by Ambrose Evans-Pritchard
November 8, 2017
China’s central bank has warned in the clearest language to date that extreme credit creation and trouble in the shadow banking system could lead to a full-blown financial crisis.
Zhou Xiaochuan, the governor of the People’s Bank (PBOC), spoke of “fierce market reactions” and a possible Minsky Moment, the tipping point when credit cycles break and euphoric booms collapse under their own weight.
It had long been assumed that this particular form of crisis cannot happen a state-run financial system where the banks are under Communist Party control.
Mr. Zhou told China Daily that asset speculation and property bubbles could pose a “systemic financial risk”, made worse by the plethora of wealth management products, trusts, and off-books lending.
He warned that corporate debt had reached disturbingly high levels and that local governments are using tricks to evade credit curbs:
“If there is too much pro-cyclical stimulus in an economy, fluctuations will be hugely amplified. Too much exuberance when things are going well cause tensions to build up. That could lead to a sharp correction, and eventually lead to a so-called Minsky Moment. That’s what we must really guard against.”
China’s lending boom since the downturn in early 2015 is comparable to the massive stimulus after the Lehman crisis. Non-financial debt has galloped up to 300% of GDP, uncharted territory for a big developing economy.
The International Monetary Fund says debts in the shadow banking system grew by 27% last year. Less widely known is that the “augmented” budget deficit – including local government spending and the deficits of quasi-state entities – has jumped to 13% of GDP.
This is an astonishing level of fiscal stimulus at this stage of the economic cycle. It was around 6% in 2010.
The extra spending has turbo-charged the economy and lifted growth to 6.7%, a figure endorsed this time even by private economists.
The boom has allowed President Xi Jinping to bask in glory at the 19th Congress of the Communist Party this week and establish an iron grip over the Standing Committee, but at the cost of greater trouble ahead.
George Magnus, from Oxford University’s China Centre, says state control over the banking system means that bad debts can be swept under the carpet for a long time but that does not in itself avert a potential crunch. “The problems on the funding side are much more pressing, and they won’t wait,” he says.
The IMF warned in its Global Financial Stability Report that the smaller and medium size banks rely on short-term funding to cover 34% of their total lending, and most of this is on maturities of three months or less.
This exposes them to a “funding shock” if conditions suddenly tighten, forcing them to sell assets into an illiquid market at fire-sale prices. This is what happened to Northern Rock, Lehman Brothers, and AIG in the global financial crisis when the wholesale capital markets seized up.
The PBOC has been tapping the monetary brakes for several months. China’s hardline banking regulator Guo Shuqinq began cracking down on shadow credit in February, greatly reducing the pace of loan growth. This has already cooled the housing market but the full impact on the economy will not be felt until next year.
The problem with the assault on shadow banking is that private companies rely on this form of credit, while the state-owned behemoths or ‘SOEs’ gobble up most of the available loans from the ‘big five’ state banks.
“There is little evidence yet of financial distress in China but what we are hearing is that a lot of small and medium-sized firms are starved of credit, or have to pay extremely high rates,” says Mr. Magnus.
The risk for China is that inflation in the US will snap back and prompt the Federal Reserve to raise rates abruptly. That would lift borrowing costs across the world and ‘stress test’ debtors in China. It would also drive up the dollar, setting off a second leg of capital flight from China.
The PBOC would then find itself trapped by the ‘Impossible Trinity’, forced to pick its poison: either follow the Fed with rate rises, or risk a run on the yuan. Capital controls can slow the outflows but they are porous.
For now, President Xi projects an image of majestic calm. The plan to double size of the economy from 2010 to 2020 will be achieved, attaining the Confucian goal of “a moderately prosperous society”. The next target is a “modern socialist economy” by 2035, and a “great socialist economy” by 2050. He promises.
Mr. Xi vowed to shake up the recalcitrant SOEs, just as he did at the Third Plenum in 2014. The reforms never quite seem to happen.
The state giants serve as a patronage machine for the party, used to reward the faithful. “When Xi talks about reforming the SOE’s, what he means is making them stronger. This has nothing to do with making them more efficient. This is all about the control of the state and Party,” says Mark Williams from Capital Economics.
Premier Li Keqiang warned at the outset of the Xi-Li era five years ago that China’s catch-up growth since Deng Xiaoping has reached its limits and that the country will slip into the ‘middle income trap’ without a new model.
He says China must open itself up to markets and foster free thought. The country has instead gone in the opposite direction. The state is all-powerful again.
There is a price to pay for this political choice: growth is likely to slide to 3% or even 2% by the early 2020s, leading to stagnation long before China achieves affluence. A Minsky Moment may bring matters to a head much sooner.