A Chinese steel worker walks past steel rods at a plant on April 6, 2016 in Tangshan, Hebei province, China. (Kevin Frayer/Getty Images)A Chinese steel worker walks past steel rods at a plant on April 6, 2016 in Tangshan, Hebei province, China. (Kevin Frayer/Getty Images)

One year after the mini-devaluation of the Chinese currency, China is getting desperate about its corporate debt situation and is directives to evergreen loans. According to an Aug. 8 Caixin report, the banking regulator is now telling banks to get rid of bad bank debt by swapping it for equity.

Local media Caixin reports that the China Banking Regulatory Commission (CBRC) issued a directive to encourage government owned so-called Asset Management Companies (AMC) to buy bad loans from banks. This exercise worked well during the last banking bail-out at the beginning of the millennium and China has prepared itself for another round since 2012, when local governments started to set up 27 new AMCs. 

Instead of keeping a loan that a company can’t repay and writing it down, the bank would get an equity stake in the company. Because banks aren’t allowed to hold equity in companies, they would sell the equity stake to an AMC at a price the bank can afford without hurting bank equity too much. AMCs would get the money from local or the central government or the central bank. 

The directive says that firms in the troubled steel and coal sectors will be the first to try the arrangement. However, only companies should be supported which have made efforts to cut overcapacity and improve profitability and whose problems are temporary, similar to another directive by the CBRC and first reported by Chinese National Business Daily about rolling over defaulted loans. 

(Société Générale)

(Société Générale)

“A Notice About How the Creditor Committees at Banks and Financial Institutes Should Do Their Jobs” tells banks to “act together and not ‘randomly stop giving or pulling loans.’ These institutes should either provide new loans after taking back the old ones or provide a loan extension, to ‘fully help companies to solve their problems,’” the National Business Daily writes.  

The recent leaks in relatively quick succession may be proof of hedge fund manager Kyle Bass’s concern of “the Chinese corporate bond market freezing up,” as he said in an interview with RealVisionTV in June. “We are seeing the Chinese machine literally break down.

“In the West, the speculation is always about the Lehman moment in China. That is a Western fantasy. Chinese politicians know what’s coming up and have a plan to manage the bad loans,” Horst Loechel, an economics professor at the Frankfurt School of Management told the Wharton Business School. Evergreening and debt for equity swaps seem to be that plan.

Kyle Bass estimates bad loans in Chinese banks could lose up to $3 trillion in bank capital if all loans were properly written down. 

In transactions from 2015, where banks sold defaulted loans to AMCs in Zhejiang province, they only received 32 percent of their original value, down from 43 percent in 2014 according to a regional AMC manager quoted by Caixin.  

The announcement comes in the wake of seven government-owned coal miners in Shanxi being allowed to extend maturities on existing debt, according to state mouthpiece Xinhua, a shipbuilder failing to make a payment on a $60 million one-year bond on Aug. 8 according to Bloomberg, and a developer defaulting on a $380 million offshore bond in Hong Kong, according to the Wall Street Journal. 

For good measure, the National Association of Financial Market Institutional Investors (NAMFII), an organization backed by the central bank, has enquired with major banks and brokers to see whether it would be possible to roll out a credit default swap market in China, according to the Wall Street Journal. Credit default swaps are insurance contracts on bond defaults, precisely what China needs right now.

According to the report, the regulator responsible for the $8.5 billion corporate bond market with soaring defaults, is drafting rules to make Chinese CDS compliant with international practices. The Journal reports that the regulator will soon ask the People’s Bank of China (PBOC) for approval.

After 39 defaults this year totalling $3.8 billion, it is about time. 

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NEW YORK—Gordon Chang was a bit ahead of the time when he wrote the book “The Coming Collapse of China” in 2001.

He predicted the collapse of the Chinese economy and the downfall of the Communist Party within ten years. As of 2015 his prediction is four years overdue.

However, many of his arguments are still accurate today. And with China’s political economy becoming ever more volatile Epoch Times spoke to Chang about China’s past and increasingly uncertain future. 

EPOCH TIMES: You wrote your book “The Coming Collapse of China” in 2001. Where are we now?

Gordon Chang: In 2001, I said it would take ten years for the Communist Party to fail. So I’m about four years out of time. But what we’re seeing right now really are the early stages of the collapse not only of the economy but also the political system.

Right now they’ve got an economy which isn’t growing at the 7.0 percent, it’s more like 1 or 2 percent. In Beijing they’re even saying privately 2.2 percent.

The most important thing: Money is coming out of the country at unprecedented rates. Bloomberg, which tracks this stuff, talked about $144 billion coming out of China in August. Goldman Sachs said, no, it was $178 Billion. That’s a real sign of the way things are going in China.

The problem for China’s leaders right now is that they cannot stop the descent of their economy. They can maybe slow the pace of decline, but they can’t change direction because everything that they’ve been using up to now—monetary stimulus, fiscal stimulus, the stock market boom, devaluations—all of these tactics have failed.

It’s not inconceivable they lose their position as No. 2 to Japan. Japan doesn’t have to grow, all it has to do is stay the same. I think China’s going to shrink.

— Gordon Chang

EPOCH TIMES: What is the root of the economic problem?

Mr. Chang: Everyone says, “Oh, it’s got the world’s biggest pile of foreign exchange reserves, how could it have problems?” Well yes, China is not going to have a foreign debt problem. It’s not going to be an Argentina.

But when you go back and look at the history of financial crises, the worst financial crises are not external, debt-driven crises, they’re internal crises, and that’s what China has.

They have a lot of debt, perhaps as much as 350 percent of GDP—when GDP is properly stated and when all debt is counted.

McKinsey said at the end of June 2014 that the debt-to-GDP ratio was 282 percent. Obviously it’s gotten worse since then. I think that they were undercounting it then. Right now it’s extremely serious, especially for a developing country like China.

EPOCH TIMES: Can the regime use policy to remedy the problem?

Mr. Chang: Since November you’ve had five reductions in benchmark interest rates, four reductions in reserve requirement ratios, no appreciable effect.

Fiscal stimulus—if they built another ghost city or another subway line in Beijing, well okay, you do create some GDP, but you create debt. Because of the malinvestment and low efficiency it’s just not a solution for them.

They had the stock market boom, which they talked up recklessly. This was a way of saving themselves, well, that’s a bust right now.

The state really can’t create growth on a sustainable basis.

— Gordon Chang

And the devaluation in August, which is still puzzling. Who knows what they were trying to do? Obviously it caused them real problems because it shook confidence; not only inside China but around the world as well.

So you look at all the things they’ve been trying to do and in the past they’ve created growth with these techniques. They can’t do it now and that really means they are in jeopardy; you’re going to have more and more protests.

EPOCH TIMES: You can only improve the situation by giving the people more freedom.

Mr. Chang: How many times have you heard, “The Communist Party lifted 400 million, 500 million people out of poverty?”

No they didn’t. Deng Xiaoping loosened up a bit and the Chinese people ran ahead. Deng Xiaoping realized they had to change agriculture a little bit, so they went to the Household Responsibility System, you know, where families could tend plots.

But under central government rules these plots could not be just run by one family. Families decided they didn’t like that idea, they wanted their own plots, so local officials just ignored that, they created this boom in agriculture. Not because of Deng Xiaoping, but because people ignored Deng’s rules.

When their last tools fail, they’ll go into freefall. And I think it’ll take the political system with it.

— Gordon Chang

Very plucky entrepreneurs, some ex-government officials, some people who were beggars, decided they were going to go out and be entrepreneurs. They created this wealth. It was the Communist Party that was holding them back. The state really can’t create growth on a sustainable basis.

You need to have a sustainable model and under the Communist Party’s desire to control too much, they end up with an unsustainable economy.

Gordon G. Chang, author of “The Coming Collapse of China,” in New York on Sept. 30, 2015. (Benjamin Chasteen/Epoch Times)

EPOCH TIMES: You also wrote in your book in 2001 that people said that China is going to be the world’s largest economy in 2010. It’s not; it’s going to be the largest economy by 2020. One problem is that China is just not innovating. They don’t have the capability to innovate and compete on a global market.

Mr. Chang: To avoid the middle-income trap, to get beyond cheap manufacturing as a basis for an economy, they need to have innovation. It’s not like the Chinese people are dullards, of course they’re not. They can be as innovative as anybody else in the world, but they can’t in the system in which they operate.

Because of control of education, control of everything, it inevitably affects the ability of entrepreneurs to innovate.

When you have real serious economic problems, I think people are going to say, ‘I’ve had enough.’

— Gordon Chang

There are some real restrictions, which are important. For instance, since the beginning of July, in order to support the stock market, Beijing has eliminated IPOs. I know Premier Li Keqiang talks about his Internet-plus economy, but you can’t have that economy if these companies can’t get cash.

By closing off IPOs it means that they are choking off the ability of really innovative small businesses to get bigger. That’s the history of Silicon Valley in California, where you take so many businesses that are now iconic; they started in a garage. Most famously Apple, but also Hewlett-Packard.

These are garage businesses that became multi-nationals because they were able to operate in California’s free-flowing environment, where they could get money, they could get expertise, they could get whatever they wanted, and they grew. But you can’t do that in China right now because of the restrictions imposed for political reason by the state.

Until they change that system, China is not going to have that innovative developed economy anyone hopes to see.

EPOCH TIMES: Tell us about risk taking, you lived in China for a long time.

Mr. Chang: They have a bankruptcy law but you can’t fail because you’re a state-owned enterprise. You can’t get capital or it’s very hard to get capital if you’re a smaller, private business.

China has a lot of very good businesses. Venture capitalists go there. Their problem is that they just can’t grow. They don’t have that same environment you have in Silicon Valley, where people can try to create a business, fail, dust themselves off, and try again.

The greatest story is Disney. Walt Disney failed so many times. All of these people who we think of as iconic, most of them have failed. Unfortunately that’s not the system in China.

Money is coming out of the country at unprecedented rates.

— Gordon Chang

It’s much too rigid, much too state-dominated. Unfortunately state enterprises are becoming so much more powerful politically, they’re really able to prevent the change that is necessary in China today, so you don’t have that culture that is in Silicon Valley.

They would love to replicate it, they can certainly build the buildings, but they can’t replicate the culture, because the culture is really one that thrives in an open and free and liberalizing society. That’s not China on any of those counts.

EPOCH TIMES: Many people who made a lot of money don’t want the system to change.

Mr. Chang: In the 2008 downturn, China decided it was going to reject the whole concept of a recession so what they did was create the world’s biggest stimulus program. Five years from 2009, they had added an amount of credit that was equal to the entire U.S. banking system. Even though at the end of 2008 the Chinese economy was not even a third the size of America’s.

So yes, they created growth, but they also put too much money into their economy and essentially what they did was create all of these asset bubbles, which they cannot unwind. That has made state enterprises enormously powerful.

They were able to capture all that money that was lent by state banks. They were able to get all that stimulus out of Beijing so they became extremely politically powerful and they’ve been to use that power in the last couple years to essentially shut out foreign enterprises as we’ve seen and also make it for Chinese domestic companies.

This is a political problem because the forces that could change China for the better, they don’t have the political power to do that. In China’s very political system, that’s what counts.

EPOCH TIMES: The country needs the entrepreneurial spirit of its people to become the largest economy, which is should be, given its size.

Mr. Chang: Absolutely, and right now China’s economy, they say it’s a $10 trillion-plus economy, we really … don’t know how big the Chinese economy is. We know that the numbers especially recently, overstate economic performance.

It’s probably not the $10 trillion Chinese leaders talk about. There’s so many indications that it is growing at a far slower pace and so therefore China might be an $8 trillion, might be a $9 trillion economy, we really don’t know, but it’s certainly not on a path to overtake the United States.

It’s not inconceivable they lose their position as number 2 to Japan. Japan doesn’t have to grow, all it has to do is stay the same. I think China’s going to shrink.

Gordon G. Chang is the author of “The Coming Collapse of China.” Chang holds an undergraduate degree from Cornell University and completed his law degree at Cornell Law School. Before becoming a writer Chang practiced law in the United States and China. 

The interview has been edited for brevity and clarity.

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