Saturday, March 22, 2014

China Enters The Great Credit Trap

Much of the recent growth in China after 2008 came from a massive 6.6 trillion dollar stimulus program that expanded credit and poured massive amounts of money into the system. This money encouraged expansion and construction with little regard as to real demand or need. Like a plane on autopilot China continued in the direction it had been on. This grow or die mentality always included building more and expanding more. Now China finds itself in a credit trap. For years the people of China have had the habit of saving much of what they earn but the low interest rates paid at banks has not rewarded savers. With few investment options much of this money has drifted towards housing and driven housing prices sky high.

Four big state-owned commercial banks and other mainly state-controlled banks account for nearly all official lending in China and their customers tend to be state-owned firms. This has left little room for private banks and this means informal lending in China has grown rapidly in the past five years. 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.

Every country has unofficial lenders, but in China individuals, companies and even local governments who can not get loans from state-controlled banks have been on a borrowing binge from these unofficial sources. After several years of growing debt concern is rising the whole unstable pyramid is about to come crashing down bringing China and possibly the global economy with it. This is not just about writing off a few bad 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. In the case of any banking crisis this could have a massive impact on the economy, since debt is estimated to be more than 200% of GDP. The Chinese central bank has reported that 89% of households and 57% of firms have borrowed money from these groups.

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 US 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 US and Europe before the global financial crisis that started in 2007.

While governments can never get rid of the borrowing in society they can ban the very high-rate loans. 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. It now appears even local government has borrowed in the shadows

If this develops into a full scale banking crash, the issue will be if the government of China can afford to or is capable of rescuing the banks. If it is able to halt a collapse the cost to growth will be severe, if not then China would be in crisis and the global consequences would be dire. In some ways since every saver is affected in the world's most populous country, it could even have a bigger effect than the collapse of Lehman. In the past, economists thought what Beijing wants it usually gets because of its total control of  the credit tap. The double-whammy of credit defaults and a deteriorating trade position, point to a new reality for Beijing as the days of backstopping growth with ever more credit appear to be numbered.

Recently, we saw China’s first-ever onshore corporate default on a bond. This default ends the belief Chinese corporate debt comes with a de-facto government guarantee and may help by injecting risk into the pricing scheme of China's massive domestic bond market. Unfortunately, many people think introducing market pricing at this stage in China’s cycle comes a bit late to instill real discipline. Instead, prepare for an ugly unraveling, as this could open the floodgates on credit defaults. The reality is that much of China’s heavy industry faces dismal fundamentals of high leverage, overcapacity and falling prices. We already know that Beijing is enforcing capacity reduction that will have spillover effects. Chinese Premier Li Keqiang recently promised 27 million tons of high-polluting steel production will be taken out this year. As much as 130 million tons of capacity may be marked for closure by 2017. This is a significant part of China’s annual 750 million ton output.

Another hurdle Beijing faces in terms of keeping the credit taps flowing is that its days of ever-increasing trade surpluses could be over. The release of February’s trade figures showed China racked up an unexpected  $22.89 billion trade deficit in February after exports fell 18.1%. The question now is whether trade deficits will become the new normal. We already know China is facing constraints on production capacity from land, labor and pollution, as well as steadily rising costs that are displacing large chunks of low-end manufacturing. Many people worry the impact from a key reversal of years of trade surpluses and foreign-reserve accumulation could be far-reaching.

 China’s current-account surpluses have fueled its huge money-supply growth within a largely pegged currency over the years. As foreign exchange piled up, the People’s Bank of China continued to print more yuan. According to some estimates, China’s banking system has grown from $10 trillion to $24 trillion since 2008. Now the reverse may happen, if the yuan weakens, the central bank will effectively have to buy its own currency using foreign reserves to maintain its peg. This could mean the external trade position would now cause the central bank to shrink domestic money supply. Beijing will need to get used to the market forced deleveraging and slower growth. It is clear the economic efficiency of credit is beginning to collapse in China and the unwinding of China’s giant credit spree could be very painful.

  Footnote; Please feel free to explore the blog archives and as always you comments are encouraged. For more on China see any of the four post below,


  1. The debt swimmer will get at least two shouts for help? The west will do all in its power to prevent this from happening quick? Many companies have no clue what will happen and need time to windup and get out! The Chinese government will blame over capacity on the western firms and not its wreckless policies. The people will turn on the west and retreat back to the hillsides and another epoch ends....

  2. I waiting for somebody to tell me why stocks in markets worldwide are not collapsing right now. The handwriting is in bold strokes with China's bond defaults and Japan's failure of Abenomics. Money is running scared, the Fed is pulling back, more than just a few guests on CNBC have said openly they're retreating into cash.

    What's keeping this all afloat? Is it that I am usually three to six to nine months ahead of the trend (like 2007, which didn't really fall apart until late 2008) or is everybody sold on the dovish Yellen coming to the rescue?

    I've seen few better times to go all in short than at the present, but the market doesn't budge... in fact, it's headed again to all-time highs.

    1. What's keeping it afloat is the Federal Reserve printing. The publicly claim to be pulling back but look at their growing balance sheet. Banks can borrow at 0.25% and but treasuries at 2.25%. That's a 2% profit at no risk. Borrow $100 billion and make $2 billion profit every year. This squeezes legitimate money out of the bond market and into the stock market.

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