Entering text into the input field will update the search result below

How Long Can The Chinese Shadow Banking System Avoid Defaults?

Jan. 28, 2014 9:34 AM ET
Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.


Seeking Alpha Analyst Since 2009

William Gamble has been active in the international business as a consultant, lawyer, investor, and corporate counsel for the past thirty years. He holds two law degrees, an executive MBA and has attended several universities in the United States and France. He has been a member of several state and federal bars. He has spoken five languages, visited over 40 countries and climbed Mt. Kilimanjaro. He has developed an original methodology derived from law and economics and game theory to determine the economic efficiency of a legal infrastructure. His premise is that economics is not just about capital and technological constraints. It is also about political-legal institutions, such as the protection of property rights and the enforcement of contracts that are critical determinants of sustainable economic growth and investment opportunities. His methods allowed him to successfully predict the crash of the Chinese, Russian, Brazilian stock markets along with the price of oil. He has appeared on many television networks including, ABC, CNN Asia, CNN FN, Bloomberg, Fox, CNBC and NDTV Profit in New Delhi. In addition to television, he has appeared on NPR, Bloomberg, and over 60 radio stations throughout the US. He has also appeared in Canada on the CBC and in China on Voice of America. His most recent book Freedom: America’s Competitive Advantage in the Global Market was published in 2007. His other publications include a book: Investing in China, Legal, Financial and Regulatory Risk, and numerous articles for various journals including Foreign Affairs, Harvard International Review, International Financial Law Review, and others for the International Assessment and Strategy Center. He has have published letters in the Wall Street Journal and over 27 in the Financial Times. He has spoken at many conferences and programs all over the world. As a participant in the CFA Institute’s Retained Speaker Program, he has made presentations in 10 countries and 10 US cities in the past year. He has testified before the US China Economic and Security Review Commission. He has been quoted in The New York Times, The ANALYST (India), CNN.com, Smart Money, USA TODAY, The Far Eastern Economic Review, The International Herald Tribune, The South China Morning Post, Sankei Shimbun (Japan), The Sacramento Bee, The Hartford Courant and on the internet at many web sites including NewsMax.com, ProDevelopment (Russia), La Opinion, Univision (Spanish).

Default. An ugly word. It is not only disturbing for lenders; it has nasty connotations for other investors, management, employees, politicians and even central bankers. Lenders could lose their money; investors their investments; management and workers their jobs; and politicians their offices. So everyone tries as hard as possible to avoid it. Sometimes too hard. But like death, default is part of capitalism and it has to be faced. But if it is put off too long the consequences can be dramatic. The time has come for China.

The Chinese have a lot of debt. Perhaps not compared to Greece, but it is certainly impressive. The money owed by Chinese companies shot up from 90% of GDP in 2007 to 124% by the end of 2013, a total of Rmb 64 trillion ($10.6 trillion). But companies were rather conservative compared to local governments. Their debt increased 70% in just two years to Rmb 17.9 trillion ($2.95 trillion). It is not just the debt itself. The money has been spent in very inefficient ways. It now takes 3 Rmb of credit to create 1 Rmb of growth

The Chinese government created this orgy of lending. much like the orgy of money printing by developed countries central banks. It was supposed to help China grow and avoid recession. It was very successful until 2010, but since then rates of growth, though still impressive, have been declining.

The reason is simple. Just because a government can create a plethora of cheap money does not mean that it will be spent wisely or even used at all. Quite the contrary, something that has a low value is bound to be thrown away. This is especially true of China where locals used massive borrowing to finance industries that were successful in neighboring provinces. This led to overcapacity especially in the steel and solar cell industries. Cheap money and local pride prevented the less efficient from being weeded out.

The Chinese leadership, like their developed country colleagues, are now trying to pull back in hopes of encouraging more efficient utilization of capital. To achieve better efficiency the Chinese and the US are beginning to tighten. The Americans are ending their experimental program of quantitative easing, while the Chinese are raising interest rates.

The People's Bank of China (PBOC) has limited the amount of liquidity it provides to the financial markets through the seven-day repo rate. This rate has shot up 5 times since last June. It increased twice in December alone and once again a week ago. It was about 4% and has increased to about 5.4%, but in for short periods of stress it has gotten to almost 10%. When it spikes, the PBOC steps in to provide more liquidity, but the trend has definitely been rising.

The result is that China's economy is slowing. Its sterling growth rate has declined from over 10% three years ago to the latest 7.7% in the latest quarter, it's slowest since 1999. Last week, China reported a flash manufacturing PMI that showed a contraction.

With credit tightening and economic growth slowing it is hardly surprising that nonperforming loans are growing. In the third quarter they increased at an annualized pace of 30 per cent in the third quarter. The level of bad loans for the banks has remained steady at about 1%, but this is accomplished in two ways. First, there is the eternal question as to what constitutes a nonperforming loan. This definition varies by bank and country. Second, new loans have been increasing faster than the recognition of bad loans. If you increase the denominator faster than the numerator, the number looks better. But these are only the loans we know about. There is a vast shadow banking which is subject to lighter regulation. Two large defaults have recently come to light.

Both concern so called trust companies. Trust companies were developed to provided borrowers, often municipalities and real estate developers with funds that were not available because of restrictions by the traditional state banks. They also provided investors with far better rates of returns. Often 5% or more over official bank deposit rates. The authorities tolerated them because they provided additional capital. Over the past few years they have exploded. Since they were often sold through the state owned banks, investors assumed that the bank and the government would stand behind them even though there are no specific guarantees.

Recently products offered by two trust companies may go in default. Both provided credit for the troubled coal industry. One product was sold by the Jilin Trust. The product worth Rmb 1 billion ($165 million) backed exclusively by loans to Liansheng Resources Group. Liansheng is a big player in the Chinese coal industry and it is insolvent. Its debts have reached Rmb 30 billion and it filed an application with the local court to restructure. Unfortunately Jilin did not take any collateral for the loans. It only has a guarantee from another coal company that is also having problems. Liansheng loan product sold by Jilin Trust was distributed in part via China Construction Bank.

Another trust company, China Credit Trust, distributed a Rmb 3 billion ($495 million) product that also provided money for another coal company, the Shanxi Zhenfu Energy Group. China Credit distributed its product through China's largest bank, the Industrial and Commercial Bank of China (ICBC). Shanxi is now defunct and the loan is due on January 31.

No trust company product has yet gone into default in China. The problems of the China Credit Trust product with the unfortunate name of Credit Equals Gold No. 1 is being dealt with in the way almost all defaults have been dealt with in China. The Shanxi provincial government is trying to put together a package to bail it out. No doubt Shanxi government has other large debts of its own. So the real issue is whether ICBC will contribute anything to the bail out.

The question is how many of these deals can be bailed out. Trust products are usually for short periods, not more than two years. More than Rmb 100 billion ($16 billion) mining related trust products are due to be repaid this year. The total number of trust products coming due is $660 billion. Some no doubt will default.

The choice for the Chinese government is whether to let the defaults take place. Throwing good money after bad is never a good idea, but if you put too much stress on an overleveraged system, you risk a systematic impact. If you don't allow some defaults, it just delays the day of reckoning. Either way, the Chinese government, like other governments, will reap what they have sown. The only question is when.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

Recommended For You

To ensure this doesn’t happen in the future, please enable Javascript and cookies in your browser.
Is this happening to you frequently? Please report it on our feedback forum.
If you have an ad-blocker enabled you may be blocked from proceeding. Please disable your ad-blocker and refresh.