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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
While manufacturing and services PMIs disappointed, the big problem in big China remains that of an out-of-control credit creation process that is blowing up. As we previously noted, instead of crushing credit creation, the PBOC’s liquidity rationing has forced distressed companies into high-interest-cost products in the shadow-banking world. Investors on the other side of “troubled shadow banking products” had assumed that ‘someone’ would bail them out but this evening Reuters reports that ICBC has confirmed that it will not rescue holders of the “Credit Equals Gold #1 Collective Trust Product”, due to mature Jan 31st with $492 million outstanding. The anxiety from contagion concerns of the first shadow-banking default has pushed the Shanghai Composite back near 2,000 for the first time since July – and to its narrowest spread to the S&P 500 in almost 8 years.
The Shanghai Composite is tumbling… to six month lows (and back near 2,000 for the firs time since July)…
and its closest (nominally) to the S&P 500 in almost 8 years…
…borrowers are facing rising pressures for loan repayments in an environment of overcapacity and unprofitable investments. Unable to generate cash to service their loans, they have to turn to the shadow-banking sector for credit and avoid default. The result is an explosive growth of the size of the shadow-banking sector (now conservatively estimated to account for 20-30 percent of GDP).
Understandably, the PBOC does not look upon the shadow banking sector favorably. Since shadow-banking sector gets its short-term liquidity mainly through interbanking loans, the PBOC thought that it could put a painful squeeze on this sector through reducing liquidity. Apparently, the PBOC underestimated the effects of its measure. Largely because Chinese borrowers tend to cross-guarantee each other’s debt, squeezing even a relatively small number of borrowers could produce a cascade of default. The reaction in the credit market was thus almost instant and frightening. Borrowers facing imminent default are willing to borrow at any rate while banks with money are unwilling to loan it out no matter how attractive the terms are.
Should this situation continue, China’s real economy would suffer a nasty shock. Chain default would produce a paralyzing effect on economic activities even though there is no run on the banks. Clearly, this is not a prospect the CCP’s top leadership relishes.
So the PBOC’s efforts are merely exacerbating the situation for the worst companies… for example… Zhenfu Energy…
Industrial and Commercial Bank of China, the world’s largest bank by assets, said on Thursday that it has no plans to use its own money to repay investors in a troubled off-balance-sheet investment product that it helped to market.
ICBC’s shares have fallen this week amid speculation that the bank would be forced to help repay investors in a 3 billion yuan ($496.20 million) high-yield investment product issued by China Credit Trust Co Ltd but marketed through ICBC branches. The product is due to mature on Jan. 31.
“Regarding this unsubstantiated rumour, a situation completely does not exist in which ICBC will assume the main responsibility (for the trust product),” an ICBC spokesman told Reuters by phone on Tuesday.
The trust product, called “2010 China Credit / Credit Equals Gold #1 Collective Trust Product”, used the funds it raised from wealthy investors in 2010 to make a loan to unlistedcoal company Shanxi Zhenfu Energy Group Ltd.
But in May 2012, Zhenfu Energy’s vice chairman, Wang Ping Yan, was arrested for accepting deposits without a banking licence.
Which Barclays warns:
In our view, despite the trust issuer, distributor bank and local government perhaps trying to bail out the mining company, the regulators and central government could probably allow the trust product default to happen as:
- government appears fairly determined to reform the financial system and cut off the implicit guarantee of financial institutions;
- the State Council is reportedly streamlining regulation of shadow banking including trust business; and
- the default of trust products could have less social impact than the default of WMPs, bonds and other products sold to the general public or have problematic practices, such as asset-pool investments.
In our view, the default of trust products could trigger some short-term negative impacts on China’s financial sector and the reputation of financial institutions. However, we believe it is positive for the healthy development of financial system in the long run because the default could do the following:
- Be a step to reduce the implicit guarantee of financial institutions for investment products. Banks could shift their financial liabilities back to the investors.
- Increase the risk awareness of both investors and financial institutions, which could correct the pricing of investment products to more risk-oriented.
Its conclusion is dire: “If the trust product goes into default, we believe it would be the first default to test the financial system.”
Here is the product…
And the growth of such products has been enormous as we have explained in great detail previously: at RMB10.1 trillion as of Q3 should the first domino fall, watch out below.
Finally for those who have forgotten, below is a quick schematic of what a WMP looks like:
“There is an unresolved self-contradiction in China’s current policies: restarting the furnaces also reignites exponential debt growth, which cannot be sustained for much longer than a couple of years.”
The “eerie resemblances” – as Soros previously noted – to the US in 2008 have profound consequences for China and the world – nowhere is that more dangerously exposed (just as in the US) than in the Chinese shadow banking sector as explained above.
I began reading Dimitry Orlov’s recent publication, The Five Stages of Collapse: Survivors’ Toolkit, last week and it has got me thinking about his thesis with respect to the revelations around the U.S. surveillance system being used globally by the-powers-that-be (both corporate and political), in combination with the ongoing exposure of manipulation of various markets and interest rates.
Orlov argues that “my five stages of collapse…serve as mental milestones…[and each breaches] a specific level of trust or faith in the status quo. Although each stage causes physical, observable changes in the environment, these can be gradual, while the mental flip is generally quite swift” (p. 14).
Here are his five stages:
a) Financial collapse where faith in risk assessment and financial guarantees is lost (think Cyprus).
b) Commercial collapse that witnesses a breakdown in trade and widespread shortages of necessities (think Greece).
c) Political collapse through a loss of political class relevance and legitimacy (think current events almost everywhere).
d) Social collapse in which social institutions that could provide resources fail (coming to a locality near you?).
e) Cultural collapse that is exhibited by the disbanding of families into individuals competing for scarce resources (hopefully we never witness this).
Stage One: Financial Collapse
Orlov states “all that is required for financial collapse is for certain assumptions about the future to be invalidated, for finance is not a physical system but a mental construct” (p. 17). It would appear that we are well into this first stage as more and more people are questioning not only the stability of the financial system, but its very structure and long-term viability.
The subprime mortgage crisis of 2008 has left lingering concerns about the fragility of the global economic system. Add to this the ongoing manipulation of global interest rates and markets that has been exposed (see this). This manipulation has little to do with improving a system for the majority but has a lot to do with enriching the elite minority and transferring wealth to them from the majority (see this and this). Add to this the ever-increasing liquidity injections (i.e. money printing) by the world’s central banks (see this) and the theft of allocated funds by unprosecuted criminals (see this) and we have a recipe for increased loss of trust throughout the global financial system. In fact, there are many who have already lost complete faith in the system and recommend disinvesting one’s savings from these corrupt institutions and investing in hard assets (i.e. gold, silver, agricultural land, art, memorabilia, farming supplies, wine, etc.) that maintain or increase their value over time relative to the government-mandated fiat currency which loses its worth due to central bank malfeasance-inflation (see this and this).
Stage Two: Commercial Collapse
A breakdown in trade is beginning as more and more sovereign nations impose tariffs and/or devalue their currency in a vicious circle: currency devaluation leads to increase in exports for the ‘devaluer’ but a decrease for competitors-it’s a zero sum game after all); the competitor either devalues their currency in kind (see this and this) or imposes tariffs on the nation engaging in purposeful devaluation (see this).
In Greece, a peripheral nation within the Eurozone and a test case for extreme austerity, this type of collapse has occurred in regions, resulting in shortages of necessities such as pharmaceuticals, energy, and food (see this and this).
Stage Three: Political Collapse
I believe we have begun down this path with evermore revelations of government malfeasance. The latest salvo in this ongoing struggle between what we are told by our governments and what is the on-the-ground reality has been launched: the American National Security Agency’s decade+ invasion of privacy through a global surveillance regime. It’s bad enough that the elite have lied about this for more than a decade; what’s worse is their targeting of whistleblowers as ‘traitors’ as this de-incentivises exposing immoral or illegal acts perpetrated by our elite (see this).
We are moving ever closer to Orwell’s vision of a totalitarian world as expressed in his book 1984. One commentator has argued that 1984 was not designed to be an instruction manual but a warning (see this), and others have been warning about this type of intrusion for some years (see this).
There are numerous examples of political malfeasance and corruption being uncovered recently. For example:
a) Toronto mayor videotaped participating with others smoking crack cocaine (see this);
b) America’s National Security Agency’s creation of a global, electronic surveillance state-apparently even used to eavesdrop on other nations’ leaders at meetings (see this);
c) Montreal mayor arrested for corruption (see this);
d) Numerous former presidents/prime ministers/etc. being arrested/charged for various crimes from torture to murder (see this, this, this, and this)
e) The current and former premier of Ontario being linked to decisions cancelling gas plants to save political seats during an election (see this).
Using Orlov’s framework to interpret these concerns, arguments, perspectives, and facts, it would appear that trust and faith in the various systems are collapsing at an incredible rate. Faith in the financial system is crumbling; commercial enterprises, especially multinational corporations, are losing support and trade barriers are beginning to be erected; and, finally, all that is needed for political collapse is for more citizens to come to the realisation that the status quo is no longer working for the benefit of all but for the benefit of the elite. When the masses finally come to better understand the corruption and malfeasance that percolates throughout the political world, collapse of the political class will occur.
However, even given the various signs that the system is on the verge of collapse, it is important to realise that NO ONE can predict when this might occur. It could be tomorrow, next week, next year, or next decade…one never knows what event, minor or major, could spin us in an unexpected direction. Learn how to protect yourself and your family financially, socially, and practically (i.e. survival skills) to be in a better position to adapt to the coming changes.