China's credit bubble in danger of imploding
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.
Frequently Asked Questions about this Article…
China’s shadow banking system refers to non‑bank credit channels such as trusts, wealth‑management funds and offshore vehicles that sit outside regular bank balance sheets. Fitch and other analysts say it’s risky because it lacks transparency — lenders, borrowers and asset quality are often unclear — and now accounts for a large share of new credit, creating systemic risk that could spill into the broader economy and markets.
According to the article, trust products make up about US$1.4 trillion of the shadow banking sector, while wealth products represent around US$2 trillion of lending. Fitch warned these wealth products act like a ‘hidden second balance sheet’ for banks, allowing banks to sidestep loan curbs and concentrate risk off balance sheet.
Bank Everbright’s recent default on an interbank loan, coupled with wild spikes in short‑term Shibor borrowing rates, signalled that liquidity in overnight and wholesale markets has suddenly tightened. Fitch said this is an early sign that stress is spreading from peripheral trust products toward the banking core.
The article reports China’s credit‑to‑GDP ratio rose by about 75 percentage points to roughly 200%, a level much higher than pre‑crisis increases in the US or Japan. For investors, a very high credit‑to‑GDP ratio indicates heavy leverage in the economy, limited scope to ‘grow out’ of bad assets, and greater vulnerability to deleveraging, slower growth and financial stress.
Analysts quoted in the article warned China could be heading towards a ‘Minsky moment’ — a sudden collapse of a debt pyramid under its own weight — or see Japanese‑style deflation if credit‑driven excesses persist. These scenarios describe sharp financial distress or prolonged weak growth and falling prices resulting from excessive leverage and overcapacity.
Fitch acknowledged the Chinese state has significant ‘firepower’ and appears willing to support the banking sector, and the article notes banks have parked over US$3 trillion in reserves at the central bank. However, analysts caution the scale of off‑balance‑sheet lending is so large that government support might stabilise banks but could still weigh heavily on growth and social or political risks.
The article warns China could face large‑scale capital outflows — especially ‘hot money’ leaving — if the US Federal Reserve tightens and the US dollar strengthens. Heightened Chinese credit stress and policy shifts could therefore ripple through global markets via capital flows, commodity demand and investor risk sentiment.
The article highlights the next six months as crucial and points to several indicators investors can monitor: increasing defaults in trust or wealth products, stress in overnight lending and Shibor rates, official policy moves such as reserve‑ratio or interest‑rate cuts, major shifts in total credit or credit‑to‑GDP estimates (the China Securities Journal mentioned up to 221% of GDP), and corporate interest‑payment burdens (the article cites about US$1 trillion in interest payments this year).
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