Hello, and welcome to the Credit Edge for Weekly Markets podcast. My name is James Crombie. I'm a senior editor at Bloomberg. This week, we're very pleased to have on the show Way Sho, who covers credit markets for Bloomberg News in Hong Kong.
How are you Way, I'm good, it's a nice day in Hong Kong.
Great, Okay. We're also delighted to welcome back to the show him Manshu Bakshi, who focuses on banks at Bloomberg Intelligence in New York. We'll be coming back to him Anshew in a bit later to talk about trouble bringing in Canada. So do stay with us. But first way, Joe with Bloomberg News, let's talk about China. You're writing a lot about local government finances at the moment, and there's a bit of a crisis going on. What are local government financing vehicles and how do they work here?
They are special vehicles set by the local governments of China to usually help with infrastructure projects like subways or high roads. They are kind of like what's first set up to skirt around the bank. Municipal authorities borrow directly from banks or selling bounds directly in the market.
So instead of going to the market the municipality or the state. Is it a city as.
Well, Yeah, it's on both a city level, county level, or provincial level.
Okay, so they go they set up a special special purpose vehicle in order to get funding for an infrastructure project.
Yeah, it's usually the case because generally LGF within China, they are kid grass as a corporate dat so investors generally assume that local governments are held responsible for them.
Okay, so how much debt do they have and what form is it in? I guess it's in local bonds.
Yeah, they constitute a large part bunk of the local debt market. It is estimate they have about a thirteen point five trillion un of outstanding on shore bounds at end of twenty twenty two, to give you an idea, that's probably about forty percent of China's non financial corporate debt market. So that's a significant part of the market.
Do we know that is in dollars?
Yeah, that's about like two trillion dollars.
Actually, well, it's a big chunk of debt. So you say that they set up these vehicles. You know, if we look at the US muni market, for example, we'd expect the state or the local government's borrowing to be directly responsible for paying that much back. Do the vehicles help these borrowers somewhat like skirt the obligation.
Yeah, because, as I said, theoretically they are actually coperated that so the local government are not naturally assumed to hold responsible for them. But in reality, everybody know it's the dat issued by the government. So I guess the local government kind of have the model has the issue here because investors do expect them to come to rescue if there is a problem, right.
So right now we do have a problem. Can you talk us through the actual crisis that's going on right now?
Yeah, I guess the problem. You know, it's always there, but it's only made apparent better pandemic because during the three year of pandemics, the local garment's physical revenue they have they were like dropping in the meantime because of a crisis related to the China's privaty market. Uh, the big chunk of local garments revenue, which is land sale,
also come to a slide. So I guess like the local governments are really struggling with their physical revenue, so they have fewer abilities to give subsidies to this local garnment financing vehicles. In the meantime, the local government financing vehicles are not really self sustainable, so we can see a few cases of last minute payment or cases of technical default of df with this year.
So all of this money, there's there's two trillion dollars worth of money, and we're starting to see defaults on some of that.
It's not really like default but more like technical defaults that only hours laid, hours past the deadline, but it still show the you know, the amount of pressure that they are facing.
So the revenue that's coming in may not be enough to cover the money that they owe or the debt payments.
Yeah, in fact, they would not be sustainable if they don't have the subsidies. Last year they receive the highest amount of subsidies on records, So without subsidies, a lot of them are actually operating at lost. That's not really a sustainable pattern for the future.
Do we expect the subsidies to go away?
The subsidies probably won't go away like right away, but we do not. Like China's economy is having a difficult year this year, and the unemployment rate is skyrocketing high. So the local government they are having difficulties, you know, like collecting physical revenues themselves as well. So it's not a certain how long they can continue that amount of subsidies in the long run.
So we are starting to see what you could describe the default wave happening.
We probably won't say a huge default wave happening soon, but we do say cases of financial stress, such as you know, like the agreements with the local banks to extend long terms, or like miss deadline for a few hours. So these cases of last minute payment do show that there is significant amount of stress in the market because it shows they basically exhaust all means to try to you know, make the payments. But I'm not sure how long they can you know, continue to do it in the long run.
So, as you said, the subsidies are going away for these local government financing vehicles. That the acronym that we hear a lot is l g f V. In this context, the danger is that some of them just can't pay, maybe a lot of them can't pay. How does that all end them mean? It sounds pretty worrying if if all of that debt you know, are trillion dollars, two trillion dollars. Sorry, if US dollars in debt, if all that defaults at once, do we do we really expect a major catastroph at this point.
Actually, even like those local garments that are struggling the most appear to be prioritizing timely bound payments because it's really would be a catastrophic signal it would send if it were unable to pay their way. But yeah, as I said, like some lf they've been really struggling and they've been making last minute payments. Yeah, but in a short term at least, the local governments are really trying to make dos at the moment.
Okay, So, given the size of this crisis, and you know, the possible magnitude of it, what impact does it have? More broadly, does it start to affect growth in the Chinese economy?
I guess, like the the Chinese economy is already having like a bump pay year this year, and if there is really a case of default happening in the market, it would create panic in the market, just like how it happened with the property crisis. You know, nobody expects every grand to default but once it's default, it's kind of uh, you know, the whole A series of other defauts follow suit. So I guess like no local government
really want to be the first case. So they are trying to, you know, get all the support they need, including help from the central government to help make these timely payments.
And obviously the government has a lot of capacity to help, and you know they've they've been applying stimulus the economy and all sorts of things. Ultimately, do we expect the government to backstop all these these local government financing vehicles and step in and help them.
Definitely, And I think they have a lot of tools. For example, most China's biggest banks are stay owned. The government for example, could ask the state banks to start providing relief, like they can ask the banks to offering longer term loans to this iltf thisse.
You mentioned the per els with the housing crisis. You know, there's been a lot of property developer distress, including Evergrand, which is a huge situation. I think it's the biggest distress debt situation in the world at the moment. In that situation, it seems like investors will take a loss. But do we do we expect investors to take a loss on this kind of debt, which is eventually essentially municipal debt. Do we do expect losses there for investors?
Well, a sector buildout is impossible in a way because just because the amount of debt in this sector, it's something beyond the garments are leveled, of beyond the garment's ability to help. But also it's it involves the question of moral hazard, right because the sector buildout would be giving signals that the central garment is encourage this rackless
risk taking behavior. So in order to curb that thinking, you kind of like can let people assume that state would always come to the rescue when since go wrong.
And that's exactly what seems to have happened in the property crisis, which is still going on, as you've been writing a lot about. I'm interested also in the developer side of the Chinese debt story and what's going on there, because we've seen Wonder bonds dropped a lot this week, We've seen lots of other developers under a lot of strain. Is that crisis still going as well?
Yeah, that's an ongoing crisis. A lot of attention has been paid to the July twenty third bound payment because that's bounds is assumed, you know, like it's gonna to make timely payments, and it was treated above nineties just a week ago, so investors do acpect it to make the repayment. But the surprise came when one that told creditors that it still has a two one hundred million
dollars short shortfall on the maturing bound on Monday. So as soon as you know it told creditors news, the bound fell twenty two cents on the day and continue failing on qday. So I guess like now we're just like less than a week from that maturity date, but people are still not sure whether bunned up when that would make that payment. That's something everybody is watching now.
Interesting, that's a that's another one like Evergham that has a lot of debt in dollars, so there will be you know, exposure from investors all over the world in that one.
Yeah, correct, he does want to be a disimblant of China.
Yeah.
Yeah, so in both cases, I mean on the local government financing vehicle side that you've done so well explaining to us, there seems to be more of a domestic exposure, but to the property developers which in a similar mess there there is likely to be losses for bondholders all around the world.
Yeah, that's it has a lot of global investors.
So the longer term impact on this, I mean, I guess you know, we talked to investors here that that must affect risk appetite for Chinese bonds, particularly junk bonds, you know, which haven't performed particularly well this year. Is this all telling us that we should be much more vigilant, much more careful when it comes to Chinese credit risk.
Yeah, and I think a lot of the investors are already start doing that, right. It's now like a lot of investors are choosing Chinese property bonds as they are a priority for investments. Some are saying, you know, like if went that word to fail to repay this bound, it will be another nail in the coffin for Chinese hio properly bounds. A lot of investors are training away
from investments like that. Like another big Chinese developer, Country Garden, it's now having its bound treaty in the twenties or thirties. So that's suggesting people are not really having face about its own time repayment.
And so before we talk to himanship actually bloom back intelligence, what's the next big thing to watch out for a way I mean we're talking about more maturities. Is there more distress coming? Is there anything else on your calendar that we should be aware of.
I guess a lot of investors they are generally interested in the Chinese Chinese government's attitude about the property sector and the LDF sector because in China the state just plays the chin important role and if the government has more stimulus or subsidies given to this subsidies, we can really say a shift of attitude in investors investment, but
don't chosen. I guess a lot of investors are just taking a wait and say attitude and say what's going to happen and what's the next stops, next steps that government is going.
To take great stuff. Way Joe from Bloomberg News, thank you so much for joining us. Thank you important story. We should all be watching it wherever we are sitting. Read all of Waye's scoops on the Bloomberg terminal and of course at Bloomberg dot com. So, as I mentioned earlier, there's a lot going on in Canada right now, and we're very pleased to have with us him Manchu Bakshi, who covers the banking sector up there for Bloomberg Intelligence based in New York. How's it going, Hi Manchu.
Hi Jims. Thank you for having me.
How are you very well? Thanks? I know you're very busy with earnings at the moment, but as you've been writing about, there's a bit of a problem with housing right now, and I wonder if you could just walk us through that.
Sure. So housing has always been a concern for Canadian banks. Recently, what we're seeing is because of higher rates on adjustable rate mortgages. We're seeing that because the mortiket rates are going up in twenty twenty five and twenty twenty six mortgage that will be due to renew those borrowers will be facing higher mortgage payments and that's a risk to banks asset quality.
So those just find those are mortgages that are short term and they're coming up for a reset on the rates.
That's that's right. So in Canada it's a little different than in the US. They have the mortgages in Canada have a contractual maturity of five year and amortization period of twenty five years, and most of the mortgages in Canada, or the adjustable rate mortgages, the way they work is their adjustable rate fixed payments, which means when market rates go up, the monthly payments don't go up immediately, they
go up at the reset. And so right now, the concern is that all the mortgages that reset at a higher rate, they will squeeze borrowers. But that's only if we assume that rates will stay higher for longer. But on the positive side, we may see wage growth through twenty twenty five, twenty twenty six, so borrows should be able to absorb some of those pressure.
But so rates, you know, since the Canadian consumers last, you know, when they first took out those mortgages, let's say five years ago, how how much higher have rates gone? I mean, how much is the mortgage in the customer right now in Canada?
So right now it's over six point eight seven percent, because right now the overnight rate is now five percent, and all these borrowers, especially if you look at twenty eighteen, twenty nineteen, even early twenty twenty, they took mortgages are less than two percent now, all these borrowers were stress tested at five point two five percent at least, but
again mortgage 'es are where above that. So if they if they have a reset date coming up, then those marketers will be reset higher and their mortgage payments will go up.
And at the same time, housing prices have shut up, haven't they in Canada?
I won't say shut up, but in recently what we saw since the Bank of Canada starting raising rates last March, we saw a decline in correction in housing prices. We saw a little optic in May after eleven months of decline, but we may see more correction because that was because the Central Bank actually stopped raising rates in chain. But we have seen two hikes since then, so we may see a little more correction through this year.
So from the credit standpoint, we look at this more from the perspective of the banks. You know, the banking system in Canada is quite different. There's only a few of them and they're you know, they're pretty conservative and they're quite stable. But how much exposure do they have to this problem of the mortgage refi and the consumers coming under so much pressure.
So the big five six banks in Canada actually control eighty to ninety percent of eighty percent of the lending and they hold eighty percent of the deposits, so their exposure to housing is about fifty percent. CIBC Canadian Imperial Bank of Commerce being the most exposed, and Bank of Montreal leased, so it's a pretty big significant exposure of their total portfolio.
So when you say CIBC is most exposed, you think they're going to sustain substantial losses.
So that's not our base case. So we think not just CIBC, but all Canadian banks have first of all, their highly profitable banks and so they have that earning scussion to absorb higher provisions if they need to. And then also the banks have been increasing their regulator has been increasing their capital requirements and therefore the banks are increasing their common equity of one capital, so they have good first line defense in the form of earnings, and
they also have good last defense as their capital. So not just CIBC, all the bank should be comfortable. We actually stress tested all the banks at a five percent loss straight on their uninsured mortgage portfolio, and even though the capital ratios declined from where they were in two q but all the banks remain well capitalized.
And to be clear, five percent is way more than anyone's expecting.
It's way more than anybody's expecting. It's way more than we start during the nineteen ninety one housing downtown And just to give you an idea, when the Bank of Canada actually stress tested banks, they forecasted that the losses on their uninsured mortgages will be point seven percent?
Are they being overly optimistic though at that point?
Well maybe, But we tried to do a direct in our stress test analysis. We try to do like a dict head to capital, so we don't We didn't assume any capital management actions from the bank. It was just a point in time dict had to capital. Can the bank survive? And we think, yes they can. It will not be a capital issue, it will be earning this issue for the banks.
And again from a credit standpoint, I mean, how do you position as an investor here and do you expect see IBC spreads to widely substantially versus comparables or how does that play?
So?
Yes, that's right. So because CIBC is most exposed if we see a larger than expected housing price correction, the bonds of banks which which are most more exposed to housing, like CIBC, will be sensitive to housing price correction. Again, our base cases not that we'll see a big drop in house prices because in Canada it's mostly a supply issue and so we don't see that happening. But if that happens, I think the bonds of CIBC will be more sensitive than all the other banks in Canada.
And what does best in this scenario? I'm sorry which bank performs best in that.
S so Bank of Montreal. If you're only looking at housing portfolio, Bank of Montreal has the least exposure. They also really big in the US, SO Bank of Montreal will be best position. And after that, I would say TD and RBC the two pick.
You know, when I go up to Canada and I tend to go to run to more than other cities. There seems to have been for quite some time a lot of overbuilding. I mean, you say that there's a shortage of supply, but the overbuilding to me seems more on the office side, and the return to office has been slower in Toronto than other parts of you know,
compared to New York for example. Is that not a big vulnerability for the banks that they that they're you know, may be more exposed on the commercial mortgage side than the reach sure.
So overall commercial is about on average forty percent of banks loan poard for you overall, and specifically if you look at CIRI, that's about ten percent on average. But as you mentioned about offices, offices, office exposure is just one percent of their total one part. So it's a risk, yes, absolutely wide risk because if you look at office vacancies, that's highest in a decade. It was I think it was up eighteen percent in one Q. It's highest in
a decade. So, yes, that's a concern, that's a risk, but that's a manageable risk because at one percent, we actually stressed us to the office exposure of all the banks and we found that actually their earnings can absorb the provisions if we assume a two percent loss rate on their office portfolio.
Okay, so what are we looking for in terms of events key events? You mentioned the resets? You know, is there is there a particular maturity hump here in terms of the resets or is there some other some other event on the calendar that could trigger, you know, an unraveling of this in terms of defaults and mortgage is that sort of thing.
I think the biggest uh factor that we're looking at is how high the rates will go, because one thing we I think I forgot to mention before that even though on all these adjusts to rate mortgages, your monthly payments don't go up immediately when rates go up. But if the rates go high enough that your monthly payments don't don't cover principle just interest, then it hits at what we call it a trigger rate, and then your
monthly mortket you wan go up. So for us, though, the one thing we're looking at right now is how high the rates will go, because if the rates keep going high, then most of these mortkeachs will head a trigger rate, and that's not what you want because that will pressure all the more.
Was then, is there a number that you're looking at in that context?
We don't expect it to go over five and.
A half, okay, but if it does, then there'll be troubled.
Then it depends again how high it goes. But that's something then will pay more attention to be already looking at it very closely. But that's then that's something that will require banks to start building provisions more aggressively if that happens.
Okay. Obviously, Canada is a huge economy, and it's adjacent to the US, and there's lots of trade ties and so on, and you know, cultural ties. But if you're not inside Canada, why do we care about this particular issue with the housing and the exposure that banks have.
So I can give you two reason. If you are just a regular person, if you have bank account Canadian banks have operations in the US, I have an accounting TV. Most people have accounting in Canadian banks. They may not know that they're Indian banks. For detail, and for investors, Canadian banks issue a lot of US dollar denominated debt. So if you're an investor, you care about Canadian banks and.
They are issuing. I mean banks are coming out of earnings now, we're seeing quite a few deals coming and we're expecting a lot more from the regional banks. What is the outlook for bond issuance from the banks? Sure?
So for the US banks, we know we were expecting issuance from the US banks because of the regulatory changes that we're expecting. So yes, the US regional banks, the big chesips, they are all actively issuing tet in Canada for the remainder of the year. We expect modest issuance for three reasons. The first one is that the loan growth is moderating, both in commercial and in housing. We
expect me to high single digit. And the second I would say is they have manageable maturities, have about twenty billion maturing three end of the year. And the last one I would say is, unlike the US, we don't have any upcoming regulatory requirements to issue debt. For the Canadian bank, there was a requirement to issue total loss of stopping capacity that and so banks started issuing senior bones a few years ago. But now as of now,
they all are away above their minimum requirements. So we expect the modestations this year.
So less than the US, A.
Wee less than the US. I think they should about seventy billion. They have twenty billion in maturity, so less than one hundred billion is what we're expecting for the second half. But we expect Bank of Montreal to be more active and TD to be least active.
Okay, so when you look at the banking system in Canada overall, and you mentioned that, you know, even though there are these vulnerabilities On the houthing side, there's still very well placed and they can do very well even in a very harsh stress test that you've put them under. How do you view them from a sort of a
more global perspective? You know, in the US there's there's quite a lot of worries about going into a downturn, potentially a recession, you know, potentially a lot more volatility in credit markets. Does that make Canadian banks in relative terms a sort.
Of I would see yes, And that's what we see if you look at from a credit ctand point, they are among the highest rated banks in the world, Canadian banks and Australian banks, they are the highest rated. And one of the main reasons that not many people know about this is because of the regulator in Canada. First of all, unlike US, we don't have as many regulators in Canada or in Australia the iostacle of Australian banks. So because you don't have you're not dealing with multiple regulators.
It's only one. It's easy to manage, and the regulator in Canada is really very proactive, so they go above and beyond of what the global requirements are. And then they they don't wait for something to happen. And that's what we have seen, like they've been increasing the capital requirements from the banks, even though they already have so
much capital. They keep increasing the requirements so they know that banks are holding enough capital, so they are prepared for if you have a stress situation and they're.
Not huge risk takers as exactly.
The exactly they are, well, I will see fired and then not as risky because he went on mortgages. You compare what we saw doing the financial crisis, Gunadian bankstead fine. Again, most of the mortgages are on their balance. They don't securitize as much as the US bankstead back then.
So something to be said from a credit sandpoint for being boring.
I can't say that.
Thank you very much, Manchu Backshi you for Bloomberg Intelligence.
Thank you for having me. James, thank you.
You can read all of his great analysis on the Bloomberg Terminal. Do check it out and we hope to see you back on the show soon. And thanks again to Wajo from Bloomberg News. Read all of her great credit scoops on the Bloomberg Terminal and at Bloomberg dot com. I'm James Crumbie. It's been a pleasure having you join us again next week on the Credit Edge.