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By Ron Rimkus, CFA

Recent attempts by the People’s Bank of China to limit shadow banking sent commercial lending rates soaring and Chinese stocks into bear market territory. Given China’s importance to the global economy, we’re running a series of short interviews with leading China experts to assess the situation. In the first installment, we spoke with Michael Pettis, who is noted for his bearishness on China.

For the second installment, we interviewed Fraser Howie, coauthor of Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Riseand Privatizing China: Inside China’s Stock Markets. Only a month ago, Howie warned that the last decade’s growth in the shadow banking sector in China posed a serious systemic risk. And while it would be nice to offer a rosier contrast to Pettis’s assessment, as you’ll see from the interview below, Howie also thinks that China faces major challenges ahead.

CFA Institute: How effective were the PBOC’s recent actions at curtailing so-called “shadow lending” in China?

Fraser Howie: It is far too early to know if its actions have been effective in the long term. The PBOC has been very effective at shocking and disrupting the market, and it has left many wondering what it was thinking and trying to achieve. The problems of poor lending and shadow banking can’t be solved by just squeezing the interbank market, but they have exposed that the banks have been too dependent on short-term, PBOC-driven liquidity. The recent spike will hopefully lead to better liquidity management by the banks, but the problems of poor allocation of capital and shadow banking are nowhere near being solved. The problems have been growing for years and only now is a concerted effort being made to tackle the excesses.

CFA Institute: How extensive are bad debts in China, and is the liquidity crunch at least in part a reflection of a bad debt situation there?

Fraser Howie: The bad debts problems are severe, but they aren’t bad enough or big enough at the moment to cause a financial crisis. China can hold its financial system together, but it will come at a cost of significantly lower growth for a period of years and some nasty shocks to the bank balance sheets over the coming years. The liquidity crunch is only slightly related to the bad debt situation, liquidity isn’t scare because loans weren’t repaid, the recent problems are far more reflective of deposits increasingly going into wealth management products and other short-term instruments, which has hit bank’s liquidity management. This has been especially true of the second tier of lenders. There are also suggestions of a lot of interbank and intrabank lending, which have gone on without proper oversight and risk management: it has meant that on paper the banks look good, yet cash on hand is relatively scarce.

CFA Institute: Are China’s banking problems resolved? If so, why? If not, how much worse can it get? Can China keep growing despite these problems?

Fraser Howie: Far from resolved. We are looking at debt issues which will take years to work out. Credit has been growing well above trend for four years, and yet growth has been getting weaker and weaker. We know that many of the poorer loans have been already rolled over for three to five years, so the problem will be out there for a long time. The problem can get really bad if growth continues to slow, don’t forget that in the late 90s the NPLs were 40%! I won’t be that bad again, but 90% of the bank credit goes to SOEs, which, without their government subsidies, lose money. As for whether China keeps growing, then yes it probably can, but the growth rates will be low single digits. Given where China has come from, that will feel like recession. Even if the new leadership are really committed to reforming the economy, it will still be a tough time. A more open economy will also mean a more volatile economy, and that is something that the leaders won’t like. The likely scenario for China is one of muddling through. Forget hopes or dreams of China as a global leader, the government will be focused on the very real challenges domestically.

Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Source: Fraser Howie On China: Expect Nasty Shocks To Bank Balance Sheets