BREAKDOWN: Gauging the risks of a China crisis

Bank of Jinzhou Co

31/10/2016 03:35

(The author is a Reuters Breakingviews columnist.  The opinions 
expressed are her own.) 
    By Rachel Morarjee 
    BEIJING, Oct 31 (Reuters Breakingviews) - Can China avoid a 
financial crisis? That's the question facing regulators and 
investors after a rapid rise in leverage in the world's 
second-largest economy. The links between the official banking 
system and shadowy institutions have also grown deeper and 
harder for regulators to fathom. Breakingviews explains how the 
People's Republic might avert a meltdown, but might find a 
credit crunch harder to dodge. 
     
    HOW BIG IS THE RISK OF A FINANCIAL CRISIS IN CHINA? 
    The amount of debt in the Chinese system has exploded. Total 
non-financial credit has surged to around two and half times 
annual output by the first quarter of 2016, according to the 
Bank for International Settlements. Debt in the still-developing 
country is now roughly the same relative to the size of the 
economy as in the richer United States.  
    Financial history shows that when debt outstrips GDP growth, 
accidents become more likely. But in China's case, it's not just 
the absolute increase in leverage that's worrying. The speed at 
which debt has expanded also means there is an increasingly 
complex web of transactions and financial products which links 
China's biggest banks with smaller peers and with shady 
financial institutions that operate outside the official safety 
net provided by the authorities. 
     
    SO WHERE ARE THE TROUBLE SPOTS?  
    Chinese banks have added $7.1 trillion in new assets - 
equivalent to around two-thirds of GDP - since the end of 2014. 
Over the same period, deposits have only risen by around $3 
trillion, according to official figures. Most of the increased 
lending is concentrated outside China's four largest state-owned 
banks. That means smaller and medium-sized banks are competing 
hard for alternative sources of funding.  
    A few smaller lenders stand out. Industrial Bank, Zheshang 
Bank  2016.HK  and Bank of Jinzhou  0416.HK  now get almost half 
their funding from other financial institutions rather than 
depositors. That makes them more vulnerable to sudden shocks in 
confidence, which could prompt other banks to pull in lines of 
credit that are often rolled over on a daily basis. 
    Mid-sized and local city commercial banks are often the main 
sources of finance for local governments and property companies. 
Rather than relying on deposits, these banks frequently bundle 
up loans into wealth management products which are sold to 
retail investors or other financial institutions. 
    Those funds are then repackaged - often many times over - 
and traded between banks and other financial outfits such as 
asset management firms. This game of pass-the-parcel enables 
small banks to support lending in excess of their official 
balance sheets, while skirting rules that force them to set 
aside chunky provisions for loans that go bad.  
     
    WHAT CAN GO WRONG?  
    The interbank market connects strong banks with weaker 
counterparts and shadowy lenders. Analysts estimate that over 80 
percent of interbank lending is done on an overnight basis. The 
People's Bank of China is trying to force banks to borrow for 
periods of seven or 14 days while making overnight funding more 
expensive. But it's hard to tell whether the central bank has 
succeeded as banks don't release data on the tenor of their 
interbank lending and borrowing. 
    Assume that China suffers a sharp correction in its dizzy 
property sector, or that a poorly run asset management firm 
collapses. Such a shock could hit the value of wealth management 
products issued by a smaller bank, prompting customers to 
withdraw funds or demand compensation.  
    This in turn could lead larger banks to scale back their 
interbank exposure to smaller lenders they perceive to be most 
at risk. Overnight borrowing costs would spike, forcing small 
banks to call in loans or launch a fire-sale of assets to meet 
maturing funds. 
     
    BUT WON'T THE PBOC COME TO THE RESCUE?  
    China's central bank can flood the market with liquidity and 
order state banks to keep lending to each other. But banks and 
non-bank financial institutions have become so entwined that 
regulators might not immediately know where the problems were. 
    Banks' claims on non-bank financial institutions in China 
have surged from 11.2 trillion yuan ($1.65 trillion) at the end 
of 2014 to 25.2 trillion yuan at the end of August this year, 
according to the PBOC. The central bank could pour liquidity 
into the market as a whole, but wouldn't be able to inject funds 
into the specific problem areas. 
    To see what might go wrong, take Shengjing Bank  2066.HK  in 
the rustbelt province of Liaoning, which has seen the value of 
wealth management products it sells rise by 754 percent since 
the end of 2014, according to an analysis by Rhodium Group. 
Those products aren't issued by the bank itself but by asset 
management companies or securities firms. Moreover, the 
principal isn't guaranteed. 
    Nevertheless, the underlying assets are tied to the local 
economy, which is in recession. Though the wealth management 
products can be cashed in at short notice, the loans have a much 
longer life. Any disturbance could leave a funding squeeze. 
     
    SO CAN CHINA AVOID A FINANCIAL CRISIS?  
    It depends what you mean by a crisis. The PBOC can prevent 
the Lehman-style collapse of a major financial institution. It 
would also step in swiftly to halt a run on any bank - sending 
trucks full of cash to reassure depositors their money is 
safe. The government has the power to force banks, brokerages 
and insurance firms to help prop up troubled firms - much as it 
organised the stock market bailout in the summer of 2015. And as 
China has comparatively little overseas debt, the risk of 
foreign creditors suddenly yanking their loans is also quite 
small. 
    But if credit continues to explode, a correction looks 
increasingly likely. A decline or even a slowdown in lending 
could trigger a cascade of defaults starting in the non-banking 
financial sector, and then spilling over into smaller banks and 
the real economy. Whether you call it a crisis or not, that will 
certainly be painful. 
        
    On Twitter https://twitter.com/morarjee 
     
    CONTEXT NEWS 
    - Credit to China's non-financial sector reached 255 percent 
of GDP in the first quarter of 2016, up from 184 percent in 
2010, according to the Bank of International Settlements. In 
absolute terms, Chinese debt has more than doubled over the 
period rising from $11 trillion in 2010 to $27 trillion in the 
first quarter of 2016.  
    - For previous columns by the author, Reuters customers can 
click on  MORARJEE/  
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    <^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ 
Bank of International Settlements Statistical Bulletin     http://www.bis.org/statistics/bulletin1609.htm 
PBOC banking data, August 2016    http://www.pbc.gov.cn/diaochatongjisi/resource/cms/2016/09/2016093016314972502.htm 
PBOC banking data, December 2014    http://www.pbc.gov.cn/eportal/fileDir/defaultCurSite/resource/cms/2015/07/2014s06.htm 
BREAKINGVIEWS - China's interbank market may spread financial 
flu      urn:newsml:reuters.com:*:nL3N1BB1RI 
BREAKINGVIEWS - China banks' shadow addiction needs a harsher 
remedy     urn:newsml:reuters.com:*:nL3N1BE14P 
BREAKINGVIEWS - China's bank watchdog is pushing on a balloon    
  urn:newsml:reuters.com:*:nL4N1AE0TN 
    ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^> 
 (Editing by Peter Thal Larsen and Kathy Gao) 
 ((rachel.morarjee@thomsonreuters.com;)(Reuters Messaging: 
rachel.morarjee.thomsonreuters.com@reuters.net)) 
 
Keywords: CHINA BANKS/BREAKINGVIEWS