Commentary on the economic , geopolitical and simply fascinating things going on. Served occasionally with a side of snark.
Sunday, February 2, 2014
China Shadow banking news and views - February 2 , 2014 -- 15 Trillion shadow over China's Banks ! Key takeaways from former Fitch China Analyst Charlene Chu - Regarding Shadow Banking in China -- “The banking sector has extended $14 trillion to $15 trillion in the span of five years. There’s no way that we are not going to have massive problems in China,” she says ....... On whether China's foreign reserves estimated at nearly 4 Trillion could be used to rescue the financial system in a crisis -- “The FX [foreign exchange] reserves cannot be used nearly to the extent that people think they can. There are some analysts that think they can’t be used at all, but I disagree with that. “I believe they can’t be used in their entirety by any means because they are offset by the other side of the balance sheet of the PBOC [People’s Bank of China]. Because of that, you can’t just run down one side of the balance sheet, the asset side, and not deal with the liability side of the PBOC balance sheet.” ....... regarding what a financial crisis in China might look like - - “This is going to be different from other markets where market forces are allowed to play out. Here the authorities get involved and that means these kind of defaults can remain one-off and isolated for quite a while,” she says. “The critical question is that, at some point are these one-off issues going to turn into a very big wave of defaults? That is going to be very difficult for the authorities to manage in the same way that they have been able to manage the one-offs.”
Drawing attention to the problems at an individual bank is never likely to make you popular, but calling time on an entire financial system is another thing entirely.
For eight years, until her resignation last month, Fitch banks analyst Charlene Chu has done just that, warning of the impending collapse of China’s debt-fuelled bubble.
Born and raised in America and a graduate of Yale, she has claimed in painful detail that China has embarked on an unprecedented experiment in credit expansion that far exceeds anything seen before the financial crisis that rocked Western markets six years ago.
Working out of Beijing, Chu has developed a reputation that has seen her hailed by some of the world’s most important money managers as a “heroine” and treated as a pariah by some within China’s financial elite.
In a country where the banks, even the largest, are not known for openness, Chu has warned since 2009 about a rapid expansion in lending that has seen something close to $15 trillion (£9.1 trillion) of credit created, fuelling a property and infrastructure boom that has no equal in history.
To say her warnings have been unusual is to underestimate quite how important her contributions have been. Chu has explained the creation – from a standing start just five years ago – of a shadow banking industry in China that today is responsible for as many loans in terms of volume as the country’s entire mainstream financial system.
Speaking for the first time since her departure from Fitch last year, Chu, who has taken a new job at Autonomous, the respected independent research firm, says she remains adamant that a Chinese banking collapse of some description remains not just an outside chance, but a certainty.
“The banking sector has extended $14 trillion to $15 trillion in the span of five years. There’s no way that we are not going to have massive problems in China,” she says.
Behind these problems lie a baffling range of “trusts”, “wealth management products” and foreign-currency borrowings that have allowed indebtedness to expand even as the authorities have attempted to clamp down on mainstream lending by the big banks.
Chu’s warnings have carried particular weight in recent weeks as the Industrial and Commercial Bank of China backed away from a 3bn renminbi (£297m) trust it had sold to its customers. The move prompted fears this could become China’s “Bear Stearns moment”, a reference to the abandonment by the defunct US broker of several sub-prime funds in the early stages of the West’s 2007 credit crisis.
In the event, a default of the ICBC trust was averted, but Ms Chu remains clear that the linkage between the official banking system and its shadow twin remains a threat.
“Banks are often involved behind-the-scenes in a lot of this shadow product,” she said. “It’s one reason why I am always emphasising this idea that is often pushed by Chinese economists and academics that the shadow banking sector and the formal banking sector are separate and therefore, if the shadow banking sector falls apart, it does not matter.
“I just don’t agree with that because there is so much inter-linkage between the formal banking sector and the shadow banking sector and this product [the ICBC trust] is a good example.” Many take comfort that foreign currency reserves, estimated at close to $4 trillion, could be used to rescue the financial system in a crisis. Chu says such optimism is wishful thinking.
“The FX [foreign exchange] reserves cannot be used nearly to the extent that people think they can. There are some analysts that think they can’t be used at all, but I disagree with that.
“I believe they can’t be used in their entirety by any means because they are offset by the other side of the balance sheet of the PBOC [People’s Bank of China]. Because of that, you can’t just run down one side of the balance sheet, the asset side, and not deal with the liability side of the PBOC balance sheet.”
However, while Chu questions the ability of the authorities to throw money at the problem, she also says there are several reasons to think a Chinese crisis would not take the form of that seen in the West. “This is going to be different from other markets where market forces are allowed to play out. Here the authorities get involved and that means these kind of defaults can remain one-off and isolated for quite a while,” she says.
“The critical question is that, at some point are these one-off issues going to turn into a very big wave of defaults? That is going to be very difficult for the authorities to manage in the same way that they have been able to manage the one-offs.”
Taking such a pessimistic view of China’s banks has not made Chu popular either with the authorities or the lenders. Her previous employer, Fitch, last year became the first of the three main ratings agencies in 14 years to cut China’s credit rating, largely based on her analysis.
Fitch and Chu both remain circumspect about how her exposure of the problems of the banks has affected business.
Chu admits that her views have made her job harder, in particular the effort to uncover decent data on what is going on inside the system. On the other hand, she adds that not being beholden to the “party line” has enabled her to analyse China more dispassionately than others.
“I still feel like, in the end, being on the outside has not hurt me too much in terms of what is going on.” Not following the party line has seen Chu travel to China to inspect first-hand the building of “ghost cities” that developers claim are fully occupied, but that appear to be deserted except for a scattering of maintenance staff and increasingly despondent “entrepreneurs”.
“The odd thing is that you will certainly encounter some developments that appear to be totally empty and yet they are totally sold out,” says Chu. “It is a very mixed picture, but I do feel in the end that the amount of real estate building that has gone on over the last few years is substantial, yet there are
still a lot of projects in the works. There is definitely reason for people to be worried that we have got a real estate bubble.”
The popping of this bubble could leave behind a very different China, and it is the post-crisis economy that is Chu’s biggest concern.
Like the West, which has implemented an array of new regulations in the wake of the crash, Chu worries that China could find it difficult to adapt to a slower pace of growth.
“This isn’t a developed market with a very strong social safety net. If we get to a situation where we are having severe financial sector problems, the chances are GDP growth is much slower than it is now for a prolonged period of time,” she says. Adding: “I think that really is where the cost of a financial sector crisis comes in. To me, it’s much less about how much the sovereign issues in terms of debt to bail out the financial sector. It comes down to how much of a hit does growth take and what is the impact of that on the populace and do we start to have any other issues that arise from that?”
Chu says that many in China’s policy elite realise the Faustian pact the country has made but, with the economy and political system so dependent on maintaining a 7pc rate of growth, there is little will to take away the punchbowl any time soon.
And that is the problem. While a crisis now would be bad, allowing the current situation to persist will only make the final reckoning that much worse, particularly for the wider international financial system.
Warnings have already been raised about the increased use of offshore dollar funding by mainland Chinese borrowers. The Hong Kong Monetary Authority has pointed to the growth of foreign currency funding of China, which is believed to have more than quadrupled in the past three years to in excess of $1 trillion.
Chu says that this remains a side issue, arguing that the longer the credit boom is allowed to continue the bigger the international leg of the crisis will become.
“One of the reasons why the situation in China has been so stable up to this point is that unlike many emerging markets there is very, very little reliance on foreign funding,” she said.
“As that changes it obviously increases the vulnerability to swings in foreign investor appetite. I do think, in the end, you look at the exposure numbers from the BIS [Bank for International Settlements] and the Hong Kong banks and you’re going to encounter a few institutions that are going to have a sizeable exposure to China.”
As the problems in the Chinese financial system become harder to ignore, it is likely Chu’s opinions are going to be increasingly sought as investors look for insight on what is going on in the world’s second-largest economy.
The rescue puts off the immediate threat but raises the stakes, writes Simon Rabinovitch
Of all the economic dangers to flare up over the past week, the most unsettling was at first glance also the most esoteric: the near default of a high-yield loan product held by a few hundred small-time Chinese investors.
Set against the turmoil in other emerging markets – steep currency falls in Turkey and South Africa that prompted their central banks to raise interest rates, stubbornly high inflation in India and a collapsing currency in Argentina – China appears to be a bastion of economic strength. Even analysts with a bearish bent still expect its growth to come in at about 7 per cent this year. The renminbi is steady against the dollar and inflation is under control. And unlike developing countries faced with cash outflows as the US Federal Reserve winds down its monetary stimulus, China is protected by robust capital controls.
Why then has the saga of Credit Equals Gold No. 1, the Chinese investment product that was rescued from the brink of failure, so captivated global attention? There are both direct and indirect reasons; the latter are especially worrying.
First, the direct risks. Credit Equals Gold No. 1 is just one of a wave of Chinese shadow banking products that will fail to live up to their outlandishly confident names when they mature this year. The drama over repayment will be played out again and again.
Over the past decade, China’s economy has grown ever more reliant on financing outside the formal banking system. Bank loans, which used to account for more than 90 per cent of total credit, fell to little more than half of new financing last year. Lending by shadow banks now totals Rmb47tn, or 84 per cent of gross domestic product, according to JPMorgan.
Reducing the dominance of banks is part of the plan for unleashing more market forces in China – a positive development. But some of the loosely regulated institutions that have plugged the lending gap are simply reckless. It is the most buccaneering of these that are now sowing doubts about China’s financial stability.
Investors who lend to indebted miners are not crazy – they are betting that government-owned banks will bail them out
This week’s story began in 2011 when China Credit Trust loaned Rmb3bn to Wang Pingyan, a coal mine operator in the northern province of Shanxi. Mr Wang made the ill-fated decision to scale up investment dramatically just as coal prices peaked. His company collapsed soon after receiving the loan.
If the pain had been confined to China Credit it would have been bad enough. But making matters worse, the case has shown that there is only a thin dividing wall between shadow banks and the better-regulated parts of the financial sector. China Credit had pitched the loan as an investment product, promising an annual return of 10 per cent. Rather than sell it directly, the product was marketed by Industrial and Commercial Bank of China, the country’s largest lender, to wealthy private banking clients.
The controversy in recent weeks about which party, if any, is responsible for the dud loan has drawn in all involved: the local government in Shanxi, which gave its blessing to Mr Wang’s plan; China Credit, which structured the investment product; and ICBC, which distributed it. In the end an unidentified entity bailed out investors by covering their principal, though not the full interest.
Those wondering where the next big troubled shadow bank loan might lurk need only look down the road from Mr Wang’s failed mine to another in Liulin, the same county in Shanxi province. Xing Libin, a coal tycoon who threw a Rmb70m wedding party for his daughter in 2012, is restructuring his mining company because it could not repay its loans. Among those debts is an Rmb1bn ($164m) investment product – structured by Jilin Trust and distributed by China Construction Bank – that falls due in a few weeks.
In all, there are about $660bn of trust products up for repayment or refinancing this year, according to Bank of America Merrill Lynch. Chinese shadow banks, by definition, have been focused on customers – miners, property developers and local governments – that regulators have deemed too risky for banks, so more problem loans are a certainty.
Shadow banks have not all been pedalling junk. Many trust companies are well run and have demanded ample collateral from borrowers. And where they have been poorly managed, China’s state-owned banks have enough assets to cover much of the damage. Most investors in trust products will walk away unscathed. It is the indirect consequences of this week’s bailout that are more worrying. As rating agency Fitch put it, the rescue of the trust product was a “missed opportunity” to create more risk awareness in the financial sector. This could cast a shadow over Chinese markets for years to come.
Chinese investors who lend money to heavily indebted miners or property developers are not crazy. They are making a calculated gamble – one that has proved mostly correct until now – that the government or state-owned banks will bail them out if they get into trouble. Yet an accumulation of bad investment decisions explains the excess capacity that plagues manufacturers from sportswear companies to steel mills. The perception of ironclad, if implicit, government guarantees is also why overall Chinese debt levels have soared from 130 per cent of GDP in 2008 to more than 200 per cent today. Similarly fast increases have been precursors to financial crises in countries from South Korea to the US.
Hence China’s uncomfortable predicament. Because the government was unwilling to see Credit Equals Gold No. 1 collapse, fears of an imminent economic meltdown are overblown. But for precisely the same reason China’s debt powder keg is only getting more tightly packed.
Rating agencies criticise China’s bailout of failed $500m trust
Rating agencies criticise China’s bailout of failed $500m trust
By Josh Noble in Hong Kong
Global rating agencies – often among the more sanguine voices on China – have warned that this week’s bailout of a soured $500m trust loan was a wasted chance to address rising moral hazard in the country’s shadow banking sector.
The words of caution follow a last-minute deal to avert the default of a Rmb3bn trust product backed by loans to a now-defunct coal mining company. The product’s issuer, China Credit Trust, on Monday said it had raised the cash needed to pay back investors from three unnamed backers.
Though such products have failed in the past, a full or partial default of the “Credit Equals Gold No. 1” trust would have been the most high-profile case in whichinvestors were left nursing losses.
Instead their investments were made good, with only the third year of interest payments held back – something ratings agencies have billed as a missed opportunity to address skewed risk perceptions within the shadow banking sector.
“By bailing out investors in this particular instance, the authorities are perpetuating moral hazard within the Chinese financial system – and this risk may in fact have become a whole lot bigger,” wrote Jonathan Cornish, an analyst at Fitch, in a research report. “We think the authorities have missed a chance of putting a clear marker in the sand that non-bank products would certainly not be supported.”
Moody’s analysts said that while the resolution of this particular trust had limited the risks of contagion across the financial system, the government had failed to create a useful framework for future defaults.
“Although the current proposed settlement does entail losses to investors in terms of foregone interest, by fully repaying their principal, it reinforces the perception that investors will be bailed out one way or another when the products go sour, which is contrary to the establishment of sound market discipline and a healthy credit market,” said Moody’s.
Liao Qiang, credit analyst at Standard & Poor’s, described the fund rescue as “counterproductive in the long run”, as it would undermine efforts to rein in the growth of such products.
The shadow banking system has risen to account for roughly a third of new credit inChina’s debt-fuelled economy. About $660bn of trust loans are due for repayment or refinancing this year, according to estimates from Bank of America Merrill Lynch, raising the prospect that investor jitters over the sector could feed into the real economy.
Trust loans, the largest form of shadow financing, have often been used by local governments to fund infrastructure projects, and by developers to buy land and build apartment blocks. Difficulty in rolling over such debts could dent economic growth across the country.
Some analysts say the impact is already being felt. On Thursday, a survey released by HSBC showed the first contraction in the manufacturing sector in six months, which Zhang Zhiwei, an economist at Nomura, said had been caused in part by rising financing costs within China.
In spite of this week’s bailout, most analysts expect more trust products to sour this year, as the economy slows, and as authorities look to introduce more market-driven mechanisms for pricing risk.
The debt problem building within China’s shadow banking system this year is likely to be “more important to the global economy than Fed policy”, Nikko Asset Management said in a research note.