To be sure, there’s every reason to devote nearly incessant media coverage to China’s bursting stock market bubble and currency devaluation.
The collapse of the margin fueled equity mania is truly a sight to behold and it’s made all the more entertaining (and tragic) by the fact that it represents the inevitable consequence of allowing millions of poorly educated Chinese to deploy massive amounts of leverage on the way to driving a world-beating rally that, at its height, saw day traders doing things like bidding a recently-public umbrella manufacturer up 2,700%.
The entertainment value has been heightened by what at this point has to be some kind of inside baseball competition among media outlets to capture the most hilarious picture of befuddled Chinese traders with their hands on their faces and/or heads with a board full of crashing stock prices visible in the background. Meanwhile, the world has recoiled in horror at China’s crackdown on the media and anyone accused of “maliciously” attempting to exacerbate the sell-off by engaging in what Beijing claims are all manner of “subversive” activities such as using the “wrong” words to describe the debacle and, well, selling stocks. Finally, China’s plunge protection has been widely criticized for, as we put it, “straying outside the bounds of manipulated market decorum.”
And then there’s the yuan devaluation that, as recent commentary out of the G20 makes abundantly clear, is another example of a situation where China will inexplicably be held to a higher standard than everyone else. That is, when China moves to support its export-driven economy it’s “competitive devaluation”, but when the ECB prints €1.1 trillion, it’s “stimulus.”
Given the global implications of what’s going on in China’s stock market and the fact that the devaluation is set to accelerate the great EM FX reserve unwind while simultaneously driving a stake through the heart of beleaguered emerging economies from LatAm to AsiaPac on the way to triggering a repeat of the Asian Financial Crisis complete with the implementation of pro-cyclical policy maneuvers from a raft of hamstrung central banks, it’s wholly understandable that everyone should focus on equities and FX. That said, understanding the scope of the risk posed by China’s many spinning plates means not forgetting about the other problems Beijing faces, not the least of which is a massive collection of debt that, thanks to the complexity of local government financing and the (related) fact that as much as 40% of credit risk is carried off balance sheet via an eye-watering array of maturity mismatched wealth management products, is nearly impossible to quantify or even to get a grip on.
Over the years, we’ve endeavored to detail China’s massive (and largely hidden) debt problem by drilling down into i) the local government debt saga (see here for the latest), ii) China’s management of NPLs (see here for instance), and iii) the lurking wealth management product problem (see here to read more than you ever cared to on this issue).
With all of the above in mind, we present the following from RBS’ Alberto Gallo who has made a valiant effort at summarizing contagion risk in China’s labyrinthine banking system.
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The investment-driven model and fiscal stimulus have helped China achieve fast growth, but also led to rapid debt built-up. Unlike the US and Europe, which have deleveraged since the crisis, debt overhangs have kept growing in China. In common with previous examples of rapid credit growth, China now also has to tackle the collateral effects like overcapacity in industrial sectors, deteriorating asset quality and loss of growth momentum.
Local governments have also become dangerously levered. Under the fiscal rules introduced in 1994, local governments in China in theory were not allowed to raise debt. Faced with revenue expenditure imbalances, they often had to circumvent the rules by creating separate entities (local government financing vehicles) to borrow, largely through shadow banking channels. An official audit released in 2014 showed that total local debt had reached RMB17.9tn ($3tn) by the middle of 2013, equivalent to 38% of GDP. This figure includes debt local governments are directly responsible for (RMB10.8tn) plus guarantees. The government has started to reform the system by allowing direct bond issuance by local governments since last year, introducing more transparency and reducing their borrowing costs. However, more radical fiscal reforms (for example, an overhaul of the payment transfer system or greater taxation power for local governments) are difficult given the complex layers of government. In China, there are five levels of governments, compared to three in most other countries. This makes it logistically difficult to closely match tax collection and spending, and sometimes can encourage regional protectionism.
Banks have been the major intermediary for lending over the past years, leaving them vulnerable to rising credit risks. As shown below, most of Chinese corporates’ credit needs are still met by bank loans rather than bonds. Loans from China’s top four banks have more than doubled over the past seven years to reach 26% of GDP by H1 2015 (Bank of China, China Construction Bank, Industrial and Commercial Bank of China and Agricultural Bank of China).
Cracks are starting to appear: NPLs still look low, but are rising rapidly. According to the banks’ H1 2015 results, NPL ratios are still low at around 1.4-1.8%. However, the nominal rises in NPL amount have been significant, leading to flat profit growth for all four banks. Moreover, it has been a common practice in China for banks to roll over loans to strategic corporates when directed by the government. Such loans, though doubtful, will not be recognised as NPLs.
The government’s ability to support banks has declined. Traditionally the Chinese government has always stepped in to help banks when needed. For example, it issued special bonds to recapitalise the big four in 1998. Given the rise in banks’ loan books, the government’s ability to shoulder losses has declined. For example, bank loans increased to 130% of China’s FX reserves by FY 2014, up from 80% in 2006.
In addition, China also faces rising financial risks in the shadow banking sector. As shown above, the share of shadow banking credit has increased rapidly over the past years. As we discussed earlier, default risks remain high in the shadow banking sector. In August, ten trust companies and a fund manager requested a bailout from the top Communist party official in Hebei province (FT), following several default episodes last year.
Conclusion: The Chinese government is aware of the build-up of financial risks in the economy, and is trying to smooth the way of debt restructuring by more monetary easing. However, it is never an easy task to engineer an orderly deleveraging process, especially as the country also faces other structural problems and is in urgent need to transform its economic model and step up financial liberalisation.
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