As the Chinese liquidity crunch enters its third week with even more worrying reports about cash shortages at domestic and foreign banks, it is worth taking a look at the fundamental problems plaguing credit markets in China. The People's Bank of China (PBOC) has a good reputation in technocratic circles. Though they answer to their political masters, they are considered well educated, competent, and knowledgeable about risks in the Chinese economy and financial markets. The PBOC understands as well as anyone the enormous risks of a potential banking crisis driven by the enormous expansion in public and private credit markets in China. This is what makes the recent liquidity staredown between the PBOC and the Chinese banking system so noteworthy.
Over the past two weeks as Chinese interbank rates passed 25% it was at first believed to signal fundamental problems in Chinese banks. Then as it became clear that the PBOC was not providing overnight liquidity to banks opinion swung and it was viewed as a punitive measure targeting smaller banks or trying to convince the big four state banks to rein in credit growth. When the PBOC pumped liquidity into banks, the markets breathed a sigh of relief believing the worst was over and that this merely marked an insignificant intra-Chinese spat. These are the wrong lessons to learn from PBOC liquidity actions.
There are a number of very important lessons to be learned from the PBOC liquidity drain. First, the PBOC is signaling that it is enormously worried about the rapid expansion in credit growth in China since 2009. As already noted, credit growth tripled in 2009 from the previous year and it has continued to expand unofficially ever since. Chinese technocrats are if nothing students of history and having witnessed the 2008 financial crisis, they see a frightening number of similarities specifically in the credit markets. If the PBOC is so openly concerned about credit markets in China, this should concern you.
Second, the PBOC is concerned about unofficial credit channels. Everyone saying that the Chinese financial market prevents the types of abuses witnessed in the 2008 financial crisis obviously are not paying attention to the reality of China. The China Daily, the official communist party mouth piece, talks about home price to income ratios around 30. Wealth management products which allow banks to move loans off their balance sheet are the latest growth industry in Chinese financials services. Public debt figures are a guess at best as many development projects are off balance sheet and Beijing hasn't released an audit of government debt since 2010. The IMF recently estimated that if unofficial financing was included, the Chinese deficit would approach 10%. These practices bear all the hall marks of the classic signs of the approach of a bubble induced crisis.
Third, the stand down by the PBOC signals either that the bankers won and credit expansion will continue its rapid growth or that the PBOC made its point to the bankers and hope to see some changes. The answer is probably a little of both though the jury remains out. Too many people mistake Beijing press releases for official policy rather than looking at data. For years, Beijing has talked about the need to rebalance the economy and for years consumption as a percentage of GDP has continued to decline as fixed asset investment (read credit growth) has continued to increase. I personally doubt that the PBOC will be able to exert any serious control over politicized bank lending and expect to see maybe a short-term decline and return to rapid expansion of credit. The bankers control of lending drive job creation and public revenues in an economy where nearly 60% of GDP is investment, provincial and local bosses are not about to take away the punch bowl.
Fourth, the change in the stance of the PBOC to providing banking liquidity does not in any way change the fundamental problem: officially Chinese banks are sitting on a mountain of bad loans. Unofficially, the picture is significantly worse. If banks were receiving regular payments from their customers, banks would not be so starved for liquidity unless credit expansion were simply exploding. In reality the Chinese banking system is suffering from both. Between a slowdown in debt repayment, new projects, and loan rollovers, Chinese banks are simply starved for liquidity. The reports I am hearing from investors anecdotally, paints a dire picture of the current state of the Chinese debt market. The PBOC liquidity injection should be seen as delaying the inevitable not fundamentally changing anything.
Fifth, the PBOC liquidity injection and the China Investment Corporation (CIC) buying of equity should really be seen as a small scale de facto bailout and not simply as normal course of business operations. This was a banking system teetering on the brink of collapse without action by the central bank and public investment for the purpose of supporting a stock price. (The CIC has previously purchased secondary offerings to both boost bank capital and increase or maintain its share of major Chinese bank equity.) Given the complete inability of the intra-bank market to maintain normal course of business liquidity, it should be a major concern that banks are that dependent on the PBOC for liquidity without collapsing.
Sixth, this is signaling the end of the Chinese growth model. Historically, China has grown by relying on export growth and domestic investment. The domestic investment would create export industry jobs and the circle was complete. However, the saturation of the export market and anemic demand in Europe and the United States has killed the export market. Domestic investment has caused so much over capacity that Chinese business is cannibalizing itself. Officially, industrial capacity in China hovers around 60% and unofficially is probably closer to 50%. China solar manufacturing capacity is 1.5 times global demand. Put another way, if China were the only global supplier of solar panels it would still only be running at 65% capacity. Investing more will only delay the inevitable.
A fixed asset is required to cash flow at a given rate or it will eventually return to its long-term level. Short or medium-term asset price deviations can be expected but over the long run, a given cash flow must support a given asset price. The fundamental problem facing China is that cash flows are not coming close to supporting current asset prices. Increased lending can only continue to support asset prices for so long before they collapse.
Anyone believing the past two weeks was a mere blip on the return to 8-9% GDP growth in China isn't paying attention or doesn't understand China. The Chinese financial system is under enormous strain as companies and households struggle to meet debt obligations in the face of anemic domestic and international demand.
The PBOC playing chicken with the bankers should tell you how seriously they view the looming debt crisis in China.
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.