21st March 2017
There’s a cute expression that last did the rounds after Lehman went belly-up. As the destruction of balance sheets tore through the the financial system, the black cry rang out that ‘there’s nothing right on the left side of the balance sheet, and nothing left on the right’. Eventually we recovered. But fast forward to 2017 and what about China, which according to the New York Fed, has accounted for a half of all new credit created globally since 2005?
China’s credit situation has been on most people’s radar screen for a little while now, but there’s been no closure, no validation of imminent demise from when Ordos (ghost town) was first noticed to last year’s financial stress. Indeed, for a year now, there’s been every indication that China’s leaders wanted and have achieved stability (at all costs) in 2017. But this isn’t the time to lose the scent, for the clues as to what happens next are still in the finance sector, and in places that many analysts don’t look. For these reasons, this blog is more essay.
To start, a quote:
“Shadow banking is not subject to full regulation, or any regulation at all. We have to focus. If not, the real economy will suffer”.
You might think this is a quote from some seasoned China-watcher, waiting with the patience of Job for the denouement of the credit cycle. But you’d be wrong: they were uttered earlier this month at the annual China Development Forum by Yi Huiman, the chairman of ICBC (Industrial and Commercial Bank of China and quoted here, the world’s largest bank, ranked by assets. He was referring to the eruption of unregulated – more likely poorly regulated – investment vehicles, such as wealth management products (WMP’s), and he did so barely a month after the People’s Bank of China (PBC) and the three other Regulatory Commissions (Banking, Insurance and Securities) had issued new draft guidelines designed to dampen down the growth in WMPs and curb the activities of banks in this sphere. And that came just 6 months after another set of regulatory guidelines to try and restrain shadow banking activity.
Why kick off with this? Everyone knows by now that China has a problem with rapid credit creation, misallocation of capital, reliance on credit to drive GDP growth, and the accumulation of bad loans on the books of Chinese banks formally estimated at less than 2 per cent of assets but privately reckoned to be more in the region of 22 per cent. Yet, the focus on debt to GDP and bad assets, while important is also inadequate, as I am going to try and explain here. In a state-owned banking system, debt accumulation and misallocation of capital can go on for a long time, even if eventually someone has to pay for it, as they always do. A lot of people who know this may be tiring of waiting for a definitive conclusion and given up, as was suggested by a recent Financial Times report .
But they should be patient. For, as this process continues, another less manageable problem becomes clear, and that problem is on the other side of the balance sheet of the financial system, that is, the liabilities, not the assets themselves. This attracts far too little attention. Rapid growth in assets has to be matched by equally rapid growth in liabilities. And this is China’s Achilles’ heel. Its rather nerdier than good old, vanilla debt to GDP, but bear with me.
Wealth management products, briefly
Having mentioned WMPs already, the more general reader should be aware of what they are, why they’re important, and that they have mushroomed from virtually nothing a few short years ago into a 76 trillion yuan ($11 trillion) market. WMPs have become very popular with investors because they offer higher yields than bank deposits, which, along with property are the two principal ways in which Chinese citizens hold wealth. They own little in the way of equities, mutual funds or more complex financial assets. WMPs come in different forms, with greater and lesser degrees of risk to the holder. According to a recent UBS report, about 56 per cent of WMPs are invested in bond and money market assets, 16.5 per cent in ‘non-standard’ debt instruments, 17.7 per cent in cash and deposits and just 10 per cent in equities and other assets.
Many, mostly smaller banks, have constituted WMPs with untradeable debt in the form of repackaged or tranches of loans, which would be among the most vulnerable to default in an economic slowdown, not to mention to depositors wanting their money back in a hurry. Bond markets in China, by the way, have been under some pressure since the fourth quarter 2016, reflecting a rising incidence of default and higher interest rates, but as yet, there hasn’t been the kind of ‘event risk’ pressure under which these products would be severely undermined.
A key thing to note about WMPs is that they are issued by banks and other financial institutions as a source of deposits, which are needed to fund loans, and sold as an investment product to other banks, institutions, households and other institutions. They now constitute the second biggest liability of Chinese banks, after regular deposits, and amount to about 30 trillion yuan – a six-fold increase compared with 2010-12. In order to bypass or minimise the effect of regulations, including those pertaining to capital adequacy, banks hold most of their WMPs off-balance sheet, utilising securities companies and other NBFIs to manage the proceeds. A high proportion is invested in the bond market, which securities companies then put into the repo market in order to leverage up the capital return.
In an echo from the pre-Lehman crisis days when complex layered leverage products known as ‘CDO squared’ were doing the rounds, China has developed a sort of WMP squared market too, with some WMPs investing in other WMPs, partly to get round regulations and partly to enhance yield. According to a Bloomberg report, these leveraged varieties have grown for less than 500 billion yuan to over 4 trillion in the last four years.
Financial system assets have boomed to 440 per cent of GDP
I’ll return to WMPs below but the next thing to recognise is the enormity of the growth in China’s financial system, and the extraordinary way in which savings in China have become increasingly diverted away from traditional and boring household deposits in banks to new, complex and much less well regulated instruments and institutions. In fact, if there is one area of reform where China has been making waves and not getting bogged down by resistance and lack of commitment, it is financial reform and innovation. The problem is that so-called ‘financial deepening’ has proceeded far faster than advances made in institutional and regulatory capacity, specifically, and in broader economic reform, more generally.
Regardless, China’s financial system has changed markedly since the financial crisis in 2008. Financial system assets, which are basically loans, have grown from around 250 per cent of GDP to 440 per cent in 2016. China’s big 4 banks have raised their share of this expanded asset base from 96 to 109 per cent, but the roughly 140 other banks (including 3 policy development banks) boosted their own share from 100 to 185 per cent.
The even more striking development is that other entities whose assets accounted for 52 per cent of GDP in 2008, lifted their share to 147 per cent by 2016. These include, mainly, securities and insurance companies, trust companies, asset and wealth management products – precisely the kind of non-bank financial intermediaries (NBFIs) at the heart of Chinese shadow banking. These and similar entities are important in China’s financial system respects for the same reason that shadow institutions were key in the West in the run up to the financial crisis. They are (and were) a significant part of the deepening and complicated leverage of banking and non-banking financial institutions against one another in which a growing proportion of the financial system’s liabilities are funded by lenders who are much less stable than households, and at maturities that could be from overnight to a week or two.
We know credit/GDP and bad assets are a problem
Some things we know. As the IMF and the BIS tirelessly point out, here for example, China’s credit gap – the deviation of credit growth away from its long-term trend – is very high in China (about 27 per cent), compared with say, Japan, Thailand and Spain, which all opened up smaller gaps before they experienced financial crises, and subsequent deleveraging. The scale of the gap and the length of time it persists is positively associated with the onset of a serious financial crisis. The level of debt to GDP, variously estimated at between 260-300 per cent of GDP, the speed with which it has risen, and the 8 or so years in which it has been continuing all make China a classic risk case for a fall, with all its attendant consequences on growth for several years after.
We also know that when banks accumulate bad assets, they breed potentially systemic problems that might overwhelm the capital of the banking system and or threaten its liquidity if confidence ebbs too much. But this is where the big macro view alluded to becomes much less urgent, because in China, where all the main financial institutions are agents of the State and instruments of the government, there clearly isn’t going to be an insolvency crisis as there was in the West in 2007-08, and later in the Eurozone.
This doesn’t mean China won’t have to do a lot more to recapitalise its banks, and address the recognition and management of bad debts on bank balance sheets, but these tasks are less important, in a way, than others. The urgent challenges are to:
a) embrace deleveraging as a goal, and so try to stabilise and then reduce the reliance on debt and leverage for growth. Since 2011, for example, the non-financial corporate sector’s ratio of liabilities to equity has risen from 75 to 85 per cent, and its liabilities as a share of earnings (before interest and tax) have grown from 7 to 20 per cent. These ratios are still expanding.
b) develop a strategy to allocate the costs of bad debts via writeoffs, restructuring or other payments – essentially to local and provincial governments and the State, since state entities have assets that can be liquidated or transferred with minimum disruption in an economy that is supposedly prioritising the development of household spending, and private businesses as employment and service providers.
It is worth noting also at this point that debt in China is correctly seen as residing predominantly in the non-financial corporate sector, especially SOEs. But the nature of this problem and how to manage it, are complicated by the fact that the roughly 20 per cent growth in total financial claims in the last 5 years has been running at about twice the rate of non-financial corporate liabilities, especially since 2014. The insightful Jonathan Anderson at EM Advisors has noted that the difference is accounted for by lending to property developers and funds and to quasi-fiscal, and quasi-corporate borrowers, including policy development banks, and local and provincial government financial vehicles, once called local government financing vehicles or LGFVs, but now masquerading as Public-Private Partnership structures, and local development and investment funds. All are heavily involved in infrastructure, development and construction activities that have been pivotal in stabilising the economy over the last year and in the run up to the important 19th Party Congress later in 2017.
But funding the assets is a more immediate problem
To meet the two challenges though requires a major change in the articulation and implementation of policy – something that the government has been unwilling to do. Since the first quarter 2017, the People’s Bank has raised lending and repurchase policy rates twice by 10 basis points each time, the second occasion in the wake of the Federal Reserve’s March policy rate increase. But no one would label this a serious tightening of monetary policy, which would entail hundreds of basis points of tightening, and everyone knows the PBC doesn’t call the shots on broader policy anyway. So we get incremental changes that look like policy restraint, but are designed to avoid liquidity or credit supply shocks and sustain adherence to the growth target of around 6.5 per cent.
There have also been relatively minor macro-prudential adjustments since 2016 to the composition of lending, to the terms of home, especially second home mortgage financing, and to bank and non-bank capital, liquidity and product management practices, but in a context where these do not lead to an overall tightening of credit creation and conditions. In the last few days, a further round of property restrictions was announced.
While this mismatch between leverage, and policies designed to curb it persists, the authorities are paying little or no attention, it seems, to managing the funding problem that is brewing as excessive lending comes to depend more and more on riskier instruments and products. Much of this is occurring in the interbank and repo markets, where institutions sell instruments with short maturities to buy them back later. Generally, banks are borrowers from these markets, while the suppliers of funds are money market investment vehicles such as WMPs, trust plans, and money market mutual funds. The IMF has noted that in 2015, 61 per cent of WMP assets had maturities of less than 3 months, and 13 per cent had maturities of less than a month.
The IMF’s Global Financial Stability Report, published in October 2016, drew particular attention to this phenomenon, noting that short maturity wholesale funding for banks had risen from a 10 per cent share of total funding in 2010 to 15 per cent in 2014, and then to 30 per cent in more recent times. For many smaller and medium-size banks, wholesale funding has grown to account for 15-30 per cent of assets. Banks operate in these markets as both buyers and issuers, mostly with big banks providing wholesale funding to their smaller peers. They do this by purchasing the WMPs of the latter, and by issuing their own WMPs to provide interbank loans. The increased riskiness in the funding structure of banking sector liabilities has three important implications, highlighted in the Report.
First, borrowers in the repo market have bigger and more frequently purchasing needs, even daily, to roll over their liabilities. This exposes them to both interest rate risk, if for example the PBC did raise rates more significantly, and illiquidity risk, if funding sources dry up.
Second, and to repeat, a high proportion of wholesale repo funding originates with NBFIs and other institutions and is tied to financial products that could be withdrawn or disappear quickly in the event of rising angst in the market place about credit quality, a significant default or similar.
Third, and this resonates precisely with the Western financial crisis of 2007-08, the lack of transparency in the financial linkages and interconnectedness among institutions and instruments means that in a credit or economic ‘event’, it is very hard to identify how and where liquidity support needs to be targeted. Western countries introduced the policy of quantitative easing originally to unblock the arteries of credit in the economy that had become sclerotic, previous piece-meal liquidity measures having failed to address the problem sufficiently. It is one thing to claim the PBC could deal with an isolated credit risk event, or flood the market with liquidity temporarily as it has done before during times of general market stress, but quite another to wonder how it might cope with a systemic crisis.
Last month, new guidelines were introduced that would, if properly implemented, prevent banks from paying out on any WMP losses or guaranteeing principal, holding them off-balance sheet to ease capital adequacy requirements, and including high yield and non-standard debt assets in their WMPs. These and other guidelines are certainly designed with the best of intentions, to try to de-risk the financial system.
Yet, it is a moot point whether incremental macro-prudential guidelines can have a lasting and effective impact when the powers-that-be are willing to allow a situation to persist where broad financial claims continue to increase by close to 20 per cent a year, and where the funding structure of the matching liabilities is becoming progressively more vulnerable and volatile.
In May 2016, a trenchant ‘anonymous source’ interview on the front page of The People’s Daily – widely believed to be close Xi adviser, Liu He – almost pleaded for this state of affairs to come to a halt and for the government to re-energise the supply-side and market reforms that have, for the most part, been diluted or been gathering dust. Nothing has happened, but optimists hope that there will be a sea-change after the 19th Congress in which China would finally put the credit genie back in the bottle and try to manage a deleveraging-led slowdown in economic growth that could end in low single digits for a while.
Sceptics acknowledge this, but wonder about Xi’s will and capacity in this regard. The alternative, though, is an event-driven denouement when key financial ratios are even more vulnerable than they are today, and probably some time in the early years of Xi’s second five year term. The catalyst could be capital flight, property prices, political or a trade shock in which there’s a scramble to withdraw liquidity. No Lehman moment as such in a state controlled financial system, but most likely the precursor to a much more difficult and protracted growth slowdown.
No one can time this. The good news is it’s not imminent or likely before the Party Congress. The bad news is that it’s probably not more than 2-3 years away if there isn’t a material change in economic policy and management.