1 You read an awful lot these days about shadow banks in China and their potential to create the next major crisis for global economics very soon. The burst of this financial bubble, economists predict, is one of the most dangerous, if not, the most dangerous risk for the global economy today. I was looking for an interconnection between the news, the bigger picture, and drew my final, utmost bitterly conclusion. Digging further, all the lose stories that you read along the year; the recent default of Chinese bonds, company bailouts, huge ghost cities constructions all over China – this week even a bank-run started – the reason why copper prices fell a few weeks ago to a 4-years-low as they usually are an indicator for the global economic growth and mainly backed up by Chinese demand – It all made sense, although western media merely reporting about the financial situation in China, their development will have severe consequences for each and everyone on this planet. This is the downturn of the next economic superpower, this is what nobody ever expected…
Or is it not? Funnily enough, Morgan Stanley supposes it is some of kind set-up. China has always been hard to predict as many of their real statistics are not published, their economic figures rates usually remain somewhat blurry. Their money reserves are endless with a 3.3$US trillion Greenback power supply. As Morgan Stanley puts it, the Chinese economy is doing well and wants us to believe that Chinese HSCEI stocks are just now worth a buy. Consumption may supposedly be “bigger than actually reported”. 2 This is the same Morgan Stanley that was selling sub-prime products back in 2007, just as they were betting against them. Trusting bank analyses in this case will not help to get a glimpse behind the curtain. 3
Starting small – What are Shadow Banks? 4 Shadow banks are simply money lenders that are not banks. This includes trusts, wealth management products (WMPs), hedgefunds and also very common in China, private money lenders, some also known as credit sharks. Especially the last ones feature a cozy relationship to the borrowers, which builds up on the Chinese principles of Guanxi, the exchange of favors. This can lead to a non-profitable allocation of investments and is usually paired with especially risky Small and Medium Enterprise (SME) loans. State banks, on the contrary, favor local government financing vehicles (LGFVs), big state owned companies, for money lending. SME’s are usually not regarded as save for money-lending. Therefore, risky SME businesses must borrow from the shadow banking sector with interest rates at up to 20%. The money of shadow banks may, as said earlier, also derive heavily from the broad public. As many investment opportunities overseas are not accessible for Chinese citizens 5 and bank interest rates barely cover the inflation rate, it is wealthy Chinese that fund huge amounts of the shadow banks assets.
This shadow bank threat is not new at all and it is not the first time that shadow banking is becoming larger than regular banking. It is also not the first time that is poses the major threat to global economic crash. The same development of shadow bank credit volume was visible in the USA in 2007, just before Lehman Brothers went bankrupt. Shadow banks, like Bear Stearns hedge funds, were investing heavily in high-risk, sub-prime loans of house-owners because shadow bank lenders were so very eager to pump even more money into the system and get high returns. Bear Stearns, valued at 60 $US billion at the time, collapsed in August 2007 and the crisis began.
The Bear Stearns Moment for China 7 For the first time in Chinas history, a state-owned company failed to repay investors: Shanghai Chaori Solar Energy Science & Technology Co. failed to repay the interest debts of earlier issued bonds. Some bank economists believe already, that the Chaori incident is Chinas’ “Bear Stearns” moment. Looking at the volume of default debts of US$ 14.7m, it is truly unlikely to have any impact on the economy at all, but it is a definite precedent of how monetary strategy in China may change. The big question is, if the government will allow more state owned companies to fail repay their loans, or not.
In my opinion, it is true that the Chinese government will not allow more state owned companies to fail, but the major part of the shadow banks assets is not funded by government owned banks.
The whole last decade it was the government that highly regulated the finance sector. SMEs were struggling to get loans from state banks, which lead to more creative financing practices and the shadow banking sector was booming. Chinese ghost stories were build all over China. Even though many construction projects ended 2011, the cities, to date, remain empty. 8 The consequences of this huge construction bubble are very likely yet to come. Chinese ghost cities are a perfect example for how money can be wasted in the housing market.
Chinese Ghost Cities: http://www.youtube.com/watch?v=rPILhiTJv7E
Chinas Measures China claims now that shadow banking is helping the economy, but in fact it is a product of the restrictive and tight banking sector. The highly regulated banks in China give out loans according to governmental steered planning and it naturally leads to a huge dislocation of profitable investments. Shadow Banking became the necessary evil to keep the system running, but to say that anybody thinks of this practice as anything but dangerous is a simple lie. To approach the problem, the Chinese government needs to liberate the banking system – a development which is very unlikely to happen at all.
Wealth-Management-Products (WMPs) 9 Short-term loans issued by banks to invest into a wide range of products, mainly used for high-return and thus, high risk assets. Banks do not list these on their official statement; they are subsequently given to trust-like organizations for further issuance.
First, in 2012, Chinese banks were forced to announce the use of their WMP’s and slowly take them off their portfolio. This seemingly worked as banks reported a decrease of those up to a third in 2012. But as it turns out, draining the cash from the market slows the growth. 10Fitch Rating reported that the percentage of Wealth Management-Products in China was increasing up to 14.5% of the total bank deposits in 2013. Then the Chinese government started to openly address the issue and its inherent, systematic flaws in the middle of 2013. 11 The central bank tried to slow the lending by squeezing the bubble and restrict wealth-management-products in 2013, 12 which resulted in the “biggest cash-crunch in more than a decade”. 13 The respectively slower economic growth of China in 2013 may have also been a result of the shadow bank drainage attempt. International Business Times reported just a few days ago that WMP’s are strongly on the rise, retaining a higher yield, meaning more profits and more risks again.
When any shadow bank loan, say, a WPM fails, it is not clear who reimburses the investors or if they get their money back at all. Not even regular banks have a deposit guarantee like it exists in the vast majority of western countries. Governmental deposit insurance is regarded as a safety net for banks and the major tool to prevent bank-runs from happening. China has, until now, not enforced such a law, which makes citizens all over the country worry if their money is safe on any banking account. Plans to do so have been around since many months and Chinese media reports the deposit insurance system might soon be launched 14 However, it still does not secure shadow bank loans as these still are completely off the balance sheets.
The Bank-Run 15 Rumors about the bankruptcy of a small bank in east China made citizens standing in line draw back their full accounts all over the province of Sheyang. Jiangsu Sheyang Rural Commercial Bank had much trouble to appease these savers and stacked piles of money at the front windows in order to show liquidity. Apparently, reasons for this bank run were closures of credit facilities in the same province. Their managers are believed to have lost huge amounts of money at investments and then left the country.
Bloomberg reports a volume of 6$US trillion of shadow banking, which was 69% of the Chinese GDP in 2012. All this is money that cannot be regulated or controlled by the government, which is the actual threat for Chinese economy right now. The below chart shows that WMPs are indeed now not actually decreasing, but mainly renewed to ensure they are not defaulting.
Xiao Gang, chairman of Bank of China admits himself, that this is a Ponzi Scheme to repay existing WMPs for never returned money from construction projects. These WMPs admittedly amounted to only 1.64$US trillion of the expected 6$US trillion that is considered to be part of the shadow bank money in China. 16 The reason for these new loan issues is that China has an enormous amount of corporate debt coming due in April and July this year. Especially coal mines are the ones that will need new money to uphold their business. 17 In this context, a major coal company was just recently about to miss a major debt payment. The Chinese government arranged a last-minute bailout through middlemen. 18. The below chart gives the explanation why economists believe the shadow bank bubble in China will burst very soon; the highest amounts of private sector loan bond repayments will become due within a few months. If SMEs fail to repay too many, it may result in a major drawback of private investments.