What Chinese Credit Markets are saying about the Chinese Economy
January 6, 2015
Three things are especially concerning in global markets in January, 2015.
Spot dollar, DXY, blasted through resistance at 90 and hasn’t looked back. This is risk-off as it represents subdued risk appetite and continued commodity weakness.
USDJPY looks like it is reversing the gains seen since early 2013. This is the Everclear version of risk-off as it represents reversal of carry flows, especially in credit.
The Chinese economy is falling off a cliff. This indicates that to a great degree the above currency moves are driven by a stall in the engine of the global economy.
We are getting more confirmation in data points that the Chinese credit bubble is bursting: inevitable Chinese defaults are coming. China has been the engine of the real global economy for years now as other economies retrench or muddle through ever-more-poor retail sale cycles. By real economy, I mean the economy that mines ores as in Brazil or Australia, the economy that drills for oil, the economy that makes machinery and chemicals. So many national economies and businesses are merely volatile derivatives of this one center of gravity. This center of gravity is looking more and more like a black hole.
The optimism expressed in Chinese equity markets is not showing up in credit. Spreads of 5 year Yuan-denominated BBB+ bond yields over matched maturity government bonds exceeds 10%. This is the data point that tells me the prices for commodities like oil and iron are right where they should be. And the decline is due to the fact that demand from a marginal buyer is collapsing. Even one-year corporate spreads are around 900 basis points.
Spread levels like this are dramatically shifting firm viability in the wrong direction. There are three types of borrowers: names that can pay interest and principal at all times; speculative borrowers that can pay interest out of cash-flow but need refinancing of principal to avoid default when loans come due; and borrowers only able to pay interest and principal if they can refinance on the basis of rising asset prices on book. The latter case really represent nothing more than a Ponzi scheme for a creditor.
To see how precarious the situation is, assume a name is levered 5 x (Debt/EBITDA), has capital expenditures 30% of EBITDA, and other cash outflows at 20% of EBITDA. If a given interest rate is 6.5%, then interest cost out of EBITDA is 32.5%. Cash interest cover is 50% of EBITDA. It can pay 17.5% of EBITDA to debt principal. If rates rise to 10% at the same leverage, the interest costs out of EBITDA is 49.73%, nearly exceeding the needed cash cover for 50% of EBITDA: these names can scarcely make the interest payments.
When a firm cannot pay both interest and principal, EBITDA doesn’t really matter much and it is not meaningful to characterize speculative and “Ponzi” borrowers in terms of EBITDA. What matters is whether the combined net present value of future cash-flows and book value of the firm exceeds its debt. It explains why these kinds of borrowers need rising book asset prices to remain solvent, and why the Chinese authorities have a nice bid underwriting asset prices—they just can’t control where all that liquidity goes.
The asset inflation policy isn’t enough to turn the ship, because inflating asset prices don’t get banks to releverage when their loan book is cratered with write-offs. They use the cash to provision and recapitalize instead. So the focal point of intervention will remain with the banks. The crisis playbook crafted over the last couple of years has been to use QE to generating a super-steep yield curve to prop up bank balance sheets and margins.
This will not stop defaults, rather it will bifurcate the credit markets into those that qualify for credit but don’t want/need it, and firms that want/need it, but can’t qualify for it. The coming realization for the Chinese financial system is that default rates spike, are correlated, and recovery rates are not uniform. The Chinese financial system will get a life-line thrown to it, and the Chinese central government will be the chief bag-holder.
I’m not even going to approach the daisy-chain of credits that will default from provincial governments to financial firms to corporations to small businesses to households. That is a story all of its own.