Bernard Hickey looks at how a collapse of China's shadow banks might affect a newly China-dependent New Zealand

By Bernard Hickey

Any New Zealander who lost money in our finance company collapses of 2006-08 will know how many individual investors in China's shadow banks will be feeling right now. 

It's a sense of foreboding and in many cases disbelief.

Some will be hoping it all works out and that the Government will bail them out. That worked in New Zealand for South Canterbury Finance, but not for most. Others will be blissfully unaware, as most New Zealanders were through 2006 and 2007 as the carnage unfolded quietly inside the balance sheets of these finance companies and as banks quietly withdrew their support. Some Chinese investors have already started complaining to the banks that distributed them, and in one case, to the Police.

The parallels between New Zealand's shadow banks and China's shadow banks are close, albeit on massively different scales.

New Zealand's finance companies were largely unregulated and their lending was mostly to closely connected property developers. They gathered deposits from savers by offering interest rates of 10% or more. They existed because savers believed they would never fail and they filled a gap left by banks who thought such lending was too risky.

China's shadow banks are very similar. They have been largely unregulated, although that is beginning to change. They also have boomed because they offered savers much higher rates than the repressively low rates offered by China's state-owned banks. These shadow banks, which are called trusts or Wealth Management Products (WMPs), are also exposed to just a few or single loans and they use their names to present an image of strength and dependability. Remember 'Provincial Finance' and Hanover Finance's 'Weathering the Storm.'?

One big difference is the connection between these trusts and government-guaranteed banks. In China these trusts are often sponsored and marketed to clients through banks, although they are carefully kept off balance sheet and are in theory not guaranteed.

The best example is the shadow bank in the news this week because it's due to default on Friday January 31. The "Credit equals Gold Number One" (yes that is the actual name translated into English) trust account was marketed by state-owned ICBC to its high net worth customers and raised US$500 million. The trust then lent all that money to a coal miner that went bust in 2012 and ICBC has been vague on whether it will pay it out, saying it is not responsible for paying it out when the account matures on Friday.

Here's a backgrounder from Bloomberg and one from Reuters, which suggests ICBC will blink and pay out. As recently as this week the chairman of ICBC told reporters in Davos that the potential collapse of the shadow banks was a "very good opportunity to educate the investors" about how it was not government guaranteed. 

China's shadow banks and WMPs now owe depositers more than US$5 trillion or more than 50% of Chinese GDP. They are now responsible for more than 30% of all Chinese lending and more than US$660 billion of the deposits in these shadow banks are due to mature this year.

This is where the big difference between China's shadow banks and New Zealand's finance companies lies. At their peak New Zealand's finance companies had collected around NZ$10.5 billion of deposits or about 7% of GDP and 4% of all lending. China's shadow banks are, therefore, a much bigger deal relative to China's economy than our finance companies were to ours.

The fear, as outlined here by George Soros in a Project Syndicate commentary, is that any crisis in the shadow banking sector will spill over into the Chinese economy, which has been powered since 2008 by massive credit growth. 

This New York Times backgrounder and chart explains just how stunning the credit growth has been.

It shows that China's money supply has tripled since 2006. Shadow bank lending has more than tripled in the last three years.

This explosion of bank and non-bank lending helped China avoid the worst of the Global Financial Crisis. Lending inside China almost doubled to 220% of GDP between 2008 and the end of 2012. No developed or developing nation has grown credit that quickly in that short a time without some sort of bust soon after.

Reserve Bank Governor Graeme Wheeler told Parliament's Finance and Expenditure select committee in November that China's shadow banking system was probably the greatest risk for New Zealand's economy, given that China was now New Zealand's largest trading partner.

Here's what he said back then:

One of the things that I was reading recently was a report by Fitch, which is one of the rating agencies, which in essence said that if you look at the housing exposure, or the lending exposure if you like, in the US banking system, it totals roughly around US$15 trillion and it has taken the American banking system 235 years to get there. The Chinese banking system, which includes the formal banking system and the shadow banking system, has got to a delta of US$14 trillion in 5 years.

But so what?

One argument put forward by those less worried about the growth of China's lending and its shadow banking system is that, ultimately, China can fix its own problems because the various players involved are ultimately controlled by the central government. China's savers may not be the same as the Government, but they don't have much individual power, or even the vote.

Also, very little of China's debt is to foreign parties and its own 'national account' is very healthy with foreign reserves of almost US$4 trillion. China does not face the same debt-driven financial crisis faced by the likes of Thailand or South Korea or Russia in the late 1990s, who were all hammered when foreign creditors asked for their money back at the same time. 

Many of China's shadow bank's loans were marketed by state-owned banks to state-owned companies, both at a local and national level.

The theory, say some, is that the Government could simply solve the problem by organising a large debt restructure where the slates are wiped clean and netted off against each other without the economy skipping a beat. China did a similar massive state bank debt restructure and recapitalisation in the early 2000s that didn't slow growth that much.

We've already seen ICBC appear to cave in to pressure to 'bail out' the off-balance sheet vehicle to keep the depositors whole. As we seen throughout the western world, central banks and Governments have an unlimited ability to use taxpayer resources and money printed out of thin spreadsheets to ensure banks stay solvent and party keeps rockin'.

In China, inflation is also not a problem, so the option of encouraging yet more lending by banks is not off the table. Even in the last year, China's authorities have blinked several times when credit stresses have forced interbank interest rates up and economic growth has slowed. Stability is valued above most other reform goals in China.

Are we immune?

Another argument is that even if a credit crunch causes an economic slowdown in China, it may not affect New Zealand that much. The explosion of credit in China in the last five years largely went into investment in infrastructure such as apartment buildings, roads, railways, power stations and airports. 

That credit bought an awful lot of concrete and steel, which was produced with iron ore and coal mined in Australia. 

However, Chinese consumers did not borrow money to buy the dairy products and meat that New Zealand has exported to China. They're also not borrowing to come on holiday here. China's consumers are still heavy savers. 

Indeed, the Chinese Government under new leader Xi Jingping has said he is determined to rebalance the Chinese economy away from investment and more towards consumption. That would tend to favour New Zealand, which exports products and services for consumers, over Australia, which exports the raw materials used in investment. This internal shift in China is one of the reasons why the New Zealand dollar has appreciated so much against the Australian dollar over the last year.

We'll see. Doomsayers about China's ability to keep growing fast have been proven wrong time and again by China's leaders, who have pulled plenty of levers to keep the engine running. Although the biggest lever has been the credit lever and just about everyone, including China's leaders, say that lever(age) has to be relied on less and less.

A slump in lending by China's shadow banks may not end New Zealand's export boom to China. 

But it is certainly worth keeping an eye on.