May 2014

INSIDE VIEW: China’s red flags

ChinaThe Chinese economy is overly leveraged and showing the same indicators that the banking industry did in 2008. Common sense has failed again, says Robbert van Batenburg at Newedge. The collapse of global financing firm Lehman Brothers proved that a single institution can be vitally important. When it fell, it was a domino that knocked over an entire delicately balanced system and started a global financial crisis. Today, markets are better protected and legislators are more aware of systemic risks, but unfortunately we are still just a similar domino fall away from another disaster. Five years ago it was a colossal business failure that proved to be a decisive catalyst in starting the chain reaction. The source of the next crisis, however, may very well be a country that is so essential to the global financial system that any weakness in it could be catastrophic. That country is China. Investors should be worried that the Chinese economy is showing the same red flags that the banking industry demonstrated in 2008. A key indicator of counterparty risk at US banks during the last financial crisis was the Libor-OIS spread, which served as a measure of the underlying health of the banking system. The Chinese equivalent of the Libor-OIS spread – the spread between China government bonds (CGB) and the equivalent duration interest rate swaps – has been rising steadily as of late. Just like Wall Street before the crisis hit, China is overly leveraged and involved in activities too opaque to be fully understood by those in control. The amount of leverage in the Chinese system is endemic. The country’s housing and commercial business sectors have been addicted to debt for years. For example, the total non-government debt in the Beijing region represents an astonishing 530% of GDP, while the figure for the Shanghai region stands at 240%. This is an aggregate of bank loans, credit bonds and trusts, but just imagine what this figure will be when government debt is added. A HIGH PRICE
By leveraging the economy to such a degree, China has doubled its economy over the last five years. But this has come at a high price. Much of the leverage in China is held in the private sector, primarily in bank loans and credit trusts in the shadow banking system. This murky, off balance sheet activity is China’s true Achilles heel. Part of the problem is that the true size of the country’s huge shadow banking industry, which is said to have grown from $3 trillion (€2.1 trillion) in 2010 to $8 trillion last year, may never be known. The growth of Chinese shadow banking has been fuelled by under-regulated wealth management and trust products. In a bid to attract more clients, Chinese banks often sold these products and effectively guaranteed both the safety of principal and a rate of return that exceeded the interest on deposits. China’s government has recently taken steps to clamp down on this shadow banking system out of fear of an uncontrollable credit bubble. Unfortunately, numerous highly leveraged businesses are now finding their line of easy credit drying up. The threat of a widespread failure to pay back these loans has become real. Earlier this year we saw the first on-shore defaults in the Chinese bond market, starting with Shanghai Chaori in March. In April, Xuzhou Zhongsen Tonghao, a construction materials company, became the first to default in China’s two-year-old junk bond market. These defaults have come as a shock because they occurred during the supposedly quiet period before maturities begin to accelerate and rumours bubbled behind the surface that the defaults are the tip of the iceberg. It may not seem significant to have a few individual Chinese borrowers default on their loans, but these small failures are all signs of a deeper economic sickness. The credit crisis that culminated with Lehman’s demise, the largest bankruptcy in US history, started much smaller. In March 2007, New Century Financial, a mid-sized mortgage finance company, went bankrupt when almost everyone still saw blue skies ahead.   TANGLED WEB
The shadow banking system means that there is a vast, tangled web of financial and economic ties between Chinese corporations and government entities, which means even the smallest vibration on the extremities of the system has the potential to be amplified dramatically in the centre. While the Chinese government insists there is no systematic risk, this is hubris. The reality is that it is almost impossible for systematically important banks to isolate themselves from defaults in the shadow banking world. The banks in China are recognising this risk. Interbank credit markets are showing that they are becoming more reluctant to lend to each other and this has in turn driven the cost of lending up further. For a system hooked on leverage this can only be bad news. At the very least, the underlying credit weakness will cause a drastic slowdown of China’s economy that will consequently have a knock-on effect for investors worldwide. At its worst, it will cause another global financial crisis with far-reaching effect. Key to this is the fact that a healthy Chinese economy is so important to numerous countries around the world. It is not just the US economy that depends on a rapidly growing China. Countries that export primarily commodities, such as Brazil, Australia and South Africa, are directly affected by China’s economic slowdown, and so will their currencies. These economic problems won’t go away easily and we should be concerned that just a few years after the last financial crisis we are seeing the same mistakes being made again. China’s reliance on leverage and the lack of transparency in its banking system are directly analogous to the situation on Wall Street prior to the collapse of Lehman Brothers. Common sense has failed again.
The sooner that people recognise these warning signs the better. After all, the danger may seem all too obvious and preventable in hindsight. By then, it may be too late. Robbert van Batenburg is director of market strategy for Newedge ©2014 funds europe

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