CHINA's $10 Trillion Disaster

Hi, welcome back to the channel. In today's episode, I want to talk to you about what's happening in the Chinese economy and specifically to talk about what's going on with the local governments and the local government debt. Now, if you follow the channel, you'll know that I've made a number of videos talking about the LGF fees, which are the local government financing vehicles, because historically local governments were not allowed to borrow any money. The Chinese authorities didn't want all the local authorities building up huge amounts of debt, getting themselves into difficulty, and then having to bail them out. But to get around that issue, local governments set up what are called local government financing vehicles. So basically they set up a separate company that was allowed to borrow debt. So these LGF fees have been used to raise lots of money. Now, historically, the local governments were making an absolute fortune from selling land because China is a very big country. They've got lots of land. And as you'll know, the property development boom that took place in the early part of the 2000s and went on for around 20 years, it was a license to print money. So every single month, the local governments would hold an auction. They would sell parcels of land to all of the big developers. And every single month, the price of that land would go up and that would fund all of the spending from the local government. So happy days for everybody involved in property and local governments. However, as you'll also be aware of, if you follow the channel for the past few years, the property sector has been in the toilet in China because nobody wants to buy property anymore. We have seen a huge fall in property prices. We've seen lots of property development companies such as Evergrande going bust. And what that's meant for the local governments is that they've no longer been able to make lots of money from selling land auctions each month. And so instead they've been borrowing more and more cash to keep funding all of their spending. And one of the things that's just come to light is that the local governments have been following a practice that's actually been outlawed in China whereby they're not allowed to issue bonds above a certain price. So to get around that, they've been following a very interesting practice. So let's walk through this example as to what the Chinese local authorities have been doing to boost the price that's paid to investors. To make the bonds more attractive because as they've taken on more and more debt, the risk is now getting higher. And so they should actually just be paying a really high coupon, but they're not allowed to. Now, just before we go on any further today, could I ask anybody that hasn't subscribed yet to please hit that subscriber button. 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If we take an example of a bond that's issued in Chinese Yuan, now the face value of that bond would be 100 Chinese Yuan. So if you bought the bond when it was issued by the local authority, you pay them 100 Yuan. You then get paid the interest during the 12 months that the bond is in issuance. And at the end of the year, you'll get your 100 Yuan back. So basically you just make your profit by getting paid the interest. But in order to pay an attractive rate, the local authorities have been doing this. So rather than issuing the bond at 100 Yuan, they've actually been giving it to a broker and the brokers have been selling them in the market for 93 Yuan on the hundred. So basically you're getting a 7% discount for buying that 100 Yuan bond. So what that means is that at the end of the 12 months, when you come to get repaid, you'll get repaid the 100 Yuan, which is on the front face of the bond, but you only paid 93 for it. So therefore you're making a 7% uplift on the capital. In addition to the coupon on that bond, which in this example has been set at 8%. So over the course of 12 months, rather than just getting paid 8% interest, which is what you would get if you bought it at a hundred, you're getting the additional 7% kicker from the uplift against the original price of 93 that you paid. So in total you're receiving 15 Yuan for a bond that you only paid 93 Yuan for. So you're basically getting a return of above 16%. Now that wouldn't be allowed. The local authorities wouldn't be allowed to issue bonds at 16%, but this is a very clever way of getting around it. But what this means from the local authorities point of view is that they're actually building up more debt for themselves because they're issuing these bonds at a discount to the broker at 93 Yuan. They're only receiving 93 Yuan at the start of the year. And at the end of the year, they're having to pay back a hundred Yuan. So they're paying 8% interest on the bond plus another 7% uplift on the discount that they paid at the beginning of the year. So these bonds are costing the local authorities 16%. Now, obviously if they don't have the cash to cover that, they're going to have to pay it by issuing more bonds. So this is a classic debt spiral that these local authorities have got themselves into. And if we have a look at this example, it shows how these bonds are trading. These are real world examples. So we've got an official rate here of 6.5% for these bonds that have been issued, but when they've been sold in the secondary market by investors, the yield on those bonds is coming in. In this example here, it's coming in at 14.6%. So that's basically the actual value that these bonds have in the market. And you can see that there's a whole range of different rates here ranging from the 14.6% down to 9.4%. So what this tells us is that the real price of these bonds for the Chinese local authorities is significantly higher than the face value of the bonds because they're issuing them at a discount. And it's now estimated that the total debt that's been built up by the local government financing vehicles is over 10 trillion US dollar equivalent. Now when that's added to the total debt for the Chinese state, it increases the debt to GDP percentage from around about 40% to closer to 100%. So the figures that we're seeing officially being published by the Chinese state do not reflect the risk that's out there in the market at the moment in terms of the amount of debt that's been built up at local authority level in China. And the problem that the local authorities have is that their main source of income, which historically was coming from the property market has been taken away because the property market is no longer functioning in China. Nobody wants to buy large parcels of land to build new cities on because all the previous cities that have been built are still half built and half empty. So the property developers don't have the capital. Therefore the local authorities aren't receiving the cash. And what this tells us is that China is now struggling with a debt crisis right across the country. So what's the summary and conclusion today? Well, I wanted to post this video because we've been talking about the Chinese economy for many years now, and we've been talking about a buildup of debt for a long time, but that debt was specific to lots of individual companies. So we started off talking about Evergrande. They were some of the first videos that I made on China. And since that time, we've been identifying lots of other problem industries. So it's not just property where they're swimming in debt. We've got lots of companies now in China that are no longer making a profit. They're banking losses. And the only way to fund a loss as a company is either from your cash reserves, but Chinese companies don't have large cash reserves because they've seen falling producer prices in every single month for the last 36 months. So they're selling their products at a lower and lower price every single year, but costs are rising and that's been wiping out profit for most companies. So over 50% are banking those losses. And that means that those 50% are borrowing money. So they're building up more and more debt. And where they're borrowing that from is the Chinese banks. So we've got a really big risk profile that's starting to emerge all across China from all of these different companies. But what we've talked about in today's video isn't company debt. This isn't down to losing profitability because you've had to cut your profits as a result of falling prices. This is actual infrastructure. We're talking about the local governments in China, not receiving enough money either from the state or from their own resources to cover their costs. As we identified earlier, historically the local governments were making lots of cash from selling parcels of land to the property developers. But unfortunately that merry go round has now stopped because the property developers couldn't get access to the debt that they needed to pay for that land. And so they couldn't cover the cost for any future purchases. And at the same time, those developers then found that they couldn't actually build out all of the apartments that they'd taken deposits and advanced payments for. And so we had a collapse of those businesses. And alongside that there was a collapsing confidence from Chinese consumers because they started to see firstly, the value of property going down. And secondly, a lot of their investments were lost because they'd put down their life savings to buy these apartments. In many cases, people were buying multiple apartments in the same building. And unfortunately a lot of those apartments still haven't been built. So the property sector has been wiped out over the past few years and the local governments are now suffering badly as a result of this because they've lost their primary source of revenue that was funding all of their growth and development. And they're now having to find other ways to fund it. And how they're doing that is by issuing more and more debt. Now there are strict rules in China in terms of what they're allowed to do with the coupon on that debt. So they can't offer a 16% coupon because questions would be asked from the top as to what's going on in your local authority. So to get around that, what the local authorities have been doing is issuing their bonds at a discount. So they've been talking to brokers, placing those bonds at maybe 7% below the face value in the primary market. Those brokers have then been selling that to investors. Those investors have then either been sitting back and taking a very healthy coupon of maybe 8% interest plus a 7% discount, giving them a total return of over 16% because they've only paid 93 Yuan on a hundred at the front end of that deal. Or they've been selling those bonds immediately into the secondary market and making a nice profit. And those bonds are now trading in the secondary at double digit returns. So the yield tells us that the local authorities are having to pay a really high price to continue borrowing. And the reason why they're having to pay that price is because the risk profile is rising as you take on more and more debt. And as your income starts to fall, as it has been as a result of the loss of the property income, then that means that you're going to make big losses. Local authorities in China are spending more than they're earning. And as you'll know, if you follow the channel, that is not a sustainable situation because the only way that they've been funding it is through debt, but it becomes a vicious debt spiral, because the more debt you borrow, the more interest you have to pay and the more discounts you're offering on those bonds. Therefore you have to borrow even more to cover all of those costs. And before you know it, you become bankrupt. Now, obviously if you're a local authority, you can't be made bankrupt in China. That's one of the reasons why they're not allowed to take on debt, but the local government financing vehicles are allowed to take on debt. They've taken on over $10 trillion worth of debt collectively, and they can't afford to pay it back. And of course, the people who've given them that debt are the investors in China, both funds and individuals. So once again, here we've got a situation where there are some major losses that are now being built up in China. And at some point there will have to be a reckoning. There is going to be a day when all of this debt needs to be paid back. And of course the local authorities, they can't pay it back. They don't have any money. The only way that they can continue paying back investors is by issuing more and more bonds. So they're getting themselves into deeper and deeper trouble at the same time as the rest of the Chinese economy is also struggling. We've got lots of companies making losses and we've got a big problem with regards to the property sector. And now we've got an issue with regards to exports as a result of the tariffs that have been applied both in the USA and in lots of other countries over the past 12 months. So China is facing a major problem. It's got falling revenue and rising debt costs. And at some point that is going to catch up with the Chinese economy and we could see a major implosion at some point over the next 12 to 18 months. So hopefully you've enjoyed today's video. 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