The back-burner does its magic in China

PUBLISHED : Saturday, 03 October, 2009, 12:00am
UPDATED : Saturday, 03 October, 2009, 12:00am

Only socialism can save China

President Hu Jintao, October 1

He is so right. No, it is not because of the 8,000 picture perfect soldiers, the 60 elaborate floats and the 100,000 well-drilled civilians on show on National Day. We have seen it all before.

It is not because of the 42,000 fireworks and 4,000 LED-equipped trees that lit up Tiananmen Square for 33 minutes. When it comes to numbers, China has no rival.

It is all about the problem-solving power of its bureaucrats, or their ability to sweep the dirt under the carpet. You have seen it at the National Day celebrations when half of Beijing was cordoned off to make way for the display of harmony during the parade and the evening gala. You can also see it with various financial policies that magically turned near-term problems into long-term issues - away from public glare.

Here are two recent examples.

It is a well-known fact that the Chinese government used to treat the banks as ATM machines. But 10 years ago Beijing decided to turn them into commercial entities, which meant transferring 1.4 trillion yuan of bad debts from the banks into asset management companies (AMCs).

In return, the AMCs issued bonds to the banks. Given the poor quality of those bad debts, the AMCs' hopes of ever repaying the principal on the bonds is close to zero. And as the decade-long 'breathing space' ends this year, many expected the Ministry of Finance to pay for the AMCs.

But no. China Construction Bank Corp recently announced that it would roll over 24.7 billion yuan (HK$28.04 billion) worth of bonds from its AMC, Cinda, for another 10 years. It is highly likely that Bank of China and ICBC, which sit on 473 billion yuan worth of AMC bonds, will follow suit.

The effect of the roll-over is that the government can delay recognition of the non-performing loans issued in the mid-1990s until the country's 70th birthday.

GaveKal Research compares this with 'a giant Ponzi scheme in which the income of the current generation is continually siphoned off to pay the bad debts of the past generation'.

A more gentle way to put it is that in a country as complicated, as giant and as ancient as China, time is often the solution to many problems; and our mandarins know this well.

Here is the second example. From this month, insurance companies are allowed to invest in the property market. The insurers are thrilled because it means diversification from bank deposits and stock investments, and enables them to match their investment horizon with a long-term repayment obligation.

That is the official reason. The unspoken benefit is that it allows the state to shuffle off underperforming commercial properties to the 'long-term asset' accounts of insurers.

The beauty of this is that the transaction can be done at 'book value', causing little damage to the banks which lend to those properties. This is because, given the insurers' long-term obligation, they can easily justify a 20-year 'fair value' calculation of an asset.

In such a case, you can make any assumptions you want about 'long-term' occupancy rates and work out an aggressive price. If the price goes under water, that is fine because short-term cyclical movements will have little impact on the value of a 'long-term asset'. The insurer's book stays intact.

However, there is one big assumption for both these tactics to work - that in the longer term there will be enough time, or should we say growth, to be able to earn their way out of any problems. It works with the 1999 tranche of bad debt taken up by the AMCs. The liability, which represented 15.6 per cent of the country's gross domestic product that year, has been reduced to only 3.6 per cent now.

In short, the higher the growth, the better the tactics work. But will they continue to work?

Analysis by GaveKal suggests the model is sustainable for another 10 years as long as 'the bad loans finance economically productive projects, the efficiency of bank lending rises over time, and structural factors more or less guarantee a trend GDP growth rate of 7 per cent or more'.

In 2019, the total fiscal burden of the bad loans is estimated to be 5 to 7 per cent of GDP. That is far from catastrophic.

But there is a big 'if' to this optimistic view. It only succeeds if, from 2011 onwards, the banks do not create more bad loans beyond their ability to provision and write down. It is a big if because there has been a huge credit expansion this year.

In the meantime, nobody seems to be worried. At Construction Bank, an independent director who asked not to be named said the bank had been given an indication from the auditor that it would not ask for a provision for the extended bond because the Ministry of Finance has issued a notice of support on the repayment of principal and interest. He added that, given the low interest rate, locking up 247 billion yuan with a bond that offered 2.27 per cent coupon rate was a better alternative to getting the money back.

Neither are investors concerned. Commenting on the new policy for insurers, an international hedge fund manager said: 'This suggests that public market investors won't be exposed to non-performing loans. It also solves the party's near-term objectives, which is to have assets 'marked to market' generously. So I am optimistic that, whatever damage has occurred to credit quality, we will not see the consequences in the near term.'

They are right. It is time to party for the nation and the bureaucrats' success.