Hamartia Antidote
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Tony Yiu
If there’s one thing I learned from 2008, it’s to watch the junk (a.k.a. high yield) portion of the bond market. Junk bonds are often the economic canary in the coal mine.
One thing you might hear people say about the economy is that, “The stock market is not the economy.” And that’s mostly true for two reasons:
- Stocks attempt to be forward looking and predict what will happen next to the economy. So sometimes when stocks are declining, it’s because investors expect the economy and therefore companies’ earnings to decline as well, even when they haven’t yet. But these expectations are just a guess and can turn out to be wrong.
- The stock decline in itself is generally not disastrous for a company. Few companies rely on consistently issuing stock in order to fund their operations (much more rely on debt, because it is generally a cheaper source of financing). So while a dip in the stock price is bad for morale and makes it harder to recruit, it doesn’t directly imperil the future of a company.
Debt is the lifeblood of many companies
But access to debt, especially junk debt, can make or break companies. In equities, the companies with the biggest market caps are generally the most successful (or at least perceived to be that way). In debt markets, the companies with the biggest representation are the ones that need the most debt — those with the crappiest balance sheets or those with the most fixed costs relative to their revenues and earnings.So to these companies, regular and affordable access to debt markets is a necessary condition for survival. Remove that and many of these companies implode and are forced to file for bankruptcy. And with these bankruptcies come unemployment, personal bankruptcies, mortgage foreclosures, and all the negative economic feedback effects that come from those.
China’s junk bonds are currently having a moment (in a bad way) — down more than 35% from their previous peak. Bloomberg’s index tracking high yield Chinese debt is down more than 50%!
A lot of this is due to property developers being major issuers of debt (read more about that Ponzi scheme here). As these developers, the housing market in general, and local governments (whose revenues and finances were heavily tied to the Ponzi) come under increasing amounts of pressure, there are two big questions:
- How exposed is China’s broader financial system and is there a chance of a 2008 style run on one or more of China’s larger banks?
- At what point will China’s government decide that it needs to step in and bail out the troubled entities in enough size that it removes any doubts about their solvency?
Financial panic?
China’s financial system (and company financials in general) is notoriously opaque with a lot of fake numbers. But in recent quarters, China’s larger banks have reported significant increases in delinquent loans. But even those amounts are still likely understated — real estate makes up roughly a fifth of China’s economy (and an even larger percentage of average household wealth). A significant slowdown of the sector is bound to at some point have large and negative knock-on effects, especially once job losses and bankruptcies cause more forced sales, triggering a negative feedback loop of home price declines and bankruptcies.At that point, many more Chinese citizens than now may opt to stop paying their mortgages because they have either lost their jobs, are underwater on their homes (i.e. negative equity), or believe that the developer will never finish constructing it. According to recent estimates (source), mortgage boycotts (since it is nearly impossible to successfully declare personal bankruptcy and have your debts forgiven in China), could impact 4% of outstanding mortgages — affecting $220 billion worth of mortgages. That’s probably a best case scenario.
Thus, China’s banks are exposed to some significant left tail risks where if the situation is allowed to get worse, it could snowball into a financial panic. Remember, during financial panics, it’s not actual solvency that matters but the perception of solvency. When everyone (banks especially) doubts the solvency of everyone else, liquidity vanishes and bills and interest are no longer paid, triggering bankruptcies.
At that point, China’s government and central bank would need to step in and guarantee liquidity and the solvency of major institutions in order to break the feedback loop. The government is currently loath to do that for several reasons:
- It’s the western way and since 2008 the CCP (Chinese Communist Party) has often used the Great Financial Crisis as a primary example of why its system is better than those of America and Europe. Doing the same thing as them would significantly impact its credibility.
- Moral hazard. The CCP instigated the current housing market crash because it felt that both debts and home prices were getting excessive. Swooping in to rescue systemically important entities creates exactly the wrong expectation going forward. It’s the old saying, when you owe the bank $100,000, you have a problem. When you owe the bank $1 billion, the bank has a problem. Instead of trading cautiously, China’s institutions will rush to accumulate enough debt to be regarded as systemically important.
