WEEKEND ECONOMIST: Escaping China's credit clamp

China's attempts to restrict credit are sending property developers to capital markets in Hong Kong, where they are forced to borrow at usurious interest rates.

Over the last week I have been visiting corporates, fund managers, central banks, sovereign wealth funds and commercial banks in Beijing, Hong Kong and Singapore.

The most important theme in my discussions revolved around the efforts of the Chinese authorities to tighten the availability of credit.

Customers advised that Chinese banks were now moving to restrict credit, despite providing ample credit on generous terms until quite recently. They were also looking to renegotiate undrawn facilities and reprice existing arrangements.

These "attacks" (described as administrative measures) seemed to be disproportionately targeted at property investors and developers rather than the general corporate space.

Policies from the government were described as "blunt" but very effective – the last round of direct controls had been instigated only a few weeks ago supplementing the recent increases in the required reserve ratio of the banks. Policies were having an effect with the volume of transactions shrinking and prices were flat.

Investors still see the fundamentals of the property market as strong. The initial wealth created by the transfer of housing assets from public to private ownership, and a subsequent upgrading process (with the legacy property rented out) has been a virtuous upward spiral. However, the central government is now worried about housing affordability for those on the outside looking in. Besides curtailing investor purchases, their key policy is to boost the supply of affordable housing through public sponsored projects. The 12th five year plan aims to build 36 million new dwellings. The issue is how this will be done when there is no central housing construction or finance agency; local and provincial governments incentives are to sell land to the highest bidder, not to provide it on a subsidised basis for low value projects; and developers enjoy huge margins in high end housing and will need very tangible incentives to change their behaviour.

The demand for credit is now above the supply. Developers have to pay a premium to obtain renminbi loans (even though our research suggests that they pre-funded 2011 activity with a spurt in lending in the second half of 2010). The second tier developers are now forced to rely on property sales for renminbi liquidity. With a property overhang looming prospects for these developers are not bright.

With credit drying up on the mainland, property companies are reverting to the Hong Kong capital market for funds. In Hong Kong, double-B rated borrowers are paying around 11 per cent in US dollars while single-B are paying 14 per cent. Not only are US dollars freely available in Hong Kong but borrowers expect the USD/CNY to keep falling, compensating the debtor for the usurious interest rates (although with nominal GDP expanding at 18 per cent, they are still affordable for mainland borrowers regardless of their FX expectations).

Another market is rapidly developing in Hong Kong – the Dim Sum renminbi-denominated bond market. Trade flows can now be denominated in renminbi, FX turnover has tripled to $1.5 billion per day and a large pool of renminbi is now building in Hong Kong. Those higher quality credits which have difficulty accessing funds on the mainland are using that market to raise renminbi at attractive rates. Other higher quality credits which want to speculate against the US dollar borrow in Hong Kong in US dollars and secure the risk with a renminbi deposit in the mainland.

Inflation and policy

Most discussions with mainland investors attributed inflation in China to the quantitative easing policy of the US Federal Reserve. The argument went that the Fed had been printing money creating cheap liquidity which had financed the upswing in commodity prices. In my discussions with Fed officials on my recent trip to the US the view was entirely different. The officials pointed out that QE had not sparked a liquidity surge with excess reserves staying on the Fed's balance sheet rather than being lent out to "speculators" and the like.

My assessment is that the inflation in both goods and services and assets, particularly property, is due to the Asian economies being behind the curve with their tightening cycles. In China liquidity is best proxied by bank loans. The 31 per cent growth pace of bank lending in China in 2009, followed with a 21 per cent pace in 2010, to my mind is a much more plausible explanation of the source of inflation in the system. This explanation has been indirectly endorsed by the Chinese authorities in their (belated?) efforts to reign in credit growth, particularly in the property space.

Until China extracts obvious traction out of its current policies to constrain bank lending other countries in the region will be a slow to respond. Looking around the region, there are few jurisdictions where rates have kept pace with the rise in headline inflation, despite the reclamation of pre-crisis activity levels some time ago. While one must acknowledge that certain countries focus on the exchange rate as their policy anchor, those that do not should act to get on top of the game.

A separate source of inflation is coming from wages policy in China. One customer who manufactures low value added goods complained about a 20 per cent increase in the minimum wage in his region. He argued that savings would have to be made out of productivity and passing on price increases with the previously "untouchable" Walmart firmly in his sights (good luck old chap). He neglected to add that minimum wage hikes across the provinces averaged 26 per cent per annum from 2004 to 2008, and it is not clear what proportion of migrant workers earn as much as the minimum wage. However, margin squeeze looks like a future reality for the manufacturing sector, which will have to try to claw back some cost escalation from their customers.

Bill Evans is chief economist at Westpac.