The rapid pace of China credit expansion since the Global Financial Crisis, increasingly sourced from the inherently more risky and less transparent "shadow banking" sector, has become a critical concern for the global markets. From the end of 2008 until the end of 2013, Chinese banking sector assets will have increased about $14 trillion. As Fitch notes, that's the size of the entire US commercial banking sector. So in a span of five years China will have replicated the whole US banking system. What we're seeing in China is one of the largest monetary stimuli on record. People are focused on QE in the US, but given the scale of credit growth in China Fitch believes that any cutback could be just as significant as US tapering, if not more. Goldman adds that China stands to lose up to a stunning RMB 18.6trn/$US 3trn. should this bubble pop. That seems like a big enough number to warrant digging deeper...
Via Goldman Sachs,
The speed of credit expansion exceeds that seen prior to other credit crises in history, this expansion has not been matched by economic growth, and, of course, the more "shadowy" sources of much of the credit growth raise doubts about its soundness.
When you look at crises elsewhere, a lot of the same precursors are present in China. ...in terms of a large run-up in credit that is not matched in GDP growth. Others include a very aggressive expansion of shadow credit, massive investment in property leading to a bubble in some locations, weak risk management at banks, and heavily state- directed financial and corporate sectors. Another very important issue in China that isn't cited often enough is moral hazard. There is tremendous confidence in the ability and the willingness of the Chinese Communist Party to bail everyone out. But as the system gets bigger and bigger, there are more questions about how feasible that is. On top of all of these financial system issues, China's growth model is peaking out. A few years ago nominal GDP growth in China was in the mid-teens. In that type of environment, problems can easily get papered over. It's only when growth slows that the challenges really start to surface.
Leverage has been increasing rapidly.
and the source is becoming increasingly in the shadows...
But shifting to these sources means increasingly expensive funding (and thus increasingly unfeasible projects in a lower growth regime)
and Corporate leverage is on the rise...
There is no formal definition of shadow banking in China, but a common understanding is that shadow banking encompasses credit exposures that are sourced from outside a formal banking system. They are summarsised as follows:
And the relationship with the formal banking system is as follows...
Meaning that problems in one leak into the other very rapidly...
We see four broader areas of potential triggers that could catalyze an undesirable credit event:
1. Weak demand. Most likely due to lackluster exports or domestic overcapacity.
2. Intentional tightening. Regulations (i.e. monetary, fiscal, FX) to slow credit growth that may have unintended consequences.
3. Dissolution of implicit guarantees. If we start to see frequent defaults from trust or wealth management products, investors may recognize that they are not guaranteed by banks, and demand for such products may plummet, leading to refinancing shortfalls. Local governments' implicit guarantees of LGFVs credits are another risk area.
4. Property sector collapse. Either caused by policymakers' intentional price expectation management downward, or unintended consequences of widespread property tax or stringent anti-corruption asset disclosure laws.
We think that the former three present more imminent risks, whereas policymakers are less likely to push hard on the latter.
Which leaves the question for policymakers - Where do we go from here: "Proactive" or "Forbearance"?
Whereas the previous leadership tended to prioritize cyclical growth, the new leadership has already started to lean towards a more proactive approach to dealing with existing credit risks as well as pre-empting new ones via fiscal, monetary and other reforms. We believe that they will prioritize being proactive, but may opt for periods of forbearance (delay dealing with problems but not exacerbate them) in order to keep growth mostly stable and avert setting off credit risk triggers. This will be a delicate balancing act, but a challenge that must be taken on in order to minimize medium term risks. In the near term, reforms may pose headwinds to China growth, equities and credit performance.
Although it is admittedly difficult to tell "bad" from "good" booms in real time, Goldman finds that around half of the "bad" booms had one of the following three characteristics: (1) credit boom lasting longer than six years, (2) annual rate of increase in credit-to-GDP ratio exceeding 25% during the boom, or (3) credit¬to-GDP ratio higher than 60% heading into the boom.
For comparison, China is in year 5 of its boom that started at the end of 2008, corporate leverage-to-GDP (including LGFV leverage) has risen at an annual rate of just under 10% per annum (and total leverage about 15% per annum on average), and the starting point of the credit-to-GDP ratio was well above 60% — corporate and LGFV leverage together accounted for 113% of GDP at the end of 2008, and total leverage was slightly above 150% of GDP. So, while not all signals are flashing "red", many are.