60 Trillion - With A 'T'

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Summary

I'm not sure if you realize why it is everyone is suddenly talking about China again.

Well, allow me to tell you a thing or two about the CNY60 trillion time bomb that's embedded in the country's financial system.

Here's a quick look at the infamous "WMP" problem.

Over the weekend, I posted what turned out to be my most successful effort yet to summarize the nightmare that is China's labyrinthine shadow banking complex.

You should probably read it if for no other reason than the fact that it's a remarkably concise rundown of a problem that's nearly impossible to write about concisely.

Because you can read it for yourself, I won't endeavor to rehash the whole story here, but suffice to say that all of the chatter you're hearing about China's deleveraging efforts is tied directly to what amounts to a giant margin call on shadow channels. Simply put, Beijing is tightening via money market rates in an effort to discourage speculation facilitated by back alley credit channels.

The most infamous of these shady leverage conduits is the wealth management product business - "WMPs" for short.

In order to give you a better idea of why these things are a systemic risk not only to China but in fact to the entire global financial system, I wanted to pen something quick on Monday that highlights how truly ridiculous the situation has become.

So basically, WMPs are a maturity-mismatched nightmare. What that means, again in the simplest possible terms, is that they (the WMPs) have to be rolled every couple of months, but the assets backing them don't mature for years. In other words, the only way this works is if existing investors roll their paper or if new investors can be found. Otherwise, the market freezes.

This is reminiscent of what happened to the Canadian asset-backed commercial paper market in 2007.

If you're interested to know what happens when the liquidity mismatch ends up creating a situation where issuers can't pay investors, you're encouraged to recall the events of July/August 2015, when investors literally kidnapped the head of Fanya Metals Exchange after payments on financial investment products it issued stopped.

As a reminder, here's a diagram that shows where WMPs fit in in the context of China's elephantine credit creation machine:

(Goldman)

Just how big of a problem is this? Well, so large that it's difficult to fathom. Here's a useful chart from SocGen:

(SocGen)

So that's CNY30 trillion - trillion with a "t". But that hardly tells the whole story. Here's the accompanying color from SocGen:

In addition, NBFIs manage CNY80tn in various forms of wealth management businesses, the main funding of which is probably from banks, on-balance-sheet ("equity and other investments" or "investments in market securities") as well as off-balance sheet (bank WMPs). Excluding possible double-counting and holding of government bonds, the total outstanding of the shadow banking activities related to the two approaches above was probably still close to 80% of GDP (~CNY60tn) at end-2016, after being only a minor segment of the financial system not even ten years ago.

You read that correctly. This is a CNY60 trillion - again, trillion with a "t" - issue.

And as that passage hints at, the real issue is that the risk associated with these products is repackaged and passed around. Here's SocGen again on the maturity mismatch problem outlined above and the "mind-boggling" cross-holdings:

Chronic duration mismatch. Banks' overall reliance on short-term funding has been rising, also due to the aggressive expansion of bank WMPs. Over half of bank WMPs are of duration shorter than six months, although their expected returns are often 200bp above ordinary bank deposits. However, the average maturity of Chinese onshore bonds, which account for at least half of banks' on-balance-sheet non-lending investments and off-balance-sheet WMPs' underlying assets (Chart 3), is three to four years. There is also significant investment in so-called nonstandard assets, which are often project financing and of private-equity nature. They are probably still more illiquid than bonds.

Mind-boggling cross-holdings. As we alluded to above, banks often hand over some of their on-balance-sheet and WMP portfolio to third-parties (NBFIs) to manage for convenience and/or higher returns. And NBFIs sometimes pass on some part of this money to yet other counterparties that can be more risk-loving. Therefore, there exists a significant amount and a complex web of cross-holdings between banks and NBFIs as well as among NBFIs. Consequently, it is nearly impossible to have a clear idea who is responsible for what when things go wrong. The danger is that since banks are the ones directly facing the mass market of retail investors, they may be cornered to internalise most of the credit risk at the end of the day.

Circling back, this is why everyone is suddenly very concerned about China hiking money market rates and this is why everyone freaks out when MLF facilities don't get rolled.

You're also reminded that the entangled mess you just read about is part and parcel of China's credit impulse and that credit impulse is a leading indicator not just for the global economy...

ChinaCreditPMIs

(SocGen)

...but for equities (NYSEARCA:SPY) and other risk assets...

(Bloomberg)

You can draw your own conclusions from that, but just be aware that anyone who isn't talking about this isn't abreast of what's driving a lot of the manic price action you've seen lately in things like commodities.

Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.