The lead story at Bloomberg is George Soros’ dire warnings about China a speech yesterday. He is talking his book; he’s short the renminbi, and pumped for China to float the Chinese currency against a broader basket of currencies, which would also lead it to decline against the dollar.
Soros made a doomsday call against Europe in 2012 that did not pan out, and he has been aggressive there in trying to influence policy, both on economics and on Ukraine. And he acknowledged that the timing of ugly end games is uncertain. Key sections from the Bloomberg story:
China’s March credit-growth figures should be viewed as a warning sign, Soros said at an Asia Society event in New York on Wednesday. The broadest measure of new credit in the world’s second-biggest economy was 2.34 trillion yuan ($362 billion) last month, far exceeding the median forecast of 1.4 trillion yuan in a Bloomberg survey and signaling the government is prioritizing growth over reining in debt.
What’s happening in China “eerily resembles what happened during the financial crisis in the U.S. in 2007-08, which was similarly fueled by credit growth,” Soros said…
Capital outflows from China are a growing phenomenon driven by the nation’s anti-corruption campaign, which makes people nervous and spurs them to pull money out, Soros said. While China’s reserves swelled by $10.3 billion in March to $3.21 trillion, they’re down by $517 billion from a year earlier.
With over $3 trillion in reserves, China would seem to have tons of firepower to support its currency. Some analysts have argued that IMF metrics suggest that below $1.8 trillion would put China at risk, which on the surface seems hard to fathom. The bigger issue with depleting reserves may actually be political: even though the reserves cannot be spent domestically, Chinese citizens regard them as wealth and have gotten upset at US moves that they perceived reduced the value of those holdings. So actual depletion to defend the currency if it continues could become a hot topic for the government.
The underlying issues with credit growth, however, are that too much easy credit eventually means bad loans. But if you are a fiat currency issuer you can just keep bailing out your banks until inflation becomes an problem of the politics of how the government does the rescues restricts future salvage operations. Soros raised the specter of 2008. But when I saw the signs of trouble in 2007 and 2008, I thought the outcome would be more like the aftermath of Japan’s bubble years: a ratcheting down of markets and the economy over a protracted period, with bad loans written off way too slowly. And the big wave of failure didn’t come until 1997, when the Japanese thought the economy had recovered enough so that they could reduce stimulus.
Mind you, the Chinese government regards producing growth as a prime directive, but bouts of inflation have generated serious unrest, so inflation is a bigger constraint than one might think.
Now Japan had only (IIRC) 11 “city banks” and 3 long-term credit banks that dominated its financial system, so it didn’t have that many moving parts to oversee. One issue that has the potential to cause more disruption is operational: whether China can shore up its various shadow banks quickly enough if they start falling over so as to prevent contagion. There have been some wobbles in the wealth management products market and the government did prop them up. But as we saw in 2008, efforts to reduce risk in a tightly-interconnected system tend to and in fact did backfire. So there’s legitimate reason to keep a worried eye on China.
Bruegel has a fresh article on the Chinese banking system which gives a good overview and discusses the major types of credit providers. Key findings:
…total bad loans reached 1.27 trillion yuan at the end of 2015, the highest since the global financial crisis, on the back of an economic slowdown and a ballooning corporate debt. All in all, one can argue that the banking sector is becoming the Achilles’ heel of the Chinese economy once again, as happened in the past. Chinese public banks are particular hit hard amidst the rise of non-bank financial institutions and rural banks. In fact, Chart 1 shows that the assets managed by large commercial banks have been dropping over years from nearly 60% of total assets in system in 2003 to about 40% in 2014. Yet compared with non-bank financial institutions and rural banks, large commercial banks generally still enjoy the support of the state, which still brings enormous benefits. The latest example can be found in the rumours saying seven listed Chinese banks may have received permission to lower their coverage ratios.
Notwithstanding the slowdown of the Chinese economy, bank credit has continued to expand quite rapidly. This includes both official bank credit but also the shadow banking. Only in the first two months of 2016, bank credit rose a significant 28% to RMB 3351 billion compared with the same period in previous year. When adding corporate bond issuance and shadow banking, total credit expansion in the economy totaled RMB 4200 billion in January and February, a 23% increase from the same period in 2015…
Over all, the outcome of the Annual Party’s congress last month has made it very clear that growth is the key target and that the rest, including excessive leverage, is to subsidiary to that. This was confirmed by the surprising move of the People’s Bank of China (PBoC) cutting the required reserve ratio (RRR) by 50 bps effective from March 1st, 2016…. The high bank loan growth was also amplified by the fact that zombie corporates rushed to get credit before the PBoC announced that banks could not grant loans to unapproved projects taken by zombie corporates, which however seems hard to implement given the overwhelming importance of the growth target.
The extensive credit expansion in January and February, especially from the banking sector, has several implications. First, it masks the growth of the non-performing loan ratio as the denominator has experienced such a big increase (see Chart 3). Second, such surge in credit granted must have had a surge in demand as well. Whether that new demand reflects an improvement in the economy or simply more financing needs is a key question. If it is the latter then it reflects an increasing demand for new funds to repay outstanding loans…
The question, thus, is how weak are Chinese banks in the current circumstances.
We cannot take banks in the whole China banking sector as homogenous. For the banking sector as a whole, pre-provision profits and cash loan loss reserves are enough to charge off bad loans as the average coverage ratio is 235%. This basically means that large banks should be quite prepared for the current economic downturn…As for the risk of contagion through a liquidity channel, the PBoC has swiftly moved to daily open market operations which lower the risk of a liquidity crisis…
All in all, it seems clear that the Chinese banking sector, which has become massive – even for China’s huge economic size – will have to navigate difficult waters in the next few years. The key risk is coming from corporate borrowing and, to a lesser extent, from the reduction of profitability stemming from financial liberalization and heightened competition.
As much as this analysis is thoughtful and measured, one is left with the similar nagging concerns in the runup to the crisis of a lack of a real grip on the situation, most of all by the authorities. Those who are confident that China can engineer a soft landing are betting on the will and skill of its financial and monetary authorities. We’ll see in due course if they are up to the test.