2014-05-16

China's Credit House of Cards

In prior posts such as Rumored Mass Death of Companies in Xiaoshan District of Hangzhou If Banks Collect on Debts and Steel Trade Lawsuits Explode; Banks' Unceasing Nightmare; Defendants Flee, I covered articles that exposed China's financing network. From the latter:
The case load is putting pressure on the court system in Pudong. The work load is heavy for each case: there's an average of 15 defendants. There's the lending contract, loan certificate, guarantee contract, mortgage contract, warehouse agreement, plus third parties involved in the steel trade. (And based on the evidence below, many of the guarantor firms themselves may be other steel trading firms also in default. This is the interconnected finance situation seen also in Xiaoshan and in fact all over China.) One case has 20 boxes of files. More cases come as parties file claims with credit insurance companies, who then come to the court seeking compensation.
There are lots of informal financing networks in China, even among companies. This situation is concentrated geographically, particularly in provinces such as Zhejiang where private business plays a greater role in the economy because private companies are starved for credit in China. Since the 2008 crisis and particularly since 2011, when credit problems started erupting in areas such as Wenzhou, firms are increasingly giving each other lifelines.

Also, there are many cases of firms entering the lending business, either directly, or indirectly as I showed in Chinese Corporate Investors in the Dark as Trust Investments Falter. As profit margins fell post 2008 and real estate boomed, many firms created real estate investment or development divisions. Many firms became high interest lenders, as was the case with the steel trading companies. Other firms discovered the return on capital from trusts was higher than the return on invested capital in their business. One way or another, Chinese firms are linked to each other and the number and size of links increases as geography shrinks.

China firms slow payments, file lawsuits, as unpaid debt weighs on finances
At Longyuan Construction Group Co, an east China builder of high-rise offices, apartments and highways, receivables last year inched up 4.9 percent to 4.1 billion yuan ($657.3 million), while on average collection times extended to 95.2 days, compared with 76.3 days for 2011.

Slow collection of money owed is causing Longyuan to delay its own payments to steel and cement suppliers, Zhang Li, the company's board secretary, told Reuters, in a ripple effect that is being repeated across the economy.

"If you don't pay me and I pay others, aren't I just a sucker?" said Zhang. "I'm not that stupid."

......Over the same period, the median collection time for billings crawled up from 71.4 days to 90.42 days. It was the first time China's market-listed firms averaged more than 90 days in a decade.

"It's a pretty loud warning bell," said Paul Gillis, an accounting professor at Peking University's Guanghua School of Management. "Companies cannot pay-off their receivables in a slowing business cycle. Some of these receivable may not get paid, which means you'll see a lot of write-offs in the future."

......Separately, CSCEC reported that its own payables rose last year by 17.7 percent, to 214.95 billion yuan, with outstanding payments to construction-related and real estate development firms comprising more than half of the total.

China West's biggest unpaid supplier was Xinjiang Tianshan Cement Co., which also is a 3.68 percent company shareholder.

Xinjiang Tianshan, in turn, owed payments to several affiliated companies, including 440.1 million yuan to Sinoma International Engineering Co.

Sinoma's biggest shareholder is China National Materials Co , the cement equipment and engineering services behemoth, which also holds a 35.5 percent stake in Xinjiang Tianshan.

The web of cross-ownership among debtors mirrors a similar increase in inter-company loans that has raised the prospect of a wave of defaults in the indebted corporate sector. Chinese companies granted a net 2.55 trillion yuan ($411 billion) in so-called entrusted loans in 2013, nearly double the 1.28 trillion yuan total in 2012.
This is just the corporate sector. Across the entire economy, a similar pattern of financing exists. This is why the local government in Xiaoshan was leaning on the banks: if they start calling loans, the whole house of cards in the local economy comes down. It's why when a steel trading company goes to court, there can be dozens of defendents and related parties.

Here is a snip from *The 1 Hour China Book*, posted at Marginal Revolution (I have not read the book, but this snip accurately describes the economy).
Looking at China today, what you don’t see is an integrated continental economy. You don’t see infrastructure connecting each part of the country, like say in the United States. That is likely the future but not yet the present.

If you look at the population and the existing infrastructure, what you actually see is a series of “clusters.” You see local groups of cities with over 60 million people. For example, Beijing/Tianjin in the North is actually a cluster of 28 cities — all tightly interconnected by roads, rail and other infrastructure. Qingdao, well known for its beer, is actually part of a 35-city cluster.

Overall, China has more than 20 of these clusters…and each of these clusters is about the size of a European country. According to government plans, China’s main clusters will cover 80% of GDP and 60% of the population.
This is due in part to much of development being controlled by local and provincial governments, and also each province practicing some forms of protectionism to help its local SOEs. My first experience with this in China was buying beer: the beer selection is different in each province because local breweries are favored.

This situation is important for financial contagion. Risk is very great in a small geographic area such as Xiaoshan district in the city of Hangzhou or the city of Zhouning in Fujian province, where many steel traders operated. The link from these areas to the wider financial system would come through the banking system, but the risk of a systematic crisis is small due to geographic isolation. Losses are great inside the network, but the total losses outside could be limited. At the corporate level, the financial risk isn't as great to individual firms, but the contagion risk is greater.

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