By Mike Whitney
The deepening debt crisis in the eurozone and increasingly poor economic data in the US, have overshadowed rapidly deteriorating conditions in the world’s second biggest economy. The China miracle is quickly becoming a nightmare as credit default swaps (CDS) spike parabolically to 3-year highs and stocks plunge “dragging the Hang Seng Index to its biggest quarterly loss in a decade.” (Bloomberg) China’s property bubble has sprung a leak dimming the outlook for future growth and putting the Chinese economy on course for a hard landing. Investors are now shedding stocks at a feverish pace anticipating a credit contraction. China might wind up being the domino that analysts failed to see due to their preoccupation with Europe and the US. That said, China’s troubles are no longer “below the radar”, in fact, the wreckage is drawing more attention by the day.
China’s problem is attributable to an undercapitalized and unregulated shadow banking system that has provided billions in loans to people and industries that are no longer able to service the debts. Sound familiar? Here’s a brief summary of the issue by author Waiching Li at Credit Writedowns:
“According to a study issued by the People’s Bank of China in 2010, non-banking sector lending has expanded to 63.3 trillion Yuan, ($10 trillion), 44.4% of total lending activities of China’s economy…
“Shadow banking in China mainly exists in the form of ‘Bank and Trust Cooperation,’ the underground financing networks; but small loan companies and pawn shops also play a role in these shadow financing activities.
“While mortgage securitization is not an issue in China, the ‘Bank and Trust Cooperation’ is a vehicle to provide ‘hidden’ loans to enterprises outside the scope of the bank’s reserve limit. Similar to the credit securitization problems in the US, the banks play the role as an intermediary. ….
“Data released on March 31th, by China Trustee Association, shows that the scale of Bank and Trust Cooperation as has already reached to 15.3 trillion yuan ($2.35 trillion). The risks of such financial arrangements are asymmetrically transferred to buyers. Since no credit ratings are available for these debts, the buyers have to blindly follow the bank’s referrals, hoping the banks, which make money from commissions and fees no matter what happens with the loan, have done due diligence and are honest.” (“The Shadow Banking Problem in China,” Credit Writedowns)
The unsupervised expansion of credit is at the heart of all financial crises. China is no exception. The impending implosion in China is likely to send tremors across the global economy pushing Europe and the US back into recession. Non financial state-owned companies have been issuing loans as an adjunct to their main business in order to improve profit margins. Liquidity is everywhere, and when credit is easily available, bubbles form and tragedy ensues. Now that the bubble has burst, manufacturing has begun to slow, credit is drying up, and capital flows have gone into reverse. That’s why the People’s Bank of China is easing reserve requirements and adding “36 billion yuan ($5.6 billion) to financial markets this week, an 11th straight week of inflows”. (Bloomberg)
Up to now, the flow of credit from unregulated players has been more than enough to offset the actions of the central bank in its fight against inflation (now at 6.5%). According to the Financial Times “the annual capital flows in the shadow market could involve as much as Rmb2,000bn ($310bn), or about 5 per cent of gross domestic product.” Here’s an excerpt from an article titled “Shadow Banks endanger Chinese Economy”:
“Economist Chaoan Jushi says, “Under the present conditions of economic contraction, these medium and small sized businesses in China that need a lot of cash, after they have borrowed money, it is very hard for these businesses to be 60 to 100 percent profitable. To put it plainly, this is a massive risk. Especially for some businesses, their way of thinking is, ‘if I can borrow money to get through the difficulties then I can keep going, if I can’t keep going then I’ll run.’”
But the money local governments and state owned businesses are lending out is money they borrowed themselves, from China’s four biggest banks. The deputy head of the standing committee of the National People’s Congress warned at the World Economic Forum in Dalian last week: “The Chinese version of the US subprime mortgage crisis is loaning money to local governments who have no way to repay it.” (“Shadow Banks endanger Chinese Economy”, NTDTV.com)
Many of these loans will never be repaid because–like subprime mortgages in the US–they were made to applicants who don’t have the means to repay them. Thus, when the daisy-chain of debt servicing lapses, the downward spiral begins. In China, the process is just now gaining pace. This is from Marketwatch:
“There is already some evidence that more corporates are in financial distress this year. Credit Suisse, in a note last week, said their proxy non-performing loans ratio jumped sharply in the first half of 2011 to 4.9%, from 1% in 2010….
According to Zhu Min, the deputy managing director of the International Monetary Fund and a former Chinese official, China has already doubled its loan ratio from under 100% of gross domestic product before the Lehman crisis to roughly 200% today. (“More warnings on China’s debt”, Marketwatch)
Property values –which ballooned by roughly 60% since 2006– have hit the wall and started to decline across China pushing developer-related stocks down 40 percent on the year. That’s put more pressure on builders who are already loaded-to-the-gills with debt. As prices continue to slip, developers will have to face brutal margin calls, selling off stocks and bonds for cash to beef up their collateral. Now that the shadow banks have pulled in their horns on risky lending, the easy money is drying up and the real estate market is headed for a crash. The coming shakedown will expose the amount of rot in the system and force many of the dodgy lenders into bankruptcy. That will lead to another slump or trigger a full-blown financial crisis. No one knows for sure.
So now China’s in trouble, as if we didn’t have enough to worry about.