Credit Market Overview

July 7, 2009

Humpty Dumpty, which we all now know as an egg was a poem originally written as a riddle 1810 for which “an egg” was the answer. Egg shells crack when you drop them from a wall or even a few inches and the size of the mess is fully dependent on whether or not the egg itself has been cooked and if so, to what degree.

All this talk of eggs and walls and cracks does have a purpose as there could be evidence mounting that the nation we think of when we here the term “Great Wall” as opposed to HD’s “great fall” might be developing some cracks of its own in its efforts to stimulate its economy.

The controlled capitalism that China practices made it easier for the powers that be to insure that government stimulus programs were carried out as designed and have been a major factor in the GDP growth experienced in the “Middle Kingdom” while that same statistic was shrinking in just about every other economy across the globe.

At a time when loan volume is up about around 30% in China it appears bank earnings are down and because the new loans have been made as corporate profits were falling, the riskiness of those loans is something people are taking notice of. “Everyone agrees that China’s stimulus lending is damaging future bank balance sheets” Daniel Rosen, a partner at Rhodium Group and a visiting fellow at the Peterson Institute for International Economics said.

It has been a trying time for the world as a whole and the deficits being piled up have caused consternation here in the U.S. as well as a downgrade of Ireland by S&P and the placement of Britain on negative credit watch. Mr. Rosen understands the need to act but cautions that “pillaging bank balance sheets is not a strategy for recovery”. Isn’t that a lesson we have all learned by now!

Wang Zhenning, spokesperson for the Industrial & Commercial Bank of China Ltd. counters Daniel’s warnings by saying, “We have never loosened our risk control assessment, not even for government-stimulus projects and infrastructure lending”.

Given that the government in China has, now, has only slightly more say as to whether Wang gets to keep his job than the CEO of GM in this country, it would be hard to imagine a different response.

Problems are also starting to appear at the sovereign level as China’s plans to hold its budget deficit to 3% of GDP are being scrutinized. The questions arise because it is not certain that all of the debt being issued within the country’s borders is being properly recorded.

The push to get China’s economy moving has left local authorities with a requirement to get projects under way but has not provided the funding for those projects, resulting in exponential growth of local government liabilities. Stephen Green, an economist with Standard & Chartered in Shanghai puts a spin on the adage about a “free lunch” when he stated, “There is no such thing as a free stimulus package”. He goes on to say he believes, “There is a huge amount of unreported government debt, and we’re adding to it now clearly.”

Ma Guoxian, a specialist on public finance at the Shanghai University of Finance and Economics, concurs saying, “Giving local governments some freedom to stimulate the economy is necessary, but the problem is that we don’t know what they’re doing. This could become a big fiscal burden in the future”.

At the sovereign level benchmark default protection for China peaked at 220bps on March 2^nd and moved down to 70bps 3 months later, almost to the day. As of last night close that number was 77bps.

There are no CDS quoted on the local government debt that appears to be the crux of the issue here but with the country’s CDS trading near its lows the market appears to be ignoring the cracks at the moment.

Hopefully “All the King’s horses and all the King’s men” won’t be needed to put China back together again once the crisis has passed.

Enjoy the week.

Jim Delaney