China's New Plan: If You Can't Beat ‘Em, Force ‘Em

Things are getting weird in China, and I don’t mean the stock market. Yes, the Shanghai Composite Index fell today by more than 6.5%  — one of the biggest daily drops in 15 years. And this comes after the market shot up 126% since this time last year, with a gain of 42% already in 2015.

But this is a side show compared to the main action. To find the real craziness in China’s financial markets, we need to look at their debt. In this area, the Chinese government is pushing on a rope.

Through the People’s Bank of China (PBoC), they’ve cut interest rates several times in the past six months, desperately trying to stimulate borrowing. Still, it hasn’t generated much activity.

The goal was to make debt cheaper, motivating borrowers to take out more loans. The cheaper part has worked (sort of), but the banks still aren’t lending, which means economic growth is stalling.

It’s not a matter of too few borrowers asking for cash. Banks are just wary of lending extra funds to the more questionable ones — namely, local governments — that have been pouring their capital into boondoggle projects.

Government officials have made it clear: They want banks to stand on their own. They don’t want them to rely on a bailout when things go south. So when borrowers fail to pay — which some of them already have — the banks have to eat the losses. It would probably be small consolation that a failed loan carried a low interest rate, which is why the rate cuts by the People’s Bank haven’t generated much lending.

Now the central government has come up with a new plan.

Recently, the central government restricted how much direct debt local governments could issue to fund their questionable projects. Local governments didn’t like this, so they sought the help of trusts and other shadow banking entities to fund their debt. That left local governments faltering under the heavy load of debt service.

So, the central government increased the amount of direct debt that local governments can issue, hoping that they would effectively refinance their outstanding debt. This direct debt carries lower interest costs than debt issued by the shadow banks that local governments used before, so it would serve to lower their debt burden.

But no one wanted to buy the new local government bonds. Why would any investor want to trade his high yielding shadow debt for direct government debt, when the backing is the same but the interest paid is lower?

The People’s Bank tried to offer banks low-cost loans if the banks would buy the local bonds and use them as collateral. Even then, banks saw the obvious risk — what if local governments fail to pay?

But, this is still China. It is a command economy, so what the Red Dragon wants, the Red Dragon gets. Now China has essentially made it the patriotic duty of bankers to buy bonds issued by local governments. They’ve ordered financial institutions to keep lending.

The Chinese government has more tools at its disposal than Western governments do when it comes to fighting an economic downturn, but that doesn’t mean the downturn won’t happen. Forcing banks to comply with questionable lending won’t save them.

China still has a colossal debt burden that will have to go through some sort of restructuring before their economy can move forward. There’s more pain ahead, it’s just a question of who will be left holding the bag.