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China’s Credit Crunch—and Prospects for a Crash

John-Paul Smith, who predicted the 1998 Russian stock market collapse, sees China’s equity markets tanking soon. “There is potential for a debt trap in industrial companies which can trigger an economy-wide financial crisis as early as next year,” said Smith, now a strategist at Deutsche Bank, in an interview this month. China today, Smith says, resembles Russia before its markets flopped 15 years ago.

China analysts, when they think about debt, focus on out-of-control municipalities and their notorious local government financing vehicles, but, as Smith reminds us, it could be Chinese corporate debt that will be responsible for the world’s next great equity crash.

China’s corporates have clearly taken on far too much debt. At the end of last year, their obligations were 113 percent of gross domestic product, according to the Royal Bank of Scotland. JPMorgan, on the other hand, thinks the figure was 124 percent, and BBVA, the Spanish bank, estimates almost 130 percent. 

All these figures, in reality, are far too low because they are based on official GDP statistics, which grossly overstate China’s output. After making adjustments to nominal GDP for inflation—this change by itself takes more than a trillion dollars off the 2012 results—and eliminating obvious fibbing, the corporate debt-to-GDP ratio becomes astonishingly high, perhaps approaching 155 percent. As Tom Holland of the South China Morning Post tells us, “China Inc.’s balance sheet is flashing danger signals.” 

As a result of their heavy debt loads, many companies are either not making payments or paying with cash substitutes, like bankers’ acceptances. Some have even failed. The most recent high-flier to fall is Liansheng Resources Group, a coal-mining company that is the largest private business in inland Shanxi Province.

Liansheng crashed fast. Its troubles are notable because its founder, Xing Libin, gained notoriety early last year for spending 70 million renminbi ($11 million) to celebrate his daughter’s wedding and the 10th anniversary of his company with an extravaganza on the resort island of Hainan. The young tycoon—he’s 46—chartered three jets to fly family and friends to the islands, hired pop stars to sing at the event, and arranged six Ferraris for the wedding procession. He even had a horse-drawn carriage with a foreigner at the reins—a rare show of opulence.

Now, Liansheng is in bankruptcy, and some, such as Quartz’s Gwynn Guilford, believe the company’s problems could bring down China’s shaky banking system. At the moment, Guilford, who wrote just four days ago, looks prescient. The country is going through another quarter-end credit squeeze, just as it did in June. Last week, interbank rates doubled, with some of them heading to historic highs and one rate actually setting an all-time record. There were rumors of default in the interbank market as banks apparently missed payments. Experts disagree as to the seriousness of ongoing disruptions in the market, but they cannot be a good sign.

In fact, the markets don’t like what is—and has—been going on. Unless there is an unprecedented upswing in the next few trading days, 2013 will be the third down year after the boom of 2009. The closely watched Shanghai Composite Index is now off 36.2 percent from the end of that bull year.

Some foreign analysts, however, are predicting a “massive multiyear bull run.” The theory is that the Communist Party will in fact embark on the reform program announced last month after its Third Plenum. Yet as Smith points out, “The proof will be in the implementation.” So far, he remains unconvinced.

Xi Jinping has been ruling China for slightly more than a year, and up to now he has presided over a period of backsliding. Beijing today, for instance, has doubled down on its exhausted state-investment growth model and waged campaign after campaign against foreign business. It’s not clear that Xi can drop his Maoist-Marxist rhetoric, overcome entrenched interests, and get behind fundamental restructuring.

Yet even if he can accomplish all this, the issue is whether he can do so in time. Today’s credit crunch is a warning to the world that the issue in China is not so much the direction of change as much as its pace. Smith is correct to warn that the elements of a nationwide failure now exist.

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