Asian Financial Crisis Part 2: China's Debt Bomb

schizo · Jan 11, 2024

China is actually Enron in disguise, only bigger, much bigger.

China’s debt isn’t the problem
ft.com

It’s important to understand that the problems don’t emerge from the liability side of China’s balance sheets. They emerge from the asset side. That’s because the losses associated with the misallocation of investment over the past 10-15 years were capitalised, rather than recognised. In proper accounting, investment losses are treated as expenses, which result in a reduction of earnings and net capital. If, however, the entity responsible for the investment misallocation is able to avoid recognising the loss by carrying the investment on its balance sheets at cost, it has incorrectly capitalised the losses, ie converted what should have been an expense into a fictitious asset.

There’s naturally a lot of attention on China’s swelling debt burden, especially after Moody’s cut the outlook on the country’s credit rating based on the “broad downside risks” posed by the borrowing binge.

That’s understandable, given that the IMF in its latest Global Debt Monitor highlighted how China’s overall debt-to-GDP ratio has increased fourfold since the 1980s. It has been particularly rapid over the past decade. Over half of the increase in the entire global economy’s debt-to-GDP ratio since 2008 is solely due to an “unparalleled” rise in China, according to the IMF.

That $47.5tn total debt pile has grown further in 2023, which might mean that China has now finally overtaken the US in debt-to-GDP terms (zoomable version of the table below):

However, the surge in Chinese debt is not itself the problem but rather a symptom of the problem. The real problem is the cumulative but unrecognised losses associated with the misallocation of investment over the past decade into excess property, infrastructure and, increasingly, manufacturing.

This distinction is necessary because much of the discussion on resolving the debt has so far focused on preventing or minimising disruptions in the banking system and on the liability side of balance sheets.

These matter — the way in which liabilities are resolved will drive the distribution of losses to various sectors of the economy — but it’s important to understand that the problems don’t emerge from the liability side of China’s balance sheets. They emerge from the asset side.

That’s because the losses associated with the misallocation of investment over the past 10-15 years were capitalised, rather than recognised. In proper accounting, investment losses are treated as expenses, which result in a reduction of earnings and net capital. If, however, the entity responsible for the investment misallocation is able to avoid recognising the loss by carrying the investment on its balance sheets at cost, it has incorrectly capitalised the losses, ie converted what should have been an expense into a fictitious asset.

The result is that the entity will report higher earnings than it should, along with a higher total value of assets. But this fictitious asset by definition is unable to generate returns, and so it cannot be used to service the debt that funded it. In an economy in which most activity occurs under hard-budget constraints, this is a self-correcting problem. Entities that systematically misallocate investment are forced into bankruptcy, during which the value of assets is written down and the losses recognised and assigned.

But, as the Hungarian economist János Kornai explained many years ago, this process can go on for a very long time if it occurs in sectors of the economy that operate under soft-budget constraints, for example state-owned enterprises, local governments, and highly subsidised manufacturers.

In these cases, state-sponsored access to credit allows non-productive investment to be sustained. And as economic activity shifts to these sectors, the result can be many years of unrecognised investment losses during which both earnings and the recorded value of assets substantially exceed their real values. Because the debt that funds this fictitious investment cannot be serviced by the investment, the longer it goes on, the more debt there is.

But once these soft-budget entities are no longer able — or willing — to roll over and expand the debt, they will then be forced to recognise that the asset side of the balance sheet simply doesn’t generate enough value to service the liability side. Put another way, they will be forced to recognise that the real value of the assets on their balance sheets are less than their recorded value.

That is the real, huge and intractable problem China faces.

As long as local governments were able to increase debt at will, they could invest to meet excessively high GDP growth targets and could avoid recognising the associated investment losses. But once Beijing imposed debt constraints, either the fictitious assets would have to be written down and the costs allocated, or, which is the same thing, the debt would have to be serviced through transfers from other sectors of the economy.

Either way, someone would have to absorb the losses, and as this happens, there are at least three impacts on the economy.

The first impact does not involve the real welfare and value of the economy, but it may be politically embarrassing. It consists of reversing the former artificial boost to income. At the macroeconomic level, this means reversing the former additions to GDP.

The second impact consists of the unwinding of a previous “wealth effect”. Households and other entities that assumed they were wealthier than they actually were tended collectively to spend more than they could have otherwise afforded — in the case of local governments, this included spending on facilities, employees and services. Once they are forced to recognise their reduced wealth, however, they must cut back on spending, with adverse effects on the economy.

The third and most important impact is what finance specialists call “financial distress” costs. In order to protect themselves from being forced directly or indirectly to absorb part of the losses, a wide range of economic actors — workers, middle-class savers, the wealthy, businesses, exporters, banks, and even local governments — will change their behaviour in ways that undermine growth.

Financial distress costs rise with the uncertainty associated with the allocation of losses, and what makes them so severe is that they are often self-reinforcing. As we’ve seen with the correction in China’s property sector, financial distress costs are almost always much higher than anyone expected.

The point is that resolving China’s debt problem is not just about resolving the liability side of the balance sheet. What matters more to the overall economy is that asset-side losses are distributed quickly and in ways that minimise financial distress costs. That is why restructuring liabilities must be about more than protecting the financial system. It must be designed to minimise additional losses.

In China, as in other countries, it is usually not the debt itself that is the main problem. Debt is just a transfer, and does not necessarily entail the assignment of losses. What matters is the value of fictitious assets that back the debt.

That’s why Beijing should focus not just on managing the liability-side consequences of excessive debt in the system but also (and more importantly) on the asset-side consequences. It must recognise the full extent of the losses and move quickly to allocate them in the most economically and politically efficient ways.

Postponing this recognition and focusing mainly on minimising financial disruption, as Japan did in the 1990s, will just increase the overall cost to the economy.

ironchef · Jan 11, 2024

piezoe said:
There seems some confusion here with what I posted. I was referring to two possibilities. Let me elaborate these: One possibility is that the former President, who has been indicted on 91 felony counts, and is attempting to to avoid prosecution by running for president again, will be found guilty and go to prison either before or after voters reject him in November. The other possibility is that he will not be convicted before the election and somehow manages to get himself elected this November. In this case, if one is to believe his rhetoric, and he does what he says he will do, the nation will be transformed during a second Trump Presidency into a one-party, de facto autocracy. And too, there are still other less likely possibilities. Regardless, what eventually happens will, despite Donald Trump's ridiculous protestations and projections of his own crimes onto others, have only very superficially anything to do with politics and instead everything to do with whether or not Trump succeeds in avoiding the rule of law being applied to himself.

Your knowledge of the Nixon era does not agree with my first hand knowledge and observations of that 1970s period in U.S. history. (I was in my early 30s then working at the University of California's Los Alamos Laboratory, and I remember the Watergate era as clearly as though it were yesterday.)

The Watergate affair was very different from what is happening today. There was no insurrection and no chaos. Nixon did not try to pull off a bloody and violent coup. Government processes remained orderly and adult-like. There was no shouting and name calling. Both sides respected the rule of law --- though President Nixon did have his on peculiar and self-serving interpretation of Presidential power. President Nixon, who knew nothing of the Watergate escapade in advance, tried to coverup the involvement of his administration. It was his attempted cover-up that got him in trouble with both political parties. The Republicans at first tried to disassociate the Watergate break-in with anything going on in the White House. This became increasingly difficult after John Dean, a young Republican attorney in Nixon's administration, told the truth about Nixon's involvement in the cover-up and incriminated himself in the process. (He later did time for his role and ended up as somewhat of a national hero.) It was discovered that tapes of conversations in the Oval Office existed. Nixon tried to claim executive privilege over the tapes. Leon Jaworski, the Independent Counsel appointed by the DOJ, brought Nixon's claim of privilege to the Court. The Supreme Court quickly ruled unanimously that executive privilege could not be asserted to cover-up potential crimes, and the tapes would therefore have to be released to the bipartisan Senate committee investigating the Watergate break in. Once the tapes were reviewed it became clear that Nixon had committed felonies. Republican friends went to Nixon and told him that he was going to be both impeached and convicted by a two-thirds majority in the Senate consisting of both Democrats and Republicans. It is then that Nixon resigned, Gerry Ford became President and subsequently pardoned Nixon, a move that was widely credited with costing Ford the Presidency when he later ran on his own. (Spiro Agnew, Nixon's original V.P., had only months before resigned over having been caught taking kickbacks in Maryland. As a result, Gerry Ford had replaced Agnew as V.P. by application of the 25th Amendment. So at the time of Nixon's resignation Ford was ready to assume the Presidency.)

There are few similarities between Watergate and what is in progress in the country right now as I write this is. In Nixon's case, it took an investigation to uncover his crimes, and after he was found out, he stopped lying and quickly vacated the Oval Office.. In Donald Trump's case, however, he has done his law breaking largely in plain sight of millions of Americans, and even after thorough investigation he continues to lie and pretend he has done nothing wrong. Millions of his own followers who obviously know he's lying, because they have witnessed his actions and words with their own eyes and ears and can not, therefore, escape the terrible inconsistency between what Trump does and what he says. Even so, his foolish followers still make excuses for him and don't seem to care that he is lying, nor do they seem to care that the existence of our democratic republic is threatened by him. This is a far cry from how members of Nixon's own party behaved when they learned he had participated in the cover-up of his administration's involvement in Watergate.

The Nixon affair and what is happening today have few parallels. There was little to no talk of an existential threat to the U.S. Democracy in Nixon's time, and the concepts of alternative facts, truthiness and fake electors had not occurred to anyone. So far as anyone knows, there was no involvement of a foreign country in U.S. domestic politics in Nixon time. It was the finding by The Watergate Committee and Jaworski that the President had committed felonies that ended Nixon's political career. He was either going to resign or be impeached and convicted. Those were his choices. Once his crimes were exposed, he did not resist the transfer of power to Ford, nor did he steal stacks of top secrete documents and claim he had declassified them. He did not launch an endless stream of meritless childish appeals, and he certainly did not insult and invent silly, childish names for the Judges that stood between him and the White House. He showed respect for Congress and the law, and he did not claim that the DOJ was being weaponized by the Democrats against him. Those were very different times not to be compared with the existential threat that confronts us all today.
More...

You put a lot of thoughts and efforts into it.

I may not agree but I do respect your view. Free speech is fundamental to democracy.

Take care.

David's faith · Jan 12, 2024

schizo said:
China is actually Enron in disguise, only bigger, much bigger.

China’s debt isn’t the problem
ft.com

It’s important to understand that the problems don’t emerge from the liability side of China’s balance sheets. They emerge from the asset side. That’s because the losses associated with the misallocation of investment over the past 10-15 years were capitalised, rather than recognised. In proper accounting, investment losses are treated as expenses, which result in a reduction of earnings and net capital. If, however, the entity responsible for the investment misallocation is able to avoid recognising the loss by carrying the investment on its balance sheets at cost, it has incorrectly capitalised the losses, ie converted what should have been an expense into a fictitious asset.

There’s naturally a lot of attention on China’s swelling debt burden, especially after Moody’s cut the outlook on the country’s credit rating based on the “broad downside risks” posed by the borrowing binge.

That’s understandable, given that the IMF in its latest Global Debt Monitor highlighted how China’s overall debt-to-GDP ratio has increased fourfold since the 1980s. It has been particularly rapid over the past decade. Over half of the increase in the entire global economy’s debt-to-GDP ratio since 2008 is solely due to an “unparalleled” rise in China, according to the IMF.

That $47.5tn total debt pile has grown further in 2023, which might mean that China has now finally overtaken the US in debt-to-GDP terms (zoomable version of the table below):

However, the surge in Chinese debt is not itself the problem but rather a symptom of the problem. The real problem is the cumulative but unrecognised losses associated with the misallocation of investment over the past decade into excess property, infrastructure and, increasingly, manufacturing.

This distinction is necessary because much of the discussion on resolving the debt has so far focused on preventing or minimising disruptions in the banking system and on the liability side of balance sheets.

These matter — the way in which liabilities are resolved will drive the distribution of losses to various sectors of the economy — but it’s important to understand that the problems don’t emerge from the liability side of China’s balance sheets. They emerge from the asset side.

That’s because the losses associated with the misallocation of investment over the past 10-15 years were capitalised, rather than recognised. In proper accounting, investment losses are treated as expenses, which result in a reduction of earnings and net capital. If, however, the entity responsible for the investment misallocation is able to avoid recognising the loss by carrying the investment on its balance sheets at cost, it has incorrectly capitalised the losses, ie converted what should have been an expense into a fictitious asset.

The result is that the entity will report higher earnings than it should, along with a higher total value of assets. But this fictitious asset by definition is unable to generate returns, and so it cannot be used to service the debt that funded it. In an economy in which most activity occurs under hard-budget constraints, this is a self-correcting problem. Entities that systematically misallocate investment are forced into bankruptcy, during which the value of assets is written down and the losses recognised and assigned.

But, as the Hungarian economist János Kornai explained many years ago, this process can go on for a very long time if it occurs in sectors of the economy that operate under soft-budget constraints, for example state-owned enterprises, local governments, and highly subsidised manufacturers.

In these cases, state-sponsored access to credit allows non-productive investment to be sustained. And as economic activity shifts to these sectors, the result can be many years of unrecognised investment losses during which both earnings and the recorded value of assets substantially exceed their real values. Because the debt that funds this fictitious investment cannot be serviced by the investment, the longer it goes on, the more debt there is.

But once these soft-budget entities are no longer able — or willing — to roll over and expand the debt, they will then be forced to recognise that the asset side of the balance sheet simply doesn’t generate enough value to service the liability side. Put another way, they will be forced to recognise that the real value of the assets on their balance sheets are less than their recorded value.

That is the real, huge and intractable problem China faces.

As long as local governments were able to increase debt at will, they could invest to meet excessively high GDP growth targets and could avoid recognising the associated investment losses. But once Beijing imposed debt constraints, either the fictitious assets would have to be written down and the costs allocated, or, which is the same thing, the debt would have to be serviced through transfers from other sectors of the economy.

Either way, someone would have to absorb the losses, and as this happens, there are at least three impacts on the economy.

The first impact does not involve the real welfare and value of the economy, but it may be politically embarrassing. It consists of reversing the former artificial boost to income. At the macroeconomic level, this means reversing the former additions to GDP.

The second impact consists of the unwinding of a previous “wealth effect”. Households and other entities that assumed they were wealthier than they actually were tended collectively to spend more than they could have otherwise afforded — in the case of local governments, this included spending on facilities, employees and services. Once they are forced to recognise their reduced wealth, however, they must cut back on spending, with adverse effects on the economy.

The third and most important impact is what finance specialists call “financial distress” costs. In order to protect themselves from being forced directly or indirectly to absorb part of the losses, a wide range of economic actors — workers, middle-class savers, the wealthy, businesses, exporters, banks, and even local governments — will change their behaviour in ways that undermine growth.

Financial distress costs rise with the uncertainty associated with the allocation of losses, and what makes them so severe is that they are often self-reinforcing. As we’ve seen with the correction in China’s property sector, financial distress costs are almost always much higher than anyone expected.

The point is that resolving China’s debt problem is not just about resolving the liability side of the balance sheet. What matters more to the overall economy is that asset-side losses are distributed quickly and in ways that minimise financial distress costs. That is why restructuring liabilities must be about more than protecting the financial system. It must be designed to minimise additional losses.

In China, as in other countries, it is usually not the debt itself that is the main problem. Debt is just a transfer, and does not necessarily entail the assignment of losses. What matters is the value of fictitious assets that back the debt.

That’s why Beijing should focus not just on managing the liability-side consequences of excessive debt in the system but also (and more importantly) on the asset-side consequences. It must recognise the full extent of the losses and move quickly to allocate them in the most economically and politically efficient ways.

Postponing this recognition and focusing mainly on minimising financial disruption, as Japan did in the 1990s, will just increase the overall cost to the economy.
More...

And the derivatives on those assets are not even mentioned. Mortgages that become unpayable once the underlying financially dissappears are also coming up. It is the very definition of a scam, the whole country accounted wrong by intention. Never trust Chinese in ANYTHING.

piezoe · Jan 12, 2024

schizo said:
China is actually Enron in disguise, only bigger, much bigger.

China’s debt isn’t the problem
ft.com

It’s important to understand that the problems don’t emerge from the liability side of China’s balance sheets. They emerge from the asset side. That’s because the losses associated with the misallocation of investment over the past 10-15 years were capitalised, rather than recognised. In proper accounting, investment losses are treated as expenses, which result in a reduction of earnings and net capital. If, however, the entity responsible for the investment misallocation is able to avoid recognising the loss by carrying the investment on its balance sheets at cost, it has incorrectly capitalised the losses, ie converted what should have been an expense into a fictitious asset.

There’s naturally a lot of attention on China’s swelling debt burden, especially after Moody’s cut the outlook on the country’s credit rating based on the “broad downside risks” posed by the borrowing binge.

That’s understandable, given that the IMF in its latest Global Debt Monitor highlighted how China’s overall debt-to-GDP ratio has increased fourfold since the 1980s. It has been particularly rapid over the past decade. Over half of the increase in the entire global economy’s debt-to-GDP ratio since 2008 is solely due to an “unparalleled” rise in China, according to the IMF.

That $47.5tn total debt pile has grown further in 2023, which might mean that China has now finally overtaken the US in debt-to-GDP terms (zoomable version of the table below):

However, the surge in Chinese debt is not itself the problem but rather a symptom of the problem. The real problem is the cumulative but unrecognised losses associated with the misallocation of investment over the past decade into excess property, infrastructure and, increasingly, manufacturing.

This distinction is necessary because much of the discussion on resolving the debt has so far focused on preventing or minimising disruptions in the banking system and on the liability side of balance sheets.

These matter — the way in which liabilities are resolved will drive the distribution of losses to various sectors of the economy — but it’s important to understand that the problems don’t emerge from the liability side of China’s balance sheets. They emerge from the asset side.

That’s because the losses associated with the misallocation of investment over the past 10-15 years were capitalised, rather than recognised. In proper accounting, investment losses are treated as expenses, which result in a reduction of earnings and net capital. If, however, the entity responsible for the investment misallocation is able to avoid recognising the loss by carrying the investment on its balance sheets at cost, it has incorrectly capitalised the losses, ie converted what should have been an expense into a fictitious asset.

The result is that the entity will report higher earnings than it should, along with a higher total value of assets. But this fictitious asset by definition is unable to generate returns, and so it cannot be used to service the debt that funded it. In an economy in which most activity occurs under hard-budget constraints, this is a self-correcting problem. Entities that systematically misallocate investment are forced into bankruptcy, during which the value of assets is written down and the losses recognised and assigned.

But, as the Hungarian economist János Kornai explained many years ago, this process can go on for a very long time if it occurs in sectors of the economy that operate under soft-budget constraints, for example state-owned enterprises, local governments, and highly subsidised manufacturers.

In these cases, state-sponsored access to credit allows non-productive investment to be sustained. And as economic activity shifts to these sectors, the result can be many years of unrecognised investment losses during which both earnings and the recorded value of assets substantially exceed their real values. Because the debt that funds this fictitious investment cannot be serviced by the investment, the longer it goes on, the more debt there is.

But once these soft-budget entities are no longer able — or willing — to roll over and expand the debt, they will then be forced to recognise that the asset side of the balance sheet simply doesn’t generate enough value to service the liability side. Put another way, they will be forced to recognise that the real value of the assets on their balance sheets are less than their recorded value.

That is the real, huge and intractable problem China faces.

As long as local governments were able to increase debt at will, they could invest to meet excessively high GDP growth targets and could avoid recognising the associated investment losses. But once Beijing imposed debt constraints, either the fictitious assets would have to be written down and the costs allocated, or, which is the same thing, the debt would have to be serviced through transfers from other sectors of the economy.

Either way, someone would have to absorb the losses, and as this happens, there are at least three impacts on the economy.

The first impact does not involve the real welfare and value of the economy, but it may be politically embarrassing. It consists of reversing the former artificial boost to income. At the macroeconomic level, this means reversing the former additions to GDP.

The second impact consists of the unwinding of a previous “wealth effect”. Households and other entities that assumed they were wealthier than they actually were tended collectively to spend more than they could have otherwise afforded — in the case of local governments, this included spending on facilities, employees and services. Once they are forced to recognise their reduced wealth, however, they must cut back on spending, with adverse effects on the economy.

The third and most important impact is what finance specialists call “financial distress” costs. In order to protect themselves from being forced directly or indirectly to absorb part of the losses, a wide range of economic actors — workers, middle-class savers, the wealthy, businesses, exporters, banks, and even local governments — will change their behaviour in ways that undermine growth.

Financial distress costs rise with the uncertainty associated with the allocation of losses, and what makes them so severe is that they are often self-reinforcing. As we’ve seen with the correction in China’s property sector, financial distress costs are almost always much higher than anyone expected.

The point is that resolving China’s debt problem is not just about resolving the liability side of the balance sheet. What matters more to the overall economy is that asset-side losses are distributed quickly and in ways that minimise financial distress costs. That is why restructuring liabilities must be about more than protecting the financial system. It must be designed to minimise additional losses.

In China, as in other countries, it is usually not the debt itself that is the main problem. Debt is just a transfer, and does not necessarily entail the assignment of losses. What matters is the value of fictitious assets that back the debt.

That’s why Beijing should focus not just on managing the liability-side consequences of excessive debt in the system but also (and more importantly) on the asset-side consequences. It must recognise the full extent of the losses and move quickly to allocate them in the most economically and politically efficient ways.

Postponing this recognition and focusing mainly on minimising financial disruption, as Japan did in the 1990s, will just increase the overall cost to the economy.
More...

Thanks for this wonderful article pointing out that the problem is on the asset side, not the liability side. I posted, briefly some comments, then realized they were bound to be misinterpreted and just deleted. Thanks again for a great article. And no i don't think China is Enron. The FT article gives the correct picture. China's problem is resolvable.
Thanks again.
China's financial woes have been exaggerated here and elsewhere.

By the way, recessions usually provides a wonderful entry point to buy equities. Problem for us in the U.S. right now is that Trump started a fight with China and our non-functional current government has made only a minimal effort to smooth things over. Our government regulators have made it difficult for us to own stocks in Chinese companies. I had a fairly large position in SNP when the regulators forced it to be delisted. Nevertheless the investment paid off handsomely. I would still want to own SNP but can't now unless I can buy the Hong Kong shares, possibly through IB? Does anyone here know if that's possible.

schizo · Jan 12, 2024

piezoe said:
I would still want to own SNP but can't now unless I can buy the Hong Kong shares, possibly through IB? Does anyone here know if that's possible.
More...

Although I personally haven't, I believe you can.

First, the preliminaries:

Hong Kong Stock Exchange (HKEX):

0386: This is the listing for Sinopec on the HKEX and represents H-shares, which are US dollar-denominated shares available to international investors.

Interactive Brokers Trader Workstation:

You can search for Sinopec using its company name or either of the ticker symbols mentioned above. Interactive Brokers will automatically display the available exchanges and listings for Sinopec based on your account settings.

Now you need to utilize your forex account for currency conversion to use the following:

vanzandt · Jan 12, 2024

schizo said:
China is actually Enron in disguise, only bigger, much bigger.

China’s debt isn’t the problem
ft.com

It’s important to understand that the problems don’t emerge from the liability side of China’s balance sheets. They emerge from the asset side. That’s because the losses associated with the misallocation of investment over the past 10-15 years were capitalised, rather than recognised. In proper accounting, investment losses are treated as expenses, which result in a reduction of earnings and net capital. If, however, the entity responsible for the investment misallocation is able to avoid recognising the loss by carrying the investment on its balance sheets at cost, it has incorrectly capitalised the losses, ie converted what should have been an expense into a fictitious asset.

There’s naturally a lot of attention on China’s swelling debt burden, especially after Moody’s cut the outlook on the country’s credit rating based on the “broad downside risks” posed by the borrowing binge.

That’s understandable, given that the IMF in its latest Global Debt Monitor highlighted how China’s overall debt-to-GDP ratio has increased fourfold since the 1980s. It has been particularly rapid over the past decade. Over half of the increase in the entire global economy’s debt-to-GDP ratio since 2008 is solely due to an “unparalleled” rise in China, according to the IMF.

That $47.5tn total debt pile has grown further in 2023, which might mean that China has now finally overtaken the US in debt-to-GDP terms (zoomable version of the table below):

However, the surge in Chinese debt is not itself the problem but rather a symptom of the problem. The real problem is the cumulative but unrecognised losses associated with the misallocation of investment over the past decade into excess property, infrastructure and, increasingly, manufacturing.

This distinction is necessary because much of the discussion on resolving the debt has so far focused on preventing or minimising disruptions in the banking system and on the liability side of balance sheets.

These matter — the way in which liabilities are resolved will drive the distribution of losses to various sectors of the economy — but it’s important to understand that the problems don’t emerge from the liability side of China’s balance sheets. They emerge from the asset side.

That’s because the losses associated with the misallocation of investment over the past 10-15 years were capitalised, rather than recognised. In proper accounting, investment losses are treated as expenses, which result in a reduction of earnings and net capital. If, however, the entity responsible for the investment misallocation is able to avoid recognising the loss by carrying the investment on its balance sheets at cost, it has incorrectly capitalised the losses, ie converted what should have been an expense into a fictitious asset.

The result is that the entity will report higher earnings than it should, along with a higher total value of assets. But this fictitious asset by definition is unable to generate returns, and so it cannot be used to service the debt that funded it. In an economy in which most activity occurs under hard-budget constraints, this is a self-correcting problem. Entities that systematically misallocate investment are forced into bankruptcy, during which the value of assets is written down and the losses recognised and assigned.

But, as the Hungarian economist János Kornai explained many years ago, this process can go on for a very long time if it occurs in sectors of the economy that operate under soft-budget constraints, for example state-owned enterprises, local governments, and highly subsidised manufacturers.

In these cases, state-sponsored access to credit allows non-productive investment to be sustained. And as economic activity shifts to these sectors, the result can be many years of unrecognised investment losses during which both earnings and the recorded value of assets substantially exceed their real values. Because the debt that funds this fictitious investment cannot be serviced by the investment, the longer it goes on, the more debt there is.

But once these soft-budget entities are no longer able — or willing — to roll over and expand the debt, they will then be forced to recognise that the asset side of the balance sheet simply doesn’t generate enough value to service the liability side. Put another way, they will be forced to recognise that the real value of the assets on their balance sheets are less than their recorded value.

That is the real, huge and intractable problem China faces.

As long as local governments were able to increase debt at will, they could invest to meet excessively high GDP growth targets and could avoid recognising the associated investment losses. But once Beijing imposed debt constraints, either the fictitious assets would have to be written down and the costs allocated, or, which is the same thing, the debt would have to be serviced through transfers from other sectors of the economy.

Either way, someone would have to absorb the losses, and as this happens, there are at least three impacts on the economy.

The first impact does not involve the real welfare and value of the economy, but it may be politically embarrassing. It consists of reversing the former artificial boost to income. At the macroeconomic level, this means reversing the former additions to GDP.

The second impact consists of the unwinding of a previous “wealth effect”. Households and other entities that assumed they were wealthier than they actually were tended collectively to spend more than they could have otherwise afforded — in the case of local governments, this included spending on facilities, employees and services. Once they are forced to recognise their reduced wealth, however, they must cut back on spending, with adverse effects on the economy.

The third and most important impact is what finance specialists call “financial distress” costs. In order to protect themselves from being forced directly or indirectly to absorb part of the losses, a wide range of economic actors — workers, middle-class savers, the wealthy, businesses, exporters, banks, and even local governments — will change their behaviour in ways that undermine growth.

Financial distress costs rise with the uncertainty associated with the allocation of losses, and what makes them so severe is that they are often self-reinforcing. As we’ve seen with the correction in China’s property sector, financial distress costs are almost always much higher than anyone expected.

The point is that resolving China’s debt problem is not just about resolving the liability side of the balance sheet. What matters more to the overall economy is that asset-side losses are distributed quickly and in ways that minimise financial distress costs. That is why restructuring liabilities must be about more than protecting the financial system. It must be designed to minimise additional losses.

In China, as in other countries, it is usually not the debt itself that is the main problem. Debt is just a transfer, and does not necessarily entail the assignment of losses. What matters is the value of fictitious assets that back the debt.

That’s why Beijing should focus not just on managing the liability-side consequences of excessive debt in the system but also (and more importantly) on the asset-side consequences. It must recognise the full extent of the losses and move quickly to allocate them in the most economically and politically efficient ways.

Postponing this recognition and focusing mainly on minimising financial disruption, as Japan did in the 1990s, will just increase the overall cost to the economy.
More...

Know what's interesting(?), and I was going to mention this earlier.... but Yum China (YUMC) hit a 52 week low today. I have followed/traded this stock forever. Bad sign for China.

David's faith · Jan 13, 2024

The downside risk for any investment in China is huge. Their balancesheets are filled with debt claimed to be assets that have close to none intrinsic value. It is abig tail risk and just the recent foreign capital decrease coupled with a housing bubble and unemployment craze might be enough to start the deadly spiral.

mervyn · Jan 13, 2024

they take adam smith's the wealth of nations to heart. staggering amount of money pouring into their infrastructures are to increase the productivities and supply chains. and these investments became not assets nor liabilities, but equities, over the long horizon. roads, trains, ports, utiltity grids are not going away.

housing is just a very small part, it is a function of public infrastracture bloom. now they have 90%+ homewonership, their kids are probabaly don't worry not have places to stay and will focus on something else to make money.

now they pour trillions into the semiconductors and space/moon programs, that is something of an opportunity. their best companies are either sanctioned or remain private, sucha s huawai and dji. us person can't even buy hsi index fund in ibkr, only castrated version of etfs.

ironchef · Jan 13, 2024

mervyn said:
they take adam smith's the wealth of nations to heart. staggering amount of money pouring into their infrastructures are to increase the productivities and supply chains. and these investments became not assets nor liabilities, but equities, over the long horizon. roads, trains, ports, utiltity grids are not going away.

housing is just a very small part, it is a function of public infrastracture bloom. now they have 90%+ homewonership, their kids are probabaly don't worry not have places to stay and will focus on something else to make money.

now they pour trillions into the semiconductors and space/moon programs, that is something of an opportunity. their best companies are either sanctioned or remain private, sucha s huawai and dji. us person can't even buy hsi index fund in ibkr, only castrated version of etfs.

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I agree with your view. Looking back in history, we only need to go back about 100 years and look how the US went overboard and built lots of railroads, other infrastructure and a lot of them were underutilized or wasted but eventually enough paid off to build a future superpower. And the US poured millions into the emerging auto industry too.

Fifty years ago, President Eisenhower unleashed on us the interstate system with lots of criticisms on wastes with many interstate freeway way underutilized....

China is in a similar situation as the US was 100 years ago during the railroad boom.

piezoe · Jan 13, 2024

schizo said:
Although I personally haven't, I believe you can.

First, the preliminaries:

Hong Kong Stock Exchange (HKEX):

0386: This is the listing for Sinopec on the HKEX and represents H-shares, which are US dollar-denominated shares available to international investors.

Interactive Brokers Trader Workstation:

You can search for Sinopec using its company name or either of the ticker symbols mentioned above. Interactive Brokers will automatically display the available exchanges and listings for Sinopec based on your account settings.

Now you need to utilize your forex account for currency conversion to use the following:

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Thanks for that helpful information. It seems some of the Chinese ADRs continue to be listed. I believe it was those with a Chinese government controlling share that were forced to delist. Sinopec is one of these. Massive dividend and a very active company worldwide! Well, perhaps not so much in the USA anymore, but as far as I know they still maintain a Houston office. Actually yes, they appear to still have a major research facility there. http://www.sinopecthc.com/