Why China’s banking system is in so much trouble; The full transcript of the Telegraph interview with China expert Charlene Chu

Why China’s banking system is in so much trouble

The full transcript of the Telegraph interview with China expert Charlene Chu

By Harry Wilson, Banking Editor

3:31PM GMT 14 Feb 2014

How bad are the problems in the shadow banking sector?

I’ve been pretty concerned at what’s going on in China since the start of the global crisis and the start of the credit boom. One of the facts that has always been an issue is that more and more credit is being extended through shadow banking channels, the trust companies being the most prominent of those. 

I think it is very hard for the market to understand what the trust companies are doing, where the money is going, how good the borrowers are. That lack of transparency, I have always felt, is going to come back as a major asset quality problem at some point, and that seems to be happening right now.

There have been a number trust products that have gone bad over the last year and a half and that’s only going to continue given the rapid growth of that industry.

Is the Chinese financial system on the cusp of a “Bear Stearns moment”?

I do feel like we’re a bit early in the game. If you just look at the sheer volume of credit extension over the last few years – the banking sector has extended $14 trillion to $15 trillion in the span of five years – there’s no way that we are not going to have massive problems in China.

Whether or not a single trust product like this [the ICBC trust] would be the start of the unravelling is much harder to tell, because you’ve got such an interventionist government in China. This is going to be different to other markets where market forces are allowed to play out. Here the authorities get involved and that means these kind of defaults can remain one-off and isolated for quite a while.

The critical question is that at some point are these one-off issues going to turn into a very big wave of defaults that it is going to be very difficult for the authorities to manage in the same way these been able to manage the one-offs.

Will China be able to use its foreign exchange reserves to deal with any problems?

The FX reserves can be used not nearly to the extent that people think they can. There are some analysts that think they can’t be used at all, but I disagree with that. I believe they can’t be used in their entirety by any means because they are offset by the other side of the balance sheet of the PBOC [People’s Bank of China – China’s central bank], because of that you can’t just run down one side of the balance sheet, the asset side, and not deal with the liability side of the PBOC balance sheet.

They did draw on the reserves in 2003 and again prior to the listings of the big state banks. There is a willingness and a history of drawing on them, but again in very measured amounts, not substantial.

I suspect if we get into a situation where we need some kind of sizeable bailout, the FX reserves will be on the table for capital injections into the state banks and then some sort of compound of bad debt and asset management companies (AMCs – Chinese “bad banks”) and other types of forebearance.

Would China need to set up new bad banks in the event of a crisis?

It wouldn’t really make a difference if it was the same entities or other ones. The complication with the existing ones is that they are not any longer 100pc state-owned. So just having them come in and sweep out a bunch of bad debt from financial institutions on a whim complicates things. So in that sense they may need to set up state-owned asset management companies, or they could take the ones that have yet to become public and just use them in a more aggressive way.

How aware are the Chinese authorities of the problems in the banks?

It’s always hard to tell what the level of familiarity is with the Chinese authorities. I do believe that they certainly do have better data than anyone out there in terms of what is going on in the shadow banking sector and the banks. I do feel like there is still not quite enough acknowledgement that the issues we are having right now in China are particularly related to the reminbi tightness and the volatility of the interbank rates – that’s all asset quality issues.

I think there is not enough appreciation by the market in general, that would also include the authorities, for how much shadow banking is distorting all the official data people look at.

A 1pc NPL [non-performing loan] ratio, which is essentially where we are still at, means nothing when you’ve got 35pc to 40pc of the existing credit stock now sitting outside bank loan portfolios. And, they’ve been very strategic about moving the worst stuff into that.

It’s a very complicated situation in China and I think in the end we are all struggling to get our hands around it.

Does the West understand what is going on in China?

I speak to a very wide range of investors and some people are very aware of what is going on and some people aren’t. In terms of people who aren’t, they continue to be wowed by 8pc, or so, GDP growth and they don’t appreciate where that growth is coming from and at what cost to the Chinese economy and the Chinese financial sector.

When it comes to the people less familiar with what is going on here, you end up with a focus on growth and less appreciation of the financial costs over the last five years.

What is the real proportion of bad debts in the banking sector?

I have no idea. Whenever I used to get that question a few years ago I would say that the only people who would really know were the auditors who are going in doing samplings of loans across several different banks, but I think that even they don’t have a full grasp of what the asset quality is any more because we have got so many different channels to push stuff off-balance sheet – to repo exposures to other financial institutions for short amounts of time, to restructure exposures into some other kind of shadow credit – that it is undermining the signalling value of the NPL ratio and several other types of data that we are looking at.

Is that because of the increased use of domestic auditors instead of international firms?

I wouldn’t say we have seen any dramatic shifts on the banking side in that regard. I think without a doubt the biggest development on the banking side has been the growth of shadow banking – it’s not about the quality of audits. It’s about the fact that so much can be transferred into those hidden channels that it’s undermining the integrity of all the other data you can look at.

When did you first become aware of the growth of shadow banking?

The first hint we got about this activity starting up was probably in 2009 when we were meeting with one of the mid-tier Chinese banks and they were talking about repackaging their loans and selling them to trust companies who would then turn them into a trust product, they would then buy the trust product and sell it as a wealth management product to their depositors.

As soon as we heard about that it immediately raised red flags. We started pursuing that a bit more and it became very clear that banks were very interested in offloading a substantial amount of credit risk through that channel. Ever since then there has just been innovation after innovation so there has just been a constant stream to keep up with.

What will be the impact of a banking crash on Chinese savers?

The vast majority believe that retail deposits will be protected. I think it really comes down to what is the severity of the problem. We are talking about a very, very big financial system at this point. The ability of the authorities of the authorities to support that becomes a bit more difficult and I think that does [put] certain liabilities under question.

Whether we would get to the point that retail deposits are in jeopardy too? That would be a very, very severe scenario. That certainly wouldn’t be the base case at this point, but we’ve still got an issue here with a significant amount of the assets being impaired and not recognising that’s obviously got to impact their ability to meet some of their liabilities

Where’s all this lending going?

The two sectors that have received the most over the last five years have definitely been infrastructure and real estate. You’ve still got a fair amount of money going into manufacturing and more traditional corporate borrowing, but without a doubt it has been infrastructure and real estate that is taking the bulk of the money.

This is where the questions about ghost cities and infrastructure projects that don’t seem to be resulting in anything that is utilised is the question. You can only build so many empty buildings before you start to have a very serious problem with overcapacity on the real estate side. And, you can only build so much infrastructure in a short amount of time.

What is happening is that a lot of this credit has gone to these areas, it’s not cash generating, there is no cash coming in on those assets, and yet banks still have liabilities to meet and this is a key reason why we are having these liquidity issues in the banking sector.

Have you visited any of these “ghost cities?

I’ve only been to a couple of them. It’s definitely a very weird real estate market without a doubt. The odd thing is that you will certainly encounter some developments that appear to be totally empty and yet they are totally sold out.

It is a very mixed picture, but I do feel in the end that the amount of real estate building that has gone on over the last few years is substantial, yet there is still a lot of projects in the works. There is definitely reason for people to be worried that we have got a real estate bubble.

How much of this credit boom is being funded offshore and what will be impact of this on Western banks?

Without a doubt that has been on the rise and was really starting to grow fast in the latter half of last year and it’s only going to continue. For the time being, it is only a fraction compared to the massive size of the financial sector, but still we’re talking about a growing amount of funding coming from offshore sources.

One of the reasons why the situation in China has been so stable up to this point is that unlike many emerging markets there is very, very little reliance on foreign funding. As that changes it obviously increases their vulnerability to swings in foreign investor appetite. I do think, in the end, you look at the exposure numbers from the BIS and the Hong Kong banks – you’re going to encounter a few institutions that are going to have a sizeable exposure to China.

But, for the most part, the real impact on global financial institutions and the global economy is not the direct exposure issue, it is the indirect just through the China growth story.

What will be crisis look like? Will it be anything like the subprime crash?

Not surprisingly, the most common question I get is ‘are we going to have a financial crisis in China?’ and that kind of thing is impossible to predict. There is certainly a scenario where you start to go down that path, but there are unique features in China such as there’s no over reliance on foreign funding, a close capital account, heavy state influence over lenders and borrowers, that contributes to a more stable situation than other emerging markets.

It’s possible that you get something more akin to a Japan type of scenario where you are not necessarily having a spectacular banking crisis in a short amount of time, but you have something that manifests in much slower growth, a correction in asset prices, and deflation over time.

Can you tell me more about the use of dollar funding?

Yeah, I think you do. The question is how vulnerable would the system be at that point if that dollar funding were just to dry up overnight? How able would the authorities be to fill that gap in funding domestically?

*People focus a lot on the FX reserves, but real firepower that they have over the short-term is the deposit reserves that have been locked up. There is about $20 trillion locked up there and that is something they could draw down if they started to have significant liquidity issues.

What are these deposit reserves?

The required reserves you have to have. I think it’s anything from 18pc to 20pc of your deposits need to be submitted to the PBOC and held as a statutory reserve. They use that triple-R not only for precautionary reserves, but also as a tool of monetary policy to mop us excess liquidity.

Is there much of a policy debate going on in China about how to deal with the credit boom?

There are many different views at all levels on the official side whether it’s the regulators or the policy-making bodies. The real trade off in China is between growth and prudence. At this point, I think most of the people you would talk to recognise there are definitely downsides to what is going on, the problem is that if you are really going to rein it in you are going to have a significant impact on GDP growth.

GDP growth is already slowing, even when you are extending credit at large volumes we are, so if you are really talking about reining this in then you are talking about a very different growth environment and I don’t know what the appetite for that is.

I think that’s why we just continue to see very large amounts of credit extension each year, why we don’t see a strong willingness to crack down on some of these shadow channels, because it comes down to the effect it would have on growth.

What reaction do you get when you tell the Chinese banks about your fears?

Generally speaking, most of the people we talk to understand and don’t necessarily disagree with the observations, but I think in the end that what they’ll say is ‘we just believe things are going to play out in a more optimistic way than you do’.

They don’t deny the risks that are out there, the signals that are already flashing, but I think there is more faith that things will somehow muddle through without it getting ugly.

What will China look like in the aftermath of a crash? Will it mirror what has happened in the West?

I think you’ll certainly see a similar push on the regulatory side and the real question is what happens to growth in that scenario because you are talking about a very different country. This isn’t a developed market with a very strong social safety net. If we get to a situation where we are having severe financial sector problems, the chances are GDP growth is much slower than it is now for a prolonged period of time. I think a whole host of other issues pop up in that type of scenario.

I think that really is where the cost of a financial sector crisis comes in. To me, it’s much less about how much the sovereign issue in terms of debt to bail out the financial sector. It comes down to how much of a hit does growth take and what is the impact of that on the populace and do we start to have any other issues that arise from that.

What impact is emerging market currency volatility having on China?

I don’t think I can draw a link with what is happening China.

How difficult have your views made doing your job?

The most difficult thing is it makes it more difficult to get information from people because if you are not playing the same game as everyone else then you are on the outside and it just becomes more difficult to get visibility on what is happening inside the system.

I still feel like, in the end, being on the outside has not hurt me too much in terms of what is going on. There are often times what you are privy to in terms of that “inside view” can be more of the party line. Not getting the party line doesn’t necessarily have to be negative. We have been able to manage fine.

Up to this point, we have yet to get into the difficult period in China. So, it has not been too much of an issue up to now. As things start to get uglier, it could get more complicated.

What are the most important indicators on Chinese banking system if official stats are questionable?

You have got to look at numerous things. This is not like GDP numbers where you can find two or three alternatives and just use them. We have got an extremely complicated story underway in the financial sector. A very substantial portion of the financial sector does not report any data at all. I think you’ve got to keep on top of many different things.

Certainly what is happening with the interbank market and the interbank rates is probably one of the things that is quite key now, as well as seeing what the PBOC has to do to intervene in terms of providing liquidity to the market. You have to be looking at both of those things to really understand the liquidity picture.

Trying to stay on top of what all the new innovations are in the shadow banking sector. You can often look at headline credit growth data and think there is a slowdown, but what has actually happened is a whole new channel has opened up that is not being captured.

It’s not quite as straightforward as it is on the macro side.

What are these innovations in the shadow banking?

When we are talking about innovations, we are talking about different sorts of trust products, different types of WMPs [wealth management products], different structures of banks repo assets, dollar financial institutions.

Can you explain the difference between trusts and WMPs?

The market is quite confused about this. The balance blew out with the increase of loan growth in 2009 and so at the end of 2009 you had banks wanting to offload large amounts of loans. They decided the best way to do that would be to sell those loans to trust companies who would then package them into a trust product then the bank would then purchase that trust product and sell that trust product as the bank-issued wealth management product to its depositors.

Often these products are directly related to one another. Since that time we have started to have trust companies issue credit completely on their own independent of banks. So they’ll find a real estate developer that they want to extend credit to and they’ll create a trust product and sell that to investors directly.

In terms of wealth management products: the WMPs are what is issued by banks and the trust products are what is issued by the trust companies. There are now whole host of WMPs being issued by banks and they don’t necessarily have to relate to a trust product.

What attracts investors to these risky products? Are deposit rates so low savers will buy anything for extra yield?

Yes. When it comes to the bank WMPs there are a few that are not that different from a deposit, though in that sense you’ve got depositors thinking that it’s a substitute and they are not exposed to any higher risk than they would be in a deposit – in reality the banks have transferred all the credit risks to those depositors.

How does Chinese financial system compare to other countries?

The broad strokes are the same that you see everywhere which is just excessive bullishness and credit growth, poor risk management, leading to asset quality problems down the road.

We certainly have more shadow banking and state influence over financial institutions in China than we do in other markets, but that’s not necessarily unique. We have seen very similar things in Japan and Korea and some of the other Asian countries, so there’s an element of things happening in other countries. What is unique is the scale. We have never seen an increase in credit of this magnitude over such a short amount of time. You do see increases of credit to GDP greater than what we have seen in China, but they tend to be really small economies. We don’t see this type of increase in the second largest economy in the world. That’s what makes it unique.

How much does what you see scare you?

I don’t know how to answer that. In the end, there’s definitely reason to be concerned. Obviously it depends on what your exposure is in terms of how concerned you need to be. The real “so what” for me is not so much about how much is it going to cost the sovereign to clean it up, it’s more about what is going to be the impact on economic growth in China. What is going to happen to the China growth story, the global growth story, what does it mean for social and political stability in China, because that is where you start to have much more serious repercussions.

Have you ever bought a shadow banking product?

No. No, I don’t even have a local bank account.

Where do you keep your own money?

I just have an account at a foreign bank branch and I transfer it. Just because of the way we were set up, I was getting paid outside of China, so I wasn’t depositing large amounts of money into a domestic bank account. Personally, I just think for conflict of interest reasons, I shouldn’t keep any money here regardless.

Why did you join Autonomous Research?

*I have been talking with Stuart [Graham – co-founder of Autonomous] for a while about this and Autonomous was at the top of the list all the way along.

Is the research of the big investment banks conflicted given they want to win business in China?

I don’t necessarily think it’s an issue of honesty, I think it’s an issue of complexity. This is a really complicated story. We now have 50pc of all net new credit coming through the shadow channels, a large portion of which don’t report any data, so keeping a handle on that and understanding what those risk are is challenging for everyone. I wouldn’t necessarily assume it comes down to a question of honesty.

How many people really understand the Chinese financial system?

I think a lot of people get it. It’s quite similar to what I was saying about the Chinese government. I think a lot of people just draw a more optimistic conclusion to what I do. I tend to think there are characteristics that make China different, but I just don’t see how that makes them immune to having some sort of problems from everything that has been going on.

How much money are the Chinese bankers making? Are people getting bonuses to sell risky products?

You definitely have those type of… whatever you want to call them. You have bad incentives in certain parts of the shadow banking sector, yes, not necessarily within the banks themselves. It varies depending on who you are talking about.

One reason why we have seen certain parts of the shadow banking sector grow so fast is because of all the revenues that they are generating. It can be quite lucrative to help desperate borrowers find money and that is what the shadow banking sector in China is all about.

How is this all going to end?

This can take a while to play out. There are factors in China that contribute to more stability in this situation than you are used to seeing in other emerging markets. That means this can go longer and the numbers can go higher than people would often think is possible.

When will it come to and end? Another decade?

I think in the end where they’ll inevitably get caught up is the interest that is owed on the debt and the ability of borrowers to service that. The authorities can do many things from a policy perspective top down to ensure that the financial institutions are able to continue extending large amount of credit. What will be very difficult for them to manage long-term is the ability of those borrowers to service this ever increasing amount of debt that they are taking on. At some point you are going to have borrowers start to pull back or start to exhibit very serious problems in meeting those interest and principal payments and that’s, I think, where the difficulties will come in.

I do feel like this cannot go on indefinitely. The numbers that we are already talking about are off the charts. But it doesn’t mean also that we’ve only got a couple of quarters. We’re somewhere in between there.

So it could go on for another two or three years?

In theory it can, yes. In the end, most of the ingredients of financial crises or financial sector problems are already present in China. You can argue, and that’s one reason why people were so focused on the trust issue in the last few weeks, is people wondering if this is going to be the event that starts everything unwinding. There’s always that risk here. But in the absence of anything triggering that, yes, I think you can go on for a while.

Is the ICBC [Industrial and Commercial Bank of China] trust essentially a package of loans originated by ICBC?

Yes and that’s not uncommon. Banks are often involved behind-the-scenes in a lot of this shadow product. It’s one reason why I am always emphasising this idea that is often pushed by Chinese economist and academics that the shadow banking sector and the formal banking sector are separate and therefore if the shadow banking sector falls apart it does not matter. I just don’t agree with that because there is so much interlinkage between the formal banking sector and the shadow banking sector and this product [ICBC trust] is a good example.

Are Chinese banks increasingly using their Hong Kong and Macau subsidiaries to fund themselves?

We are definitely seeing very rapid growth in those entities, but when you compare that to the size of the Chinese banking sector you are still talking about something on the margins, but it is growing faster and the bigger it gets the more important it will become.

What do you think of the growth of London as renminbi trading centre?

The real reason why London was allowed to start up was the internationalisation of the renminbi. That’s the underlying motivation here. That has opened offshore funding opportunities for banks and corporates that didn’t exist before and they are starting to take advantage of that. The real policy emphasis is on internationalisation of the currency.

Would you buy bonds from offshore Chinese entities?

I would have to know who the issuer was and what the terms and the pricing were.


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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