The Chinese credit crisis gets messy
No one has denied that China was overdue for a credit shakeout due to the Chinese government’s desire to stem excess credit growth as the economy rebalances. The question has always been about how much of a shakeout Chinese policy makers are willing to accept and how destabilizing the shakeout would get regarding economic growth and employment. We seem to be reaching another level in terms of jitters with bank runs and commodities sector bankruptcies. Some thoughts below
As China tries to liberalize the banking sector in order to prepare its currency for fewer capital controls and better convertibility, the problem is that shadow lending has increased in importance and banks are feeling threatened. For example, even state-owned lenders are now launching investment products to compete with the money-market funds introduced by tech-sector rivals like Tencent and Alibaba. In June 2013, Alibaba launched a money-market-like fund called Yu’e Bao or “leftover treasure” which hoovered up $66 billion in ‘deposits’ by mid-February of this year. Tencent and Baidu have followed suit.
Because more than 500 million Chinese now have smartphones, Tencent and Alibaba have moved aggressively into the financial sector by providing financial services directly on mobile phones. The banks are fighting back by making transfers into these funds difficult. China’s central bank has temporarily suspended use of two smartphone payments vehicles as well, making it seem like they are picking sides in the heated battle between banks and the shadow banks in the technology sector.
And as Chinese authorities try to tame excess credit growth, the credit crackdown is concentrated in shadow lending, which is diminishing in importance as a result. In the first two months of 2014, lending by trust companies fell from nearly 11% of new credit to just over 5% according to the Financial Times. For example, one very public incident came when a coal company default exposed six shadow lenders to losses on over $800 million in loans. Chaori Solar in the renewables sector was another default of note related to high debt and overcapacity in infrastructure. Other examples of high profile distress are proliferating, especially in the commodities and property sectors. The problem is that Chinese corporate debt has soared since the Great Financial Crisis due to unprecedented stimulus from the government. Non-financial company debt is now 120% of GDP, up from about 85% in 2008. Reuters sums this up nicely by saying China credit strains rise as Beijing embraces failure.
The worry is that all of this will lead to financial distress, panic and a sharp correction in real economy growth. Evidence that this is indeed occurring is mounting. A three-day bank run began in Sheyang county on Monday based on a rumour that a small rural lender had turned down a customer’s request to withdraw 200,000 yuan (about $32,000). The bank and local officials say this never happened but it didn’t stop a panic from developing and people started to pull their money. The central bank was forced to step in.
This has put the real economy under mounting stress. The economic figures are consistently poor. For example, industrial output in the first two months of the year was the weakest since the financial crisis as the manufacturing PMI hit a seven-month low in February. Fixed asset investment is at the lowest level since 2002. Last week, Goldman Sachs cut its forecast for China’s Q1 annualized growth rate to 5% from 6.7%. That is well below the 7.5% target by government.
And this has and will continue to have knock-on effects elsewhere. The IMF says that if China sneezes, Africa can now catch a cold because “growing links with China have supported economic growth in sub-Saharan Africa.” In the FT this was an interesting take I saw:
When China’s growth rate slows by 1 per cent, emerging markets suffer a slowdown of 0.7 per cent. Australia is not an emerging market but it will also suffer disproportionately from any slowdown in China, along with Indonesia, Brazil, Chile and Peru, according to JPMorgan. Recently, an official at one Asian sovereign wealth fund with a $30bn portfolio of Chinese shares sought advice from a big Hong Kong-based hedge fund manager on how to hedge that portfolio in the face of falling growth on the mainland. One answer: short Aussie dollars.
And we know that the copper price unwind is inextricably linked to the slowdown in China.
So the only question here is how far down will this go before government responds, not whether there will be a slowdown. And then we have to ask will the response arrest the slide before more contagion takes hold. For example, as credit tightens in China, Chinese are selling Hong Kong luxury real estate to get liquid. This is the hallmark of a credit crisis and represents how contagion usually occurs. The individuals and companies which are levered and face liquidity constraints cannot sell distressed assets. So they sell the best assets they own in order to have the maximum amount of liquidity. Only later do the distressed assets get sold, when the liquidity from the good asset sales is not enough.
That’s where we are now. The Chinese government has said it will accelerate measures to stabilize growth but Premier Li Kequiang has said that his major concern is employment. And so how aggressively the government acts will depend on this factor.
We have seen this picture before. And China has averted the worst with a soft-ish landing by ramping up the stimulus. But Morgan Stanley thinks China’s Minsky moment is approaching, when the Ponzi finance stage of the cycle is finally revealed and the credit unwind happens in earnest. I think they are right. And the likelihood is that this unwind will be so uncontrolled that it will have serious real and financial economy knock-on effects within China and globally.