Global Meltdown Predicted by Charlene Chu

Following on the heels of a report that appeared in the Telegraph on the topic, William Pesek at Bloomberg has recently also written an article about Charlene Chu (formerly with Fitch, nowadays with private firm Autonomous Research) and her opinions on China's shadow banking system and the dangers it represents. The article is ominously entitled “China, the Death Star of Emerging Markets”. 

China has recently made unwelcome headlines, as one of the shadow banking system's countless 'wealth management trusts' which was evidently invested in a bankrupt venture (in this case in a coal company – reportedly a great many such investments in insolvent coal mines exist) was about to go belly-up and then was bailed out at the last minute. Here is a recent article by Mish on the trust that was ironically named “Credit Equals Gold Number 1”. At first it was reported that the trust wouldn't be bailed out, but in the end its 700 investors were able to 'breathe a sigh of relief' as Tom Holland remarked in the South China Morning Post (SCMP). However, Holland also cautioned  that by bailing out this trust, China has laid the foundations for a much bigger crisis down the road, as moral hazard has increased considerably as a result.

 


 

shadow banking chinaThe size of shadow-bank lending relative to China's GDP, via the SCMP

 


 

 

 

 

Interestingly, Holland actually disagrees on a major point with Charlene Chu and Pesek. Let us first look at what Pesek writes:

 

“On any list of banking accidents waiting to happen, China is assured a place at the very top. But could a crash there take the entire global economy down with it? Absolutely, says Charlene Chu, who until recently was Fitch's headline-generating analyst in Beijing. Chu has fearlessly trod into an area that China is trying desperately to keep off limits: its vast shadow-banking system. Now that she's working for a private firm that doesn't have to rely to governments for revenue, as do rating companies, Chu is free to speak completely openly. And is she ever.

"The banking sector has extended $14 trillion to $15 trillion in the span of five years," Chu, who is now with Autonomous Research, told the Telegraph. "There’s no way that we are not going to have massive problems in China." What's more, she added, China "could trigger global meltdown."

The travails of Greece continue to preoccupy the world, but its $249 billion economy is a rounding error compared to China's $8.2 trillion one. In December 2005, for example, China announced its output had unexpectedly grown by $285 billion. In other words, it had suddenly found an economy bigger than Singapore's that its statisticians hadn't known about. Today, simply put, a Chinese crash would make the 2008 collapse of Lehman Brothers seem like a mere market correction.

The kind of meltdown Chu suggests is possible would end Japan's revival, slam economies from South Korea to Vietnam, savage stock and commodity prices everywhere, force the Federal Reserve to end its tapering process and prompt emergency national-security briefings in Washington. So feel free to obsess over Turkey and Argentina, but the real "wild card" is the world's second-biggest economy.”

 

(emphasis added)

As noted above, that certainly sounds quite ominous.

 

Opinions Differ …

Not so fast, says Tom Holland. While agreeing that China will eventually face a credit crisis and quite possibly a severe economic downturn, he points to the fact that the closed capital account and China's vast foreign reserves make a 'global contagion' event of such enormous magnitude unlikely. This particular scare story he avers, is not something to worry about, which he inter alia tries to buttress by comparing China's situation to Indonesia's prior to the Asian crisis. Below are a few relevant excerpts from his article:

 

“As a headline, it was certainly eye-catching. "Currency crisis at Chinese banks could trigger global meltdown," declared a story in the Sunday edition of London's Daily Telegraph. The article noted nervously that foreign currency borrowing by Chinese companies has almost quadrupled in just four years to more than US$1 trillion. Any substantial appreciation of the US dollar – and many analysts are indeed expecting gains this year – could open up a dangerous cross-currency mismatch, forcing Chinese borrowers to default and inflicting shattering losses on international lenders, the story warned.

[…]

The chance that China will suffer a currency crisis at any time in the foreseeable future is precisely zero. And even if the country were struck by crisis, there would be no danger of a global financial meltdown. It is certainly true that China's foreign liabilities have grown rapidly in recent years; a quadrupling since 2009 is about right. But, if anything, the Telegraph's figure of US$1 trillion is rather too modest. According to Beijing's State Administration of Foreign Exchange, at the end of 2013 China had foreign liabilities of a thumping US$3.85 trillion; roughly 40 per cent of its gross domestic product.

But the lion's share of those liabilities – some US$2.32 trillion – consists of highly illiquid inward foreign direct investment. That money is staying where it is. On top of that, a further US$374 billion is foreign portfolio investment in China's stock and bond markets. That's money that has flowed in under Beijing's qualified foreign institutional investor program, whose rules impose strict limits on the size and frequency of repatriation payments. However, that still leaves around US$1.15 trillion in short-term foreign liabilities, consisting largely of loans from international banks.

[…]

In 2014, China has no such problems [compared to Indonesia prior to the Asian crisis, ed.] . External debt is small relative to GDP. And with US$3.82 trillion in foreign reserves at the end of last year, Beijing can cover China's near-term foreign liabilities more than three times over. Sure, the shrinkage of the central bank's balance sheet were it actually forced to sell assets in order to fund the country's external liabilities would inflict a painful monetary tightening on China's domestic economy.

But with Beijing sitting on such a large pot of foreign reserves, such an extreme crisis is hardly likely. And even if it did happen, there would be no "global meltdown". Despite the opening of recent years, Beijing's controls on the free flow of capital mean China's financial sector remains relatively closed, and the exposure of the global financial system to the country is low.

That's not to say there wouldn't be casualties from a sudden strengthening of the US dollar against the yuan, or from a marked slowdown in China's domestic economy. At the end of October last year Hong Kong's banking system was owed US$300 billion by mainland banks and another US$100 billion by mainland companies. Clearly the local pain would be intense. But a Chinese currency crisis triggering global meltdown? Happily not.”

 

(emphasis added)

Readers may recall that we have also recently mentioned the exposure of Hong Kong's banks to Mainland China. We believe Mr. Holland is correct in one sense, but we also think he underestimates the contagion potential.

 

Contagion Through Many Different Channels

It is true that China's closed capital account as well as the government's tight control over the financial system makes China's situation fundamentally different from that of countries with open capital accounts from whence foreign investors can at anytime flee in droves if they get cold feet over an overextended bubble.

In fact, we have  pointed out in the past that the great degree of central control over the economy (and especially the banking system) which China's government enjoys makes it inherently more difficult to time a putative demise of the credit bubble than elsewhere – and such things aren't easy to time to begin with. 

However, a sharp decline in the yuan's exchange rate may be seen as necessary by China's leadership if a crisis threatens social stability (and with it the party's rule) in China. China has already devalued a great deal on one occasion (in 1994), an event that in hindsight seems to have precipitated a chain reaction (first the yen followed the yuan lower, and then the currency pegs in various 'Asian Tiger' economies went overboard).

Today, China is a far bigger player in the world economy than in 1994, and we believe that Mr. Holland underestimates how today's economic and financial interconnectedness may produce contagion effects even in light of the closed capital account and China's large reserves. We also don't necessarily regard  the exposure of Hong Kong's banks as a de facto 'internal affair', as the territory is outside of the ambit of China's capital controls and the yuan. It is not only Hong Kong's banking system that one must worry about though. Consider what would happen if China were indeed forced to draw down its reserves to serve the $1.5 trillion in short term foreign liabilities, or a sizable chunk thereof. Given that this would inevitably result in a much tighter domestic monetary policy (provided the PBoC doesn't take inflationary measures independent of its forex reserves), all sorts of malinvestments in China would be revealed as unsustainable. A number of industries would be faced with a major bust, and it is a good bet that commodity imports would plunge.

However, once that happens, one must immediately begin to worry about Australia's banks, which have financed a giant housing bubble  on the back of the country's commodities boom and in turn rely greatly on short term foreign funding. So there would immediately be a crisis in both Hong Kong's and Australia's banking systems, and it does not take a great leap of the imagination to see how contagion could spread further from them. Naturally many other raw materials exporting countries would also be hit hard, we mainly picked Australia as an example because its banks are so reliant on short term foreign funding, so they would presumably be among the first in line.

Lastly, here is a recent chart of NPLs in China's official banking system (listed banks only, i.e. the biggest ones):

 


 

Statistic_id235732_non-performing-loan-npl-ratio-of-chinas-listed-banks-2012NPLs at China's biggest banks – this looks good! In fact, it looks too good – click to enlarge.

 


 

As can be seen, NPLs at the major banks have declined to a negligible percentage (compare this with crisis-stricken Spain's near 13% or so NPL ratio, which is understated to boot). However, there are plenty of credible rumors that China's banks are keeping loans that would normally be regarded as dubious alive by all sorts of tricks. Not only that, they are definitely backing a great many of the 'shadow banking' businesses, which have developed in China mainly in order to circumvent  restrictions on banking activities.

In view of everything that is known about credit growth in China, we would regard this extremely low NPL ratio as a contrary indicator even if it were credible.

 

Conclusion:

No-one knows for sure how big a problem China's economy will eventually face due to the massive credit and money supply growth that has occurred in recent years and no-one know when exactly it will happen either. There have been many dire predictions over the years, but so far none have come true. And yet, it is clear that there is a looming problem of considerable magnitude that won't simply go away painlessly. The greatest credit excesses have been built up after 2008, which suggests that there can be no comfort in the knowledge that 'nothing has happened yet'. Given China's importance to the global economy, it seems impossible for this not to have grave consequences for the rest of the world, in spite of China's peculiar attributes in terms of government control over the economy and the closed capital account.

 


 

ShanghaiShanghai's A-share index (which is heavily weighed toward banks) continues to wallow near its lows of the past several years – click to enlarge.

 


 

Addendum:

The BIS is currently 'warning regulators and governments' about excessive borrowing and shifts in borrowing patterns by emerging market-based companies.

Why, thanks boys for this timely intercession! What would we do without you?

 

 

Charts by: SCMP and Forbes / Pricewaterhouse-Coopers, BigCharts


 

 
 

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9 Responses to “How Dangerous Is China’s Credit Bubble for the World?”

  • jimmyjames:

    However, once that happens, one must immediately begin to worry about Australia’s banks, which have financed a giant housing bubble on the back of the country’s commodities boom and in turn rely greatly on short term foreign funding. So there would immediately be a crisis in both Hong Kong’s and Australia’s banking systems, and it does not take a great leap of the imagination to see how contagion could spread further from them

    **********

    As always- there is no such thing as an action without a reaction- especially in this case when all things economic are joined at the hip.. via FRB with a paper fiat as a base… and everyone hates gold… go figure

  • No6:

    I don’t need to know the details, all I need to know is that all the banks are insolvent and interconnected. So I keep my assets outside of the banking system minus daily expenses.

  • Crysangle:

    Along the lines of aka 77 previously asking you to outline what drives the FX market PT , what I find hard to fathom in simple English is the flow of reserves and their weight on the various markets . For example, when you talk of China drawing down 1.5 tr of reserves to offset liabilities , from what I understand those reserves would be mostly US sovereign debt and not necessarily available without a shift in the US market or US treasury policy ? LZ states just below that the yuan fluctuates on reserve levels , though I understood that the yuan was pegged at China’s will (as long as it held the reserves necessary to do that at least ) – are there two or more yuan trading floors ? We hear stories of London exchanges covering Chinese reserve movements and so forth – does anyone really know how the table is spread , who holds the most leverage in the show , and how much of what goes above board is tied directly to what goes on under the table ? I don’t expect there are clear answers to questions like these , but it would be useful to know how large foreign reserves are liquidated and exactly how much control over the value of the yuan the Chinese government is able to exert ( with and without foreign cooperation) .

    ?

    • It would definitely have repercussions if China’s reserve position were to change. I think the effect on treasuries may be less than most people think, mainly because they are a very liquid and deep market, and a drawdown in reserves would not happen all at once, but gradually over time. By the time it happens the Fed may already be back in full blast ‘QE’ mode as well.
      As to the yuan, the PBoC controls its level by means of market intervention within China. Since the yuan is not freely convertible, it exerts a great deal of control. However, the level of reserves is indeed an important factor in the game. Consider that whenever the PBoC buys dollars from exporters and issues yuan for them, the yuan money supply theoretically increases by this amount. In order to keep the money supply under control in spite of this, the PBoC adjusts the reserve requirements of banks, which puts a brake on the amount of money that can be pyramided atop these new yuan deposits. As a result, reserve requirements are an extremely important monetary policy tool in China, which is obviously quite different from the US and Europe (where required reserves are either laughably low – just 1% in the euro area – or for all intents and purposes are far lower than their official levels due to ‘sweeps’ – the method employed in the US. Of course sweeps have lost their relevance due to QE and the associated accumulation of excess bank reserves).
      Obviously though the foreign exchange reserves held by the PBoC so to speak provide ‘backing’ to the yuan in issue. If these reserves were to decline meaningfully, the calculus for the yuan would change. At first the extant yuan money supply would likely be supported by lowering reserve requirements, but there would no longer be any motive for keeping the yuan at its current level. It would likely see a significant devaluation in that case – still controlled by the PBoC, but we only need to look back to 1994 to see that it will act decisively if it thinks the exchange rate too high.

      • Crysangle:

        Thanks .

        I personally shun modern bank accounting practices in my perspectives , and I would not hope (nor wish) to properly understand them . In the case of China I find no reason that any shortfall in earnings or solvency could not be brushed over firstly at a local level in yuan , or that the government is able to cover eventual foreign withdrawals in dollars by dipping into its dollar reserves . The dollar reserves have depreciated along with the dollar , so although parity has been roughly enforced , in the global economy the Chinese have accepted a devaluation of income in their savings/earnings , or alternatively have allowed US monetary expansion to go unnoticed in trade price terms . All is relative . Should the Chinese choose to devalue the official rate against the dollar I don’t read trade or even domestic economics as the main driver , or only included as part of the political economics that exists domestically and with the US . I think the main problem for China will be managing its financial economy and keeping it coherent in appearance , that knocks directly onto the real economy there and elsewhere obviously . So to say that reducing foreign reserves will shrink the CB balance sheet and lead to tightening is not a given , in fact a chosen route of purposeful devaluation would be the opposite , they have the means to achieve this , and especially while running a surplus . I agree that the Chinese will not hesitate to maintain central control should it come to it , a very fine line to walk even with the modest amount of reform that has taken place so far .

        • Crysangle:

          … and when I say I shun modern bank accounting practices I do not mean the sort of explanations you replied with , I mean the basic framework of un-backed financial handling and the attributes that are later assigned to them … I find them deceptive to say the least .

  • I think they are missing the point. Pater brings up the unsustainable mal-investment. I believe I read the portion of the Chinese economy devoted to investment is around 60% of GDP. This means the rest is only 40%, which means if they had to stop all the bubble investment, the debt to GDP would be 2.5 times what it is now. $11 trillion in credit, even in an economy that large, has to create a boom/bust.

    Andy Xie wrote an article on Chinese housing in 2009. He calculated the Chinese needed 7.5 billion square meters of housing to solve the entire needs of the country for the long term future and at that time they had 2 billion under construction and 1.5 billion coming every year. Well, we are at 2014. This figure, roughly 15 billion square feet dwarfs the housing boom in the USA that likely peaked at less than 4 billion square feet. Do the Chinese continue this time forward to build what will amount to empty housing and squander their wealth, or do they stop? If they stop, what do they do with the resources that were building 4 times the peak boom of the US?

    This is the true extent of boom mal-investment. It isn’t just that the resources are wasted, but the employed resources have to stop being employed. What happens if 1/3 of the investment portion of the Chinese economy has to shut down? If my figures are correct, their GDP drops 20%, plus the associated demand attached to the 20%. I suspect this is what occurred in the US during the Great Depression, as foreign financing failed and with it went the demand for the products of the US into a downward spiral.

    Despite all this growth, the Chinese stock market has gone nowhere for 5 years. It rallied earlier than the other markets, but has since declined to a level roughly 1/3 the 2008 top. I suspect this is a sign China is in a deflation, indicated by the fact the inflation that has occurred, hasn’t moved the market.

    • SavvyGuy:

      I agree that China’s meteoric hyper-growth has been aided and abetted by astronomically-increasing levels of debt.

      Nobody can predict how long this can continue, though educated guesses on probabilities can be arrived at by using multiples of “pi” and Fib ratios. However, when (not if) this tottering pile of festering liabilities encounters its Minsky moment, it will make the 2008 GFC look like a warm-up!

  • LZ:

    Exactly right about the yuan. Most analysts who tell you the Chinese reserves are there ignore the fact that the yuan will plunge quite a lot if those reserves come down, and the yuan has sunk when reserves turned ever so slightly negative in the recent past. Some Chinese economists have even said the reserves could be gone within 3 to 5 years if the economy did not rebalance away from government led investment. I don’t think the Chinese would tighten much either, they would print more. Even today the yuan can weaken quite a lot if you consider how far credit growth has outstripped reserve growth.

    The shadow banking system also had quite a downturn in January, with raised capital dropping more than 60%.
    http://investinginchinesestocks.blogspot.com/2014/02/chinese-credit-contraction-fundraising.html

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