By Jonathan Wu*
[This is the second in a series on China. The first one is here. ]
The market has raised plenty of concerns about China’s “shadow” banking system, describing it as a monumental debt bubble just ready to burst at the seams.
This fear has clearly fed on itself in the last 6 weeks or so and hence seen another weight of money leaving the emerging markets including China and being placed back into developed market equities.
First and foremost, is China’s credit growth an issue?
Yes and no is the answer.
If this is a true bubble, then historically people would not have seen it coming.
Many examples prove this from the first tulip bubble in 1637 to the GFC of 2007, it was simply a fact that no one saw it coming.
Yet in this case, everyone has identified it.
This in fact has allowed the Chinese leadership to address it straight away. If only the same reports were coming out in 2005 or 2006 regarding the risks that unprecedented levels of lending were being generated in the US could cause, the crisis that then ensued would not have been so serious.
So how is the leadership addressing it?
They effectively froze liquidity in late July within the interbank system causing the SHIBOR (Shanghai Interbank Rate) to shoot up from 4% normalised levels to circa 15%.
At the same time the CSRC (China Securities Regulatory Commission) gave the banks a stern warning regarding their lending standards and the way they are lending out the money.
Some history and context needs to be provided here. Since the 2008-09 stimulus worth US$ 4 tln, the Chinese government was very encouraging with regards to M2 or loan growth.
A lot of this money has since gone into the investment side of the GDP equation where some of which went into social financing and not into productive sectors of the economy. This is where the problem lies.
Compounded with this is China’s ultra conservative banking system where loan to deposit ratios are capped at 75% making them net borrowers as opposed to net lenders. (In New Zealand it is 140%; in Australia we are far above 120% and deregulated.)
Where most banks have to obtain interbank funding for short, medium and long term loans, Chinese banks historically only meaningfully dip into the short term market as they are well capitalised.
With such a strict limit, the banks started to become somewhat creative and created short duration Wealth Management Products (WMPs) and trusts which has led to credit misallocation and inefficiency. This is the yes part of the credit growth problem.
The No part is focused on the government’s actions to date which includes strict rules forcing WMPs to readjust their asset allocations to publicly listed assets and away from small-time property developers and local government financing vehicles.
Further to this, China’s Ministry of Finance has banned local governments from placing public assets, such as schools or hospitals into trusts or WMPs.
There are also increased levels of deposit requirements for provincial governments on property purchases and in some cities, outright bans on multiple property purchases.
So the action taken by the government to date has been strong and heavy handed.
[The third and final part in the series will be published tomorrow: 'The true issue facing China is its middle class'. ]
Jonathan Wu is an associate director at Premium China Funds Management. You can contact him here