Is China Dodging Its Debt Bomb?

Last week, we got an unofficial announcement from the Chinese Government that was totally overshadowed by Mario Draghi’s bazooka but was probably more important. As Reuters reported, China is preparing for an unprecedented overhaul in how its banks treat non-performing loans.

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Prominent hedge fund managers have focussed on a “short Yuan” trade the past several months. The centerpiece of their investment thesis is the “neutron bomb” at the heart of China’s impaired financial system–trillions of dollars of non-performing loans (NPLs) held by the Chinese banks.

Officially, the amount is $614 billion—bad enough– but Kyle Bass and other analysts place the real total at anywhere from 8% to 20% of China’s total of $35 trillion in bank assets. It is the unknown impact of these NPLs that is the greatest threat to China’s financial system and the fundamental catalyst behind record capital flight as depositors move their savings as far as possible from China’s domestic bank.

The conventional thinking by Bass, Ray Dalio, KKR and many others, is that China will have to devalue its currency in order to inflate away its excess debt problem. The alternative would be massive debt default, “admitting” to the world just how insolvent China’s state-owned banks truly are, followed by layoffs of tens of millions of workers by zombie companies unable to pay their bank debts.

It looks like the hedge fund boys are about to be served up a meal consisting of their own body parts. The Chinese government remains a totalitarian regime able and willing to do whatever it takes to crush its opponents.

According to Reuters, China’s central bank is preparing regulations that would allow commercial banks to swap non-performing loans for shares. Sources say the new policy is imminent. According to Reuters, the move would represent “on paper, a way for indebted corporates to reduce their leverage, reducing the cost of servicing debt and making them more worthy of fresh credit.”

The proposal supposedly entails nationalization on a grand scale. China’s impaired commercial banks – all of which are implicitly state controlled – would get equity from the companies they made secured loans to, amounting to the biggest debt-for-equity swap ever. This policy would free up corporate balance sheets to layer on fresh trillions in bad debt, the same debt that pushed these zombie companies into insolvency to begin with. It gets better…

This move would also slash NPL ratios at commercial banks, reducing the cash they would need to set aside to cover losses incurred by bad loans. These funds could then be freed up for fresh lending to finance a new wave of infrastructure construction and factory upgrades the government hopes will rejuvenate the Chinese economy.

Of course, none of this addresses the real underlying problem—many of these businesses are not viable due to unprecedented excess capacity and low commodity prices. But this is still a Communist country, lest we forget, so who cares? Essentially, Beijing is about to GUARANTEE trillions in insolvent Chinese debt, nationalizing its least efficient, biggest zombie companies.

Going back to Reuters, it reports, that “the new regulations would be promulgated with special approval from the State Council, China’s cabinet-equivalent body, thus skirting the need to revise the current commercial bank law, which prohibits banks from investing in non-financial institutions.”

No need to play by the rules after all.

Maybe this is not the time to be short the Yuan?