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Why Even China Isn’t Immune to a Debt Crisis

Most investors are aware of the elevated levels of government debt across the developed world, most notably in the eurozone periphery, the U.K., the U.S., and Japan. But fewer recognise that even China is vulnerable to an explosion in debt.

Chinese corporations, local governments, and state-owned enterprises have piled on alarming levels of debt over the past five years. So far, large-scale defaults have been avoided, largely because China’s banks have decided to roll over a large number of these loans. But for how long can this practice continue?

Chinese firms continue to pile on debt
According to GK Dragonomics, a China-based economic research firm, indebtedness among the country’s corporations soared from an already alarming 108% in 2011, to 122% last year, the highest level in at least 15 years.

This data illustrates a dangerous trend that has been unfolding among the nation’s companies. Faced with slowing growth and tighter margins, Chinese corporations have responded by taking on more debt — a course of action that could lead to a disastrous end game.

There are plenty of examples of heavily-indebted Chinese firms. Yingli Green Energy Holding Co Ltd (NYSE: YGE), the third-largest solar-panel maker in the world, has languished at the hands of colossal losses and a plunge in the prices for its products. Yingli’s shares have collapsed from its late-2007 high of nearly $40 a share to less than $3 a share currently.

You’ll note that the company is listed on the New York Stock Exchange. Now, if Yingli were a U.S. firm facing those same difficulties, some might think it was just a matter of time before it filed for bankruptcy (unless, of course, it was too big to fail). But not in this case.

China’s state-owned banks keep spoon-feeding credit — at below-market rates — to the unprofitable solar-panel manufacturer. Since 2009, Yingli’s outstanding short-term loans have nearly tripled.  Unfortunately, the solar company isn’t an isolated case. Rather, it’s a microcosm of the state of China’s corporate sector.

Chinese corporate indebtedness and overcapacity
Reuters recently surveyed 40 of China’s most indebted corporations and found that the majority of them were in sectors that are burdened by gross overcapacity. The news agency’s analysis unveiled a dangerous combination of soaring debt levels and falling profits among the 40 firms, which included Xinjiang Goldwind Science & Technology Co Ltd, a manufacturer of wind turbines, and COSCO Shipping Co Ltd.

Overcapacity appears to be getting worse. More commentators are recognising this as a serious flaw in China’s economy. Important industries, such as aluminum, coal, construction, and steelmaking, continue to be burdened by excess capacity and shrinking margins. But, instead of reducing capacity — as rational economic motives would dictate — they continue to expand. But why?

Many of them have been instructed by the central government to continue increasing capacity. Helen Lau of UOB Kay Hian, explains:

All the big producers have strong backing from the state banks. That is why they have been adding new capacity. This is not a commercial decision but a political one.

There you have it. It’s a government decision, not an economic one. According to Lau, China’s largely state-owned steel industry is 200 millions tons over capacity . Yet, it shows no signs of slowing down. Where will all the steel go?

When in debt, roll over
Upon closer inspection, it appears that China’s debt has grown much faster in the five-year period since 2008 than debt in either the U.S. or the eurozone periphery in the five years leading up to those regions’ respective crises. All other things being equal, this would suggest that China’s downturn — if there is one — could be much more severe.

The big question now is how all this debt will be repaid. On the face of it, China is no different from Western economies like the U.S. and those in the peripheral eurozone, which racked up tons of debt during economic boom years, only to be faced with the seemingly insurmountable challenge of reducing it during a period of slow global economic growth.

Though only time will tell, some feel that a number of recently-issued Chinese loans will eventually turn sour. When? That’s tough to say. The issue hasn’t come to the surface yet, because the country’s banks, instructed by the central government, continue to roll over debts. Faced with a ton of loans coming due within the next couple of years, they have decided simply to extend loan maturities as a way of delaying repayment and avoiding large-scale defaults.

While some commentators are confident that debt-financed investments launched in recent years will easily generate a rate of return above their cost of financing, skeptics have issued warnings that the practice of rolling over loans will end badly. They suggest that it will continue adding to banks’ bad loans, while keeping their overall balance sheet quality favourably disguised. Eventually, they argue, it could jeopardise the entire banking system’s liquidity.

According to Zhang Zhiming, head of China research at HSBC:

If lenders stopped rolling over debt, everyone would have trouble. Then, there would be a chain reaction and there will be a systemic risk.

Final Foolish thoughts and ways to invest in China

While large-scale debt rollovers may be an adequate short-term solution, the practice is clearly unsustainable. As Herbert Stein, chairman of the Council of Economic Advisers under Richard Nixon and Gerald Ford, famously said, “If something can’t go on forever, it won’t.”

That’s not to say there aren’t Chinese stocks worth considering. Many investors have turned their attention to Chinese technology stocks, often predicated upon the premise that the nation’s growing middle class presents tremendous opportunity for this sector. The number of Chinese Internet users swelled to 538 million last year, according to the China Internet Network Information Centre, while penetration levels remained relatively low at 40%.

Many suggest that the growing number of Chinese Internet users, projected to rise to 800 million by 2015 according to one estimate , should provide a catalyst for companies like Baidu (NASDAQ: BIDU) , China’s largest search engine, SINA (NASDAQ: SINA), which offers services similar to Twitter, and Youku Todou (NYSE: YOKU) , which offers video content similar to YouTube.

Baidu and SINA shares took a hit after reporting third quarter earnings that offered gloomy projections, including a sequential decline in revenue for the fourth quarter. On the other hand, Youku Todou saw an immediate surge following its third quarter earnings report, as it projected much higher revenue for the fourth quarter than the consensus estimate.

While these companies no doubt face their share of challenges, they may be worth investigating further based upon favourable long-term trends like the projected growth in Chinese Internet and smartphone users over the next few years.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. This article was written by Arjun Sreekumar, and was first published on fool.com.  Arjun is a contributor at fool.com, and does not own any of the shares mentioned. The Motley Fool owns shares of Baidu.