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In its Feb. 2013 report of "China: Shadow Banking: Road to Heightened Risk," Credit Suisse states:

"China saw the biggest credit expansion relative to GDP over the past decade than any other country in modern history. China's M2 GDP ratio now stands at 187%, its gross capital formation GDP ratio at 48%, and its credit (based on total social financing) GDP ratio at 176%."

(click to enlarge)

Source: Credit Suisse

At the unprecedented level of 176%, credit-to-GDP ratio in China surpasses Japan, the EU and U.S. What is alarming is not just the magnitude of this ratio, but the sizable deviation of this ratio above trend, or Credit-to-GDP gap. Credit-to-GDP gap captures excess credit activities relative to GDP and a mismatch between the financial cycle and business cycle. When the ratio line stays consistently above its trend line in a lengthy period of time, it indicates that an upturn in financial cycle goes too far and a systemic risk is building up as the result of aggressive credit creation. It gives out an illusion of robust growth that can't be sustained. The deeper and more persistent the deviation, the more likely a financial distress happens subsequently. At the first glance, the seemingly significant gap in the graph foreshadows the possible onset of systemic banking distress in China. In its 2011 "Macroprudential Policy: An Organizing Framework", IMF wrote:

"In the time dimension, indicators to assess risks related to procyclicality (aggregate risk) can be categorized by main sources and propagation channels,…(III) credit-to-GDP gap measures, developed recently and found to be particularly reliable and forward looking indicators."

A credit boom can end up in bust. Credit-to-GDP gap gives out an early warning signal in the period leading up to financial crisis. Popular price-based indicators, such as CDS spread, Value-at-risk, implied volatility and etc, fail to detect financial fragility ahead of time and leave little room to react. Bear Stearns and Lehman Brother CDS spread was in decline in the period of 2004-2007 and dropped below 20bbs at the end of 2006. It came later when the CDS spreads were finally up in the midst of 2007.

Similarly to the pre-crisis situation in the U.S. and EU, China's big 5 banks show strong profitability, in fact up 12% in 2012. This impressive growth in profit has mostly come from rapid credit expansion. A large portion of this expansion can be attributed to shadow banking or alternative financing. Financial liberalization and structure change, such as off-balance sheet lending via securitization and non bank financial sector lending, has taken off in the recent years. It indeed helps recent economic growth in China, but sows the seed of financial vulnerability. As a result, a rapid increase in non-core liability and decrease in asset quality in the banking sector gives rise of heightened systemic risk in China.

Depending on the source, the size of shadow banking in China can be somewhere at 30-54% of GDP. Credit Suisse estimates its size at RMB 22.8 trillion, 44% of GDP, 25% of total credit outstanding or 50% of new credit issued in 2012. The discrepancy in estimations lies in so-called underground lending, or informal lending, or black market lending. This type of informal lending is highly unstructured and impossible to track. However, the bailout of Wenzhou in 2012 demonstrated its devastating effects on economics.

Another similarity in the lead-up to the U.S. and EU crisis is inflated property values. Property values in China achieved a new high last month. Overall lending is heavily concentrated in the real estate sector. Enticed by the phenomenal appreciation in the housing market, investors in China often view real estate as THE place to invest, a riskless asset with high perpetual return. Heavy inflow of credit creates an overheated market. The majority of the collateral for loans is land. Although it might be relatively liquid in the boom period, the liquidity and true value become an issue in the event of a downturn.

China has been struggling in transitioning from its export and fixed-investment-oriented economic policy to a consumer-based one in the recent year. So far, the transformation has not been particularly successful. With its export sector faltering, investment is the key driver behind its economic growth. Some projects built are deemed unnecessary and might be more beneficial to be built in the future. By pulling future economic growth forward in time, China risks sacrificing tomorrow for today's gain and in turn overheats its credit market. Subsequently, credit tightening and loan quota are forcing Chinese major banks to shy away from SMEs (small and middle enterprise) and property developers, opening the door for shadow banking. Going forward, the central government has to walk a fine line between promoting growth-oriented policies and reigning in a rampant credit market. Any events that disrupt the credit chain would be a potential tipping point for the system to collapse. Such events would come as output shock , such as declining aggregate productivity or increasing bankruptcies in borrowers, or as a credit squeeze, such as interest rate hikes, a drop or reverse in capital flow or a sharp decrease in property values.

Many view the recent regulatory actions by the Chinese government as sufficient to contain the risks. Interbank lending spreads have been stabilized in the recent month and short-term of WMPs (wealth management products) are in decline due to tighter regulation. Barclays predicts that 40% of investment in WMPs will move back to deposits. However, lower measured risk might not necessarily mitigate financial vulnerability stemming from the credit boom. The percentage of risk-weighted asset at U.S. bank holding companies was in decline in the period prior to the crisis in 2007. Asset quality also deteriorated in the meantime.

New regulations alone won't erase the existing credit-to-GDP gap and prevent risks to propagate. The transition from a boom to bust is often precipitous. The tipping point is difficult to predict and often comes as a sudden stop. The Chinese government is working on building up its counter-cyclical capital buffer. Credit-to-GDP gap is the common reference point in making the buffer decision under Basel III. However, its real-time estimator can be misleading and is susceptible to data errors. The data from China are notoriously unreliable. There is also a debate on whether a common threshold should be applied uniformly across emerging and advanced economies. Basel III lists different macro variables to be applied in different economies alongside credit-to-GDP gap.

Another early warning indicator that is less susceptible for data manipulation is the ratio of core liability and non-core liability of the bank sector. Compared to M2, bank sector aggregates better capture on and off-balance sheet risks and derivatives' exposures. Compared with an advanced economy with a sophisticated bank system, China posts a higher non-diversifiable aggregate risk since its banks hold a larger share of total social lending and the bank portfolio is more concentrated. By dissecting bank sector aggregates, we get a better picture where the risk lies.

Many quantitative methods can be applied to determine whether Credit-to-GDP gap has crossed the threshold, and whether bank liabilities have outstripped its assets, especially loss-absorbing assets, in China. So we can get a better sense of the likelihood and severity of the financial crisis in China in the future. In any case, the saving grace might be the Chinese peoples' saving habit.

Disclosure: I am long FXP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Source: Credit-to-GDP Gap, Shadow Banking And The Fragility Of The Chinese Banking System