by Ambrose Evans-Pritchard
May 18, 2017
China’s authorities are increasingly worried by stress in the country’s financial system and the sudden slowdown in economic growth, fearing that it may now be too dangerous to press ahead with their draconian crack-down on shadow banking.
The People’s Bank (PBOC) began signaling late last week that it would soften its assault on the credit markets, shifting instead to pro-growth policies and efforts to prevent a liquidity shock before the Communist Party’s 19th Congress in November.
Then on Sunday (5/15), Premier Li Keqiang told the International Monetary Fund that regulatory overkill would be a mistake at this delicate juncture. The state media says “financial stability” is now deemed a greater priority than efforts to control debt.
“They are spooked. They know that shadow banking is running amok but they are not really willing to follow through and take the leverage out of the system,” says George Magnus from the China Centre at Oxford University.
Trouble has been building for weeks. “Certain China macro-indicators that we follow are starting to wave red flags. China’s Monetary Conditions Index (MCI) has seen four consecutive months of declines suggesting liquidity conditions are starting to tighten” says Jeremy Hale from Citigroup.
China’s credit cycle is an extremely powerful force for the world economy. When it shifts direction, the effects ricochet through the commodity bloc and emerging markets. Secondary waves ultimately reach Europe and the US.
The ‘credit impulse’ first rolled over in November. The gauge – watched as a leading indicator – has since turned negative. It points to much weaker growth later this year.
The PBOC is alarmed by the scale and opaque practices of ‘wealth management products’ and other shadow banking instruments, estimated by Moody’s at $9.4 trillion or 87% of Chinese GDP.
Minsheng Bank has been fined for issuing such products to cover losses on trade credits, a pattern of abuse akin to tricks used by Icelandic banks at the onset of the global financial crisis.
Nikolaos Panigirtzoglou from JP Morgan says Chinese money market funds, wealth products, and trusts, are intertwined through complex ‘repo’ trades and leveraged cross-holdings – a precarious web that some compare to a giant Ponzi scheme.
“The financial interlinkages are reminiscent of the chain-reaction that occurred in the US and Europe following the collapse of structured investment vehicles (SIVs) after the Lehman crisis,” he says.
Banks have been borrowing on short-term capital markets to lend “long” – like Northern Rock and Lehman Brothers – creating a perilous mismatch of maturities. Huge sums must be refinanced every three months, or sooner.
“This is their Achilles Heel. It is very similar to what happened in the West in 2005 to 2006,” says Oxford’s Dr. Magnus.
“Does this mean it is all going to blow up over the next six months? I don’t think so, but what happened in Japan shows that you can have a domestic banking crisis even if you have high savings and no foreign debt,” he says.
The shift in policy over recent days suggests a Politburo power struggle over how to calibrate a soft-landing. Just a week ago the state mouthpiece Xinhua ran an editorial vowing that there would be no let-up in the war against rogue finance.
“China is in the midst of its harshest crackdown on financial risks in history. One thing is clear: China will not backtrack – deleveraging is good for the economy. A financial crisis occurs when those in power bury their heads in the sand and refuse to act,” Xinhua says.
There has been a whirlwind of tough rules and fines since Guo Shuqing – heir to the great reformer Zhu Rongji – was appointed chief banking regulator in February with a mandate to cleanse the Augean Stables.
His zeal has turned gentle tightening into a full-blown squeeze. Net bond sales by Chinese companies have been negative for the last five months. Over $17bn of new issues were cancelled in April.
Five-year borrowing rates have shot up by 150 basis points since November to over 5%. Real rates are rising even faster as factory gate inflation drops back. The long term yield curve has “inverted”, typically a harbinger of recession in Western economies.
The question is whether the new policy language implies a tilt or a complete reversal. Chang Liu from Capital Economics says Beijing will stick to its guns on deleveraging unless there is a sharp slowdown in growth, or a surge in lending costs and bankruptcies, or a lack of jobs. “We think the deceleration in the economy will be gradual,” he says.
China’s Caixin manufacturing gauge dropped to a seven-month low in April. The growth of fixed investment in the sector has fallen to zero. Output of cars and mobile phones has stalled as internal demand is squeezed. Iron ore prices have slumped.
The IHS Materials Price Index measuring everything from energy and metals, to lumber, fibers, and freight rates has fallen 11.2% since its peak in February, suggesting that the world may soon a fresh wave of imported- deflation from China. While oil has rebounded, that is because of output cuts by OPEC and Russia rather than evidence of strong demand.
China’s property market is still hot but curbs are starting to bite. The minimum down payment for a flat in Beijing and Shanghai is now 60%, and 80% for second home. The boom is still raging in the smaller inland cities, but housing is cooling already on the eastern seaboard.
We can see with hindsight that China resorted to extreme credit creation and fiscal spending to avert a crunch eighteen months ago. This stimulus began to run out of steam late last year, with effects that only became clear this spring.
The latest loan spree has pushed the debt ratio to 260% of GDP. The Bank for International Settlements says the ‘credit gap’ is 30%. No country in modern times has emerged from such levels without a non-performing loan crisis.
Beijing has the means the keep this game going for a while yet, but it is a Faustian Pact. The Chinese Communist Party is riding a tiger. Getting off is becoming almost impossible.