Thursday, June 30, 2016

China's Debt Problem Grows More Ominous!

The last few weeks Brexit has been sighted as the reason for much of the volatility roiling markets across the globe, however, it is possible much of the problems are actually flowing from China. Could it be that Britain is merely being used as the excuse of the day? In finance, volatility is the degree of variation and distortion in trading prices. The ongoing efforts of China to stabilize their sagging economy by flooding the markets with liquidity have resulted in a ripple effect and added to the nervousness of markets. At one time I felt that it was only when we look back on events that we get a clear picture of just how events unfolded, sadly I have come to realize that even then the is truth difficult to identify. History is generally written by the victor and shaped by those with an agenda to fit their narrative.

China has a massive problem in that growing debt has hamstrung its economy. When coupled with the overcapacity that developed as the country raced ahead on a wave of easy and cheap money it now finds itself in a situation similar to that which America faced in 1929 following a period of rapid growth and credit expansion. Time and time again history has shown that when an economy has overbuilt, over-leveraged, and overreaches a reset occurs. As of late, all indications are China has again started flooding the market with money and liquidity to halt their collapse and this appears to be what is driving commodity and other prices higher while economies struggle. In the past year alone, China has spent nearly $200 billion to prop up its stock market, $65 billion of bank loans have gone bad, financial frauds have cost investors at least $20 billion, and $600 billion of capital has fled the country.

Money Supply And Debt Has Surged
A question we must ask is just how large this newest wave of liquidity really is and where it will lead. For years the numbers flowing out of China have been viewed with suspicion. Questions of just how much these numbers are tinkered with for political reasons and concerns the system supporting economic data collection is not fully developed has caused many people to discount their accuracy. Few China watchers, however, question that debt has soared and credit expansion has unleashed a huge amount of new money into the system.

Debt May Be Larger When All Shadow Banking Is Counted

The chart to the left shows how debt has soared from 150% of GDP in 2008 to 258% at the end of 2015. Since that time the trend has continued and China has seen a dramatic rise in debt. Few countries have gone on borrowing binges of that magnitude without hitting a crisis. Many people feel a large part of China's problem lies in the shadow banking system that is often misunderstood. Part of the issue is that much like the derivatives market shadow banking can be hard to define and how extensive it is can be blurred by this limitation.

For a long time, I have contended if anything the debt problem is much larger than indicated because of the large role the mostly unregulated shadow banking system plays in China's economy. Even local governments borrow from the shadow banking system. Shadow banking is a slightly sinister name for trusts, leasing and insurance companies and other non-bank financial institutions which perform banking functions without a banking license. No one really knows how big the shadow banking sector in China is because it is largely unregulated by the banking authority, but shadow loans are estimated to make up 20% of all loans. The shadow banking sector is so large that concerns exist about contagion and a domino series of defaults that might rack the economy as savers lose money. It is reported that 89% of households and 57% of firms have borrowed money from these groups, however, it is not just about size, it is how deep, and where the roots of this system run.

Shadow bank loans can charge as much as 24-30% in interest and be for as short a period as just three to five days if someone really is in need of cash. One shadow banker confessed that he charged interest rates of up to 100% and lent on average 6m yuan per month, which is around one million U.S. dollars. Many people see the shadow banking system as a channel to get money to solve business problems as it's efficient and quick even if the rate is much higher than the banks. It seems these shadow banks have been selling wealth management products (WMPs), which offer returns that far outstrip the official deposit interest rate of 3%. A big problem is these unregulated products are riskier and reminiscent of some of the horrifyingly complicated products sold in the U.S. and Europe before the global financial crisis that started in 2007.

This is not just about writing off a few bad loans, it is important to remember the money fueling these loans come from Chinese savers who have taken on more risk to get a better yield on their savings, when loans go bad they are the losers when the smoke finally settles. One of China's most notorious shadow bankers is now in jail serving a life sentence but this does not help those who loaned this person money because of the high rates he paid. The "investors" become victims and often lose everything they have saved to retire on when a shadow bank goes bust. In some cases, people lend money to someone like their boss to earn more interest than the meager rate offered by the bank. During the global financial crisis the central government launched a spending program, however, rather than provide funding for this it left getting financing for projects up to local governments, the fact that some of them borrowed from the shadow banks is proof of just how extensive shadow banking is.

China’s debt mania, by this I mean madness, craziness, and frenzy is now the largest ever experienced in the postwar emerging world. After holding steady at around 150 percent of GDP for much of the boom, China’s public and private debts surged after 2008. While governments can never get rid of the borrowing in society they can ban the very high-rate loans.  In the case of any banking crisis, the shadow banking sector would act as a destabilizing factor and have a massive impact on the economy. Cracks have developed in the Chinese financial system in recent years. They include a cash crunch in 2013, a wave of shadow-banking defaults in 2014, a stock market collapse in 2015 and a surge of capital flight at the start of 2016.

As the China story unfolds it is clear the scope for a debt meltdown in China remains immense. China's banking sector is the biggest in the world, with assets of $30 trillion, this is equivalent to 40% of global GDP. China’s four biggest banks are also the world’s four biggest. Its stock markets, even after the crash, are worth $6 trillion, second only to America’s, and its bond market, at $7.5 trillion, is the world’s third-biggest and growing. Keynes' theory was the government should create demand when the economy starts to contract and reverse when the economy recovered. Increase the debt to stimulate and decrease debt once the economy recovered. It appears China as in the U.S. has only followed half that theory and encouraged debt to stimulate the economy. Do not expect this to end well.

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