China: Threats of a crisis lurking in the shadows
Fears are starting to escalate that China’s heated financial sector is about to reach boiling point.
Commentators around the world have started to voice these concerns with greater urgency, and a narrative saying China could trigger a global systemic crisis is gaining credence in some quarters.
At a global macro outlook event last week, Ian Amstad, a senior economist with Prologue Capital, predicted that in the medium term, there would be “some kind of banking crisis” in China, and its chief investment officer David Lofthouse called it “the biggest concern among fund managers”.
The opaqueness that epitomizes Chinese shadow banking is a key cause of the problem and a reason its full extent is not understood.
Shadow banking is huge, and its link to ‘legitimate’ banks is often underestimated. At a Fitch Global Banking Conference earlier this month, senior director Charlene Chu pointed out that two-thirds of the Chinese financial system’s impressive $14 trillion growth since 2008 – equivalent to replicating the entire US commercial banking system – took place in the shadow system.
Debunking common myths surrounding shadow finance, she went on to say banks are not insulated from losses, but rather they are involved in three-quarters of shadow finance transactions – and this exposure is made more severe by the lack of loss absorption of the non-banks on the other end.
Adding to this is the fact banks’ exposure to risky sectors, such as the Chinese property bubble, is masked by shadow operations. Much of this banking activity is booked through manufacturing companies, explained Chu, which in turn have property subsidiaries, thus exposing banks even though it might not appear as such on the books.
However, while it’s hard to know exactly how much more risk there is under the surface in China, there is little doubt there is more than meets the eye.
Take the NPL ratio of around 1%, for example. Some cite it as a positive for the Chinese banking sector – though most acknowledge it is quite unlikely this is the actual figure. But Chu points out that, regardless, such a small number is meaningless when 36% of credit is outside of loan portfolios and bad assets can be unloaded at any time.
She later said Fitch uses an NPL ratio of 20% to 30% for the Chinese banking sector when conducting internal analysis.
The weakest link, as perceived by analysts, according to Chu, is trust products. And here signs of strain are visible, as several problem trust products – most recently Citic Trust – are either at high risk of default or have defaulted.
Wealth management products are arguably a close second, plagued by mismatches between assets and liabilities and a lack of liquidity.
However, despite all of these problems, which point to an increased likelihood of a crisis in China, Chu and Prologue Capital are less worried that such a crisis would induce global systemic risk.
Both were quick to point out that the People’s Bank of China (PBoC) is flush with reserves. Amstad stressed that the central bank’s reserve requirement – at about Rmb20 trillion or $3.2 trillion – would be used as a buffer in the event of a banking crisis.
He further added that China’s fiscal situation is “reasonably solid” and that given it is largely Chinese money backing the banks, the global impact would not be as severe.
The question that follows is whether or not the government and the PBoC can be relied upon to step in. The situation, with respect to the interbank loan rate in recent days, suggests they can be.
Just before the PBoC injected cash flows on Friday, Fitch wrote that “the Chinese authorities have the ability to address the liquidity pressures, but their hands-off response to date reflects in part a new strategy to rein in the growth of shadow finance by constraining the liquidity available to fund new credit extension”.
The rating agency is optimistic regarding this new approach, saying it expects it to be “more effective and swift in slowing shadow activity than previous efforts, which have focused predominantly on rules and regulation”, but it’s unlikely that a crisis can be averted this late in the game.
Nonetheless, though the initial delay served to make clear that authorities are working to address shadow banking through these new approaches, the fact they did ultimately intervene when the overnight repurchase rate rose 527 basis points to an all-time high suggests they are invested in ensuring the situation does not get out of hand.
So while a crisis of some sort looks to be on the cards for China, fears of a severe global impact appear premature.