Is China headed for a crash?

They’re from a country making up nearly 20% of the world’s population.  In five years they replicated the entire U.S. banking system.  Thanks largely to shadow banking, their financial services sector churns out an average of 115 products per day, including items backed by street lenders, private investors and entities of unknown origin.

Welcome to the Chinese banking system.  Know it well, because its overall state will be one of the biggest factors affecting world economic health in the next few years.

Widespread attention was drawn to to the Chinese banking system after Fitch warned the shadow banking system was “out of control.” Largely made up of short-term loans that need to be constantly rolled over in order for the system to continue, Fitch warned that a reckoning is coming and that the Chinese system, driven largely by this credit, cannot possibly continue on its current path. It was this environment that led Fitch to trim the local currency debt rating, the first time in 14 years one of the big three agencies had taken such a step.

“The credit-driven growth model is clearly falling apart,” Charlene Chu, Fitch’s Senior Director in Beijing, recently told the Daily Telegraph.  “This could feed into a massive over-capacity problem and potentially into a Japanese-style deflation.”

Ah yes, Japan.  The Chinese government would be wise to look to their neighbor’s late 20th century experience for counsel on the effects of different strategies.

The 1980’s were a golden age for the Japanese economy.  Residential land prices in the six largest cities were on their way to increasing tenfold in only 20 years.  Banks were only too happy to lend to people hungry for property, and grew sloppy in their assessment of ability to repay, lest the iffy borrowers took their business to the only too willing bank down the street.  The real GDP growth rate, which was a robust 4.3% for the decade, rose to 5.1% in the latter half of the eighties.

In 1985, Japan entered into the Plaza Accord with West Germany, the U.S., France and the U.K.  Designed to lower the US dollar in relation to the yen and Deutschmark, the Plaza Accord did just that, but also hurt the Japanese economy by making exports more expensive and hurting overall competitiveness.  This coincided with ebbing population growth, an aging, and rising youth unemployment.

The 1980’s heyday gave way to the lost 1990’s, a period from which Japan has not completely recovered.  Real GDP growth plummeted to 1.2%.  Land prices went off a cliff, dropping by 50% in those six largest cities.  Borrowers, whose property was highly collateralized, were unable to pay their debts.

Yet the full extent of the crisis was tough to determine because the stresses were hidden behind evergreen loans, zombie banks and zombie companies that kept the hurt at arm’s length from the balance sheets of the traditional institutions.

Among the many characteristics the current Chinese economy shares with its 1980’s Japanese counterpart is the murkiness of their non-traditional financial entities.  The Japanese zombies have been replaced by equally scary elements that thrive away from the light, and just like a cheap B movie where some government experiment runs amok turning sub-human creatures on to the unsuspecting populace, the Chinese government was a big reason these shadow banks are now inflicting damage on the citizenry.

The Chinese government has a history of shielding their largest banks, which nominally are independent but which really function as de facto government institutions.  In the 1980’s this took the form government approving investments they deemed too risky for state banks.  These trusts financed export zones and other novel initiatives.

The shadow banking system stayed operational but low key, until 2010.  That is when the forces of darkness were unleashed as the government dramatically curtailed traditional bank lending after flooding the country with cash immediately following the recession.  The resultant effect saw everyone everyone except for state-backed industries with high collateralization get shut out from traditional lenders.

Maneuvers such as this may be a remnant of the communist philosophy that the strong arm of the state can adeptly steer the economy where it needs to go.  “The Financial Times recently noted that a sign hangs in a hall in Guiyang that says ‘The government is the engine and the market gives it a push.’ With a successful transition from a market to a planning economy, the emphasis should be reversed,” says Dr. Penelope Prime, Professor at Georgia State University and the Director of the China Research Center.  “That is, the market should lead with the government giving it some direction where needed.  This, in my mind, is the crux of China’s problems today.”

Still the government went ahead with moves that severely hurt the economy.  Their funding pullbacks included lower amounts for inter-bank lending that sets the overnight and short term rates.  The move caused complete chaos as interbank rates yo-yo’d from the reliable 2-3% to as high as 25% before settling in around 6.6%.

Some analysts do not see anything wrong with the central government controlling the system, and that it could end up being a plus, as they theorize an active government simply will not allow a collapse to occur.

Dr. Prime takes issue with that belief for two reasons.  Some analysts assume there have been no market reforms, which is not true, she says.  Interest rate caps, credit controls and capital account controls have all been tried and efforts to circumvent them and make higher profits have been successful and have contributed to making China’s economic situation what it is today.

If the Chinese government is going to oversee the financial system, one place they could focus their attention is on providing proper incentives and disclosing information in an effort to ensure the effectiveness of business investment is being maximized.  Citing solar panel overcapacity, the housing boom, and permitting investors to choose quick returns as opposed to real investment, Dr. Prime sees an expanded role for effective government oversight.  “These inefficiencies are affecting overall growth.  There is also some lending today just to stave off bankruptcy of some firms, which also contributes to inefficiencies.”

Private industry and local governments are forced to fend for themselves in this environment of leaderless leadership, and for lack of a better alternative they went en masse to shadow lenders, with staggering effects.  In 2012 total lending was 198% of GDP, up from 115% in 2008.  Credit is also growing twice as fast as GDP, and shadow banking is expanding by more than 50% annually.  Most projects developers and governments enter into are longer term initiatives, so these higher interest short term loans need to be rolled over several times over the life of the project.

Chinese bank assets grew $11.2 trillion between 2009 and 2012 and may expand by as much as $20 trillion this year alone.  If realized, the growth of China’s bank assets in the last five years would more than double the asset total of the entire U.S. commercial banking system, which has $13.4 trillion under control.

As the government cut back, the shadow banks continued to gobble up space.  Between 2010 and 2012 it is estimated the total value of outstanding loans extended by shadow banks grew to $5.8 trillion, which is 70 percent of Chinese GDP.  One category of shadow lenders are the ubiquitous “trust” companies, who, with $1.4 trillion under control, are the second largest lender after banks in the Chinese economy.

Things may not be at their worst.  Fewer Chinese purchases at a time the US Fed is considering ending Quantitative Easing alters the roles of two big players from the world’s markets.  Less money moving around China because of government cutbacks and because of less money coming in from regular external customers means the reliance on these suspect organizations could grow.

Chinese banks obviously think it can judging by their actions.  They continue to loan money to private investors looking to earn more than the low rates controlled by Beijing.  Some of this money is being used for shadow loans.  In other cases the partnership is clearer, as the banks team up with the shadow lenders to offer products to investors, including some marketed in the banks themselves.

Then there are the “wealth-management products.”  Loans, mortgages and other traditional bank products are packaged together and sold to investors, thereby taking them off the banks balance sheets and painting a picture of health that is entirely inaccurate.  Bank employees are only too happy to push these, as their bonuses can be 10 to 20 times their monthly salary.

So with less government funds and less external purchasing what is left to fill the void when looking for funding is to borrow from suspect and unregulated lenders making loans with money from unidentified sources and selling products with questionable contents.  “There is no transparency in the shadow banking system and systemic risk is rising,” Chu told the Daily Telegraph.  “We have no idea who the borrowers are, who the lenders are, and what the quality of the assets is, and this undermines signalling.”

Many do not even have any idea of what will happen because for a large part China does not even fit into a typical market framework.  Dr. Prime has looked extensively at different sectors of the Chinese economy and how they fit into market models.  Not many do.  “The only group of firms that fit the (typical market framework) reasonably well were small and medium-sized private firms in the coastal areas,”  she offered.  “None of the others, including large private firms and mixed ownership firms of any size or age, fit well at all.  This suggests the reform transition has a way to go.”

Adding to the mess is the fact that some of these loans are going to dodgy developers and projects that shouldn’t qualify for a loan even in a healthy economy.

Take an unregulated industry packaging combinations of suspect products and foisting them on investors.  Add a banking system blinded by short term profits and bonuses that throws due diligence out the window and we have…Wait. Haven’t we seen this movie before?

Yes we have, but much like the case with Alvin and the Chipmunks the Squeaquel this time around could be much, much worse.  Chinese banking officials have appeared confident they can withstand any crisis, saying that with $3 trillion plus in reserve they should be able to withstand a downturn.

That looks like a lot of money, but much like Al Bundy sitting on the couch and passing out $20s to everyone including the dog, the funds can be depleted quickly.  Remember that overall credit that could expand by more than $30 trillion in the five-year period ending in a few months?  That makes the estimated  $2 trillion “second balance sheet” that the actual banks are estimated to have seem like a drop in the bucket.  In the years preceding the economic crisis, the US ratio of debt to GDP rose 40 points.  It has gone up nearly double that for China.

How is the world affected by a weaker China?  The Chinese themselves are hurt because as more of their available finances go to cover short-term debt rollover costs, less is available for GDP increasing functions such as hiring, expansion and capital purchases.  It therefore takes more and more money to generate smaller GDP increases, an unsustainable situation.  The debt service ratio of many companies is nearing 30%, the rate at which companies may not be able to pay off interest on the principal.

“As is often the case, small companies and families are being hurt the most in this process and would be if there was a major crash,” Dr. Prime explains.  “A Financial Times article described a village where public services have been shut down because of a lack of government funds and lack of money available to the construction firm building the infrastructure nearby.”

This created another series of loopholes for enterprising individuals to burst through and they have done just that.  “The combination of pressure on local officials from their superiors to increase their growth figures, and the opportunity for officials and business people to make personal fortunes doing this, has distorted the growth path that China has experienced,” Dr. Prime explained.  Local governments could not issue bonds so they created arms length bodies that could.  “Not enough of the borrowed funds were repaid.”

You would think people would stop at this point, but developers continued to bring more and more land into the system, which created more and more loans, which kept mutating the credit to GDP level.

It also leaves them with less money to buy other countries raw materials and exports.  Many of these countries desperately need Chinese activity as they struggle with their own economic troubles.  Brazil, South Africa and Australia are big exporters of commodities to China.  As the Chinese consume less they need to purchase less.  Brazil’s exports for the year were already down 11.8% through May.

South Korea is another emerging market that is substantially hurt by a Chinese downturn as one quarter of their exports are sent to China, a similar rate to Taiwan.  The IMF stated in 2012 that China was either the first- or second-largest trading partner of 78 countries, which account for 55 per cent of global gross domestic product.   It would not take long for the effects of a China in crisis to spread around the globe.

So will China be able to avoid a crash?  Dr. Prime is not sure at this point.  “I believe the central government will do what they can to avoid one, but the problem is very large across the economy and local governments and even the state banks have their own interests that do not necessarily match those of the central government.”  Dr. Prime acknowledged inflation carries “historical political risks” and would only be used as a last resort.

She does see signs of optimism coming from Beijing.  “The June incident where the Central Bank did not intervene to increase liquidity to the inter-bank market was a start in sending the right signals to the players.  Loans should come from a standard process of project evaluation on the books, not from off-the books, very short-term inter-bank loans.”

Other tools being discussed include state commercial bank privitization along with the creation of such instruments as asset securitization, venture capital, and bond issuance.

“Allowing the interest rate to be market determined would be a major step,” Dr. Prime said.  “The official rates have been much lower than the underground rates, so presumably the “real” market rate would be higher.  There is of course a lot of pressure not to do this as those in need of funds would have to pay much more, but in the end, it is this interest rate differential that caused the shadow system in the first place.”

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