Utterances.net edited by Jalel Harchaoui.

12 September 2015

The first signs of China’s economic woes currently in the headlines, became visible in mid-2013.
The gradual buildup of China’s economic troubles
by Jalel Harchaoui.
Since Nov. 2008, Beijing’s massive stimulus-package money has flowed almost exclusively into state-owned corporations’ infrastructure projects. Meanwhile, shadow financing ballooned. On 07-Sep-15, the Financial Times wrote “credit markets are still sanguine.” Such pronouncements might be premature: credit defaults might still turn out to be at the very heart of the current disruption. The remarks below were written in Oct. 2013; they have only gained in pertinence ever since.
The gradual buildup of China’s economic troubles

Uninhabited megacity in China.

"Two parallel financial universes coexist in China. The traditional-banking one; and the shadow-banking one.

"Little is known about the latter. In China, the state (i.e., the Communist Party) decides the deposit rates paid by traditional banks. The traditional banks, which are owned by the state, lend only to large state-owned companies. By virtue of Beijing’s suppressed-consumption policy, the general population consumes very little compare to Western populations. Instead, it deposits its money into savings accounts at state-owned banks. Those savings accounts, because they are plentiful, enjoy a low interest rate (usually 3%). Indeed, the Communist Party often sets the official deposit rates below the rate of inflation. But there is another sector of the Chinese population that boasts untold wealth: high-net-worth individuals. ("Let some people get rich first” was part of the economic reform strategy launched in the 1980s by Deng Xiaoping.) Wealthy individuals know that their cash is valuable and seek to receive more than the state’s official deposit rate. The latter is artificially low: yuan funds are extremely hard to come by; and traditional banks and state-owned corporations struggle to borrow cash. Outside of the state-owned ecosystem, wealthy individuals are left searching for means of being paid a higher rate of return for their excess cash. Simultaneously, many private entities (private companies, incorporated villages, municipalities, etc.) still look to build new factories, bridges or other bricks-and-mortar items. State-owned banks—instead of declining to fund those construction projects outright—use shadow banks as a means of extending off-balance loans to those risky borrowers. Wealthy individuals are promised higher rates and their cash, through opaque trust companies subject to almost no oversight or regulation, flows into riskier projects such as the construction of a steel mill, highway, luxury building, plant, or other largely unneeded infrastructure. Between 2010 and 2012, Beijing pressured state-owned banks into curbing their lending practices. As a result, during that period, shadow lenders doubled their outstanding loans to almost $6 trillion (i.e., 69% of China’s GDP).

"A certain percentage of China’s shadow-banking loans have defaulted but that figure is not known. When defaults occur, troubled borrowers have usually been bailed out by the government. Moreover, a widespread perception among wealthy investors is that the central bank’s $3.3 trillion of foreign-exchange reserves will be used by the government to handle emergencies, in case defaults spread suddenly. “You will never lose money” investing with trust companies, a rich Shanghai designer told the WSJ (24-Jun-13). If China’s economy cools off markedly, the contagion might accelerate in ways wildly inconsistent with investors’ perception, i.e. in ways the central government will not or cannot stove off. “Economists […] worry that shadow lenders are introducing risks reminiscent of America’s subprime-mortgage boom by backing projects that may never pay off, failing to disclose fully what they are asking investors to fund and appearing to give banks a way to get rid of problem loans—without really doing so” (WSJ, 24-Jun-13).”

On 28-Jan-14, in a separate post, I went on to write “‘more bad data out of China and the news of several trust [defaults].’ The Chinese economy—a colossal importer of raw materials from emerging countries—has been showing signs of trouble. The latter has been accompanied with “financial stress among [China’s] shadow-finance institutions.” The latter have lent out approximately $1.3 trillion at interest rates ranging between 10% and 40%. “The line between what is official and regulated and what is shadow and gray is completely blurred” (FT, 28-Jan-14). Hence the risk of “widespread panic,” “spillover effects” and “possible contagion.” These high-interest loans fund largely unneeded, non-viable projects. Hence the risk of a panic seizing China’s entire system. On 28-Jan-14, “China avoided what could have been a destabilizing hit to its financial system: a major ‘shadow’ lender arranged a [last-minute] bailout for investors who bought an investment product that was about to go bust” (WSJ, 28-Jan-14).”

Such measures have helped bolster the perception among wealthy investors in Mainland China that the central government’s foreign-exchange reserves will be resorted to by the Communist Party to handle emergencies, in case defaults spread. We are currently, at a large scale and at a rapid pace, witnessing the consequences of the above dynamics.

~ Jalel Harchaoui.