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    The Koyal Group, China's Industrial-Sized Debt


    The economic news from China this week is nominally positive, as HSBC's Purchasing Managers' Index shows industrial production picking up. This seems to confirm reports that Beijing decided in July that growth had slowed too much. The state-owned banking system pushed out some new loans to finance investment by state-owned companies.

    This has China bulls smiling, because they believe that rebalancing toward greater consumption will happen eventually and without serious dislocation. China bears, by contrast, see it as adding to a debt reckoning that is on the horizon.

    In particular, analysts are now concerned with the leverage of Chinese companies as a whole, rather than individual industries like property developers. Ratings agency Fitch warned this month that the country's total credit-to-GDP ratio is on track to reach 270% by the end of 2017. That's more than double pre-crisis levels in 2008 and an extraordinary number for a developing economy.

    Another way to look at this is that the "credit intensity" of China's growth has increased, meaning that for each unit of GDP more loans are required. A standard measure is called the incremental capital output ratio, and it has risen sharply since Beijing unleashed its stimulus program in response to the 2008 global panic.

    Meanwhile, China analyst Francis Cheung of CLSA this week noted that industrial capacity utilization has fallen to 78.6%, a level last seen during the 2008 crisis, and he predicts it will reach 73% by 2015. Given that fixed-asset investment is increasing at around 23% year on year while output grows at 13%, he's not going out on a limb. Mr. Cheung warns that past experience suggests that China will slip into deflation if utilization hits 70%, and the only way out will be for companies to write off some $229 billion in investment.

    For the moment Chinese companies are still making money, though profits are falling. And there is always the possibility that a recovering world economy will increase demand for exports. However, China's economy is so large now that if it continues to invest more than one-third of GDP annually in new capacity, as it has for the last five years, there must come a point when the world simply can't absorb all those goods.

    Corporate debt is also worth watching because the mechanism by which it could lead to an economic slowdown is much clearer than other threats that China bears perennially mention, such as banks' off-balance-sheet lending or local government debts. Since banks and governments are part of the state, their bad loans can be shuffled around almost indefinitely.

    State-owned enterprises won't be allowed to go bust either, but when their factories are idle they stop buying raw materials, and they often short-change workers on salaries. Private entrepreneurs tend to lock the gates and disappear overnight to escape angry creditors, since China lacks workable bankruptcy laws.

    Some analysts compare China's credit expansion to the U.S. before 2008, implicitly warning of a crisis. A better analogy is 1980s Japan. When a truly massive credit bubble popped in 1990, a financial meltdown did not ensue. Like Beijing, Tokyo kept tight control over the banking system, and domestic savers rather than foreign bond-holders were the source of the lost capital, both of which provided some breathing room. Unfortunately, loans to zombie companies were simply rolled over instead of written off, so the work-out period turned into protracted stagnation.

    In the late 1990s to early 2000s, the last time China faced serious overcapacity problems, Beijing didn't fall into that trap. A strong political consensus made possible the closure of thousands of rust-belt state enterprises and lay offs of tens of millions of workers. Even then, the implementation taxed the famously strong-willed Premier Zhu Rongji to his limit.

    So far China's leadership seems to lack that kind of resolve, and a leader of Mr. Zhu's caliber hasn't emerged. For all the talk of China rebalancing the economy, this week's news confirms it isn't happening. The longer it is delayed, the more likely it becomes that the next buzz word will be deleveraging.

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