Huge Credit Stress Starting in China May Easily Rock the Whole World

Many people asked me to comment on Evergrande. 

First let’s start with a WSJ article then a closer look at a pair of excellent Tweet threads by Michael Pettis and Girolamo Pandolfi.

Collapse of Evergrande – Background 

The WSJ comments China Evergrande’s looming collapse and its ripple effect on the economy will pose a test for the government’s campaign to keep housing affordable for the masses.

Please consider How Beijing’s Debt Clampdown Shook the Foundation of a Real-Estate Colossus. 

In a risky race against time that ran for two decades, China Evergrande Group turned billions of dollars in borrowed money into the dream of homeownership for millions of Chinese citizens.

It launched project after project in every Chinese province, selling apartments years before they were completed and scratching together enough cash to stay just ahead of massive interest bills.

The party has ended. Years of aggressive borrowing have collided with Beijing’s crackdown on debt, leaving the giant developer on the brink of collapse. Construction of Evergrande’s projects in many cities has stopped. The company has faced a litany of complaints and protests from suppliers, small investors and home buyers who sank their savings into properties the company promised to deliver.

Cash is so short that this summer, the developer said it began paying bills to contractors and suppliers with unfinished apartments instead of actual money.

A paint supplier based in the southeastern province of Fujian said Evergrande recently paid off the equivalent of $34 million in bills with three unfinished properties, which the supplier is trying to sell. 

The looming collapse is a microcosm of China’s overheated housing market, in which prices have been climbing for years. Evergrande’s problems—and their ripple effects on the economy and social stability—are the biggest test of Beijing’s rejuvenated campaign to end debt-fueled speculation and stop home prices from surging while the government tries to lower inequality and keep housing affordable for the masses.

Pettis on Evergrande 

1. Even as the chairman was proclaiming that a basic principle of his business is that cash is king, he was pulling cash out of the company. According to WSJ: “As it piled on debt, Evergrande paid out billions in dividends to stockholders, with most of that cash going to Mr. Hui as its largest shareholder.“
2. “The payouts helped him become one of China’s richest men. He has received more than 34 billion yuan, the equivalent of $5.3 billion, in dividends since October 2018.”
3. Someone must have know that this was problematic because, at the same time, Evergrande was doing everything possible to raise cash, not just from banks, but also from employees through wealth management products, from customers through pre-purchases and deposits, and from suppliers and contractors by paying them in commercial paper.
4. If you have to leverage itself to the hilt — often with very expensive financing — just to keep operating, it isn’t a good idea to pay large dividends unless there is, to put it politely, an information asymmetry.

Pettis Evergrande Tweet Thread

Pettis WSJ Evergrande Tweet Thread

China’s Lehman Moment

The Guardian comments ‘China’s Lehman Brothers Moment’: Evergrande Crisis Rattles Economy.

As angry protesters occupied the headquarters of the troubled property developer in recent weeks, some analysts have described the Evergrande crisis as “China’s Lehman Brothers moment”. Only this time it’s a credit-fuelled housebuilder that suddenly can’t pay its $300bn debts, rather than a blue-chip investment bank that many assumed was too big to fail but was instead thrown to the wolves 13 years ago.

Although there may be some parallels, the more extreme prophecies of doom for China may be no more correct than the assumption that Beijing will simply step in and bail out Evergrande to make sure the fallout from the failure of a property giant does not spread to other areas of the Chinese economy.

“It seems that we may have already started the financial distress process. As the risk of insolvency increases, the behaviour of sales agents, homebuyers, suppliers and other stakeholders changes in ways that further undermine revenues and raise expenses,” said Michael Pettis, a professor of finance at Peking University. “Once that process begins, conditions can quickly spiral downwards unless someone like the government steps in to guarantee payments.”

Dynamics Started a Decade Ago

Pettis on the Lehman Moment

1. The former head of the CSRC says that, compared to other countries, too much of China’s household wealth is tied up in real estate, and too little in financial assets. With property accounting for 70-80% of Chinese household wealth, he’s right.
2. But of course with real estate 3-4 times as expensive in China (relative to income) as it is in other major economies, it would be pretty hard for it to be otherwise. Only a sharp and sustained fall in property prices relative to income, or a stock market bubble, can resolve that imbalance.
3. Japan in the late 1980s had even higher real estate prices and a truly epic stock market bubble, and I think real estate accounted for roughly 65-70% of Japanese savings.

Lehman Moment Tweet Thread

Pettis Lehman Moment Tweet Thread

Pettis on the Problem for Central Bankers

1. This is an interesting problem for central banking geeks. Many of China Evergrande’s suppliers, who were paid not with cash but with Evergrande commercial paper (CP), are now finding it hard to get paid, and so are worried about their own solvency and liquidity.
2. “The plight of Wu and many others like him has thrown a spotlight on the extensive use of CP in China’s property sector. Developers favour it as they prefer to not pay upfront and because it doesn’t count as interest-bearing debt.”
3. This is an obvious problem for Evergrande’s suppliers, who might not be paid after having delivered products, but, as I plan to explain in my central bank seminar tomorrow, it is in fact also a monetary problem. As long as CP from large property developers was widely accepted as an efficient payments mechanism, it was not much different from other forms of money.
4. As Hyman Minsky liked to point out, while anyone can make money, the hard part is getting others to accept it, and this CP was widely accepted as money.
5. As such it formed part of China’s money base. Money isn’t a “thing” so much as it is a quality inherent — to very different degrees — in all assets. If suppliers now become reluctant to accept CP issued by property developers, this will have two macroeconomic impacts.
6. First, obviously, it will reduce the efficiency of business transactions — i.e. raise frictional costs — in the property sector. Second, it will cause a contraction in China’s “real” money supply as an asset that was once highly “money-like” becomes much less so.
7. To the extent that the PBoC recognizes this, they should expand the domestic money supply to make up for the partial demonetization of Chinese CP.

Central Banker Tweet Thread

Pettis Tweet Thread on Problems for Central Bankers

Double or Triple Books

Girolamo Pandolfi on Evergrande (Charts Below – Emphasis Mine)

1. Evergrande: why most analysis is dead in water and how best to understand and navigate what’s happening? Both denialists and alarmists are getting it wrong. Let’s start by understanding this: what is happening is the result of a CCP-initiated policy change to curb leverage. 
2. It started a while back and has seen other defaults, including SOEs. What are the specific policy changes? Most important is the introduction of the 3 red lines a year ago: – L/A < 70% – net leverage < 100% – cash to ST debt > 1
3. What’s the point of the 3 red lines [italicized]? First and foremost to forestall a systemic crisis that could have brought down the whole financial sector if left unchecked. Real estate amounts to a significant chunk of China GDP with strong linkages upstream and downstream. 
4. And believe it or not, the sector was levered to the gills. The 3 red lines are hardly draconian, yet all the CCC, a large chunk of the B and a good 1/3 of the BB did not pass them a year ago. Needless to say, it was really not too early. But there is more to it than leverage
5. One common practice of these construction companies,a game Evergrande excelled at, was to bid land at prices significantly higher than market. It didn’t matter to them, coz the risk got transferred to flat buyers and banks that financed the purchase. 
6. That model worked well for local governments, banks and households because house prices were going up. So much so over the last 15 years, that a serious affordability crisis emerged in major cities AND HH debt soared way above disposable inc – below HH debt as % GDP [See Chart Below]
7. So it wasn’t hard to figure out the economic disaster in the making: exponential price rises with explosive HH and Construction leverage. But that’s not all. There is another problem that escapes most China analysts. 
8. As a result of years of seeking easy growth through construction and leverage, the misallocation of capital was : 1- capital starving more innovative and high tech sectors and 2- creating a headwind for a re-balancing towards a more consumption driven growth. [See Chart Below]
9. At some point, reigning in lending to the RE sector became vital in order to address the structural issue of capital misallocation. That also explains the curbs on VC investments in RE and most importantly, a curb on all the irregularities that characterized RE.
10.  The issue of irregularities is at the core of what is happening with Evergrande. More on that later. It’s a long introduction, but it seemed important to explain these issues to understand the long term nature of this problem and why it’s resolution will be tedious. 
11. So there is a new paradigm dictated by a set of economic realities that CCP could no longer ignore and most importantly, they can relax the rules a bit, but can’t reverse course. They can’t allow consumers to be bust nor a rogue unproductive sector to balloon further. 
12. The tail risk emanating from the implementation of this new paradigm is being priced in. It’s not only Evergrande’s credit that is collapsing but the whole HY market. Contagion is AT work. China HY is some 10% away from it’s March 20 low….that’s not benign [See Chart Below]
13. Within construction many weak operators are seeing their credit collapse: Fantasia, R&F, Suna, China Aoyuan. But that’s not all. The stress is spreading to the banks and financials. Here is Minsheng and Ping An – next level up would be IG starting to show stress. [See Chart Below]
14. So we established that we are in the phase of pricing the tail risk. All in all pretty China centric for now. How could it create contagion beyond. There are significant losses already for the international holders of China credit and equities. That’s one channel.
15. Any broader contango on towards the financial sector in China will prompt temporary policy responses like liquidity injection (done this week). But don’t expect a turnaround. They can’t. How will it resolve itself? Well, it started with leverage as the big issue.
16.  So it will get resolved through asset sales. Idiosyncratic stories will dominate. Stronger balance sheet players will snap land and construction sites. SOEs will snap some assets. State will unwind bad players to help make whole employees and home buyers. 
17. There is a shady side to many of these construction cies, non more so than Evergrande and their Wealth management products sold mostly to employees. They can’t discharge the guarantees on many of these products and there are rumors of insider selling.
18. Expect more rot to be exposed, trials, accountability, compensation, etc…Stabilizing the onshore property market will be long, arduous, and risky. Evergrande alone has an order book of 1,7 m residential units. Those are down paid for, yet unfinished. 
19. Uncertainty and volatility will remain elevated. None of the ill-informed « they will bail them out » scenarii is possible. One thing is certain, there will be a protracted construction slump in activity and price increases. CCP might not allow for house and land price 
20. There’s obviously a read- cross for all commodities, but mostly steel. Dalian Iron Ore started collapsing in July and never looked back. Unsurprisingly, August showed the biggest drop in steel output on record… [See Chart Below]
21. And guess who is taking note? The miners are. That’s how contagion works. Aussie miners are the obvious play here: you can see that RIO has established a downtrend and is looking primed for a large move down. $BHP and $FMG looking equally awful. [See Chart Below]
22. It’s not only a commo issue. China’s consumers are very levered and while output has been restored to pre-COVID levels, consumers can’t keep up. Retail sales plunged recently to 11% below trend and all high frequency measures are showing sluggish spending. Chart Pictet [See Chart Below]
23. And China is looking at a winter of power shortages that’s gonna challenge it’s output further. It’s looking pretty dire and a last level of pernicious contagion will come from the losses all unsuspecting US moms and pops will incur following years of reckless inflows. 
24. While some signs of funding stress are emerging like the Onshore USD/CNY 1y swap rates ticking up, it’s still largely benign. China is a financial system where state and banks are 1 and liabilities locally dominated and held. 
25. If funding stress signs don’t emerge, don’t conclude that there is no contagion. Contagion is playing out already if you know where to look. End

Pandolfi Tweet Thread

Girolamo Pandolfi Evergrande Tweet Thread.

Pandolfi Point #6 – China Household Debt as Percent of GDP

Pandolfi Point #8 – High-Tech Exports

Pandolfi Point #12 – High Yield Bond Market Implosion

Pandolfi Point #13 – Credit Collapse 

Pandolfi Point #20 – Collapse in Price of Iron Ore

Pandolfi Point #21 – Aussie Miner Rio Tinto – RIO.AX

Pandolfi Point #22 – China Retail Sales Collapse

Key Point 

“If funding stress signs don’t emerge, don’t conclude that there is no contagion. Contagion is playing out already if you know where to look.”

Not Just Evergrande

The mess in China does not stop with Evergrande. 

Consider this Tweet Thread by Michael Pettis on the debt crisis at Baoneng, China’s Most Famous Corporate Raider – article paywalled.

1. Another large Chinese conglomerate is facing a debt crisis. Few economists, especially those focusing on the Chinese economy, understand how financial distress behavior is set off and how it systematically forces worse outcomes than expected.
2. This passage from Caixin demonstrates typical problems: “With 200 billion yuan ($31 billion) of debt, Baoneng faces employees demanding unpaid wages, suppliers clamoring for overdue payments, and creditors seeking loan payments.
3. The company, which obtained a 12 billion yuan strategic investment from the Guangzhou government, is frantically trying to scrape up cash by selling assets and requesting more government support.”
4. The point is that as the perceived risk of insolvency at a company like Baoneng begins to rise, and as cashflow becomes tighter, what started off as a linear process of credit deterioration at some stage becomes non-linear as credit deterioration suddenly accelerates.
5. The reason, as this passage implies, is that in response to deteriorating prospects, at some point employees, suppliers, creditors, customers, managers, owners, competitors and regulators all begin to change their behaviors in ways that cause revenues to drop, expenses to rise, and even greater balance-sheet fragility. 
6. At a certain point the only way to prevent a balance-sheet collapse is for a credible external agent to step in.
7. We are likely to see this story played out many more times. Beijing should either rescue companies in trouble early or liquidate them quickly. The longer the process of deterioration, the higher the financial distress costs to the economy.

What About Huarong?

Huarong Puts $58.8 Billion of Bad Assets Up for Sale.

1. “Current estimates put the size of the capital injection Huarong needs at around 100 billion yuan. Citic Group will provide the lion’s share of the funds, between 20 billion yuan and 50 billion yuan, most likely raised through bond issuance.”
2. Now that Huarong’s intervention has been completed and it is in the process of recapitalization, it’s easy to forget about it, but the ways in which the authorities dispose of Huarong’s assets will tell us something about how future large insolvencies will be treated.
3. For now they seem to be moving quickly to liquidate assets, which is a very good thing, although it is not clear if these will be sold at clearing prices or whether there will be pressure on buyers to pay whatever amount Huarong needs to be remain technically solvent.
4. It is worth noting that to the extent that Huarong’s overvalued assets are written down to their correct values, this represents the amortization of bezzle.

Huarong Tweet Thread

Here is the Pettis Tweet Thread on Hyarong 

Amortization of Bezzle

Let’s discuss the amortization of Bezzle.

Transitive Verb
Dialectal, Chiefly British : WASTE, PLUNDER

Savings Imbalance Theory Revisited

I seldom disagree with Michael Pettis on anything but the notion of excess savings is one area. 

I discussed savings on September 17 in Giant Sucking Sounds, Mexico, NAFTA, Global Trade, and Gold

The discussion involved trade imbalances. Pettis stated “These excess savings abroad are the root cause of American deficits.”

I countered:

The root cause of these imbalances and debt buildups is lack of an enforcement mechanism, not excess savings.

Importantly, it’s not even possible to have excess savings. Can one be too prepared for the future? That’s impossible, isn’t it?

Savings Glut Theory

Former Fed Chair Ben Bernanke said the world was suffering from a “savings glut”.

Yeah right, with total credit market debt of $84.56 trillion.

I am quite sure Pettis would redefine “glut” as an “imbalance” as opposed to an “excess”.

Importantly, note the word “abroad” in his sentence “These excess savings abroad are the root cause of American deficits.”

I still do not accept that theory although it is certain we have enormous imbalances. 

Confusing Money Printing With Savings

Central banks and economists repeatedly conflate money with savings. 

In the classic sense, savings equals production minus consumption.

If the US government spends $1 trillion on a bridge and it collapses, there is a trillion dollars still sloshing around but where is the bridge?

The answer is the bridge was consumed, but savings supposedly went up by a trillion.

If the government paid people not to work (and didn’t we just do this thrice?) what was produced? The answer of course is nothing. 

We need to really rehash this “excess savings” idea from a classical definition standpoint because the classical definition, not money created out of thin air is the correct definition of saving.

Confusing Cause With Result

I certainly grant the notion of huge imbalances. The entire global economy is imbalanced beyond belief.

But savings imbalances are a “result” not a “cause” of anything. The “cause” is lack of an enforcement mechanism that was automatic under a gold standard.

Maybe there is a “pool of real savings” but that pool is dramatically overstated by malinvestment and debt.

The pool is not necessarily overseas.

Lack of An Enforcement Mechanism

In the wake of Nixon killing gold redeemability debt soared. Money was wasted. Imbalances grow every year.

No one seemingly has to pay for mistakes, not governments nor warmongers but the imbalances keep rising. 

There is no incentive on governments to reinstate the gold standard because politicians like to spend and pass the debt to future generations. The US national debt remains (to the tune of $28 trillion) but the real savings is largely consumed. What isn’t consumed goes in the pockets of the already wealthy.

China finances US debt but a lot of that went up in smoke in corrupt and bankrupt State Owned Enterprises.

That’s part of the easily seen imbalances.

And the Fed’s (central banks in general) response to this convoluted mess is their attempt to force more inflation and still more money and credit into a system literally choking on it.

This money sloshing around, created out of thin air is constantly confused with “saving”. 

What About Money?

There are many disputes as to how to measure it. I discuss money in What is the Best Measure of Monetary Inflation?

In a fiat world where money is created at will, it’s easy to confuse money with real savings, the production of goods.

Money was nearly always a placeholder out of necessity (e.g. grains spoil, produce rots), but money is now diluted almost beyond recognition as the level of debt shows.

Savings Imbalance or Outright Theft?

With that, let’s return to Pettis comments on Everglade. 

• “It is worth noting that to the extent that Huarong’s overvalued assets are written down to their correct values, this represents the amortization of bezzle.“
• “We are likely to see this story played out many more times.”
• “This is an obvious problem for Evergrande’s suppliers, who might not be paid after having delivered products. It is in fact also a monetary problem.”
• “Even as the chairman was proclaiming that a basic principle of his business is that cash is king, he was pulling cash out of the company.” 
• According to WSJ: ‘As it piled on debt, Evergrande paid out billions in dividends to stockholders, with most of that cash going to Mr. Hui as its largest shareholder.’
• “The payouts helped him become one of China’s richest men. He has received more than 34 billion yuan, the equivalent of $5.3 billion, in dividends since October 2018.”
• “As Hyman Minsky liked to point out, while anyone can make money, the hard part is getting others to accept it.“
• “The former head of the CSRC says that, compared to other countries, too much of China’s household wealth is tied up in real estate, and too little in financial assets. With property accounting for 70-80% of Chinese household wealth, he’s right.“

Wealth Tied Up In Real Estate

How much is it really worth? 

In my post on savings, I asked, “If the US government spends $1 trillion on a bridge and it collapses, there is a trillion dollars still sloshing around but where is the bridge?”

In China, hundreds of billions went into property that never was built, or will be, or was built shoddily.  

That alleged “saving” just went up in smoke. 

“It is worth noting that to the extent that Huarong’s overvalued assets are written down to their correct values, this represents the amortization of bezzle,” says Pettis.

I suggest the saving is the true value of those assets minus the debt still owed.

Regarding Hyman Minsky and developers being paid in half-built property that cannot be sold, where is the “saving” when others won’t accept it or have to be forced to accept it.

Confusing Money With Savings 

In a fiat world where money is created at will, it’s easy to confuse money with real savings, the production of goods minus the consumption of goods.

In this case, the goods have inflated value. Thus, saving is overstated. To the extent creditors were “paid” in half-completed projects that are likely worthless, there is no savings at all.

Savings Glut or Fiat Ponzi Scheme?

Everglade shows the theft of wealth and money in a giant Ponzi scheme, not to be confused with real savings (i.e. net tangible assets at true market value)!

There is no savings glut. 

The alleged savings glut is nothing but a fiat Ponzi scheme where central banks have to keep money supply soaring to keep asset prices (based on debt) from imploding!

How much longer this setup can continue before it blows up in a currency crisis, war with China, or some other major economic disruption remains a key mystery.

Perhaps it’s started.

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