By June 23, 2013 Read More →
Tremors in the Chinese (Shadow) Banking system

Tremors in the Chinese (Shadow) Banking system

In a white paper published earlier this year, asset manager GMO argued that China’s credit and banking system is looking increasingly fragile. A key point made by the authors is that China has experienced de facto liberalisation of its financial sector, which, for decades, has been under tight state control. The explosion of the shadow banking system in recent years has been the primary manifestation of this “liberalisation”,  and has been paralleled by spectacular credit growth. As Morgan Stanley’s Ruchir Sharma writes in a piece for the Wall Street Journal,

Since 2007, the amount of new credit generated annually has more than quadrupled to $2.75 trillion in the 12 months through January this year. Last year, roughly half of the new loans came from the “shadow banking system,” private lenders and credit suppliers outside formal lending channels. These outfits lend to borrowers—often local governments pushing increasingly low-quality infrastructure projects—who have run into trouble paying their bank loans.

As credit growth has surged in the past few years, it appears that the quality of loans has deteriorated. According to Reuters,

Overall financing in the Chinese economy increased 52 percent in the first five months of 2013 compared to the same period last year, which analysts say was led by a surge in shadow banking activity and wealth management products that promised investors high returns.

Yet few analysts seem to have registered the risks this is likely pose for future growth – until recently. Why might this be? In tackling common misconceptions that mark the debate over  China’s debt-dynamics, Michael Pettis observes that

One of the big problems with analysis of China is that most analysts seem to have little experience with other developing countries, and especially with debt problems in other developing countries. As a result they tend to repeat mistakes in a fairy predictable way. For one thing, they look at current debt levels without factoring in what I call balance sheet inversion in my 2001 book The Volatility Machine.

Basically what this means is that under certain kinds conditions or balance sheet structures, an adverse shock, or slowing growth, causes an explosion in contingent liabilities, most often through the banking system, and it is this explosion in contingent liabilities that creates the debt problem for the country. If growth slows in China, in other words, this should cause a sharp rise in NPLs, especially if borrowers are counting on rising prices to service the debt, which will itself cause slower GDP growth, and so on in a self-reinforcing way. If we want to understand the debt problems facing China we have to consider not just the current debt on the balance sheet but also what the balance sheet is likely to look like after an adverse shock.

As recent events in China’s interbank market might suggest – where lending rates spiked a few days ago, before returning to more moderate levels – an adverse shock may be materialising. Interestingly, the shock seems to have been generated as a result of Chinese government policy; since March of this year, as Nomura writes,

the government has introduced a series of tightening measures in the shadow banking sector to contain financial risks. The cumulative effects of these measures have kicked in. Total social financing dropped sharply to RMB 1.2trn in May from RMB 2.5trn in March.

Could this lead to a wider unravelling of China’s credit markets, in the form of disorderly deleveraging? It would appear that for now, at least, the situation is stabilising, most likely as a result of the Chinese central bank’ efforts to make cash available to selected lenders. While things may have been contained in the short-term however, a wider dynamic of financial fragility persists. As the authors of a Nomura note observe,

we expect a painful deleveraging process in the next few months. Some defaults will likely occur in the manufacturing industry and in non-bank financial institutions. In particular, we see risks in local government financing vehicles, trust companies, property developers, credit guarantee companies, and leveraged manufacturers in industries with over-capacity problems. The non-performing loan ratio will likely rise, and we expect GDP growth to trend down to 7.2% y-o-y in Q4.

Read more: 

FT Alphaville – Is it Policy? China Edition – David Keohane

Naked Capitalism – Chinese interbank markets having a heart attack – Yves Smith

Bloomberg – China Money Rates Retreat after PBOC said to Inject Cash

Bloomberg – China Bubble Call Pits Fitch’s Chu Against S&P

INET – Why did Chinese Shadow Banking surge after 2009? 

GMO – Feeding the Dragon: Why China’s Credit System looks Vulnerable – Ed Chancellor & Mike Monnelly

About the Author:

William Oliver is Nabateans’ editor for international economics and Middle East current affairs. He obtained his degree in History from the School of Oriental and African Studies in London. While his studies focused on the Middle East in the 18th and 19th centuries, William has a long-standing interest in international finance and the political economy of development. William’s work is aimed at understanding how the Middle East integrates with the global economy, and into the wider geopolitical landscape.

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