china's vulnerable financial underbelly

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20 wilmott magazine W estern understanding of China has never greatly progressed beyond Charles de Gaulle’s statement that: “China is a big country, inhabited by many Chinese.” Despite constant analysis of develop- ments in China in excruciating detail, economists seem to have only recently identified its debt prob- lems. In fact, the country has had a 35-year addic- tion to cheap credit. Quantum matters… Since the 2007/2008 global financial crisis (GFC), China has experienced strong credit growth. The crisis and the resulting rare synchronous recessions in the developed world exposed China’s economy, especially its export sectors, to a large external demand shock, slowing growth. Beijing deployed massive resources to restore growth to counter the economic and social impact of the slowdown. In late 2008, China announced a fiscal stimulus package of 4 trillion renminbi (RMB) (about $600 billion) over two years, a budget deficit of around 2.2 percent of gross domestic product (GDP). The modest fiscal measures were augmented by a sig- nificant expansion in credit known as total social financing (TSF), covering a mix of loans, bonds, bills, and even some equity financing via the large policy banks, which are majority government owned and controlled. Post-GFC, new lending by Chinese banks has been consistently around 30 percent or more of GDP. Around 90 percent of this lending was direct- ed toward investment in building, plant, machin- ery, and infrastructure, especially by state-owned enterprises (SOEs). According to the World Bank, almost all of China’s growth since 2008 has come from “government influenced expenditure.This expansion led to a rapid increase in the level of debt. Due to unreliable data and measure- ment problems, the exact level of debt remains unclear. Most estimates now put total debt of the Chinese government (including local govern- ments), corporations, and households at around 200–250 percent of GDP, up from around 140– 150 percent in 2008. According to a 2013 report from China’s National Audit Office (NAO), Chinese govern- ment debt, including local government debt, is at around 55 percent of GDP (around $5 trillion), an increase of around 60 percent since 2010. The NAO argues that this figure includes around $1.6 trillion of contingencies (debts of government-owned financing vehicles), of which the government in the worst case would only have What 35 years hooked on cheap credit will do to a country to cover a small portion (say, 20 percent). This would reduce the actual public debt to around 39 percent of GDP. But the official Chinese government debt figure may be incomplete, as it may exclude some debts of local governments and central departments outside the Finance Ministry. It may also exclude debt of large state-owned enterprises (SOEs), state-owned policy banks, and special-purpose asset-man- agement companies that hold nonperforming loans purchased from state-owned commercial banks, which all trade on the basis of explicit or implicit government support. For example, China’s Railways has debt of around $270 billion, which may not be included, despite the fact that it is run by a central government ministry. If these items were included, then China’s government debt, including contingent liabilities, would be higher – perhaps as high as 90 percent of GDP. There has been a parallel increase in private Satyajit Das China’s Vulnerable Financial Underbelly

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Page 1: China's Vulnerable Financial Underbelly

20 wilmott magazine

W estern understanding of China has never greatly progressed beyond Charles de Gaulle’s statement that: “China is a big country, inhabited by many

Chinese.” Despite constant analysis of develop-ments in China in excruciating detail, economists seem to have only recently identified its debt prob-lems. In fact, the country has had a 35-year addic-tion to cheap credit.

Quantum matters…Since the 2007/2008 global financial crisis (GFC), China has experienced strong credit growth.

The crisis and the resulting rare synchronous recessions in the developed world exposed China’s economy, especially its export sectors, to a large external demand shock, slowing growth. Beijing deployed massive resources to restore growth to counter the economic and social impact of the slowdown.

In late 2008, China announced a fiscal stimulus package of 4 trillion renminbi (RMB) (about $600 billion) over two years, a budget deficit of around 2.2 percent of gross domestic product (GDP). The modest fiscal measures were augmented by a sig-nificant expansion in credit known as total social financing (TSF), covering a mix of loans, bonds, bills, and even some equity financing via the large policy banks, which are majority government owned and controlled.

Post-GFC, new lending by Chinese banks has been consistently around 30 percent or more of GDP. Around 90 percent of this lending was direct-ed toward investment in building, plant, machin-

ery, and infrastructure, especially by state-owned enterprises (SOEs). According to the World Bank, almost all of China’s growth since 2008 has come from “government influenced expenditure.”

This expansion led to a rapid increase in the level of debt. Due to unreliable data and measure-ment problems, the exact level of debt remains unclear. Most estimates now put total debt of the Chinese government (including local govern-ments), corporations, and households at around 200–250 percent of GDP, up from around 140–150 percent in 2008.

According to a 2013 report from China’s National Audit Office (NAO), Chinese govern-ment debt, including local government debt, is at around 55 percent of GDP (around $5 trillion), an increase of around 60 percent since 2010.

The NAO argues that this figure includes around $1.6 trillion of contingencies (debts of government-owned financing vehicles), of which the government in the worst case would only have

What 35 years hooked on cheap credit will do to a country

to cover a small portion (say, 20 percent). This would reduce the actual public debt to around 39 percent of GDP.

But the official Chinese government debt figure may be incomplete, as it may exclude some debts of local governments and central departments outside the Finance Ministry. It may also exclude debt of large state-owned enterprises (SOEs), state-owned policy banks, and special-purpose asset-man-agement companies that hold nonperforming loans purchased from state-owned commercial banks, which all trade on the basis of explicit or implicit government support. For example, China’s Railways has debt of around $270 billion, which may not be included, despite the fact that it is run by a central government ministry.

If these items were included, then China’s government debt, including contingent liabilities, would be higher – perhaps as high as 90 percent of GDP.

There has been a parallel increase in private

Satyajit DasChina’s Vulnerable Financial Underbelly

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sector debt. Business and household debt levels have reached around 150–170 percent of GDP, a large increase from around 100–115 percent in 2008. Corporate debt has increased sharply, approaching 150 percent of GDP. Historically, Chinese governments have supported many large, strategically important, or politically well-con-nected private corporations, meaning that some corporate borrowing may end up as public debts.

Traditionally, considered compulsive savers, Chinese households have increased borrowing levels from around 20–30 percent to 40–50 percent of GDP. The rise in household debt has been driv-en by inflation. Sharply higher home prices require greater borrowings. The devaluation of purchasing power encourages debt-fueled consumption.

In a little more than five years, total credit in China has expanded from around $9–10 trillion to $20–25 trillion, effectively replicating the entire US commercial banking system.

Beijing city limits…French author Marcel Proust once wrote that: “The real voyage of discovery consists not in seeking new landscapes, but in having new eyes.” There is now belated concern about the sustainability of Chinese debt.

While high, China’s debt level is lower than that of developed economies, allowing govern-ment officials to claim that it is at a “safe level.” But developed economies may not be an appropriate benchmark as, generally, emerging nations, like China, have lower debt capacity, reflecting lower incomes, wealth, and shallower, less-developed financial markets which are in the early stages of “financial deepening.”

If all borrowings are included, then China’s overall debt is high, especially when benchmarked against comparable emerging markets. Many Asian emerging markets had lower debt and high-er per capita GDP prior to the Asian monetary cri-sis of 1997/1998. Interestingly, China has similar debt levels but lower per capita income compared to Japan prior to the collapse of its bubble economy in the late 1980s.

Private sector debt levels are lower than that in developed markets such as the US or UK (200 per-cent of GDP) but are much higher than the 50–80 percent levels common in emerging markets.

Corporate debt levels are above those in developed countries (averaging around 90 percent of GDP) and well above those of firms in other emerging markets (less than 100 percent in Brazil, around 80 percent in India, and 60 percent in Russia). Household debt remains well below personal debt levels in the US or Europe (above 100 percent of GDP) but is increasing.

The high debt levels are exacerbated by an inverted debt structure (described by Michael Pettis in his book, The Volatility Machine). In emerging nations, when the economy slows, debt levels, both direct and contingent, increase rapidly.

The rapid rate of increase in debt, based on a number of empirical measures, is also concerning.

An increase in debt of around 30 percent of GDP in five or less years is regarded as problem-

atic. Such consistent above-trend increases in borrowing levels have historically provided early warning of problems.

Several economies – Japan in the late 1980s, South Korea in the 1990s, the US and UK in the early 2000s – experienced such rapid growth in credit, ending in serious financial crises. China has experienced a similar expansion in debt.

The credit gap (the difference between increas-es in private sector credit growth and economic output) provides another measure of the rise in indebtedness. Research studies have found that 33 countries with significant credit gaps experienced a subsequent rapid slowdown in growth, typically by at least 50 percent. In China, the credit gap since 2008 has been over 70 percent of GDP.

Chinese credit intensity (the amount of debt needed to create additional economic activity)

has increased. China now needs around US$3–5 to generate US$1 of additional economic growth, although some economists put it even higher, at US$6–8. This is an increase from the US$1–2 need for each dollar of growth 8–10 years ago.

The increased credit intensity reflects the use of funds. Debt can be used to finance invest-ment, consumption, or assets that already exist. Consumption or investment contributes to eco-nomic activity. Purchase of existing assets does not add directly to economic activity. In China, traditionally, debt has primarily financed invest-ment but is used increasingly to fund purchases of existing assets.

Chinese data measures two different types of investment – gross fixed capital formation mea-sures investment in new physical assets, which

contributes to GDP, and fixed-asset investment measures spending on already existing assets, including land. In 2008, gross fixed capital forma-tion and fixed interest investment were roughly equal. Today, gross fixed capital formation has fall-en to about 70 percent of fixed-asset investment, consistent with increasing turnover of already existing assets at frequently rising prices.

Lack of service…Investment in new assets has been heavily focused on frequently large-scale infrastructure and property. The major concern is that many of the projects will not generate sufficient income to service or repay the borrowing used to finance the investment.

Stories, some apocryphal, abound about wasteful expenditure. A significant proportion

The crisis and the resulting rare synchro-nous recessions in the developed world exposed China’s economy, especially its export sectors, to a large external demand shock, slowing growth

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rachel ziemba

of the investment in politically driven super-fast trains, new airports, and express roads is likely to prove unproductive. Excessive investment in many heavy industries, such as steel, has created signifi-cant overcapacity.

China has also benefited from a large expan-sion in residential construction in recent years, resulting in a glut of properties. Official data esti-mates that unfinished housing stock is equivalent in value to more than 20 percent of GDP. The most infamous is the “ghost city” of the Kangbashi district of Ordos in Inner Mongolia, which at one stage had apartments to shelter a million persons, about four times its current population. But other, less obvious but equally troubling examples are available.

The city of Tianjin, about a half-hour jour-ney by high-speed train southeast of Beijing, has invested more than $160 billion in an effort to cre-ate a financial centre. The amount spent is almost three times that spent on China’s Three Gorges Dam, one of China’s costliest projects. Changde, a city of six million in Hunan province in southern China, has raised more than $130 million in debt to finance, among other things, an international marathon course, following the 2008 Beijing Olympics.

Debt-fueled investment in dubious projects reflects the need of ambitious government offi-cials, especially in the provinces and at the munic-ipal level, to meet centrally set growth targets. As Yuan Zhou, then Mayor of Guiyang, capital of the south-western province of Guizhou, stated in a radio interview in 2011: “We need to struggle for GDP. Only with higher GDP will people’s lives be improved.”

The increased level of debt and the often uneconomic projects financed have led to increas-ing concern as to whether the debt can be ser-viced.

A 2012 Bank of International Settlements research paper on national debt servicing ratios (DSRs) found that a measure above 20–25 percent frequently indicated a heightened risk of a finan-cial crisis. Analysts estimate that China’s DSR may be around 30 percent of GDP (around 11 percent goes to interest payment and the rest to repaying principal), which is dangerously high.

The debt problems are compounded by other

factors. A large portion of the debt is secured over land and property, whose values are dependent on the continued supply of credit and strong eco-nomic growth.

A high proportion of debt is short term, with around 50 percent of loans being for one year, requiring refinancing at the start of each year. As few Chinese borrowers have sufficient operating cash flow to repay loans, new borrowings are needed to service old ones.

Around one-third of new debt is used to repay or extend the maturity of existing debt. With a sig-nificant proportion of new debt needed to merely repay existing debt, the amount of borrowing needs to constantly increase to maintain econom-ic growth. The process is not seamless and the requirement for regular refinancing exacerbates the risk of financial problems.

The concern is that debt-fueled investment has created economic growth but in the medium to long term will result in rising bad debts and financial problems.

Economist Hyman Minsky identified three phases of finance during periods of prosperity, with financial structures become progressively more risky. Hedge financing is where income flows can meet principal and interest on debt used as finance. Speculative financing is where income flows cover interest payments but not principal, requiring debt to be continually refinanced. Ponzi finance is where income flows cover neither prin-cipal nor interest repayments, with the borrower relying on increasing asset values to service debt.

China observers now worry about whether the high absolute levels of debt, rapid increases in borrowing, increasing credit intensity, servicing problems, and the quality or value of underlying collateral are likely to result in a financial and eco-nomic crisis – a Minsky Moment.

Local but national…Chinese debt concerns are complicated by two structural issues – the rise in borrowing by local governments and the increasing role of the shad-ow banking system.

Governors and senior officials of China’s prov-inces, regions, and centrally controlled munici-palities are appointed by the central government in Beijing after receiving the nominal consent of

the National People’s Congress. But, outside of security matters or foreign affairs, they enjoy sig-nificant autonomy.

Regional development, improving living standards outside of the coastal areas of China, has been a key national policy objective. After the GFC in 2007/2008, the aggressive stimulus mea-sures to boost economic activity assumed a signif-icant contribution from local government.

This required the central government to relax controls on local government spending programs. But by law, China’s local governments are not allowed to borrow. This required creative solutions with the tacit approval of Beijing. Local authorities created local government financing vehicles (LGFVs), also known as urban develop-ment and investment companies (UDICs). These special-purpose arms-length vehicles, which are separate from but owned or controlled by the local government, are used to borrow.

The basic structure entails the province, city, or municipality transferring land to a specially incorporated LGFV, which then borrows using the real estate as collateral for the loan. The local government may also provide additional guaran-tees.

The money raised is used to compensate the original owners of the land and also build essential infrastructure (roads, sewerage, utility connec-tions, etc.). The LGFV then sells the improved land at a higher price to a property developer for the construction of houses, apartments, or industrial estates.

The purchase price paid by the developer, typically funded by debt again secured over the property, enables the local government to gener-ate revenues for its normal activities, including investment in amenities and the provision of services to the community. The process of shift-ing assets between the local government, LGFV, and developer, funded by debt, is then repeated, usually increasing in scale over time, to meet the needs of the municipality for additional revenues to continue operations.

The LGFV generally borrows funds predom-inantly from banks (as much as 80 percent or more), with the remainder raised by issuing bonds or other equity-like instruments to insurance companies, institutional investors, and individu-

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als. In recent times, with pressure on banks to cur-tail loans, LGFVs have borrowed from the shadow banking system.

Local government borrowings raise several issues.

With over 10,000 LGFVs in China, the exact level of borrowings remains in dispute, despite increasing scrutiny. Many of the new vehicles are in the less developed and remote Central and Western provinces, where governance standards are less rigorous.

There is concern about the quality of the underlying projects financed, which are some-times politically motivated, expensive trophy projects. Many LGFVs do not have sufficient cash flow to service debt, being reliant on land sales and high property prices to meet debt obligations. Collateral quality is questionable, with overvalu-ation (well above market values) being common. The LGFVs also have significant mismatches between short-term borrowings and the long-term investments being financed.

A 2013 research study by Japanese investment bank Nomura found that more than 50 percent of LGFVs have unsustainable debt levels and face the risk of insolvency. This would increase to around 70 percent in adverse market conditions. The report concluded that LGFVs are reliant on fiscal subsidies and aggressive accounting to meet debt obligations. With cash flow insufficient, many LGFVs now use new borrowings to repay matur-ing debt.

Local governments themselves may not have the tax base and financial capacity to ensure the solvency of their LGFVs. According to the World Bank, China’s local governments have responsibil-ity for 80 percent of total spending but only receive about 40 percent of tax revenue.

With few assets other than land, they are reliant on land sales and development taxes for a large portion of revenue. This restricts their financial flexibility, especially if the real-estate prices fall.

Pathology of a crisis…The pathology of China’s local government finan-cial problems is recognizable. The combination of excessive borrowing, capital misallocation, and debt servicing based on increasing property prices is familiar.

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Eager for growth and increased revenue, local governments increase borrowings to create ever-larger development projects, resulting in a rapid increase in the supply of new properties and land inventory held by the LGFVs. Land and prop-erty sales slow and prices come under pressure, constraining the ability to monetize the assets to meet debt obligations.

Lender concern reduces credit availability and increases interest costs, further straining cash flows. The LGFVs have insufficient finance to continue, resulting in slower completion or incomplete projects. Contingent liabilities are not honored, such as the build-transfer commitments, whereby local governments request LGFVs to

construct infrastructure that they promise to purchase in the future. Ultimately, the LGFVs and the local government must be bailed out or face insolvency.

There are political complications. Local gov-ernment debt-financed investments helped main-tain China’s growth after the onset of the GFC. This was crucial in assisting the central government to save face and maintain social stability. Deep-seated links, systems of patronage, and factional competi-tion within the Chinese Communist Party make it difficult for Beijing to take drastic steps to abruptly reverse policy.

An ancient Chinese proverb – shan gāo, huángdì yuǎn – states: “The mountains are high and the emperor is far away.” The saying implies that Beijing’s control over its regions is historically weak, with local autonomy and little loyalty, mean-ing that central authorities have limited influence over local affairs.

Lengthening shadows…shadow banking, a term used by US investment manager, PIMCO’s Paul McCulley, in 2007, refers to a diverse set of institutions and structures used to perform banking functions outside regulated depository institutions. In the period leading up to the GFC, the shadow banking sector in devel-oped markets expanded rapidly, growing to rival the regulated banking system. A complex array of investment funds, hedge funds, asset and loan securitizations, and structured investment vehi-cles rapidly expanded the supply of credit, contrib-uting to the financial problems,

In recent years, China has evolved its own substantial, multi-layered shadow banking system,

subject to various degrees of regulatory oversight.There is the informal sector that encom-

passes direct lending between individuals and underground lending, often by illegal loan sharks (referred to as curbside capitalists and back-alley bankers), that provides high-interest loans to small businesses.

The larger sector consists of a range of non-banking institutions. It involves direct loans of surplus funds by companies to other borrow-ers or trade credit (often for extended terms). It involves finance companies, leasing companies, or financial guarantors. There are also more than 3,000 private equity funds, some funded in part by foreign investors. In personal finance, it encompasses micro-credit providers, consumer credit institutions, and pawnshops. The largest portion of the non-banking institution sector is trust companies and wealth management products (WMPs). There are also capital markets allowing

The saying implies that Beijing’s control over its regions is historically weak, with local autonomy and little loyalty, meaning that central authorities have limited influ-ence over local affairs

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insurance companies and institutional investors to purchase debt and equity securities.

A central feature of China’s shadow banking sector is its relationship with its regulated coun-terpart. Banks may arrange and act as an agent in a loan from one non-financial company to another (known as entrusted loans). Banks can sell assets to trust companies or create WMPs to channel client funds to them. Banks use undiscounted bankers’ acceptances to transfer assets to the shadow banking sector, against a partial or full payment guarantee from the issuer.

Corporate bonds may be bought by trusts, which are then repackaged into WMP products for bank depositors.

Need shade…The growth of the shadow banking sector is driven by the structure and regulation of China’s financial system.

The credit markets are dominated by the four major banks (Bank of China, China Construction Bank, Industrial and Commercial Bank of China, and Agricultural Bank of China). Partially govern-ment owned and tightly controlled, these banks frequently act less like commercial entities and more as an instrument of state policy.

They focus on lending to SOEs, firms associat-ed with the government, and officially sanctioned projects. This reflects both official pressure and control of borrowing rates, which favor less risky and secured loans.

Other businesses have more limited access

to bank credit. Underdeveloped bond markets and the complex process for gaining approval for issuing equity mean that these firms have limited access to capital. The shadow banking sector fills this market gap.

Government regulation of deposit interest rates also facilitated the growth of the shadow banking systems. For much of recent history, bank deposit rates have been below inflation rates. Negative returns and the loss of purchasing power have led savers to seek higher available rates in the shadow banking systems.

Other regulations also drive the shadow banking system. Borrowers must be up to date on existing borrowings to be eligible for new loans. Insufficient cash flow to repay short-term loans at year-end requires borrowers to seek expensive bridge finance from shadow banks until they are eligible for new facilities.

In recent years, the central government has sought to rein in runaway credit expansion, by reducing loan quotas, limiting lending to specific sectors, such as local governments and property companies, or restricting riskier transactions. This has perversely encouraged the growth of the shad-ow banking sector.

In effect, the structural weaknesses of the financial system have driven the growth of China’s shadow banks. This exemplifies a popular Chinese saying – shang you zhengce, xia you duice – mean-ing: “Policies come from above, countermeasures from below.”

Trust WMPs…Trust companies are the most important compo-nent of the Chinese shadow banking sector. They finance riskier borrowers and transactions that banks cannot or will not undertake, in part due to regulations.

Trust assets are estimated at more than $1.8 trillion (20 percent of GDP). While only a small part of total credit in China, trust assets have been growing at an annual rate of over 50 percent in recent years and constitute 10–20 percent of new TSF.

Trust companies raise money from investors, usually high net-worth individuals or corporations that can meet required minimum wealth standards (several million RMB in assets) and the minimum investment size (typically, 1 million RMB (about $160,000)).

Trust companies primarily finance local gov-ernment infrastructure projects (via LGFVs), real estate, and industrial and commercial enterprises. Following the central bank’s decision to restrict banks’ financing of local governments and prop-erty projects, trust companies have become major providers of finance to these sectors.

Trust company loans generally specify the use of funds vaguely – for example, working capital or (the tautological) liquid funding purposes. In reality, a significant volume is used for refinancing existing bank debt.

The major attraction for investors is the high returns – around 9–12 percent per annum com-pared to bank deposits rates in low single digits. After adjusting for the trust company’s fee of 1–2 percent of loan value, the ultimate borrower must pay around 10–15 percent per annum for the funds, well above the 7–8 percent charged by banks.

The high interest rates mean that the borrow-ers are riskier. Problems with assets supporting trust loans are well documented, most notably the “Purple Palace,” a half-built and abandoned luxury development in Ordos.

WMPs are higher-yielding deposit or invest-ment products, with a variety of seductive moni-kers – Easy Heaven Investments, Quick Profits, and Treasure Beautiful Gold Credit. WMP assets are estimated around the same level as trust assets and are also growing rapidly.

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in effect, the structural weaknesses of the financial system have driven the growth of China’s shadow banks. This exempli-fies a popular Chinese saying – shang you zhengce, xia you duice – meaning: “Policies come from above, countermeasures from below.”

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WMPs are sold through banks or securities brokers to a broader investor base than trust com-pany investments. The minimum investment is 50,000 RMB (around $8,000). Investments are typically short, around six months. WMPs offer investors a return of around 2 percent above bank deposits. They can be sold with or without a guar-antee of the payment of interest or principal from the sponsor.

WMPs invest in a variety of assets, ranging from low-risk inter-bank loans, deposits, and dis-counted bills to higher-risk trust loans, corporate securities, and securitized debt.

Banks have complex relationships with trust companies and security brokers in relation to WMPs. Trusts and security brokers can package WMPs that are then distributed through bank dis-tribution channels. Banks can also work with these firms to shift assets off their balance sheets; these are then repackaged assets which are sold back to the bank’s depositors as WMPs.

Dark side…The Chinese shadow banking system poses increasing risk.

First, while the exact size is disputed, the Chinese shadow banking system is large, estimated at around 70–100 percent of GDP ($6–9 trillion) and growing rapidly.

With Chinese banks’ share of new lending hav-ing fallen to around 50 percent, from 90 percent a decade ago, the economy has become increasingly reliant on shadow banks as an important source of finance. This is especially true for local govern-ments and property companies that make up more than 80 percent of the borrowings from the sector. It is also an important source of finance for small and medium-sized enterprises, which contributes around 60 percent of GDP and around 75 percent of new jobs.

Second, the credit quality of borrowers from shadow banks is uneven. Credit quality has dete-riorated over time as the emphasis on regional development and urbanization has resulted in the entry of third- and fourth-tier local governments into the market. But, in fairness, the majority of WMPs are invested in interbank deposits, money markets, and bond markets.

Third, the collateral securing loans is variable.

A high proportion of trust loans and some WMP investments are secured by real estate. This expos-es investors to losses if property values fall sharply. The Golden Elephant No 38 WMP, which offered investors 7.2 percent per annum, was found to be secured by a deserted housing estate in a rice field in Jiangxi province.

Other forms of collateral, such as industrial machinery and commodities, have become more common. Industrial firms have been observed purchasing equipment, surplus to requirement, on favorable deferred payment terms from manufac-turers, for use as collateral for additional borrow-ings.

Commodities, such as copper and steel, which are key inputs in construction, have been used as security for debt. This has led to large stockpiles of copper and steel, surplus to immediate require-ments.

In a few cases, the collateral has been more exotic (tea, spirits, graveyards, etc.). In some cases, lenders seeking to foreclose loans have discovered that the underlying collateral has been pledged more than once or does not actually exist.

Fourth, the products entail significant asset-li-ability mismatches, with short-dated investor funds being used to finance long-term assets, which are sometimes non-income producing (e.g., undeveloped land). This reflects investor preferences for liquidity, but also the practice of regulatory arbitrage. Banks use WMPs not only to circumvent deposit rate restrictions, but also for managing their balance sheets. Many WMPs mature prior to the end of each quarter, with inves-tors re-depositing the funds paid back with the sponsor banks to ensure that the required loan-de-posit ratio of 75 percent is satisfied.

The asset-liability mismatch necessitates regu-lar refinancing. For example, in 2014, around $660 billion of trust products will mature. The constant repayment or refinance requirement exposes the vehicles and the financial system to the risk of a liquidity crisis.

Fifth, the credit quality of sponsors, such as the trust companies and the financial guarantors, is variable, with many lacking adequate capital. Trust companies have average leverage of over 20 times, which is high, given the nature of the investments.

Sixth, the structures are opaque. Many prod-

ucts do not detail the exact use of investor funds. For example, it is not unusual to merely disclose that the trust or WMP will invest up to 70 percent of the funds in debt with at least 30 percent in bonds and money market instruments. The docu-mentation is vague. Levels of due diligence by the sponsor or investment managers, enforceability of security interests, and investor rights are unclear. As the system operates with only limited regula-tions, controls and oversight are weak.

Seventh, inter-connections between the shad-ow banking system and the traditional banking system create additional risk.

Banks frequently use the shadow banking sys-tem to shift loan assets off their balance sheets and ‘window dress’ financial statements for regulators and investors. Banks also use trust companies and WMPs to arrange high-interest loans to compa-nies, such as property developers, that they are unable to lend to due to risk of regulatory reasons.

Banks work closely with trust companies and security brokers to create investment products for depositors seeking higher returns, effectively acting as a conduit between savers and borrow-ers. Bank issuance of WMPs has increased from around $100 billion to $2.5–3 trillion. Banks increasingly rely on these products to maintain market share and earnings, via fees and commis-sions received from distributing shadow banking products.

The linkages can be complex. Banks sell accep-tance bills or risky loans to a trust which is then repackaged as a WMP to be sold to bank clients. There are transactions between different shadow banking entities. A financial guarantee can be used by a firm or individual to borrow from a bank, with the proceeds invested in a trust or WMP. Banks, trusts, and WMPS sometimes pool deposits as well as assets or securities from different schemes. New products are created to raise funds to meet repay-ments of maturing products.

Eighth, the complexity of the arrangements has outstripped the capabilities of regulators, the infrastructure, and the expertise of many partici-pants. Critics have drawn analogies with the rapid growth in the shadow banking networks in devel-oped markets, which contributed to the problems of the GFC.

There are differences, such as the absence of

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compounded leverage and the simpler instru-ments used. But many features, such as the orig-inate-to-distribute business model, overvalued collateral, asset liability mismatches, interconnect-ed networks of risks, and linkages back into the banking system, are similar.

Ninth, there are significant issues of moral hazard.

In principle, the risk of these structures and investments rest with the investors. WMPs state that returns are expected rather than guaranteed or promised returns. WMP investors are typically required to confirm that they will bear the finan-cial shortfall if assets funded by the pool default. In part, these provisions are included to ensure that WMP sponsors are able to keep the liabilities raised from investors and the assets purchased off the balance sheet. But the ultimate responsibility for defaults is more complicated.

Investors in trusts may believe that they are

protected from loss because the trust companies risk losing their operating license if their products suffer losses. In recent years, trust companies have sometimes concealed losses by using their own capital, arranging for SOEs to take over impaired loans, or using proceeds from new trusts to repay maturing investments.

The relationship between banks and shad-ow banking operators adds to the complexity. Investors may assume that banks will guarantee repayment and returns on shadow banking invest-ment. This impression is reinforced by the transfer of bank assets to trust companies and WMPs and the distribution of shadow bank products by banks.

These problems are compounded by the lack

of sophistication of some buyers and willful igno-rance of others. Banks also bear reputational risk. Regulators would be concerned about systemic risks.

Failure of a riskier trust or WMP may lead to inability to issue fresh products or withdrawal of funds, requiring sponsoring banks to support these vehicles, as happened in 2007/2008 in developed markets. The resulting losses and cash outflows could trigger wider problems within the financial system, which would affect solvent busi-nesses and growth. Smaller private banks would be potentially exposed to liquidity problems in such a case.

Policy makers would also be concerned about customer anger. In recent years, there have been a number of scandals where investors who had invested in products believing that they were guaranteed by the selling banks laid siege to the sponsoring bank. The political risk may result in

governments forcing banks to support the struc-tures to avoid any threat to social stability.

Putting worms back in cans…Chinese authorities are not unaware of the issues. In recent years, policy makers have taken steps to slow the rapid growth in debt and the expansion of the shadow banking system.

Policy makers have used quantitative mea-sures to reduce credit creation, increasing reserve requirements to reduce bank lending. Qualitative measures, primarily loan quotas and specific restrictions on certain types of loans, have also been used to control borrowing growth.

In early 2014, the central government announced plans for measures designed to rein

in shadow banks. Banks are to be subject to more rigorous enforcement of existing rules and bans on moving certain loans and assets off the balance sheet. Banks would be required to set up separately capital-ized and provisioned units for wealth management businesses. Cooperation between banks and trust companies or security brokers would be restricted.

Trust companies would be prohibited from pooling deposits from more than one product or investing in non-tradable assets. Private equity firms would not be allowed to lend to clients.

The central government also announced plans for three to five new private banks to increase the capacity of the banking system, outside the domi-nant state-owned lenders.

In mid-2013 and again in early 2014, author-ities also intervened in money markets, draining liquidity and increasing interest rates to restrict excessive credit growth and to improve bank risk management practices. The actions resulted in a sharp rise in interest rates (in June 2013, they reached more than 13 percent) and increased volatility. They also revealed weaknesses in the structure of the financial system, particularly the instability of the shadow banking system.

The large Chinese state banks control the major proportion of customer deposits. Other banks tend to have smaller deposit bases. They rely on wholesale funding, particularly from the interbank market, to finance their balance sheet. Liquidity in the interbank market depends on the larger banks which are net lenders in this segment and WMPs which invest in money market instru-ments, many of which are sponsored by smaller banks.

Reduced liquidity and higher rates can quickly set off a chain reaction. Tighter conditions in the interbank market place pressure on smaller banks. They also trigger redemption of WMPs, which further reduces the availability of funding in the interbank markets, setting off a cycle of increasing rates. Unlike large banks, smaller banks hold lower amounts of government bonds, limiting their abili-ty to raise funds using the securities as collateral in repos. Smaller banks may be forced into distressed selling of illiquid assets, causing prices to fall.

The deteriorating financial position of small-er banks would force up their cost of borrowing. Some banks can lose access to funding, due to con-

after both episodes of intervention by the central banks, authorities stepped in and supplied significant amounts of liquidity to alleviate concerns about a slowdown in growth and financial problems

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cerns about their solvency. The actions of authorities can affect solvent

and viable businesses in an undesirable way. In June 2013, the interest rate for AAA-rated corpo-rate bonds rose rapidly by 2 percent per annum. Like the experience of money markets in devel-oped countries during 2007/ 2008, scarcity of funds combined with payment or solvency issues in small banks or the shadow banking system can quickly trigger broader economic problems.

Despite the increasing urgency of interven-tion, the actions have had limited success, with the central bank’s broad measure of TSF only showing some slowing in its growth rate.

A central problem is the reliance on debt- funded growth and the need to expand credit to maintain high levels of economic activity. In addition, the increase in the size and complexity of the shadow banking sector reflects structural problems. The need is for major and widely based economic, financial, and structural reform, which is politically unpalatable.

As a consequence, attempts to slow credit growth, regulate the shadow banks, and reduce speculation are inconclusive. After both episodes of intervention by the central banks, authorities stepped in and supplied significant amounts of liquidity to alleviate concerns about a slowdown in growth and financial problems.

Responding to the regulations covering shad-ow banking in January 2014, Anne Stevenson-Yang at J-Capital wrote: “The hilarious new Document 107 on shadow banking betrays how toothless the government is in the face of the mounting debt, because the only solution presented is more debt.”

Quick and slow deaths…Understandably, the major focus now is on the denouement of the crisis.

Pessimists are concerned about a catastrophic crash. Optimists are more sanguine, expecting a soft landing, with gradual reforms correcting the systemic issues.

The crash scenario is predicated on continu-ing increases in debt levels and overinvestment. Policy adjustments are fatally delayed. Ultimately, authorities are forced to tighten credit aggressive-ly, triggering failures in the financial system and a sharp slowdown in growth.

Weaknesses in financial structure exacerbate the money-market tightening, causing liquidi-ty-driven problems both for vulnerable smaller banks and the shadow banking entities. The rapid decline in credit availability results in problems for leveraged borrowers, such local governments and property companies. The larger banks which are likely to benefit from the flight to quality are unable or unwilling to expand credit to cover the shrinkage from smaller banks and the shadowing banking sector, due to risk aversion or regulatory pressures.

The deceleration in credit growth and liquid-ity results in lower levels of economic activity. Combined with cost pressures and weak external conditions, Chinese businesses, which are major suppliers of cash to the economy, experience a decline in cash flows, which compounds the liquidity problems.

Foreign capital inflows, which have enabled the People’s Bank of China (“PBOC”), the central bank, to provide liquidity to the financial system, slow and then reverse. At the same time, capi-tal outflows, especially from corporations and also the politically well-connected and wealthy, increase and accelerate, driving further contrac-tion in credit.

The confluence of a liquidity crisis, financial system problems, slowing growth, and capital out-flows would feed negative feedback loops which would be difficult to deal with.

The optimists counter that the debt levels, while high, are manageable because of high growth rates, the domestic nature of the debt, high savings rates, and the substantially closed econo-my. They argue that the banking system has low leverage, a large domestic funding base, and low levels of non-performing loans. They also rely on the high level of foreign exchange reserves and modest levels, at least by developed-country stan-dards, of central government debt.

The optimists believe that reform programs, albeit slow in implementation, will ensure a smooth transition. China will rebalance its economy from investment to consumption. Deregulation and structural changes will improve the resilience of the financial system.

The strength of the banking system is probably overstated, primarily because of the understate-

ment of bad loans and the relationship with shad-ow banks. Real levels of a non-performing loan may be as high as 5–10 percent of assets, about five to ten times the reported levels. The risk of a significant portion of assets held in the shadow banking system may ultimately come back into the banking system.

China’s foreign exchange reserves (invested in high-quality securities denominated in dollars, euros, and yen) may prove difficult to realize without triggering losses or currency issues. More fundamentally, the reserves are not true savings, being matched by RMB created by the PBOC and paid to domestic entities in exchange for foreign currencies.

In effect, the flexibility of Chinese authorities to deal with any problems may be more con-strained than assumed. But the risk of a major col-lapse, while always present, is, at this stage, low. A familiar endgame, entailing bank failures, deposi-tor runs, massive outflows of foreign investors, or a sovereign default, is unlikely. The central gov-ernment is seeking to steer a middle path, which is difficult and also has significant risks.

Middle Kingdom, middle path…The strategy will entail continued credit expan-sion, providing liquidity, managing non-perform-ing assets, and using transfers from households to the financial and corporate sector.

First, the central bank will continue to provide abundant liquidity to the financial system through a variety of mechanisms.

Lenders have been instructed to roll-over loans to local governments which cannot be repaid out of current cash flow. Maturities are being extended for up to four years, to alleviate refinancing pressures on the around $1.5–2 tril-lion of debts that mature over the next three years. Chinese authorities subscribe to the theory that “a rolling loan gathers no loss.”

A variety of alternative funding structures are now being used to circumvent regulations. Authorities have altered regulations to allow local governments to issue public bonds, for the first time in 20 years.

Synthetic loans are common. Private equity funds subscribe equity which the sponsor con-tracts to repurchase at a future date, at an agreed

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price. Insurance and security companies are partnering with banks to invest in real-estate proj-ects, which are then re-sold to banks at an agreed future date, at an agreed price which guarantees the investor a fixed return. Securitization of future cash flows is used to raise debt.

With banks unable to increase their exposure to local governments, LGFVs have established subsidiaries, designated as small and medium enterprises with preferential access to finance, to raise funds which are then on-lent to the parent. Property companies use related industrial com-panies to apply for loans which are on-lent to the real-estate venture.

Provinces and local governments have estab-lished development funds, which are permitted to borrow from banks and then on-lend to the rele-vant sponsor, ostensibly to support industry. For example, the fund can finance the construction of a new factory, which will inevitably include the

cost of clearing the land on which the old factory stood and building the infrastructure needed for a property project.

Second, defaults will be managed. The failure of a bond issuer (Chaori 11) has been incorrectly interpreted as a shift in policy where the authori-ties will allow default. The reality is more complex.

Where considered appropriate, banks and state entities will intervene to minimize investor losses, by taking over the loans or reintegrating assets into regulated banks.

In a recent case, investors in the $500 million

Credit Equals Gold No.1, managed by China Credit Trust, one of the country’s biggest trust compa-nies, faced losses. The trust’s principal asset was a loan to an unlisted mining company, Zhenfu Energy, which could not meet repayments. Investments in the vehicle had been distributed by ICBC, China’s largest bank, to around 700 wealthy individuals expecting a return of around 10 per-cent per annum.

With default threatening, ICBC made it clear that it had not guaranteed or assumed liability for returns or repayment of the investment. After a period of uncertainty, an unnamed third party agreed to purchase an equity stake in the under-lying venture, which then was granted a valuable mining license. With the borrower’s ability to repay restored, investors in Credit Equals Gold No.1 suffered only modest losses.

The case is not isolated. A number of trust company and WMP investments have missed

payments, with many having been rescued, some-times under mysterious circumstances.

Authorities have chosen to intervene to avoid a loss of confidence in these vehicles, the result-ing withdrawal on investments, forced selling of assets, and crippling the sector which has become an important source of credit within China. One analyst told a reporter: “Moral hazard in China is state policy.”

Third, as in previous Chinese episodes of bad lending, the State will have to recapitalize banks and non-performing loans (NPLs) will be sold to

asset management companies (AMCs) to avoid a financial crisis.

Following the 1983 li gai shui reforms and 1984 bo gai dai reforms, the big State-owned banks increased lending substantially to provincial gov-ernments and SOEs to fund politically motivated, sometimes uneconomic projects. This resulted in a sharp increase in bad debts around 1993, requir-ing the government to recapitalize the banks. Subsequently, the process repeated itself with new bad debts requiring further recapitalization in 1998 and 2004.

In the late 1990s, the banks incurred NPLs exceeding 30 percent of assets, primarily from the collapse of a property and equity boom. The problem was resolved by a combination of recap-italization by the government, restructuring of loans, debt write-offs, and transferring bad loans to AMCs. The actions were taken to allow the Chinese banks to list on the Hong Kong Stock Exchange, in order to raise new capital.

As part of this process, in 1999, the central government established four big AMCs (one for each of the major policy banks) to purchase $170 billion of bad loans generally at face value. The AMCs issued government-guaranteed ten-year bonds back to the bank to finance the purchase.

With recoveries insufficient to repay the bonds when they matured in 2009, the AMCs replaced the original funding with new ten-year bonds. Since 2012, the AMCs have repaid around 45 per-cent of these bonds. The source of funding is not clear but appears to be from the government. It appears that this was done to provide liquidity to the banks forced to hold the original AMC bonds. It was also designed to allow the AMCs to raise new capital. At least one AMC has undertaken a successful IPO in Hong Kong, with other such equity raisings likely.

These actions may be part of a strategy to allow the government to use the AMCs to deal with the expected rise in NPLs from the current round of credit expansion. There is currently some evi-dence for this, with the AMCs purchasing certain assets from banks.

In effect, instead of resolving the debt prob-lems, the Chinese government will oversee a pro-cess of supporting over-indebted borrowers and the banking system. As in a shell game, bad debts

These actions may be part of a strategy to allow the government to use the aMCs to deal with the expected rise in NPLs from the current round of credit expansion. There is currently some evidence for this, with the aMCs purchasing certain assets from banks

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will be shuffled from entity to entity, delaying the recognition of losses.

The actions will reduce the immediate financial pressure, but merely defer the debt problem. The primary objective of the strategy is to maintain high growth for as long as possible and also pre-serve social order. It reflects the fact that a financial and economic crisis in China is synonymous with a loss of confidence in the state itself and in the Chinese Communist Party.

The price to pay…The ultimate price of this strategy will be to lock the Chinese economy into a lower growth path, with the risk of a destabilizing crash.

Over time, increasing amounts of capital and resources will become locked into unproductive investments which do not generate sufficient returns to service the debt incurred to finance them.

The need for economic growth will continue to drive increases in debt-fueled investments with inadequate returns. When the debt incurred can-not be serviced or paid back, more capital will be tied up in warehousing the losses to avoid a bank-ing crisis.

If returns on investment are insufficient, then there must be a transfer from one part of the econ-omy to another to cover the shortfall. This cost will be borne by households, with slower improvement in living standards and erosion of the value of their savings.

Authorities will have to keep saving rates high to provide the capital needed to pursue this strategy. They will ensure that the bulk of funds remain in the form of low-yielding deposits with policy banks, which can be directed by the central government as required. Interest rates will remain low, below inflation. Banks will need to maintain a large spread between borrowing and lending rates to ensure sufficient profitability to absorb the cost of non-performing loans. Borrowing rates and the cost of capital will also need to be kept low to sup-port the investment strategy and also reduce pres-sure on unprofitable or insolvent businesses.

The loss of purchasing of household savings will provide the economic basis for the transfer of resources, amounting to as much as 5 percent of GDP, to banks and to borrowers, primarily SOEs and exporters.

The necessity of high saving rates will impede the rebalancing from investment to consumption. It will also impede the development and deepening of the financial system. China will also have fewer resources available to improve health, education, aged care, and the environment.

In the short run, continued malinvestment and deferring bad debt write-offs will provide the illusion of robust economic activity. Over time, households will discover that the purchasing power of their savings has fallen. Wealth levels will be reduced by the decline in the prices of overval-ued assets. Businesses and borrowers will find that their earnings and the value of their overpriced collateral are below the levels required to meet out-standing liabilities.

The alternative is equally problematic. If the government moved to liquidate uneconomic busi-nesses and unrecoverable debt, then it would need to finance the recapitalization of businesses and banks. This cost would require a sharp increase in taxation, which would also result in a slowdown in economic activity.

In reality, China’s Potemkin economy of zom-bie businesses and banks will create progressively less real economic activity.

Historical convergence…There is increasing concern that China risks turn-ing Japanese. There are points of correspondence and divergence between the positions of Japan in the early 1990s and China today.

In both cases, investment levels were high, in similar areas such as property and infrastructure. Chinese fixed investment, at around half of GDP, is higher than Japan’s peak by around 10 percent and well above that for most developed countries, of 20 percent.

Like Japan before it, China’s banking system is vulnerable. Rather than budget deficits, China has directed bank lending to targeted projects to main-tain high levels of growth.

The reliance on overvalued assets as collateral and infrastructure projects with insufficient cash flows to service the debt means that many loans will not be repaid. These bad loans may trigger a banking crisis or absorb a big portion of China’s large pool of savings and income, reducing the economy’s growth potential.

One difference is that, whereas Japanese bad debts affected private banks and businesses, the State effectively underwrites Chinese banks and many debtors. In addition, China is a less-devel-oped economy and has greater growth potential.

But at the onset of its crisis, Japan was much richer than China, providing an advantage in dealing with the slowdown. Japan also possessed a good education system, strong innovation, tech-nology, and a stoic work ethic that helped adjust-ment. Japan’s manufacturing skills and intellectual property in electronics and heavy industry made it less reliant on cheap labor, allowed the nation to defer but not entirely avoid the problems.

By contrast, China relies on cheap labor to assemble or manufacture products for export, using imported materials. Labor shortages and rising wages are reducing competitiveness. China’s attempts at innovation and hi-tech manufacture are still nascent.

China’s credit-driven investment model may have reached its limits. Continuing existing poli-cies increases domestic imbalances, misallocation of capital, unproductive investments, and loan losses at government-owned banks.

Currently, policy makers and investors are in the position described by George Eliot in Middlemarch: “We are all humiliated by the sudden discovery of a fact which has existed very comfortably and perhaps been staring at us in private while we have been mak-ing up our world entirely without it.”

Chinese achievements over the last 30 years are considerable. But until 1990, Japan too was successful, growing strongly with only brief inter-ruptions. Since the bubble economy burst, Japan has had almost two decades of uninterrupted stag-nation. Today, with or without change, China faces a prolonged and difficult period of adjustment.

© 2014 Satyajit Das All rights reserved

about the authorSatyajit Das is a former banker and author of Extreme Money and Traders Guns & Money.

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