China’s Runaway Train Is Running Out of Track

China’s Runaway Train Is Running Out of Track

A financial drama is unfolding in China as the new year begins. Last week, for the second time in six months, interest rates in the critical interbank lending market spiked above 10 percent, prompting fears of a liquidity crisis that would trigger mass defaults and cripple the world’s second-largest economy. Western investors largely ignored the cash crunch and failed to grasp its potential significance. Although the situation has largely eased after the People’s Bank of China hastily injected at least $55 billion into the market, that isn’t the end of the story. These repeated crises are a sign that the foundations of China’s investment-driven growth model are crumbling — with unsettling implications for the rest of the global economy.

To those who wrote off China’s first banking seizure in June as a fluke, this latest episode appeared to come out of nowhere. They cast about for explanations: Perhaps some seasonal surge in cash withdrawals was to blame, or the U.S. Federal Reserve’s decision to taper its bond-buying policy. Optimists assumed the Fed was tightening credit on purpose, as a warning to banks to rein in unsafe lending practices. With inflation at manageable levels, they reasoned, the People’s Bank of China had plenty of room to loosen monetary policy again and ease the cash crunch.

In fact, loose monetary policy is the problem, not the solution. Two simple words — bad debt — are the key to understanding why China has too much money, yet not enough. In the years since the global financial crisis, China has racked up impressive growth in gross domestic product by engineering an investment boom, fueled by a surge in easy credit. Total debt has risen sharply, from 125 percent of GDP in 2008 to 215 percent in 2012. Credit has spiraled to $24 trillion from $9 trillion at the end of 2008. That’s an additional $15 trillion – – the size of the entire U.S. commercial banking sector — lent out in just five years.

A lot of that money has gone into projects whose purpose was to inflate the country’s economic statistics, not to generate a return. Officially, China’s banks report a nonperforming loan ratio of less than 1 percent. In reality, they are rolling over huge amounts of bad debt, both on their own books and by repackaging it into retail investment products — many of them extremely short-term — that promise ever higher rates of return.

China’s banks can hide bad debt by playing this shell game, yet that doesn’t change the fact that they’re not getting their money back. With their capital locked up in existing projects, the only way they can finance the next round of big investments — and keep China’s GDP growth rates from collapsing — is by expanding credit. More and more of that new credit is now eaten up paying imaginary returns on the growing pile of bad debt.

This year, total credit in China grew about 20 percent, from an extremely high base — hardly tight money. Yet the cash needs of China’s banks aren’t what they seem. In addition to its declared balance sheet, each bank is juggling a host of dubious assets and hidden cash obligations (in the form of quasi-deposits) on what amounts to a “shadow” balance sheet. Rein in credit growth, even modestly, and there isn’t enough to go around.

That’s what Chinese authorities discovered in June, and again last week. In both instances, the People’s Bank of China didn’t take away the punch bowl by tightening credit, it merely tried to resist handing over an even bigger punch bowl. The result, both times, was a near-meltdown in the interbank lending market that threatened to unleash a cascade of defaults throughout the economy. Nor have the signs of financial stress been limited to the interbank market: Over the past few months, yields on Chinese government and corporate bonds have steadily risen, even as the economy slows.

The PBOC could, and did, halt the immediate liquidity crisis by injecting more cash. But in doing so, it effectively cedes control over monetary policy to the shadow banks. Runaway lending continues, bad debts mount even higher, and the need for more cash to paper over losses becomes that much more acute. Far from solving the problem, pumping in more cash just kicks the can farther down a dead-end street.

The implications of this brewing storm are bigger than many global investors realize. China’s credit-fueled investment boom has been a driver of metals prices and machinery exports. China has become the world’s largest automobile market, its largest oil importer, and its largest buyer of gold. Although foreign banks have relatively little direct exposure to Chinese financial markets, capital flows into and out of the mainland are potentially large enough to have a significant impact on asset classes not normally associated with China. A financial train wreck would send tremors through global markets.

The detailed blueprint for market reform published by the Communist Party in November encouraged many. China’s leaders clearly recognize that its economy needs to move in a new direction. But the first crucial step, weaning China away from its addiction to debt-fueled stimulus, is proving a lot harder than many imagined. China’s leaders are riding a runaway train that they don’t quite know how to stop. And they’re running out of track.

(Patrick Chovanec is managing director and chief strategist at Silvercrest Asset Management, and a former associate professor at Tsinghua University’s School of Economics and Management. Follow him on Twitter at @prchovanec.)

To contact the writer of this article: Patrick Chovanec at pchovanec@silvercrestgroup.com.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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