The Perils of a Resurgent China Credit Boom

Doug Nolan

There’s this uneasiness – an eeriness – in the markets; in the world (I’m not touching politics). 
 
Seemingly out of nowhere, the U.S. dollar index surged 1.7% this week. Notably, the Chinese currency fell 0.8% versus the dollar, the biggest weekly decline since January. Copper dropped 2.4%. Most EM currencies were under pressure. I suspect fears of heightened Chinese vulnerability have again become a major force behind unstable global markets.

We’re all numb to the big numbers. China’s debt has rapidly inflated to over 250% of GDP (Bloomberg at 247% to end ’15 from ‘07’s 150%), in what has evolved into history’s greatest Credit Bubble. Total Social Financing, China’s aggregate of total Credit (excluding government bonds) is on pace to expand almost $3.0 TN this year. A headline from Bloomberg TV: “China’s Total Debt Grew 465% Over Past Decade”

Global markets were troubled earlier in the year by fears of a faltering China Bubble – a stock market collapse, destabilizing outflows and a fledgling crisis of confidence. Market recovery owed much to the visibly heavy hand of Beijing frantically plugging holes and spurring a Credit resurgence. Those efforts ensured ongoing China economic expansion that, when coupled with $2.0 TN of QE, supported a short squeeze turned major rally throughout EM and commodities markets. Surging commodities and EM took pressure off troubled sectors, bolstering U.S. and developed market rallies generally. Highly leveraged speculators, commodity producers, companies, countries and continents were granted new leases on life.

The downside of ongoing massive QE and negative rates has of late become a market concern, and with concern comes heightened vulnerability. This ensures keen focus on the other major source of 2016 market support: The Resurgent China Boom. Here as well, the downside of egregious inflationism has become increasingly conspicuous. China’s Credit Bubble is completely out of control – and it’s become deeply systemic. We’re numb to how dangerous circumstances have become.

The banking system continues to balloon uncontrollably, as does so-called “shadow banking.” 
 
Reported bank assets have reached $30 TN, having more than tripled since 2008. According to Moody’s, shadow banking has expanded from from 40% to 78% of GDP - in just the past two years. Contemporary Chinese finance is nothing if not incredibly convoluted.

October 12 – Financial Times (Gabriel Wildau): “What is the true size of China’s debt load, and how fast is it growing? The answer has significant implications for the global economy. Global watchdogs including the International Monetary Fund and the Bank for International Settlements… have become increasingly shrill in their warnings that China’s rising debt load poses global risks. Estimates of Chinese debt based on official figures are frightening enough — an FT analysis put the figure at 237% of GDP at the end of March — but an increasing number of analysts now believe that the true figure may be higher. The reason is not… that China’s government statisticians are intentionally cooking the books. Instead, financial engineering and rising complexity in the shadow banking system are outstripping the ability of traditional indicators to track debt flows from all sources. In focus is a once-obscure data series that tracks bank lending to non-bank financial institutions (NBFIs)… Bank claims on NBFIs… have increased massively, from to Rmb11.2tn at the end of 2014 to Rmb25.2tn at the end of August.”

As the banking system self-destructs, the problematic local government debt situation only worsens. What's more, Corporate Credit continues to expand rapidly, in the face of an increasingly hostile pricing and earnings backdrop. Corporate debt has ballooned to $18 TN, or to almost 170% of GDP (from Reuters).

Meanwhile, real estate finance is today a full-fledged “Terminal Phase” disaster in the making. 
 
Various government efforts over recent years to rein in an aged Credit cycle have failed, repeatedly shoved to the back burner by fear of an unacceptable bust. Last month from the WSJ (Anjani Trivedi): “More than 70% of new loans in August were to households, much of that in the form of mortgages… a remarkable shifting of the fire hose of credit… China’s stock of mortgages stood at 16.9 trillion yuan ($2.5 trillion) as of June 30. Almost a quarter of that was built up in just the past year…”

A Thursday headline from Bloomberg: “Global Stocks Slide, Treasuries Gain as China Concern Resurfaces.” Various articles pointed to the worse-than-expected 10% y-o-y drop in September Chinese exports, the largest decline since February (imports down 1.9%). More important, the People’s Bank of China weakened the yuan seven straight days to a new six-year low. Most importantly, Beijing is – once again - intensifying its push to rein in debt growth. There is an acute need to act, as well as lurking fragility that ensures acting is a high-risk proposition.

When markets are in a bullish mood, faith comes easy that enlightened central bankers have mastered QE infinity. Similarly, astute Chinese authorities have become exceptionally proficient at financial and economic tinkering. Reality is a different story. Whether it is global central bankers or Chinese communist leadership, once monetary inflation really gets heated up there will be no cataclysm-free resolution. There remains a complacent view that patient central bankers will successfully wean the world off this torrent of cheap liquidity. Beijing will cautiously take its time in resolving structural Credit and economic issues. The harsh reality is that all these central planners badly missed their timing. At this point, the consequence of patience and caution is deeper maladjustment.

Mortgage Credit booms are dangerously prone to the type of prolonged excess that ensures deep structural (financial, economic and social) impairment. Systemic risk rises exponentially late in the Credit cycle. Rapid Credit growth, much of it from weak borrowers, inflates home prices to precariously unsustainable levels. To be sure, China’s mortgage finance Bubble is putting U.S. subprime to shame. China essentially has unlimited numbers of borrowers. 
 
Inflating apartment prices continue to provide owners unprecedented increases in (perceived) wealth, providing the resources for larger down-payments for more expensive units (and/or more units). And keep in mind that this is more of an apartment rather than a “real estate” Bubble – and, for the most part, shoddily constructed apartments. There is also basically endless supply.

Chinese authorities have initiated attempts to tighten mortgage Credit going back in 2010. 
 
Beijing and local governments have to this point not been willing to inflict the type of pain necessary to break entrenched inflationary psychology. Ill-conceived efforts to tighten mortgage Credit in 2014, while permitting loose finance to fuel an ongoing Credit Bubble, ensured a spectacular stock market boom and bust. And last year’s equities bust – and resulting stimulus-induced Credit/liquidity surge - incited speculative “blow-off” dynamics into “safe haven” real estate. Mania.

Markets have good reason to fear the consequences from the latest round of tightening. System Credit has exploded since 2010. Financial and economic fragilities are much more acute. From Thursday’s WSJ: “China Sees ‘New Challenges’ in Mortgage Surge;” followed with Friday’s: “China’s Ballooning Mortgage Debt Built on Shaky Foundation.”

In the unfolding worst-case scenario, the rapid buildup of household sector debt has compounded systemic vulnerability from already heavily leveraged corporate and local government sectors.

October 12 – CNBC (Huileng Tan): “China's economic transition has caused a problem for the government—how to avert a sharp slowdown while keeping a lid on ballooning debt. In a report Thursday, rating agency Standard and Poor's highlighted the ‘tough choice between supporting growth and controlling debt sustainability’ as China tries to find new ways to fund public investments. ‘Although aggregate and provincial GDP growth stabilized in the first two quarters of 2016, we believe the fiscal conditions of Chinese local governments are under more pressure given the weakened economy,’ S&P wrote… The rising debt pile of local government financing vehicles (LGFV) raised questions on credit risks, said S&P.”
October 12 – Bloomberg: “Finance firms that help keep cash flowing to China’s towns, cities and provinces face rising risks of landmark bond defaults just as they turn to global markets for funds. China’s economic slowdown is weighing on revenue at regional governments, hampering their ability to support the 5.3 trillion yuan ($789bn) of outstanding onshore notes from local-government financing vehicles, which have yet to suffer nonpayments. Such issuance fell 18% last quarter as regulators curbed sales, forcing some to seek funds overseas. Financing units in provinces including Hunan, Jiangsu, Hubei and Sichuan are considering or planning U.S. currency notes, people familiar with the matters have said.”
Corporate debt is arguably China’s most precarious sector Bubble. In conjunction with the release of a new report on Chinese corporate Credit, Terry Chan – head of Asia-Pacific Analytics and Research - S&P Global Ratings – appeared Monday evening on Bloomberg TV:

Chan: “We estimate at the end of 2015 [there was] 5.6% problem credit. We use credit rather than loans because it’s a broader definition. If it slows down, as we expect, by 2020 it will be about 10%. It’s manageable given the returns they have. But if the rate doesn’t stop – if credit still grows around 15-16% - we think problem credit could reach 17% by 2020. And that’s basically ‘the straw that breaks the camels back.’ So what the banks would have to do is actually raise fresh capital – we estimate about $1.7 TN, or about 16% of China GDP. So those are big numbers… Obviously the state-owned enterprises are a massive part of the economy. In our sample of the 200 top corporates, for example, 70% are state-owned and they have 90% of the debt. So it’s a really big problem… At least for the next two years it is going to get worse. We see the momentum already in our study of the top 200 corporates. 2016 is as bad as 2015 was. It’s going to take a while. They are pressing the brakes slowly. They’re not going to slam on it. If credit doesn’t really slow down by the end of next year, we could be in a bit of strife.”

I would argue that a tremendous amount of global strife unfolds when the Chinese Credit boom succumbs. Chinese banks now lead the list of the world’s largest financial institutions. The performance of China’s economy now has major global ramifications. Reporters were quick to point to China to explain Friday’s global market rally. “Economic Data Signals Turnaround, Stability in China;” “China’s Days of Exporting Deflation May Be Drawing to a Close.”

There is great instability in China, masked by historic Credit expansion. It’s important to appreciate that China is new to this Capitalism thing. They’re completely inexperienced when it comes to mortgage finance Bubbles – and that goes for apartment owners, bankers and regulators. They are novices with massive corporate debt booms. They are newcomers in the face of a $30 TN banking system. They have outdone even the U.S. in mismanaging “shadow banking.” The Chinese have followed the “developed world” lead in repo, derivatives and “sophisticated” structured finance.

Years of exceptionally loose finance have surely nurtured unprecedented amounts of fraud and malfeasance – not the recipe for a sound financial system. Worse yet, they grabbed the Credit Bubble baton at the worst possible time – the conclusion of a historic global Credit Bubble, with all the associated economic, financial, social and geopolitical risks. Chinese rulers saw their juggernaut economy as ensuring global power and prestige. Things – at home and abroad – are developing much differently than they had anticipated.

New realities were discussed in a Friday FT article, “China Rethinks Developing World Largesse as Deals Sour.” With clients such Venezuela, Zimbabwe and Sudan, China developed into the world’s subprime lender. Form the FT: “Six of the top 10 recipients of Chinese development finance commitments between 2013 and 2015 were classified alongside Venezuela in the highest category of default risk ranked by the… OECD.”

October 13 – Financial Times: “When China signed up to build Venezuela’s Tinaco-Anaco Railway in 2009, the scheme was hailed as proof of the effectiveness of socialist brotherhood.
Gleaming new Chinese trains were envisaged, whisking passengers and cargo along at 137mph on about 300 miles of track. Hugo Chávez, the late Venezuelan president, called the $800m project ‘socialism on rails’ and said the air-conditioned carriages would be available to everyone, rich or poor. But the endeavour has become what locals call a ‘red elephant’, the vandalised and abandoned symbol of Venezuela’s deepening economic crisis… For China, the project represents more than just an isolated example of a dream turned to dust. Over the past decade, the country has transformed itself from a marginal presence to the dominant player in international development finance with a loan portfolio larger than all six western-backed multilateral organisations put together. Outstanding loans from the two big Chinese ‘policy’ banks and 13 regional funds are well in excess of the $700bn owed to the western-backed institutions…”
As we closely monitor the Chinese Credit Bubble over the coming weeks and months, let’s be mindful of the central role China has come to play in the greatest global Bubble the world has ever experienced. There is tremendous uncertainty as to how this will play out.

As I’ve argued in the past, China is one enormous EM Credit system and economy. EM Credit Bubbles notoriously end with a destabilizing “hot money” exodus. A crashing currency then limits the central banks ability to reflate, and the whole thing turns sour.

In contrast, Beijing has orchestrated this strange dynamic of aggressive “money” and Credit inflation, while significantly restricting the capacity for this liquidity to exit the Bubble. Might this have only created a wall of “hot money” to be let loose once the dam breaks? How much leverage has accumulated with funds borrowed cheap overseas to speculate in higher yielding Chinese securities and financial instruments? Lots of questions and few answers. I’m not so sure Chinese policymakers have the answers either. They just recognize they have a major problem. We all share the problema.

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