Michael Pettis: The Chinese Rebound Will be Short

Read it at Naked Capitalism
Michael Pettis: The Chinese Rebound Will be Short
Cross posted from MacroBusiness
Exclusively from Michael Pettis’ newsletter

Prof. Pettis uses the term "inverted balance sheet" in his post. He explains the meaning in another post:

To be hedged means to make money when things are otherwise going badly for you and to lose money when things are otherwise going well. It is only when the balance sheet is what I called “inverted” in my book that you have a problem.

Take copper financing by lenders in China. This is an example of an inverted balance sheet. As the biggest consumer of copper, China largely sets global copper prices. If China is growing quickly, this tends to push up the price of copper, and lenders who are secured by copper see the value of their loans increase – they become more secure. The lenders of course are delighted. They are probably making good money because China is growing, and on top of it their loans are becoming more secure than ever.

Of course this changes if the Chinese economy were suddenly to slow, especially if it slows sharply. In that case the lenders would probably see their revenues decline at the same time as the value of the collateral supporting their loans declines. If their borrowers are then forced to liquidate the collateral in order to repay the loans (which is likely to happen if the economy slows sharply), the liquidation value could easily be less than the value of the loans. In that case China would see an unsustainable rise in its debt – and notice this always happens at exactly the wrong time.

It is important to remember this when thinking about financing risks in China. We often hear analysts argue that because China has little consumer financing and because mortgage margins are high, they don’t have a debt problem. This argument is about as useless as the claim that because China has large reserves it is unlikely to have a financial problem. The limited consumer and mortgage financing in China means that china will not have a US-style financing problem, and the large amount of reserves means that China won’t have a Korean-style financing problem, but no one has ever seriously argued that those are the kinds of risks China faces. What matters is the level of debt, whether or not its growth is sustainable, and the kinds of contingent structures that are embedded. I would argue that all three measures are worrying.

It’s Not Just the West: China at Risk of Its Own Financial Debt Crisis
at Financial Sense (Feb 7, 2011).