Mainland defaults leave Hong Kong banks vulnerable

May 19, 2016 18:33
Hong Kong banks are vulnerable to rising corporate defaults in the mainland because of their massive exposure to Chinese companies. Photo: Bloomberg

Corporate defaults are on the rise in China but the central bank is unlikely to pump massive liquidity into the system.

That's according to a recent article in the official People's Daily, which quoted an "authoritative figure".

Mainland companies might have a bigger challenge paying debt, leaving Hong Kong banks exposed to them quite vulnerable.

It’s estimated that 17 defaults have struck mainland firms this year, involving 15.5 billion yuan (US$2.37 billion), according to Bloomberg.

The worst is yet to come given the high debt ratio of mainland companies and the possibility that the government will reverse its monetary easing policy.

As of the end 2015, Chinese companies owed a record 111.7 trillion yuan, about 1.65 times gross domestic product, according to Bloomberg estimates.

Corporate debt is up 2.5 times from 2008, at a compound annual rate of 20 percent, outstripping the GDP growth rate.

That means credit has grown faster than the economy in the past seven years. There is increased risk of a credit bubble.

If the central bank maintains a loose monetary policy, it could buy some time for the next debt issue.

The “authoritative person” strongly criticized the credit-driven growth model and said the government should let zombie companies go bankrupt.

The remarks suggest Beijing has jettisoned the idea of a credit stimulus and will not bail out these walking dead.

Meanwhile, new yuan loans, M2 growth and outstanding total social financing posted faster than expected declines in April from first-quarter levels.

And rising defaults indicate that central government policy is shifting toward a trajectory that was suggested by the “authoritative person”.

If so, corporate defaults could worsen for the rest of the year.

The Hong Kong Monetary Authority's Distance to Default Index fell close to the 2008 financial crisis level. The lower the index, the bigger risk of default.

What happens if a full-blown credit crisis occurs in China?

It could produce an immediate shockwave to the Chinese job market and weigh on the economy and the stock market. China’s economic growth might fall below 6.5 percent this year or in the first half of 2017. The Shanghai Composite Index might test multi-year lows.

It’s worth noting that defaults in the mainland could become a “black swan” event -- a period of extreme uncertainty -- for Hong Kong banks.

Since the financial crisis, local banks have been increasing their exposure to mainland loans.

As of late 2015, they had total exposure HK$3.3 trillion, about 44 percent of all loans and advances in Hong Kong.

More Chinese companies have reported defaults this year, which could trigger an unexpected credit crisis in Hong Kong’s banking sector if the situation gets out of control in the mainland.

Nevertheless, it remains unclear how the prognostications of the “authoritative person” will  influence the central government's policy direction.

This article appeared in the Hong Kong Economic Journal on May 19.

Translation by Julie Zhu

[Chinese version 中文版]

-- Contact us at [email protected]


Hong Kong Economic Journal chief economist and strategist