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Global Meltdown Predicted by Charlene Chu
Following on the heels of a report that appeared in the Telegraph on the topic, William Pesek at Bloomberg has recently also written an article about Charlene Chu (formerly with Fitch, nowadays with private firm Autonomous Research) and her opinions on China’s shadow banking system and the dangers it represents. The article is ominously entitled “China, the Death Star of Emerging Markets”.
China has recently made unwelcome headlines, as one of the shadow banking system’s countless ‘wealth management trusts’ which was evidently invested in a bankrupt venture (in this case in a coal company – reportedly a great many such investments in insolvent coal mines exist) was about to go belly-up and then was bailed out at the last minute. Here is a recent article by Mish on the trust that was ironically named “Credit Equals Gold Number 1”. At first it was reported that the trust wouldn’t be bailed out, but in the end its 700 investors were able to ‘breathe a sigh of relief’ as Tom Holland remarked in the South China Morning Post (SCMP). However, Holland also cautioned that by bailing out this trust, China has laid the foundations for a much bigger crisis down the road, as moral hazard has increased considerably as a result.
The size of shadow-bank lending relative to China’s GDP, via the SCMP
Interestingly, Holland actually disagrees on a major point with Charlene Chu and Pesek. Let us first look at what Pesek writes:
“On any list of banking accidents waiting to happen, China is assured a place at the very top. But could a crash there take the entire global economy down with it? Absolutely, says Charlene Chu, who until recently was Fitch’s headline-generating analyst in Beijing. Chu has fearlessly trod into an area that China is trying desperately to keep off limits: its vast shadow-banking system. Now that she’s working for a private firm that doesn’t have to rely to governments for revenue, as do rating companies, Chu is free to speak completely openly. And is she ever.
“The banking sector has extended $14 trillion to $15 trillion in the span of five years,” Chu, who is now with Autonomous Research, told the Telegraph. “There’s no way that we are not going to have massive problems in China.” What’s more, she added, China “could trigger global meltdown.”
The travails of Greece continue to preoccupy the world, but its $249 billion economy is a rounding error compared to China’s $8.2 trillion one. In December 2005, for example, China announced its output had unexpectedly grown by $285 billion. In other words, it had suddenly found an economy bigger than Singapore’s that its statisticians hadn’t known about. Today, simply put, a Chinese crash would make the 2008 collapse of Lehman Brothers seem like a mere market correction.
The kind of meltdown Chu suggests is possible would end Japan’s revival, slam economies from South Korea to Vietnam, savage stock and commodity prices everywhere, force the Federal Reserve to end its tapering process and prompt emergency national-security briefings in Washington. So feel free to obsess over Turkey and Argentina, but the real “wild card” is the world’s second-biggest economy.”
As noted above, that certainly sounds quite ominous.
Opinions Differ …
Not so fast, says Tom Holland. While agreeing that China will eventually face a credit crisis and quite possibly a severe economic downturn, he points to the fact that the closed capital account and China’s vast foreign reserves make a ‘global contagion’ event of such enormous magnitude unlikely. This particular scare story he avers, is not something to worry about, which he inter alia tries to buttress by comparing China’s situation to Indonesia’s prior to the Asian crisis. Below are a few relevant excerpts from his article:
“As a headline, it was certainly eye-catching. “Currency crisis at Chinese banks could trigger global meltdown,” declared a story in the Sunday edition of London’s Daily Telegraph. The article noted nervously that foreign currency borrowing by Chinese companies has almost quadrupled in just four years to more than US$1 trillion.Any substantial appreciation of the US dollar – and many analysts are indeed expecting gains this year – could open up a dangerous cross-currency mismatch, forcing Chinese borrowers to default and inflicting shattering losses on international lenders, the story warned.
The chance that China will suffer a currency crisis at any time in the foreseeable future is precisely zero. And even if the country were struck by crisis, there would be no danger of a global financial meltdown. It is certainly true that China’s foreign liabilities have grown rapidly in recent years; a quadrupling since 2009 is about right. But, if anything, the Telegraph’s figure of US$1 trillion is rather too modest. According to Beijing’s State Administration of Foreign Exchange, at the end of 2013 China had foreign liabilities of a thumping US$3.85 trillion; roughly 40 per cent of its gross domestic product.
But the lion’s share of those liabilities – some US$2.32 trillion – consists of highly illiquid inward foreign direct investment. That money is staying where it is. On top of that, a further US$374 billion is foreign portfolio investment in China’s stock and bond markets. That’s money that has flowed in under Beijing’s qualified foreign institutional investor program, whose rules impose strict limits on the size and frequency of repatriation payments. However, that still leaves around US$1.15 trillion in short-term foreign liabilities, consisting largely of loans from international banks.
In 2014, China has no such problems [compared to Indonesia prior to the Asian crisis, ed.] . External debt is small relative to GDP. And with US$3.82 trillion in foreign reserves at the end of last year, Beijing can cover China’s near-term foreign liabilities more than three times over. Sure, the shrinkage of the central bank’s balance sheet were it actually forced to sell assets in order to fund the country’s external liabilities would inflict a painful monetary tightening on China’s domestic economy.
But with Beijing sitting on such a large pot of foreign reserves, such an extreme crisis is hardly likely. And even if it did happen, there would be no “global meltdown”. Despite the opening of recent years, Beijing’s controls on the free flow of capital mean China’s financial sector remains relatively closed, and the exposure of the global financial system to the country is low.
That’s not to say there wouldn’t be casualties from a sudden strengthening of the US dollar against the yuan, or from a marked slowdown in China’s domestic economy. At the end of October last year Hong Kong’s banking system was owed US$300 billion by mainland banks and another US$100 billion by mainland companies. Clearly the local pain would be intense. But a Chinese currency crisis triggering global meltdown? Happily not.”
Readers may recall that we have also recently mentioned the exposure of Hong Kong’s banks to Mainland China. We believe Mr. Holland is correct in one sense, but we also think he underestimates the contagion potential.
Contagion Through Many Different Channels
It is true that China’s closed capital account as well as the government’s tight control over the financial system makes China’s situation fundamentally different from that of countries with open capital accounts from whence foreign investors can at anytime flee in droves if they get cold feet over an overextended bubble.
In fact, we have pointed out in the past that the great degree of central control over the economy (and especially the banking system) which China’s government enjoys makes it inherently more difficult to time a putative demise of the credit bubble than elsewhere – and such things aren’t easy to time to begin with.
However, a sharp decline in the yuan’s exchange rate may be seen as necessary by China’s leadership if a crisis threatens social stability (and with it the party’s rule) in China. China has already devalued a great deal on one occasion (in 1994), an event that in hindsight seems to have precipitated a chain reaction (first the yen followed the yuan lower, and then the currency pegs in various ‘Asian Tiger’ economies went overboard).
Today, China is a far bigger player in the world economy than in 1994, and we believe that Mr. Holland underestimates how today’s economic and financial interconnectedness may produce contagion effects even in light of the closed capital account and China’s large reserves. We also don’t necessarily regard the exposure of Hong Kong’s banks as a de facto ‘internal affair’, as the territory is outside of the ambit of China’s capital controls and the yuan. It is not only Hong Kong’s banking system that one must worry about though. Consider what would happen if China were indeed forced to draw down its reserves to serve the $1.5 trillion in short term foreign liabilities, or a sizable chunk thereof. Given that this would inevitably result in a much tighter domestic monetary policy (provided the PBoC doesn’t take inflationary measures independent of its forex reserves), all sorts of malinvestments in China would be revealed as unsustainable. A number of industries would be faced with a major bust, and it is a good bet that commodity imports would plunge.
However, once that happens, one must immediately begin to worry about Australia’s banks, which have financed a giant housing bubble on the back of the country’s commodities boom and in turn rely greatly on short term foreign funding. So there would immediately be a crisis in both Hong Kong’s and Australia’s banking systems, and it does not take a great leap of the imagination to see how contagion could spread further from them. Naturally many other raw materials exporting countries would also be hit hard, we mainly picked Australia as an example because its banks are so reliant on short term foreign funding, so they would presumably be among the first in line.
Lastly, here is a recent chart of NPLs in China’s official banking system (listed banks only, i.e. the biggest ones):
As can be seen, NPLs at the major banks have declined to a negligible percentage (compare this with crisis-stricken Spain’s near 13% or so NPL ratio, which is understated to boot). However, there are plenty of credible rumors that China’s banks are keeping loans that would normally be regarded as dubious alive by all sorts of tricks. Not only that, they are definitely backing a great many of the ‘shadow banking’ businesses, which have developed in China mainly in order to circumvent restrictions on banking activities.
In view of everything that is known about credit growth in China, we would regard this extremely low NPL ratio as a contrary indicator even if it were credible.
No-one knows for sure how big a problem China’s economy will eventually face due to the massive credit and money supply growth that has occurred in recent years and no-one know when exactly it will happen either. There have been many dire predictions over the years, but so far none have come true. And yet, it is clear that there is a looming problem of considerable magnitude that won’t simply go away painlessly. The greatest credit excesses have been built up after 2008, which suggests that there can be no comfort in the knowledge that ‘nothing has happened yet’. Given China’s importance to the global economy, it seems impossible for this not to have grave consequences for the rest of the world, in spite of China’s peculiar attributes in terms of government control over the economy and the closed capital account.
The BIS is currently ‘warning regulators and governments’ about excessive borrowing and shifts in borrowing patterns by emerging market-based companies.
Why, thanks boys for this timely intercession! What would we do without you?
Charts by: SCMP and Forbes / Pricewaterhouse-Coopers, BigCharts
Did you know that financial institutions all over the world are warning that we could see a “mega default” on a very prominent high-yield investment product in China on January 31st? We are being told that this could lead to a cascading collapse of the shadow banking system in China which could potentially result in “sky-high interest rates” and “a precipitous plunge in credit“. In other words, it could be a “Lehman Brothers moment” for Asia. And since the global financial system is more interconnected today than ever before, that would be very bad news for the United States as well. Since Lehman Brothers collapsed in 2008, the level of private domestic credit in China has risen from $9 trillion to an astounding $23 trillion. That is an increase of $14 trillion in just a little bit more than 5 years. Much of that “hot money” has flowed into stocks, bonds and real estate in the United States. So what do you think is going to happen when that bubble collapses?
The bubble of private debt that we have seen inflate in China since the Lehman crisis is unlike anything that the world has ever seen. Never before has so much private debt been accumulated in such a short period of time. All of this debt has helped fuel tremendous economic growth in China, but now a whole bunch of Chinese companies are realizing that they have gotten in way, way over their heads. In fact, it is being projected that Chinese companies will pay out the equivalent ofapproximately a trillion dollars in interest payments this year alone. That is more than twice the amount that the U.S. government will pay in interest in 2014.
Over the past several years, the U.S. Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England have all been criticized for creating too much money. But the truth is that what has been happening in China surpasses all of their efforts combined. You can see an incredible chart which graphically illustrates this point right here. As the Telegraph pointed out a while back, the Chinese have essentially “replicated the entire U.S. commercial banking system” in just five years…
Overall credit has jumped from $9 trillion to $23 trillion since the Lehman crisis. “They have replicated the entire U.S. commercial banking system in five years,” she said.
The ratio of credit to GDP has jumped by 75 percentage points to 200pc of GDP, compared to roughly 40 points in the US over five years leading up to the subprime bubble, or in Japan before the Nikkei bubble burst in 1990. “This is beyond anything we have ever seen before in a large economy. We don’t know how this will play out. The next six months will be crucial,” she said.
As with all other things in the financial world, what goes up must eventually come down.
And right now January 31st is shaping up to be a particularly important day for the Chinese financial system. The following is from a Reuters article…
The trust firm responsible for a troubled high-yield investment product sold through China’s largest banks has warned investors they may not be repaid when the 3 billion-yuan ($496 million)product matures on Jan. 31, state media reported on Friday.
Investors are closely watching the case to see if it will shatter assumptions that the government and state-owned banks will always protect investors from losses on risky off-balance-sheet investment products sold through a murky shadow banking system.
If there is a major default on January 31st, the effects could ripple throughout the entire Chinese financial system very rapidly. A recent Forbes article explained why this is the case…
A WMP default, whether relating to Liansheng or Zhenfu, could devastate the Chinese banking system and the larger economy as well. In short, China’s growth since the end of 2008 has been dependent on ultra-loose credit first channeled through state banks, like ICBC and Construction Bank, and then through the WMPs, which permitted the state banks to avoid credit risk. Any disruption in the flow of cash from investors to dodgy borrowers through WMPs would rock China with sky-high interest rates or a precipitous plunge in credit, probably both. The result? The best outcome would be decades of misery, what we saw in Japan after its bubble burst in the early 1990s.
The big underlying problem is the fact that private debt and the money supply have both been growing far too rapidly in China. According to Forbes, M2 in China increased by 13.6 percent last year…
And at the same time China’s money supply and credit are still expanding. Last year, the closely watched M2 increased by only 13.6%, down from 2012’s 13.8% growth. Optimists say China is getting its credit addiction under control, but that’s not correct. In fact, credit expanded by at least 20% last year as money poured into new channels not measured by traditional statistics.
Overall, M2 in China is up by about 1000 percent since 1999. That is absolutely insane.
And of course China is not the only place in the world where financial trouble signs are erupting. Things in Europe just keep getting worse, and we have just learned that the largest bank in Germany just suffered ” a surprise fourth-quarter loss”…
Deutsche Bank shares tumbled on Monday following a surprise fourth-quarter loss due to a steep drop in debt trading revenues and heavy litigation and restructuring costs that prompted the bank to warn of a challenging 2014.
Germany’s biggest bank said revenue at its important debt-trading division, fell 31 percent in the quarter, a much bigger drop than at U.S. rivals, which have also suffered from sluggish fixed-income trading.
If current trends continue, many other big banks will soon be experiencing a “bond headache” as well. At this point, Treasury Bond sentiment is about the lowest that it has been in about 20 years. Investors overwhelmingly believe that yields are heading higher.
If that does indeed turn out to be the case, interest rates throughout our economy are going to be rising, economic activity will start slowing down significantly and it could set up the “nightmare scenario” that I keep talking about.
But I am not the only one talking about it.
In fact, the World Economic Forum is warning about the exact same thing…
Fiscal crises triggered by ballooning debt levels in advanced economies pose the biggest threat to the global economy in 2014, a report by the World Economic Forum has warned.
Ahead of next week’s WEF annual meeting in Davos, Switzerland, the forum’s annual assessment of global dangers said high levels of debt in advanced economies, including Japan and America, could lead to an investor backlash.
This would create a “vicious cycle” of ballooning interest payments, rising debt piles and investor doubt that would force interest rates up further.
So will a default event in China on January 31st be the next “Lehman Brothers moment” or will it be something else?
In the end, it doesn’t really matter. The truth is that what has been going on in the global financial system is completely and totally unsustainable, and it is inevitable that it is all going to come horribly crashing down at some point during the next few years.
It is just a matter of time.