China Tightens Grip On Shadow Banks

[Sancho Panza]

WSJ 6/1/14

'

BEIJING—China is tightening oversight of rapidly expanding shadow-banking services, in a sign the country's leadership is seeking to slow a run-up of debt and bolster financial stability.

China's cabinet has distributed rules to regulators aimed at limiting the growth in loans created outside formal channels for bank lending, according to a copy of the document reviewed by The Wall Street Journal. In the plan, which was sent in December and hasn't been made public, the State Council calls for stronger oversight of such informal lending by the central bank and other regulators.

The plan, which amounts to an instruction to the country's top financial regulators, falls short of launching a full-blown crackdown on the sector, suggesting leadership wants to preserve what has become a key source of credit for the economy even though it has contributed to industrial overcapacity and high debt levels at local governments.

China's shadow lenders—a mélange of traditional banks' off-balance-sheet lending arms, trust companies, insurance firms, pawnbrokers and other informal lenders—are at the center of concerns about whether the country's slowing economy could trigger a debt crisis. Economists inside and outside China worry that shadow lenders are introducing risks reminiscent of the U.S.'s subprime-mortgage boom by backing projects that may never pay off, often failing to disclose fully what they are asking investors to fund, and appearing to give banks a way to get rid of problem loans without really doing so.

China's shadow banking isn't regulated as closely as traditional banking activities, and shadow lenders often don't disclose much about what they are investing in or how their loans are performing.

"The failure to get shadow banking under control is due to the lack of a comprehensive regulatory framework. The regulators are clearly behind the market when it comes to financial innovation," said Steve Wang, research director at Reorient Financial Markets, a Hong Kong-based research firm.

The plan comes on the heels of statements by various government agencies about economic priorities including restructuring the state-owned sector, opening China's government-contracting sector to foreign firms, clearing the way for more rural migrants to settle in China's cities, and defining what is permitted in a new free-trade zone in Shanghai. In all cases, officials stated general principles but left it to regulators to provide details later.

The Chinese government effectively is trying to put into action the general pronouncements made during a November meeting of top Communist Party leaders, who pledged that market forces would play a "decisive" role in the economy.

Shadow banking presents an especially difficult challenge. On one hand, Beijing wants to encourage the development of nonbank financial institutions, which often lend to smaller firms that are overlooked by China's biggest state-owned banks. In addition, many important borrowers, especially local governments, are heavily indebted and owe much of their financing to nonbank sources.

On the other hand, the rise of shadow banking has been a major reason that China's debt has increased at a pace similar to the U.S., Europe and Asian nations before they crashed. Since 2008, domestic debt has ballooned to 216% of gross domestic product from 128%, and could climb to 271% by 2017 if not corrected, according to Fitch Ratings.

Overall, 43% of local governments' 17.9 trillion yuan ($2.93 trillion) in debt as of the end of June 2013 came from nonbank sources, according to a National Audit Office report released last week. Shadow-banking institutions, including trust companies, securities firms, insurance companies and leasing companies, accounted for 11% of the local governments' debt. The rest of the nonbank debt is from bonds, individuals and a variety of loan guarantees. Any crackdown on shadow banking could threaten the financial viability of the local governments and their ability to repay loans and bonds.

From 2010 to 2012—a period during which traditional banks scaled back lending—shadow lenders doubled their outstanding loans to 36 trillion yuan, J.P. Morgan Chase has estimated.

For months, China's central bank and other regulators have been debating how to slow debt growth without sinking the economy. Late last month, Chinese Premier Li Keqiang said that while China would keep a prudent monetary policy as well as "appropriate" liquidity next year, he expected there would be reasonable growth in credit. He gave no hint of a crackdown on shadow lending.

In some cases, regulators' attempts to introduce tougher rules to curb shadow banking have been met with opposition from the country's banks and other interest groups, according to banking officials. The China Banking Regulatory Commission has delayed issuing much-anticipated new rules targeting the sector for several months, according to the officials.

The indecision about how to deal with shadow banking has been one reason China's markets have faced three cash crunches during the past six months, including one last month. The People's Bank of China, the central bank, has pushed up borrowing costs in the interbank market as a way to curb the growth of shadow banking. Banks turn to the interbank markets for funds and lend the money to other institutions. Higher interest rates would raise the cost of capital for shadow banking and, in theory, make borrowers more wary about taking on too much debt.

But sometimes the central bank misjudges how much money is needed in the system, sending rates skyward—they reached 30% for a short time in June—before it provides more funds and quells the crisis.

"There needs to be coordination among different regulators and ministries. Otherwise the PBOC will look lonely and ineffective," said Yu Shao, chief economist at Orient Securities.'

[TheCountOfNowhere]

At least we know where the next financial crisis is coming from....

[Eddie_George]

At least we know where the next financial crisis is coming from....

Osbrown: "The 2014 Financial Crisis, that started in China ........"

[crashmonitor]

Osbrown: "The 2014 Financial Crisis, that started in China ........"

Why shouldn't it, what is China other than a corrupt undesirable overcrowded slum. Whilst foreign investors were getting their money in in 2013 and taking a good head kicking on their investments to boot; the Chinese populace have been desperate to get their money out, I wonder why. I guess they see Europe and the US as a safer bet.

Edited January 9, 2014 by crashmonitor

[fluffy666]

Why shouldn't it, what is China other than a corrupt undesirable overcrowded slum. Whilst foreign investors were getting their money in in 2013 and taking a good head kicking on their investments to boot; the Chinese populace have been desperate to get their money out, I wonder why. I guess they see Europe and the US as a safer bet.

Problem is, a huge crash in China has been forecast for a long time now..

You wonder to what extent the Authorities are capable of engineering a currency 'reset' there which would eliminate such a crisis. How heavily connected is Chine to the outside currency/financial markets anyway?

[Sancho Panza]

Problem is, a huge crash in China has been forecast for a long time now..

You wonder to what extent the Authorities are capable of engineering a currency 'reset' there which would eliminate such a crisis. How heavily connected is Chine to the outside currency/financial markets anyway?

http://www.peakprosperity.com/podcast/82631/michael-pettis-future-china

'Few people can see the big picture in China more clearly than Michael Pettis, Beijing-based economic theorist and Professor of Finance at Peking University. Michael sees China's future prosperity tied to its ability to successfully address:

• Overinvestment - Its political and economic systems are now dependent on elevated levels of investment spending. Moreover, a decreasing amount of those investment dollars are able to generate net-positive financial or social returns.
• Currency undervaluation - Money printing and excessive foreign reserves are creating imbalances that will be very hard for the central authorities to unwind without painful repercussions.
• Low wages (and wage growth) - Chinese household income has not grown as fast as GDP, creating big wealth disparities in favor of the elite.
• Over-indebtedness & low interest rates - Much of China's new borrowing is used to pay interest on current debt. Any material rise in interest rates is sure to create a cascade of insolvencies.
• Asset bubbles - Much of Chinese wealth is tied up in assets that are exhibiting dangerous levels of price inflation, real estate being a prime example. (Property prices in Beijing and Shanghai are higher than Manhattan, which is astounding considering the much lower average Chinese income)

Pettis, to put it mildly, is skeptical that China will be able to resolve these issues gracefully. In fact, he feels we've seen this movie before with predictable outcome. Just perhaps not on so grand a scale:

In order to understand the story of China, it is important to start with the recognition that contrary to much of what we have been hearing in the last few years, there is nothing particularly unique or extraordinary about what is happening within the economy. Certainly China has grown at a tremendous rate in the last 30 years, but lots of countries have had investment-growth miracles. Maybe not as long as China and maybe not as profound as China’s investment, but there is quite a lot that we can learn about what is happening in China from looking at previous experiences.

It turns out that the Chinese growth story is one we have seen many times before, and it typically starts out very well. The story begins with the period in which the country, in this case China, has come to be systematically invested.

Twenty years ago, thirty years ago, China had no roads, no airports, no manufacturing capacity.

Its economy had been pretty much decimated between the period of the anti-Japanese war and then the first two or three decades of Communist leadership.

So what China really needed was a significant increase in investment to raise its productivity level, and in fact, that is what happened. We saw investments grow very rapidly during this period. And with all of that increased investment, investment in manufacturing capacity and investment in infrastructure, etc., with all of that investment, we saw very strong, very robust growth take place in the Chinese economy.

But the problem that this model has always faced is that after many years of investment, two things happen: First, the political and economic system gets built around this constantly increasing level of investments, and second, we move from a period in which it is fairly easy to identify economically viable projects – basically, China did not have anything and could use a little bit of everything – to a period in which investment levels are still high. China has the highest investment rate ever recorded, and the highest growth rate of investment probably ever recorded, that we

start to run out of economically viable projects

. But

because the system was so geared towards continuous increases in investment, we keep on investing, and when that happens, investments become allocated into projects that do not generate sufficient real returns on a social basis.

And so, since these investments are funded by debt, one of the consequences is that automatically you find debt growing faster than debt servicing capacity, which, of course, is unsustainable. This, by the way, has happened to every single country that has followed this growth model, so it should not be such a shock to us, but it is happening to China, too. The problem is, we have been doing this for so long, I think in retrospect

we will probably look back and see China as the most extravagant period of overinvestment ever seen, exceeding even Japan in the 1980s

– that is, if the result has been that that debt models in China are extremely high.

So all of this talk about rebalancing the Chinese economy is basically a recognition of this fact. We can no longer count on investment to drive growth, because investment is being mis-allocated, but unfortunately, the economy is so dependent on investment that if you bring investment levels down – which you have to do if you want to address the debt problem – then you also bring growth down very significantly. We just started to see that process. Investment has not come down, it has not even slowed that dramatically; it has slowed a little bit. Growth rates dropped from roughly 10%, which is where they were before 2008, 2009, to around 7% today, and I suspect

they are going to drop an awful lot more before this process stops.'

[wonderpup]

How odd that a capitalist USA and a Communist China should both end up being owned by bankers- I guess greed is a universal constant and who is better placed than a banker to exploit it?

The Chinese seem to be as captured by their out of control financial sector as the US- neither leadership can seriously take on their own finance sector without risking a catastrophic crash.

[Sancho Panza]

How odd that a capitalist USA and a Communist China should both end up being owned by bankers- I guess greed is a universal constant and who is better placed than a banker to exploit it?

The Chinese seem to be as captured by their out of control financial sector as the US- neither leadership can seriously take on their own finance sector without risking a catastrophic crash.

Bankers funded by state freebies.Who says Marx lost?

Edited January 10, 2014 by Sancho Panza

[wonderpup]

Bankers funded by state freebies.Who says Marx lost?

Socialism for the rich as the endpoint of neo liberal economics- who knew?

[buyerbeware]

Some extracts of an article I have subscribed to; could this be the mythical black chicken that people talk about. China has masses of USD it seems that they can just dole those out to the big banks to pay off the debt? What happens to the dollar then. Is this why the chinese government is buying gold?

According to the audited report from the PRC government, the shadow banking system has a loan size of around RMB 17.9 trillion (US$3.0 trillion). Given a GDP scale of US$8.23 trillion in 2012, the shadow banking loan size could be around 36% of GDP. According to some analysts, actual shadow banking loan size could be around RMB 36 trillion (US$5.9 trillion), or around 71% of GDP.

Since early 2013, central government has started to adopt anti-corruption policy, thus affecting economic activities in China. Possible GDP growth slowing and potential property price correction may escalate the risks associated with the shadow banking system.

How can the central government tackle the issue?

Undoubtedly, shadow banking is a time bomb for the PRC economy and the financial system. Nevertheless, there is no clue about the timing for the issue to become a big problem. The central government would like to handle the issue by balancing both 1) economic and 2) political factor. Indeed, anti-corruption policy may have posed some pressure from politics perspective. As such, the central government may intend to maintain steady GDP growth (i.e. not lower than 6%) and steady political environment.

To be frank, the way to tackle the shadow banking issue is very crucial for China in coming 2 to 3 years. If property market decline, this may cause the default loan size from the shadow banking system to increase.

From the bottom line, the Central government may provide liquidity to the large-sized state-owned banks, thus maintaining the stability of the banking system. Nevertheless, we foresee uncertainties for some local governments, smaller-sized government enterprises and/or private enterprises (e.g. infrastructure and property companies) in coming 2 to 3 years.

[buyerbeware]

The cause of shadow banking system

In late 2008 and 2009, the PRC government launched mega fiscal stimulus package of RMB 4 trillion, aiming to support economic growth. The government’s plan is to invest in infrastructure assets (especially in the Western part of China), thus buoying economic growth. The central government provided funds of around RMB 1.2 trillion. In other words, both the public and private sectors may need to seek 70% of the funds via internal resources or borrowings.

Local governments (especially from the less-affluent provinces), property companies and infrastructure companies have to seek funds from the banks. Nevertheless, the state-owned banks may not consider loan applications from the smaller state-owned enterprises and the private companies. As such, these enterprises had to seek funds through bond issuance, borrowing from mid-sized banks and/or shadow banking system.

The shadow banking system consists of private financing companies or investors who are willing to lend money to the enterprises. Nevertheless, interest rate from the shadow banking could be quite high. For example, a property developer may need to afford interest rate of 8%-15% p.a. by issuing bond. This implies finance cost could be as high as 20%-35% p.a. by seeking fund at the shadow banking system.

[zugzwang]

This is the most important story for the world economy in 2014. The next liquidity squeeze is due at the end of January.

http://www.reuters.com/article/2014/01/08/markets-china-debt-idUSL3N0K910B20140108

SHANGHAI, Jan 8 (Reuters) - China's interbank market dealers are braced for a rocky ride in 2014 as it becomes increasingly clear that Beijing will tolerate extreme short-term liquidity squeezes to deter sloppy lending by domestic banks.

The People's Bank of China (PBOC) confounded the market in December when it allowed a second dramatic rise in short-term money rates. Previously, many economists had suggested that a crunch that roiled domestic and global markets in June was a one-off and the PBOC was unlikely to allow another.

But that theory went out the window when the central bank again deliberately held back from injecting enough money to satisfy market demand, and banks saw themselves pay record-high rates for cash or see their ATMs run dry.

Dealers are now asking if these lessons will get banks to fall into line on improving their liquidity management.

"Twice-bitten banks should have gotten the message from the PBOC that they have to deleverage to better manage their cash flows," said a trader at a Chinese commercial bank in Shanghai.

"But it takes time for banks to carry this out, so periodic market squeezes will repeat time and again in 2014."

Defending themselves against accusations of irresponsibility in the aftermath of the mini-credit crises, central bankers have said there is plenty of liquidity in the system - banks are just misallocating it.

Traders say the next crunch could come as soon as later this month, when seasonal demand for cash will jump for the Spring Festival, or Lunar New Year, but expect spikes to occur regularly at the end of financial quarters.

Traders also warn that the resumption of initial public offerings in China this month could put cyclical pressure on short-term liquidity as subscriptions to new issues typically temporarily lock up huge amounts of cash.