Is China Facing a Financial Crisis?

In a first for Chinese Banks and its Big Four, the Industrial and Commercial Bank of China (ICBC) unseated Exxon Mobil last year to take the top spot on the Forbes Global 2000[i] as the world’s largest company. China Construction Bank moved up 11 spots to No. 2 on the list. Agricultural Bank of China stood at No. 8 and Bank of China with its double digit growth in sales and profits; improved its ranking by 10 places to No. 11[ii]. However what is more interesting is that ICBC, world’s largest and most profitable bank itself was on the verge of defaulting until a last minute decision to bail it out earlier in January this year. A 3 Billion Yuan (around $500 million) product issued by China Credit Trust Co., a shadow bank and marketed through ICBC was underpinned by a loan to a mining operation of Shanxi Zhenfu Energy Group that later collapsed as the price of coal plummeted. Investors were promised a hefty 10% annual return over three years, but were told in January not to expect payment. Some of the investors, who reportedly put as much as $500,000 each into the fund, said ICBC should reimburse them since it had marketed the product. ICBC insisted that it had never guaranteed the product, and had no legal responsibility to pay investors. The bank’s chairman even went so far as to describe the episode as a learning opportunity for investors, shadow banks and ICBC. However the learning opportunity was missed, thanks to a bailout by an unnamed third party that ensured investors will recover their initial investment, though interest will not be paid[iii].

Shadow Banking in China comprises of a web of non-banks that includes pawn shops, underground banks, various wealth management products, trust companies, and guarantors – many of which don’t take deposits to insure against risky lending activities and operate completely beyond the eye of regulators and authorities.These firms offer loans to companies or individuals that may have trouble securing traditional bank financing. Often, the loans are then packaged and sold to investors looking for higher returns. In China, the sector’s exact reach is unknown, but some estimates put its size at roughly 60% of China’s GDP[iv]. The China Banking Regulating Commission (CBRC) caps the value of loans that banks can extend relative to the value of deposits at 75%. Because of this cap, banks prefer to issue off-balance sheet loans in order to maintain lower loan-to-deposit ratios (LDRs).While the latest estimates for lending from China’s biggest banks put February 14’s new loans at 800 Billion Yuan, the highest February figure since the 4 Trillion Yuan stimulus in 2009, reports are emerging that the strength in new loans is not driven by real demand, but rather by banks moving off-balance sheet loans on to the balance sheet as part of the government’s broader crackdown on shadow banking[v]. It is one of the many indicators that signify the slowdown of Chinese economy.

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In 2012, there were two trust defaults, one for a product distributed by Huaxia BankLtd. and one sold by CITIC Trust. While it was learned thatZhongfa Industrial Groupin the end guaranteed the first, the solution to the second was never made public[vi]. Beijing knows that a default could prompt investors to pull theirmoneyfrom other trust products and stop providing the deposits needed to supply credit and fuel economic growth. A default would likely lead to a loss of confidence in China’s trust and other shadow credit markets and a shrinkage of liquidity in those markets, and hence, a credit crunch. Some analysts however argue that a default is needed to demonstrate Beijing’s commitment to allow market forces to play a larger role in the economy, and to send a message to investors that high-yield investments carry significant risk. The China Banking Regulatory Commission said non-performing loans (NPLs) made by Chinese lenders reached 592 Billion Yuan in the final three months of last year. The last NPLs were at the same level was September 2008, the month when US investment bank Lehman Brothers collapsed. Loans by Chinese lenders have grown at an unprecedented rate in the past five years, with banks increasing the size of their balance sheets by 89 Trillion Yuan, an amount roughly equivalent to the size of the entire US banking industry[vii].

Chinese non-financial companies held total outstanding bank borrowing and bond debt of about $12 trillion at the end of last year – equal to over 120 percent of GDP – according to Standard & Poor’s estimates[viii]. Trust companies along with other non-bank financial institutions such as securities brokerages have become a vital source of credit, allowing banks to arrange off-balance-sheet refinancing for maturing loans that risky borrowers such as the local government financing vehicles (LGFV) cannot repay from their internal cash flow. By law, China’s local governments are not allowed to borrow. After the 2008 global financial crisis, Beijing conceded some relaxations and local governments created LGFV (Local Government Financing Vehicles), also known as UDICs (Urban Development and Investment Companies), which though separate from but owned or controlled by the local government, were permitted to borrow. The LGFV generally borrowed funds predominantly from banks (as much as 80% or more), with the remainder raised by issuing bonds or equity-like instruments to insurance companies, institutional investors and individuals. Recently, with pressure on banks to curtail loans, these financing vehicles have borrowed from China’s shadow banking system. Audits released for the first time show that China’s wealthiest eastern provinces are the most indebted, though repayment burdens are more onerous in poorer areas such as the southwestern provinces. Tibet was the only region that did not release an audit report[ix].

According to statistics from the National Audit Office, as of June 2013 government debt at all levels totaled about 20.7 Trillion Yuan (US$3.4 trillion), of which domestic government debt accounted for around 10.9 Trillion Yuan (US$1.8 trillion). Of this amount, 2.39 Trillion Yuan (US$390 billion), or 22%, is due in spring of this year[x]. We can add that including the local government debt that matures this year, there is an estimated 5 Trillion Yuan of trust products that are maturing, including as much as 1 Trillion Yuan in May[xi]. If the China Credit Trust product was allowed to default, China’s financial system might have been sitting on hundreds of billions, if not trillions of Yuan worth of non-performing loans in just a few months time. Chinacan rarely allow corporate failures, particularly of state-backed companies, partly out of fear that widespread layoffs could lead to social unrest. All this makes things all the tougher for the People’s Bank of China especially when interbank rates are at an all time high to control the local debt. Further the rising Chinese Yuan, which has gained around 33% since 2005 against the U.S. currency, increases their returns has led to asurge in loans to Chinese companies from outside the country has contributed to big inflows of cash into the mainland (mainly short-term and speculative in nature), trying to profit from the mainland’s relatively highinterest rates[xii].

Hence when the more the PBOC pumps into the system, the more it encourages risky lending, pushing the country closer to a debt crisis. But when the central bank has declined to add cash to the system—notably in June and December of 2013—liquidity has seized up. The scale of trust assets however still pales in comparison to total banking sector assets of more than 100 TrillionYuanas of the end of June. But without trusts, the banking system’s non-performing loans (NPL) ratio might be much higher, although accurate estimates are not possible[xiii]. China bears argue that a vast majority of the trust loans cannot be repaid, which will eventually require substantial bailouts and lead to a collapse in the banking system and a larger economic crisis. Even if this is exaggerated and the assets are good, huge liquidity risks exist given the known mismatch between the duration of trust loans and their underlying investments.

[i] The Forbes Global 2000 are public companies with the top composite scores based on their rankings for sales, profits, assets and market value.

[ii] Forbes: The World’s Biggest Companies at http://www.forbes.com/sites/scottdecarlo/2013/04/17/the-worlds-biggest-companies-2/

[iii] Charles Riley, “China’s $500 million shadow bank rescue”, January 28, 2014 at http://money.cnn.com/2014/01/28/investing/china-icbc-default/

[iv] ibid

[v] Oliver Barron, “Latest Developments for China’s Shadow Banking and its Implications for RMB”, February 26, 2014 at http://www.forbes.com/sites/oliverbarron/2014/02/26/latest-developments-for-chinas-shadow-banking-and-its-implications-for-rmb/

[vi] Oliver Barron, “China Trust Default Avoided… What Comes Next?”, January 27, 2014 at http://www.forbes.com/sites/oliverbarron/2014/01/27/china-trust-default-avoided-what-comes-next/

[vii] Harry Wilson, “Chinese bank bad debts hit crisis level high”, February 14, 2014 at http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/10638811/Chinese-bank-bad-debts-hit-crisis-level-high.html

[viii] Matthew Miller and Umesh Desai, “China’s $12 trillion corporate debt pushes up refunding costs, drives mergers”, February 25, 2014 at http://www.reuters.com/article/2014/02/26/us-china-debt-companies-idUSBREA1P06420140226

[ix] “China details $3-trillion local public debt risk”, January 27, 2014 at http://www.reuters.com/article/2014/01/27/us-china-economy-debt-idUSBREA0Q0LA20140127

[x] “RMB350bn in local government debt up for repayment”, February 27, 2014 at http://www.wantchinatimes.com/news-subclass-cnt.aspx?id=20140227000050&cid=1202

[xi] Oliver Barron, “China Trust Default Avoided… What Comes Next?”, January 27, 2014 at http://www.forbes.com/sites/oliverbarron/2014/01/27/china-trust-default-avoided-what-comes-next/

[xii] Enda Curran and Prudence Ho, “Concern Over Hong Kong Banks’ Growing Lending into China”, February 27, 2014 at http://www.marketwatch.com/story/concern-over-hong-kong-lending-to-china-2014-02-27-124492221

[xiii] Gabriel Wildau and Lu Jianxin, “Growth in China trust assets slows as shadow banking crackdown bites”, August 6, 2013 at http://in.reuters.com/article/2013/08/06/us-china-economy-trust-idUSBRE97504Q20130806