China's credit bubble in danger of imploding
China's shadow banking system is out of control and under mounting stress as borrowers struggle to roll over short-term debts, Fitch Ratings has warned.
The agency said the scale of credit was so extreme that China would find it hard to grow its way out of the excesses as in past episodes, implying tougher times ahead.
"The credit-driven growth model is clearly falling apart. This could feed into a massive over-capacity problem and potentially into a Japanese-style deflation," said Charlene Chu, the agency's senior director in Beijing.
"There is no transparency in the shadow banking system and systemic risk is rising. We have no idea who the borrowers are, who the lenders are, and what the quality of assets is," she said.
While the non-performing loan rate of the banks may look benign at just 1 per cent, this has become irrelevant as trusts, wealth management funds, offshore vehicles and other forms of irregular lending make up over half of all new credit.
"It means nothing if you can offload any bad asset you want. A lot of the banking exposure to property is not booked as property," she said.
Concerns are rising after a string of upsets in Quingdao, Ordos, Jilin and elsewhere, in so-called trust products, a $US1.4 trillion ($1.47 trillion) segment of the shadow banking system.
Bank Everbright defaulted on an interbank loan 10 days ago amid wild increases in short-term "Shibor" borrowing rates, a sign that liquidity has suddenly dried up. "Typically stress starts in the periphery and moves to the core, and that is what we are already seeing with defaults in trust products."
Fitch warned that wealth products worth $US2 trillion of lending are in reality a "hidden second balance sheet" for banks, allowing them to circumvent loan curbs and dodge efforts by regulators to halt the excesses. This niche is the epicentre of risk. Half the loans must be rolled over every three months, and another 25 per cent in less than six months.
This has echoes of Northern Rock, Lehman Brothers and others that came to grief in the West on short-term liabilities when the wholesale capital markets froze.
Ms Chu said the banks had been forced to park over $US3 trillion in reserves at the central bank, giving them a "massive savings account that can be drawn down" in a crisis, but this may not be enough to avert trouble given the sheer scale of the lending boom. Overall credit has jumped from $US9 trillion to $US23 trillion since the Lehman crisis. "They have replicated the entire US commercial banking system in five years," she said.
The ratio of credit to GDP has jumped by 75 percentage points to 200 per cent, compared to roughly 40 points in the US over five years leading up to the subprime bubble, or in Japan before the Nikkei bubble burst in 1990. "This is beyond anything we have ever seen before in a large economy. We don't know how this will play out. The next six months will be crucial," she said.
The agency downgraded China's long-term currency rating to AA- in April but still thinks the government can handle any banking crisis, however bad.
"The Chinese state has a lot of firepower. It is very able and very willing to support the banking sector. The real question is what this means for growth, and therefore for social and political risk," she said.
"There is no way they can grow out of their asset problems as they did in the past. We think this will be very different from the banking crisis in the late 1990s. With credit at 200 per cent of GDP, the numerator is growing twice as fast as the denominator. You can't grow out of that."
The authorities have been trying to manage a soft-landing, deploying loan curbs and a high reserve ratio requirement for banks to halt property speculation. The home price to income ratio has reached 16 to 18 in many cities, shutting workers out of the market. Shadow banking has plugged the gap for the past two years.
Wei Yao from Societe Generale said the debt service ratio of Chinese companies had reached 30 per cent of GDP - the typical threshold for financial crises - and many would not be able to pay interest or repay principal.
She said the country could be on the verge of a "Minsky moment", when the debt pyramid collapses under its own weight. "The debt snowball is getting bigger and bigger, without contributing to real activity," she said.
The latest twist is sudden stress in the overnight lending markets.
"We believe the series of policy tightening measures in the past three months have reached critical mass, such that deleveraging in the banking sector is happening. Liquidity tightening can be very damaging to a highly leveraged economy," said Nomura's Zhiwei Zhang.
"There is room to cut interest rates and the reserve ratio in the second half," wrote a front-page editorial in China Securities Journal on Friday. The article is the first sign that the authorities are shifting to a looser stance after a spate of bad data over recent weeks.
The journal said total credit in China's financial system may be as high as 221 per cent of GDP and warned that companies will have to fork out $US1 trillion in interest payments alone this year.
"Chinese corporate debt burdens are much higher than those of other economies. Much of the liquidity is being used to repay debt and not to finance output," it said.
It also signalled worries over an exodus of hot money once the US Federal Reserve starts tightening. "China will face large-scale capital outflows if there is an exit from quantitative easing and the [US] dollar strengthens," it wrote.