China has deleveraging options – and killer infrastructure

POSTED ON November 16, 2015 BY Benjamin Cox
CATEGORY China,

City development in China: long cranes

Third in a series on currencies and leverage, by Benjamin Cox

China made the right choice to sell a “leveraged growth” story. They ended up with roads, steel mills, bridges, buildings, and ports. Frankly, even with the cost of a debt default or an inflationary period, they will have - on a net basis - greatly benefited from their strategy. Now they are facing the choice of which clean-up cycle to use before they can grow again.

They have options. Growth is a long way from over, but how they move forward will dictate the length of the slow-down before they will be able to restart their economic engine. The fact that most of their debt is denominated in local currency gives them choices, and they can print money to pay off debts, or default and let them fail, without international intervention.

In an ideal world, they want the weak companies to fail and the successful companies to receive more capital. In simple terms, they want to bankrupt the weak steel mills and construction companies, and force the dumb regional governments to wise up and “get in line.”

If they simply print new currency and bail out everyone, they will just create a larger bubble that will not be fixable, and that will burst five years from now.

That said, I think the problems they face today are solvable.

What are their options?

Print new currency to pay off all their debts. This will trigger inflation, but it will also create a serious boom as local currency will be weakened, the balance of trade will pick up, and exports will grow.
Decide on the winning and the losing companies based on a rational cut-off, and pay off the debt from the healthy companies, while freezing the weak companies to death.
Roll all debt for 10-20 years and leave zombie loans and companies. This was Japan's solution post-1989 and it led to a “lost” decade or two.
Default and leave the status quo, letting the market decide the outcome. This would wipe out some domestic banks.

My educated guess is that China will print currency to pay off some debts (not all of them). That strategy will create both safe and unsafe options.

I think they need to be rational and decide on a cut-off to determine who gets a bailout. For example, in steel production, that would be to determine that blast furnaces that are under x million tonnes of capacity are shut down, and the rest get their debts paid off. I know that sounds cruel, but if they bankrupted the weakest 15% of the steel industry and bailed out the top 50%, they would end up with a healthy steel industry for the next 15 years. The bankrupted mills at the bottom would shut down, the sites would be redeveloped, and the larger, healthier mills would end up stronger.

It is good to get rid of the small, old, dirty industrial production of China. The jobs are low-paying, the pollution is high, and the production is pushing prices down for outputs from the "healthy" companies. I think if they lost 10% of the industrial base, the total production would be flat, but the air would be cleaner as production shifted from the nasty old mills to modern, cleaner mills. I think this philosophy could be applied to every other sector, including power generation.

Now the question is whether China can do this rationally, or whether politics will play a role on this - and I think the jury is out. I think and hope that they will be rational, pay off some of the debts, bankrupt the weaker companies, and get ready for the next round of growth.

The other option I think they’ll look at is the 1989 Japanese-style deferral of the rationalization. My fear of that outcome is limited, as I think the Chinese are rational and have no problem with massive national-level decisions.

One of the best things I ever remember hearing, in 2004, was a Chinese regional government representative who said that the buildings and mills that were built in the early 2000s were going to get bulldozed in 20 years and replaced. Now let’s see if they are actually going to do it.

Part 1: The big print: 18 trillion reasons to fire up the presses

Part 2: Currency printing and why a flash default is the way to go

Benjamin Cox

Prior to founding Oreninc, Mr. Cox served as a senior analyst at the D.E. Shaw Group and as a consultant with the GLG Group, where he worked directly with 15 Wall Street teams in the mining deal space. Mr. Cox is the Chief Executive Officer and a Director of Aston Bay Holdings Ltd. (TSX-V:BAY), a copper and zinc company with properties in Nunavut, Canada. Mr. Cox has researched and developed business, financial, and shipping models for every major global iron ore project. He is also an expert on mining industry market dynamics and metals, with a focus on raw materials including base metals, iron ore, platinum group metals, and industrial materials such as potash and lithium. Mr. Cox holds a B.S. from Brandeis University and an M.B.A. in Finance from Portland State University. More →

bjc@oreninc.com

Benjamin Cox

bjc@oreninc.com

Disclaimer:

Readers are advised that the material contained herein is solely for information purposes. Readers are encouraged to conduct their own research and due diligence, and/or obtain professional advice. Nothing contained herein constitutes a representation by the publisher, nor a solicitation for the purchase or sale of securities. The information contained herein is based on sources which the publisher believes to be reliable, but is not guaranteed to be accurate, and does not purport to be a complete statement or summary of the available data. Any opinions expressed are subject to change without notice. The owner, editor, writer and publisher and their associates are not responsible for errors or omissions. They may from time to time have a position in the securities of the companies mentioned herein, and may change their positions without notice. (Any significant positions will be disclosed explicitly. This article is not intended to meet your specific individual investment needs and it is not tailored to your personal financial situation. Nothing contained herein constitutes, is intended, or deemed to be — either implied or otherwise — investment advice. Thomas Humphreys, Pacific Website Company Inc., and other entities in which he has an interest, employees, officers, family, and associates may from time to time have positions in the securities or commodities covered in these publications or web site. We reserve the right to buy and sell such securities or commodities without notice to readers. While the information herein is believed to be accurate and reliable it is not guaranteed or implied to be so. The information herein may not be complete or correct; it is provided in good faith but without any legal responsibility or obligation to provide future updates. Neither Thomas Humphreys, nor anyone else, accepts any responsibility, or assumes any liability, whatsoever, for any direct, indirect or consequential loss arising from the use of the information in these publications or web site.

Forward-Looking Statements: This article may include certain "forward-looking information" within the meaning of Canadian securities legislation. Forward-looking statements include predictions, projections and forecasts and are often, but not always, identified by the use of words such as "seek", "anticipate", "believe", "plan", "estimate", "forecast", "expect", "potential", "project", "target", "schedule", budget" and "intend" and statements that an event or result "may", "will", "should", "could" or "might" occur or be achieved and other similar expressions and includes the negatives thereof. All statements other than statements of historical fact included in this release, including, without limitation, statements regarding the potential of the Company's properties are forward-looking statements that involve various risks and uncertainties. There can be no assurance that such statements will prove to be accurate and actual results and future events could differ materially from those anticipated in such statements. Forward-looking statements are based on a number of material factors and assumptions. Important factors that could cause actual results to differ materially from Company's expectations include actual exploration results, changes in project parameters as plans continue to be refined, future metal prices, availability of capital and financing on acceptable terms, general economic, market or business conditions, uninsured risks, regulatory changes, delays or inability to receive required approvals, and other exploration or other risks detailed herein and from time to time in the filings made by the Company with securities regulators. Although the Company has attempted to identify important factors that could cause actual actions, events or results to differ from those described in forward-looking statements, there may be other factors that cause such actions, events or results to differ materially from those anticipated. There can be no assurance that forward-looking statements will prove to be accurate and accordingly readers are cautioned not to place undue reliance on forward-looking statements which speak only as of the date of this article. The Company disclaims any intention or obligation, except to the extent required by law, to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Always do your own due diligence. We seek safe harbor.