Eurozone
According to Eurostat, after 18 months of contraction the eurozone grew 0.3% in the second quarter, led by a 0.8% rebound in Germany which represents 30% of the eurozone. Although this is a plus for the eurozone economy, global investors are likely to make more of it than is warranted, since growth is unlikely to meaningfully accelerate in the second half of 2013. In Italy and France necessary labor market reforms are being delayed, which will keep unemployment high and growth muted in the second and third largest members of the eurozone. Although the eurozone notched positive growth in the second quarter, Italy remains in a recession that has persisted for two years. Individuals and businesses are increasingly falling behind or defaulting on their loans. According to the Bank of Italy, non performing loans have increased from $207 billion at the end of 2010 (8.9% of total loans) to $329 billion (14.2% of total loans) as of March 31, 2013. In response to the deterioration in the banking system, the Bank of Italy is reviewing the loan portfolios of eight top banks, and launching on site inspections of an additional 20 banks.
More importantly, the deleveraging of the eurozone’s banking sector may prove the most significant brake on growth in coming years. Over the next three to five years, eurozone banks will have to reduce their balance sheets by $4 trillion to meet stricter rules on capital, according to an analysis by the Royal Bank of Scotland. The eurozone’s biggest banks should be able to meet the new requirements by raising capital from financial markets. But that may prove expensive, as Barclays recently found out after Britain’s bank regulator determined its capital needed to increase by 38%. Barclay’s stock lost 10% of its value in the three days after the announcement.
Small and medium sized banks in the eurozone may have a more difficult challenge since they are likely to remain frozen out of the financial markets and unable to receive support from their country’s government. This will force many banks to not renew maturing loans, which could prove especially hard on small and medium sized companies, since they do not have access to loans via capital markets. Eurozone banks provide 80% of the credit created in the eurozone so the ongoing contraction in lending will weigh on growth in many eurozone countries. Small and medium sized banks will also need to sell assets during the next few years to shrink their balance sheet. Assets sales by local banks will pressure asset prices throughout the eurozone, but have a greater negative impact in Spain and Italy, where smaller banks represent a larger part of the financial system in those countries.
In June, lending to companies and consumers in the eurozone fell by a record -1.6% from June 2012, according to European Central Bank (ECB). A high level of household and corporate debt in the Netherlands, Spain, Portugal, France and Ireland could keep consumption and investment weak in these countries, especially if access to credit is limited over the next three to five years.
China
Exports represent 31% of China’s GDP, and in July, Chinese exports grew 5.1% from a year ago, after falling -3.1% in June. Shipments to the U.S rose 5.3%, and after several months of contraction, rose 2.8% to the European Union (EU). Total electricity usage was up 8.8% in July, a healthy improvement from the 6.4% gain in June from a year ago. The China Flash HSBC Manufacturing Purchasing Manager Index (PMI) for August rose to 50.1 from 47.7 in July, which was the weakest reading since August 2012. New orders jumped to 50.5 from 46.6 in July. However, the sub-index for new export orders fell in August, after falling in July at their fastest rate since last October. This suggests that export growth may weaken in coming months. After reaching its lowest level since March 2009, manufacturing employment improved in August, but the employment index remained under 50, according to China Flash HSBC Manufacturing PMI survey.
As we discussed at length in our June commentary, growth is unlikely to accelerate anytime soon as China grapples with excess capacity in the very sectors that fueled growth over the past decade. According to the National Bureau of Statistics of China, there is 3.7 billion square meters of property under construction, which is enough to satisfy demand for almost four years without starting a single new property. Steel production is becoming a chronic problem, almost 90% of the aluminum produced is sold at a loss, and the utilization rate for cement producers in 2012 was 65%, according to the China Enterprise Federation.
Excess capacity and low utilization rates have hurt state owned firms particularly hard. In 2012, state owned firms generated an average 4.6% return on assets, compared with 12.4% for private sector firms. Only 8% of private sector firms operated at a loss last year, versus 25% of state owned firms, according to the National Bureau of Statistics of China. Through June, sales for the state owned firms grew 5% from 2012, while private firm’s sales grew 10.9%. State owned firms comprise 25% of China’s industrial output, but could have a greater impact on China’s banking system since they can borrow money at lower rates than private firms from state owned banks. According to the Beijing based Unirule Institute of Economics, state owned firms would have made no profit from 2001 to 2008 if they had been forced to pay market rates for capital, land, and other inputs. State owned banks have also been more lenient in lending to unprofitable and marginally profitable state owned firms. One of the reasons Total Social Financing grew by 50% through May was the willingness of state run banks to extend non-performing loans, rather than label loans in default.
According to Fitch Ratings Inc., bank assets soared 126.5% over the past four years. Based on market capitalization, four of the world’s 10 largest banks are Chinese. However, Chinese banks are thinly capitalized with equity representing only 6.5% of total assets, which is far less than U.S. banks equity capital ratio of 11.5%. A recent analysis by ChinaScope Financial shows that China’s banks will have to raise $50 billion to $100 billion through equity sales in the next two years just to maintain their current capital ratios. We think non-performing loans will increase in coming quarters, as China’s growth gradually slows. This will keep utilization rates low and result in more losses for state owned companies. Sooner or later, Chinese banks will find it difficult to continue to extend maturing loans to avoid defaults.
Prior to the financial crisis in 2008, large U.S. banks used Structured Investment Vehicles (SIV) to increase lending that was not counted against their capital ratios. Although the banks booked fees from the SIV’s, they did not include them as part of their ‘official’ balance sheet. When the first tremor of the financial crisis shook the financial system in August 2007, Federal Reserve Chairman Bernanke had the CEO’s from several of the large investment banks attend a meeting to explain how the investment banks were using Structured Investment Vehicles. Although the Federal Reserve had regulatory oversight of banks, the Fed wasn’t even aware of their existence.
The China Banking Regulatory Commission has tried to curb the runaway lending by Chinese banks in recent months. Their efforts have been somewhat thwarted by Chinese banks which have learned how to circumvent regulations, just as their American counterparts. Regulations limit lending to corporations and customers to 75% of a bank’s deposits. Banks at the loan-to-deposit limit, who want to make a loan to a corporate customer, have developed a nifty scheme to avoid the regulation. First, the bank makes the loan to another bank, which lends the loan amount to a second company, which lends to a trust company, which then lends to the first bank’s customer. Banks are not allowed to lend directly to trust companies, which is why the second bank in this lending daisy chain lends to the second company, so it can lend to the trust company. Every link in this chain collects a fee and, at the end of this process, the first bank has made the loan to its corporate client. Even though the first bank is at risk if the corporation defaults, the loan shows up as a loan to a bank, which does not count against the lending limits.
The other advantage is that a loan to another bank requires less capital to be set aside than a corporate loan. This means Chinese banks are even more under-capitalized than the official figures indicate. Two midsize lenders who disclose this type of loan, Industrial Bank Co. Ltd. and Chongquing Rural Commercial Bank Co. Ltd., said this lending arrangement represented 32% of their bank’s outstanding loans at the end of June, up from 20% a year ago. Since it is impossible to get exact figures on the total amount of lending through this arrangement, estimates range from $600 billion to $1.2 trillion.
In the short run, state run banks in China can easily continue this charade. As noted in last month’s commentary, a recent analysis by Bloomberg determined that each $1 increase in credit during 2007 lifted China’s GDP by $.83. Over the last year, each $1 of new credit only yielded $.17 in GDP growth. At some point, (2014 or 2015?), slowing growth and the thin capital base of many Chinese banks could expose how leveraged the Chinese banking system is. Should that day come, China could prove vulnerable to large capital outflows that would create liquidity problems for China’s state run banking system and deflate China’s credit bubble.
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