Mr. Zhang Ke is worried. Mr. Zhang is the vice-chairman of China's accounting association. He and his firm audit the books of Chinese local governments. According to Mr. Zhang the debts of the local governments are is "out of control" and could spark a bigger financial crisis than the US housing market crash. In a way this is not news. The only thing that is news is that a senior Chinese figure is talking about it. But if China's debts are so big, why doesn't it spark a panic?
Mr. Zhang's assessment of the Chinese debt situation has a lot of company. The IMF and the rating agencies have all flagged the issue. Recently Fitch cut China's sovereign debt rating, the first such cut since 1999. A rare downgrade in a world where many emerging markets are seeing more optimistic outlooks.
China's debt problems have been around since the recession of 1999. To avoid a recession in 2009, the Chinese government opened the monetary flood gates by forcing the banks to make loans and lend they did. Most of the money went to provinces, cities, counties and villages for various projects. The problem with financing projects with bank loans rather than taxes is that the projects have to generate sufficient income to service the loans. According to Mr. Zhang this is not happening. The local governments were not paying back the loans are just rolling them over. "The only thing you can do is issue new debt to repay the old," he said.
Like the US Federal Reserve, this type of stimulus has been going on for the past 4 years. The pile of debt is now quite high. It is estimated to be between Rmb10tn and Rmb20tn ($1.6tn and $3.2tn), equivalent to 20-40 percent of the size of the Chinese economy. It hasn't stopped. Despite the questions over solvency, the hunt for yield has allowed the local governments to issue Rmb283bn of bonds in the first quarter of 2013. This is more than double the total for the same period last year. In theory local governments are prohibited from issuing bonds. But thanks to investment companies, a financial innovation designed to get around the restrictions, they have been flooding the market.
Sadly, like Federal Reserve's efforts, the massive stimulus in all forms is having a limited effect. China's growth has slowed to 7.7%. The mercantilist money machine has been stopped by falling demand in China's main export markets. The structure of the stimulus is aimed at the wrong segment of the Chinese economy, local governments and state owned business rather than private businesses. The structure of the Chinese system makes it exceptionally difficult for it to rebalance. Even the economist Prime Minister, Li Keqiang, has admitted that the economy will have to "climb hills and cross ridges." So China might be rolling down a hill, but will it fall off a cliff? Will China's problem morph into a panic? To determine the answer we must look at the causes of a panic.
At their very core, business cycles are about the tension between greed and fear. Excessive optimism about the future creates greater risk taking. This can be exacerbated by extended periods of accommodative monetary policy. The expansion of credit coupled with assumed government guarantees of easy money allows fear to recede. Growth appears to be a one way bet. With access to easy credit, investors increase their bets. This drives asset prices away from fundamentals. The combinations of imperfect information, asymmetries and ever optimistic forecasts seem to justify the inflated asset prices. After several years of this, the markets are in the middle of a full blown credit bubble that inflates an asset bubble. Financial innovation or financial reform can change the financial system in ways that obscure the risk
The classic example is the US collapse. Alan Greenspan and his successor Ben Bernanke convinced the markets that low interest rates would help to rejuvenate the American economy. The housing bubble was considered an accurate valuation by the market. The financial innovation of collateralized debt was seen as an efficient way to spread the risk throughout the market. Since the assumption was that collateralized debt was perfectly safe, the financial system could use huge amounts of leverage, but the exact amount was unclear and could only be estimated. The demand for collateralized debt created a market for any collateralized debt regardless of the ability of the borrower to repay the loan. The result was, of course, the Great Recession.
How does China fit into this description? As I noted above the Chinese government has been flooding the economy with money for years. Money to state owned enterprises (SOEs) and local governments is lent at subsidized rates basically without restrictions. So there is a vast potential for leverage. Since both the locals and the SOEs are branches of the Chinese government, investors and banks have assumed that they cannot default. The Chinese government has the enviable reputation of being able to engineer one of the most successful development stories in history. So the assumption is that the country will continue to grow its way out of any temporary pullback. Recently more money was funneled into the system through financial liberalization. The so called shadow banking system has provided investors ways to get far better interest rates than are on offer at the state owned banks.
Still the Chinese economy is different. It is heavily state controlled. Just because it seems to fit into the template does not mean that there will be a horrific meltdown. The estimable Financial Times Beijing bureau chief, Jamil Anderlini, doesn't think that a panic is possible. Slow growth definitely, but no panic.
His analysis divides recent panics into three categories: interbank freeze, or foreign capital outflows, and depositor bank runs. An example of an interbank freeze would be the collapse of Lehman Brothers. The Lehman collapse was particularly horrific because the problem had to do with counterparty exposure. Large leveraged trades were made between banks. If one side defaulted the other would also lose money. When Lehman went under, no one knew who was exposed or how much. So all lending stopped. Mr. Anderlini doesn't think this is a problem in China. China's regular financial system is composed of state owned banks. In a crisis the Federal Reserve or the European Central Bank can only provide liquidity and hope. In China the government can actually order the lending to continue.
Foreign capital outflows were the cause of the Asian Financial Crisis. Many of the Tiger countries like Thailand had borrowed in dollars. When the crisis hit, foreign investors pulled out, putting the economies into a tail spin. There is a similar issue in the Eurozone. Countries like Greece sold euro bonds to foreigners who assumed a credit rating equal to Germany. When the crunch came the foreigners left.
China does not have a convertible currency. Its exposure to international investors is quite limited. Besides it has $3.44 trillion in foreign exchange reserves. So it has the firepower to avoid a meltdown.
So far I agree. China cannot have a liquidity or a currency crisis, however a depositor bank run in my view is possible. Mr. Anderlini believes that the state owned banks including the big three - Industrial and Commercial Bank of China (OTCPK:CICHY), China Construction Bank (OTCPK:IDCBY) and Bank of China (OTCPK:BACHY) - "are effectively backed by the full weight of the Communist party" and the Chinese state. This is certainly true. Chinese banks are all state owned and too big to fail, but there has been a major change.
What is not too big to fail are the local government bonds, trust vehicles, Wealth Management Products (WMPs), real estate and other private company bonds - in short the Chinese shadow banking system. These are credit flows that have been transferred off bank books or securitized loans. The shadow banking system has increased fourfold in size since 2008 to about Rmb20tn ($3.2tn), or 40 percent of gross domestic product. It could be as much as Rmb24.4tn, or nearly 50 percent of GDP. Recently it has been metastasizing at an incredible rate. Conventional bank loans from the state banks made up 95% of loans in 2002. This has decreased to 58% last year. Total financing has increased almost eightfold during that time. Trust loans surged 679% in last December alone to 264 billion yuan from a year earlier. The recent growth of the Chinese economy would have been impossible without these loans.
But these loans suffer from two major problems. Although the purchasers assume they are as safe as bank deposits, they are not backed up by banks or anyone else. Second, there is the classic bank issue: an enormous asymmetry between the assets and liabilities. The most popular WMPs have durations of one to three months. But the funds provide financing for much longer terms, often multi-year loans.
WMPs and bonds are considered safe, because firms, especially firms connected to the government, do not default. Private firms go under. Usually the owner disappears at night. But state firms or large firms partially owned by the state are kept afloat either by mergers or by rolling over loans, until now. Recently two solar firms Suntech (NYSE:STP) and LKD's - bonds went into default. Also banks are having problems with WMPs. Customers at a China Construction Bank branch in the northeastern province of Jilin complained to regulators that they lost more than 30 percent. One of CITIC's, a large financial conglomerate, products was at risk because of an overdue loan worth more than Rmb70m ($11m). Losses from a product sold by Huaxia Bank could reach up to Rmb100m ($16 million). These losses are small, but the surprising thing is that they are happening at all.
So all the elements are in place: Financial innovation, an extended period of easy money, credit expansion, assumption of government guarantees, poor risk assessment, and worst of all, poor information. As China slows not doubt the defaults will increase as will unhappy customers. In an era of social media, it will be more difficult for the government to prevent people from removing their money from the system. As faith in the financial system declines, no doubt so will the faith in the communist party, which , according to a quickly terminated online survey, has an 80% disapproval rating. Like Mr. Anderlini, I have no doubt that China will slow, but it could be in for something much worse as Mr. Zhang noted.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.