CHINA’S CREDIT BUBBLE IS A MINSKY MOMENT

Beijing.  China’s shadow banking system is out of control and under mounting stress as borrowers struggle to roll over short-term debts, Fitch Ratings has warned.

The agency said the scale of credit was so extreme that the country would find it very hard to grow its way out of the excesses as in past episodes, implying tougher times ahead.

In an interview with Charlene Chu, Fitch’s senior director in Beijing, she explained to me:

"The credit-driven growth model is clearly falling apart. This could feed into a massive over-capacity problem, and potentially into a Japanese-style deflation. There is no transparency in the shadow banking system, and systemic risk is rising. We have no idea who the borrowers are, who the lenders are, and what the quality of assets is, and this undermines signaling."  

While the non-performing loan rate of the banks may look benign at just 1%, this has become irrelevant as trusts, wealth-management funds, offshore vehicles and other forms of irregular lending make up over half of all new credit.

"It means nothing if you can off-load any bad asset you want. A lot of the banking exposure to property is not booked as property," said Mrs. Chu.

Concerns are rising after a string of upsets in Qingdao, Ordos, Jilin and other peripheral regions, in so-called trust products, a $1.4 trillion segment of the shadow banking system.

On June 6, Bank Everbright defaulted on an interbank loan amid wild spikes in short-term SHIBOR (Shangai Interbank Offered Rate) borrowing rates, a sign that liquidity has suddenly dried up. "Typically stress starts in the periphery and moves to the core, and that is what we are already seeing with defaults in trust products," said Mrs. Chu.

Citigroup is now warning that surging SHIBOR rates will cascade through the banks and damage growth later this year, with knock-on effects for commodity prices and emerging markets worldwide.

Fitch warned that wealth products worth $2 trillion of lending are in reality a "hidden second balance sheet" for banks, allowing them to circumvent loan curbs and dodge efforts by regulators to halt the excesses.

This niche is the epicenter of risk. Half the loans must be rolled over every three months, and another 25% in less than six months. This has echoes of Northern Rock, Lehman Brothers and others that came to grief in the West on short-term liabilities when the wholesale capital markets froze.

Mrs. Chu said the banks had been forced to park over $3 trillion in reserves at the central bank, giving them a "massive savings account that can be drawn down" in a crisis, but this may not be enough to avert trouble given the sheer scale of the lending boom.

Overall credit has jumped from $9 trillion to $23 trillion since the Lehman crisis. "They have replicated the entire US commercial banking system in five years," she said.

The ratio of credit to GDP has jumped by 75 percentage points to 200% of GDP, compared to roughly 40 points in the US over five years leading up to the subprime bubble, or in Japan before the Nikkei bubble burst in 1990. "This is beyond anything we have ever seen before in a large economy. We don’t know how this will play out. The next six months will be crucial," she said.

The agency downgraded China’s long-term currency rating to AA- debt in April but still thinks the government can handle any banking crisis, however bad. "The Chinese state has a lot of firepower. It is very able and very willing to support the banking sector. The real question is what this means for growth, and therefore for social and political risk," said Mrs. Chu.

"There is no way they can grow out of their asset problems as they did in the past. We think this will be very different from the banking crisis in the late 1990s. With credit at 200% of GDP, the numerator is growing twice as fast as the denominator. You can’t grow out of that."

The authorities have been trying to manage a soft-landing, deploying loan curbs and a high reserve ratio requirement (RRR) for banks to halt property speculation. The home price to income ratio has reached 16 to 18 in many cities, shutting workers out of the market. Shadow banking has plugged the gap for much of the last two years.

However, a new problem has emerged as the economic efficiency of credit collapses. The extra GDP growth generated by each extra yuan of loans has dropped from 0.85 to 0.15 over the last four years, a sign of exhaustion.

Wei Yao from Societe Generale says the debt service ratio of Chinese companies has reached 30% of GDP – the typical threshold for financial crises — and many will not be able to pay interest or repay principal. She warned that the country could be on the verge of a "Minsky Moment", when the debt pyramid collapses under its own weight.

"The debt snowball is getting bigger and bigger, without contributing to real activity," said Ms.Yao.

The latest twist is sudden stress in the overnight lending markets. "We believe the series of policy tightening measures in the past three months have reached critical mass, such that deleveraging in the banking sector is happening. Liquidity tightening can be very damaging to a highly leveraged economy," said Zhiwei Zhang from Nomura.

"There is room to cut interest rates and the reserve ratio in the second half," wrote a front-page editorial in the official China Securities Journal on June 14. The article is the first sign that the authorities are preparing to change tack, shifting to a looser stance after a drizzle of bad data over recent weeks.

The journal said total credit in China’s financial system may be as high as 221% of GDP, jumping almost eightfold over the last decade, and warned that companies will have to fork out $1 trillion in interest payments alone this year. "Chinese corporate debt burdens are much higher than those of other economies. Much of the liquidity is being used to repay debt and not to finance output," it said.

It also flagged worries over an exodus of hot money once the US Federal Reserve starts tightening. "China will face large-scale capital outflows if there is an exit from quantitative easing and the dollar strengthens," it wrote.

The journal said foreign withdrawals from Chinese equity funds were the highest since early 2008 in the week up to June 5, and withdrawals from Hong Kong funds were the most in a decade.

Premier Li Keqiang has until now vowed to press ahead with loan curbs, insisting that the economy is strong enough to withstand the strain. There is now, however, a clear sign that the Communist Party is preparing a volte-face, discovering that it is harder to manage a calibrated soft-landing than originally assumed.

Ambrose Evans-Pritchard is the International Financial Editor of the London Telegraph.