In the case of 1MDB, most of the headlines concerned the allegations of embezzlement and the cover up. Few actually considered the actual business model i.e. is it possible for a sovereign debt fund to function in the first place.
Surprisingly, this concept of a debt funded investment is quite common in China. In fact, the amount of debt in China, as reported as ““Total Social Financing” an appropriately Communist sounding title, was RMB 200.75 trillion as of end Dec ’18 (USD $29.7 trillion). That is a lot of debt!
For years, economists have predicted that the great day of reckoning will one day come and China will find itself in a banking crisis the likes the world has never seen. And this year certainly looks like a year where this prediction could come true.
Already, the default rate tripled in 2018, with 119 corporate bond defaults versus 35 in 2017. If 2019 was going to be any better, the market has been severely disappointed as one of the most famous private investment vehicles, China Minsheng Investment Corp, has defaulted on a bond that was due to be paid on Feb 1. Currently, China Minsheng Investment has RMB 232 billion in debt or USD$ 34.19 billion. Another borrower, Wintime Energy is unable to pay up 20% of principal on its debt, and it has RMB 63.2 billion or US$ 9.3 billion in debt.
So what happens now?
To give you some perspective, things can go very bad, very quick. This is because retail investors may be tempted to pull money away from the debt market, which makes it difficult for other debt zombie companies to find financing. So then these companies start to default, which makes more people pull money away from the debt market. Quite quickly, you can see how things can go out of control.
For China, the corporate bond market is about RM 20.13 trillion (US $2.97 trillion). The GDP of the country is $12.24 trillion. So is this bad? Is this comparable to the sub-prime crisis in the US?
In 2008 , the total CDO (“toxic debt”) outstanding in the US market was $1.04 Trillion. US GDP was $14.72 trillion at that point, so in a like-for-like comparison, China is in a much worse state as it has a smaller GDP base and a larger potential debt problem. This is because we have not even included the other elephant in the room – bank loans of RMB 134.69 Trillion (or USD $19.9 Trillion) or the other shadow banking loans – trust loans and entrusted loans of RMB 20.21 trillion (US $2.98 trillion).
As of 2018, China’s Commercial bank NPL ratio climbed to a 10 year high of 1.89% and total bad debts was RMB 2 trillion (USD $296.5 B). We can expect this ratio to double to 3.90% by end of 2019, meaning that total bad debts on commercial banks would have doubled to RMB 4 trillion, corporate bond default rate would have gone up three to five times, with over RMB 2 – 3 trillion of corporate debts in the bankruptcy court and another RMB 2 – 3 trillion of entrusted loans / trust loans blowing up.
Add all these together and the problem credit is of the order of RMB 6 – RMB 10 trillion (USD $0.9 Trillion – USD $1.9 Trillion).
This is sufficient to send China to a severe recession, perhaps similar in intensity to what the US experienced in 2008.