Yves here. Even the China bulls are coming to see the financial system as a risk factor.
By David Llewellyn-Smith, the founding publisher and former editor-in-chief of The Diplomat magazine, now the Asia Pacific’s leading geo-politics website. He is also the co-author of The Great Crash of 2008 with Ross Garnaut. Cross posted from MacroBusiness
The AFR finally has some realism coming out of the spate of mining conferences underway in Hong Kong:
While the view on China is overwhelmingly positive on the main floor of the Credit Suisse Asian Investment conference, where executives are talking about continued strong demand for steel and a fast-growing economy, a darker picture has emerged in the private rooms and closed sessions such as the one titled Asian banks: banking crisis – who’s next, India or China.
For China, the fear is that all the preconditions are in place for a banking crisis, including an explosion in credit at the same time the economy is slowing.
“I think there is a 60 to 70 per cent chance that the Chinese government will need to bail out the banks in three years,” said one participant. He warned that the knock-on effects for growth and commodity prices would be severe.
“If China can’t maintain the pace of fixed asset investment, then growth falls below 5 per cent or even to zero,” he said. “The market is not mentally prepared for that.”
Hear, hear. As it happens, yesterday UBS also clarified a recent note on its concerns about Chinese shadow banking:
The concerns we raised over growing shadow banking in China in a recent note got overwhelming support, but some were critical, saying most of China’s shadow banking is regulated, and that its size is still very small compared with that in developed markets and China’s own formal banking system. We were never in the ‘hard landing’ or ‘imminent financial crisis’ camp, but there are factors investors or policy makers should not ignore.
In fact, we agree that (i) most of China’s shadow banking is regulated – since much of it is off-balance sheet credit activities of (regulated) banks and trust companies that are regulated by the same CBRC; and (ii) the size of shadow banking is still small – about 40% of GDP compared to 100% of GDP in some developed markets. However, being regulated is not same as being well regulated.
Most people would agree that the off-balance sheet activities of regulated banks are not as well regulated as regular bank lending, and trust companies and other non-bank institutions are not under the same kind of scrutiny as banks. Also, while the size of shadow banking is still relatively modest, which should reduce systematic consequences of any problem, the very rapid growth, coupled with less-strict regulation, are causes of concern.
Again, we are not saying that China is facing a financial crisis. It is our long-held view that despite some structural issues and some non-performing loan problems, China’s banking system does not have systematic risk in the near term. However, to say that China’s financial system is not about to collapse does not mean that there is little risk to concern investors or that policy makers should ignore some of the clearly unhealthy and unsustainable developments.
…In the near term, we see macro risk and liquidity risk as the two biggest risks arising from the rapid shadow banking credit expansion.
On the macro side, the rapid growth in shadow banking credit has led to a significant easing of overall credit conditions since mid 2012. While this has been helpful for growth recovery, people including policy makers who have focused on the traditional broad money and bank lending indicators may misjudge the true credit conditions in the economy. In such a case, policy adjustment may be delayed until massive leverage increase has led to over-investment, inflation, and/or asset bubbles. By then, the government may have to tighten credit abruptly, causing more pain to the economy and leaving NPLs in the wake.
Another major risk is economic volatility related to unexpected liquidity tightening. Liquidity in the shadow banking sector is generally not very stable compared with deposit-funded regular bank lending, and depends heavily on market confidence. Payment issues in parts of the market (for example, wealth management products or local government platforms) could shake confidence and dry up liquidity suddenly. Alternatively, the government may decide to clamp down on some specific WMPs or irregular local government financing practice, leading to a quick shrinkage of some shadow banking activities. In these cases, the most likely scenario is that banks either bring the underlying assets back to their balance sheets (along with deposits), or develop other products to take things over. However, either takes time and banks’ balance sheet can not expand quickly enough to completely compensate for the drop in shadow banking, especially as banks face credit quota and other regulatory constraints. In both cases, a liquidity and credit tightening occurs, perhaps even unintended by the government, in which case it may loosen later, but the damage would have been done, leading to volatility in the economy. This is kind of what happened in the summer and Q3 of 2011.
In the near term, these two risks are our main worries about China’s rapid shadow banking development. Of course, if such rapid development is left unchecked for a long time, we will also worry about systematic risks. At the moment, not facing a big systematic issue is not a reason to ignore the development in shadow banking or overall credit conditions, especially for gauging cyclical developments and policy directions.
What might happen next? We believe that while the authorities have generally been supportive of the shadow banking development, they have expressed some concerns on the lack of transparency in some wealth management products, and in excessive debt accumulation of some local government platforms. Even if the government does not tighten or change monetary policy direction soon, the speed of credit expansion is likely to slow, at the latest in H2, and activity growth will slow as well.
In short, the price of reform is now cheaper than the risks of letting the model run.