By Christopher Balding at Seeking Alpha

The Chinese economy is under an enormous amount of stress and there are no easy answers.

Banks and bond markets have tilted heavily to short-term lending.

China over estimates the economy’s ability to absorb additional stimulus.

There is very little appreciation for just how fragile Chinese banks are and how poor their history of lending has been.

The Chinese economy is entering an interesting state. Producer prices are falling relatively rapidly due to lack of external demand and a supply glut with producer output falling moderately. A major real estate developer defaulted this past week (although this more likely owes to corruption scandals than financial problems, no one is quite sure) and maybe the biggest news of all is that a Chinese SOE with a mainland bond defaulted. Add in the 1% cut in the RRR by the PBOC and while Beijing may not be pushing the panic button, but they appear to be making sure it is working properly.

The Chinese economy is under an enormous amount of stress and there are no easy answers. There are a number of problems. First, banks and bond markets have tilted heavily to short-term lending. This means that the amount that has to continually be either repaid or rolled over is high. According to the Asian Development Bank, nearly 60% of corporate bonds are under 5 years with large amounts falling due within the next two years. Banks have shortened maturity periods with some banks having more than 65% in lending under 1 year. While it may give some comfort that relatively little external finance exists in China, it should cause high levels of concern over the significantly shortened maturities.

Second, despite the self-congratulations being handed out that China has significant scope to ease monetarily, this overestimates the economy’s ability to absorb additional stimulus. Many industries in China already suffer from surplus capacity, infrastructure white elephants litter the country, and major firms with access to credit are already over levered. Easing monetary conditions is right out of the Macroeconomic I textbook, but here it is like trying to sober up a drunk by buying him a beer.

Third, there is very little appreciation for just how fragile Chinese banks are and how poor their history of lending has been. I have a forthcoming paper in the Journal of Financial Perspectives which details some of the problems. From banks that only list a loan as doubtful until after the borrower has declared bankruptcy, ceased operations, and been out of business for at least one year to banks that declare losing loan paperwork as a risk to being repaid, there is little appreciation for their perilous state. Bad loan numbers are, even while amazingly generous in the definition, spiking rapidly and expected to climb. China has also started recapitalizing policy banks this past week by converting existing loans into equity. While the official reason is to boost investment in the Silk Road projects, given the conversion method of existing loans and in the very unknown projects well off in the future, I remain skeptical towards the official reasons.

There are very real risks to the Chinese economy and financial sector, and there should be a lot of attention paid to those risks as repayments come due.

via The Perilous State Of The Chinese Economy | Seeking Alpha.