In our last two blogs, we described the truly amazing amount of capital infrastructure construction going on in China, and we described how this amazing feat is being financed – by Special Investment Corporations – whose debts are really the debts of individual local governments, but those debts don’t get recorded anywhere.
So what we have is unrecorded debt of very large amounts, owing by Special Investment Corporations, which debt doesn’t show up anywhere, and China Banks who have lent all of this money to these Special Investment Corporations.
The case in point used as an example is the city of Wuhan, with about 9 million people.
Real Estate Values as Collateral for this Debt
Now banks don’t usually lend without some sort of security. In the case of Wuhan, it seems that local land value is the collateral. Local land value has moved dramatically higher in value in recent years, to the point that it seems almost unsustainable.
Compare this to the situation in the USA, where a very large percentage of mortgage loans (some statistics say over 20 million such loans) are in default because real estate values have plummeted.
Perhaps Chinese land values are quite different. Perhaps those values will never fall. Perhaps the examples of USA, or Japan, or Europe are simply irrelevant in this case. Perhaps.
Off Balance Sheet Financing
Across China, these Special Investment Corporations are used to finance projects. Some of these projects are empty cities. Some are marvelous subways in major showcase cities. But the debt for all of them is carried in roughly the same way.
In the world economic meltdown of 2008, the greatest culprit was off-balance sheet financing. Derivatives ran amok. Partnerships after Partnerships were set up by the major Western trading houses and banks so that they could be free from reporting their off balance sheet liabilities on their own financial statements.
Enron was forced into bankruptcy because of off-balance sheet financing.
Lehman Bros was forced into bankruptcy because of off-balance sheet financing.
But perhaps China is different. Some of us still believe in the tooth fairy.
China’s Amazing Transition
It is possible that the conversion of a billion or two people from poverty to middle class will eliminate all sins and miscalculations. Perhaps this is even probable.
The issue is, just how many bad loans do the Chinese banks have on their books. How much of this debt cannot be repaid. One can build the most marvelous buildings, but if the rents don’t cover the operating expenses and the debt, there will a big problem being a loan that cannot be repaid.
So the question remains, “How many of these loans will fall into default?”
The Issue is RISK
As an investor, if you know that something is wrong, or something seems unusually, why take on greater risk. Investing is difficult enough, without taking on additional risk.
This Time it is Different
So far, in my economic lifetime, it has never been different. Ever time something went to excess, it returned to normality.
Is it different this time?
Much of the information given in this blog was obtained from an article in the National Post of July 8, 2011 written by David Barboza.
The views expressed in this blog are opinions only and are not investment advice. Persons investing should seek the advice of a licensed professional to guide them and should not rely on the opinions expressed herein. This blog is not a solicitation for investment and we do not accept unsolicited investment funds.
Our next blog will be delayed. Please look for us later in September.
