China's stocks extend bear market as debt threatens economy

Investors have recently been mostly focused on Europe's sovereign debt problem and have pushed stock markets there into bear territory. However, China's stock market has been in bear territory for even longer.

The Shanghai Composite Index had hit 3,471.44, its peak for the current cycle, back on 4 August 2009. That came just five months after most of the rest of the world's stock markets began their cyclical bull phase.

On Monday, China's investors came back from a week-long National Day holiday to push the Shanghai Composite Index down 0.6 percent to 2,344.79. That leaves the index 32.5 percent below its cyclical peak and at its lowest level since April 2009.

While Europe has sovereign debt issues, China has local government debt problems of its own. Reuters reports:

China's local governments have piled up a mountain of bad debt, some of it to finance bridges to nowhere and other white elephant projects, which now threatens to constrict growth at a time when the global economy is sputtering. It is adding to other systemic risks in China, including a sharp downturn in the property market and a rapid rise in problematic loans.

Local governments had amassed 10.7 trillion yuan in debt at the end of 2010. The government expects 2.5 to 3 trillion yuan of that will turn sour, while Standard and Chartered reckons as much as 8 to 9 trillion yuan will not be repaid -- or about $1.2 trillion to $1.4 trillion.

In other words, the potential debt defaults could be even larger than the $700 billion U.S. bail-out programme during the 2008 crisis.

Apparently, banks have become concerned about the debts being piled up by local governments and the latter's ability to service those debts.

"Right now, most banks have cut off new loans to local government financing firms," said a senior executive at a medium-sized bank in Beijing, who declined to be named because he was not authorised to speak on the matter.

But that may not have stopped the lending.

Enter the "shadow bankers". These are the underground lenders and trust companies who extend credit to people and companies that may not qualify for loans otherwise. They then slice and dice those loans into investment packages, akin to what American banks did with sub-prime mortgages for much of the past decade.

Credit Suisse last week described the burgeoning growth of informal lending as a "time bomb" that posed a bigger risk to the Chinese economy than even the local government debt pileup.

The Chinese government is widely expected to bail out local governments though. And the big Chinese banks appear to be getting some help with state-run Central Huijin Investment buying their shares on Monday.

In contrast, smaller firms have to deal with debt problems largely on their own. From Xinhua:

According to a Xinhua investigation, at least 80 cash-strapped businesspeople in Wenzhou have skipped town or declared bankruptcy to invalidate more than 10 billion yuan (1.6 billion U.S. dollars) in debt.

Just last month, two local entrepreneurs in Wenzhou killed themselves by jumping off the buildings and another broke his leg in a similar suicide attempt.