the slowing in development and property prices will impact their economy and population heavily
5. To help reduce the burden of debts – interest rates are dropped in China recently – where most nations are increasing rates – China has dropped their rates this year from 4.25% down to 3.7%
6. But civil unrest is beginning where people are saying they are going to stop paying mortgages on properties not developed yet – even though they owe money on these
   1. 85% of Chinese property market is currently being sold through pre-sales – you pay 100% upfront for a place you may move into at a later date – to buy these people take out mortgages – pay the developer the full amount upfront and then start paying the mortgage debts back from day 1 –
   2. But what happens if this property starts to get delayed – especially from additional delays from covid lockdown policies – developers are struggling to honour their agreements and mobs are starting to form
   3. The list of large-scale developments where this is occurring is over 300 at present – which includes thousands of people – as these developments normally incorporate multi-block apartments – each 20 stories tall – with 10 or more apartments per level – doing some estimation maths – this could account for anywhere between 240,000 to 1m people
   4. Given that $350bn in payments are at risk – I would estimate that it is on the higher end of this margin
   5. If these people simply stop paying their mortgages and default – then there will be a large risk to the Chinese economy
7. This can become a self-fulfilling prophecy – due to additional fears that property developments may never be completed – lowering demand for new property purchases
   1. If demand for property developments go down – this means less cashflow to developers – meaning they may never complete the developments already underway – This being a feedback loop into itself
8. There are also signs of a banking crisis – as smaller rural banks are in a delicate position as people are starting to lose confidence in the banking system –
   1. There are around 4,000 banks in rural areas – these banks were able to offer additional interest rates on savings accounts to incentivise savings
      1. But what banks did is use this money for investment product purposes rather than lending –
      2. Money in deposits is guaranteed by the CCP – whilst money in investment products is not – depositors had no idea their money was being used in this manner
   2. Trust is one of the most important factors in any economy – With any banking system, trust is needed to operate – people need to be able to trust that their deposits are going to be safe
      1. Why western countries have the banking insurance schemes – just to instil trust
      2. If this breaks down – it spells the collapse of the domestic banking system – leading to further debt issues for China

In summary –

9. China has a combination of domestic debt and overseas debt problems, slowing productivity and growth, civil unrest and the population losing trust in the banking system –
   1. What makes their productivity worse is the high levels of unemployment for younger people – 1 in 5 ages 16 to 24 are unemployed
   2. Internationally – There are hundreds of billions of dollars that can be defaulted on by emerging markets as 60% of low-income countries are now in a position of high debt default risk – China now finds itself in the position of either needing to extend additional loans to these countries – which further puts them into the hole – or cutting their losses – trying to recoup some funds
   3. As bad as this sounds – the vast majority of these loans are collateralised in commodity rich nations – so these loans could be services through the proceeds in commodity export profits
      1. The larger implications are the cross-boarder financial contagion and increased influence China will have in emerging markets
   4. Rather than focusing internationally – China will have to focus on domestic issues – and is moving into the role of the IMF rather than the world Bank through helping to simply bail out countries they have lent to, rather than issuing new loans for spending projects
      1. A sudden drop in the credit growth for these emerging nations could have a significant impact on these nations and financial markets
      2. But after years of malinvestment – this was inevitable – if you lend to countries or borrow to invest domestically in projects that have no hope in paying back the debt – then there is only so long that this practice can continue for before is falls apart