Shock rise in China's shadow banking enrages Xi Jinping

Chinese President Xi Jinping
Chinese President Xi Jinping has called for 'zombie companies' to be flushed out

China’s central bank has revealed shocking figures on the scale of shadow banking operations in the country, admitting that off-balance sheet business is more than double previous estimates.

Bank assets are approaching $38 trillion (£29 trillion). The explosive growth of hidden activities on the margins of the financial system has alarmed the People’s Bank (PBOC), and suggests that the two-year credit spree since the downturn in early 2015 is treacherously unstable.

The Chinese version of the PBOC’s Financial Stability Report – not yet available in English – shows that the shadow banking nexus is bigger than all other regular activities of the lenders put together.

Regulators had thought it was equivalent to 42pc of on-balance sheet business at the end of 2015. They have revised this drastically, admitting that it reached 110pc by the end of last year.

President Xi Jinping called for a hard-headed campaign to curb systemic risk and to flush out “zombie companies”, warning over the weekend that financial stability was a matter of urgent national security.

It is the first time that a Chinese leader has chaired the National Finance Work Conference – held every five years to thrash out long-term plans – and is a sign of rising concern as debt reaches 280pc of GDP.

In a move that will send shivers up the spines of local party officials, he said they will be held accountable for the rest of their lives for debts that go wrong. Any failure to identify and tackle risks will be deemed “malfeasance”.

For now the economy is firing on all four cylinders. Growth has been 6.9pc over the last year. It accelerated in June after a soft patch, with industrial output jumping to 7.6pc and retail sales rising 11pc as the car industry came back to life.

While private analysts take the ‘smoothed’ GDP data with a pinch of salt, the economy is clearly bubbling.  “It is too early to turn bearish on the Chinese economy,” said Wei Yao from Societe Generale.

This surge in growth is happening despite eight months of monetary tightening and lending curbs.  What it shows is the sheer unstoppable power of credit booms once they are underway.  

Central bankers face the proverbial task of pulling a brick across a rough table with elastic: they tug, and tug, and nothing happens; they tug harder and the brick suddenly jumps and smacks them in the face.

The PBOC is particularly worried about an array of asset management products (AMPs) issued by securities firms, funds, and insurers. These are a key reason why Chinese banks have built up exposure to assets equal to 650pc of GDP.

This is higher than the ratio in financial entrepots such as the Singapore, Switzerland, or the UK. The vast volumes are levered off a thin capital base of 20pc of GDP.

In theory Chinese banks act as agents while buyers take on the risk. In reality the public buy these instruments on the assumption that they will always be bailed out. This has become the Achilles Heel of the Chinese financial system.

“If the banks’ implicit guarantee starts to unravel, households may rush to withdraw funds,” said Capital Economics.

“This could snowball into a growing number of AMP defaults since maturity mismatches mean that issuers often rely on new inflows to pay out maturing bonds. The impact on financial stability would be significant. Issuers would see their revenues collapse and smaller banks could face liquidity problems,” it said.

“While it makes sense to crack down on AMPs sooner rather than later, doing so carries risks. Regulators need to be careful not to drive too rapid a slowdown in issuance or else their efforts to stave off financial instability could end up being the spark that ignites it,” said Capital Economics.

Patrick Chovanec from Silvercrest Asset Management said the authorities will blink before long. “They always back off once they have to face the consequences. The trouble is that if they pull on a thread, they just don’t know what will unravel,” he said.

Shanghai
Shanghai in China, where there has been a surge in economic growth despite monetary tightening and lending curbs

“The banks have been selling products saying it isn’t our risk. Investors have been buying them saying it’s not our risk either. They all think the government will save everything. So what the markets are pricing is what they think is political risk, not economic risk,” he said.

Jahangir Aziz and Haibin Zhu from JP Morgan said the debts of the state-owned entities (SOEs) have alone reached 90pc of GDP or $13.3 trillion. 

Nearly 60pc of new credit this year is being used to repay old loans. It takes four times as much new credit to generate a given amount of  extra of GDP as it did a decade ago. “China’s rising indebtedness has come to represent all that is disconcerting about their economy,” they said in a report entitled “The Sum of All Fears”.

The credit-to-GDP gap tracked by the Bank for International Settlements as an early warning indicator is currently at 24pc, far above the threshold level of 10pc that usually foretells a banking crisis within three years.

Most of the debt is domestic, the local savings rate is high, and foreign reserves are huge. All this offers some protection but JP Morgan argues that much the same was true of Japan before it slid into intractable slump.

The widespread assumption is that there cannot be a financial crisis in China’s closed state-controlled system, and that any denouement is more likely to be a slow loss of dynamism. Growth rates could fall to 2pc by the early 2020s if the Communist Party fails to grasp the nettle of reform.

Yet this could prove complacent. The shadow banking data released by the PBOC opens a window into something more disturbing. China may not see a classic ‘Minsky Moment’ like Lehman but there could be traumatic ending nevertheless, with distinctly Chinese characteristics. This year at least looks safe.

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