2014-02-17

Is China's Shadow Banking System Contracting, Is The Bubble Growing, Or Both?

There has been a spate of articles claiming China's credit bubble is close to, if not already bursting, while others point to rising loans in January as evidence of the bubble's extant nature.

Here's ZeroHedge giving the bearish take: "Off The Charts" How China Fooled The World.

A more balanced take, published on ZeroHedge by AsiaConfidential: Xi's Tinkering Risks China Hard Landing, in which he points out the lack of deleveraging, a response to an article by Ambrose Evans-Pritchard.

My though on the matter is quite simple. Below is a chart of Total Credit Market Debt Outstanding from 2006 through 2009. Here is The Rise and Fall of Subprime Mortgages, in case you are unclear on when the housing market started slowing and when lenders began tightening credit. As the chart below shows, total credit increased continuously right into 2009. Even breaking out the financial sector from Z1 data shows the sector did not deleverage until the crisis was in full bloom in 2008. In contrast, the subprime market had burst, home prices were falling and the bearish pundits were proved correct in their forecasts of a systematic financial crisis.


Similarly, China will not deleverage all at once. Credit bubbles don't give little warning and then supernova. Instead, the most marginal, riskiest portion of the market will contract first. At the time, this will be considered an unimportant event because it is small and offset by a comparatively large amount of equity. It appears contained. In reality, the financial system is leveraged to the hilt and the expectations of lenders and borrowers are for growth to continue at current rates. Real estate developers are leveraged to the hilt assuming demand from home buyers will continue at forecast rates, for example, but what is fueling the entire system is an increase in credit. When credit tightens, the most egregiously over leveraged firms go bust, often with some corruption thrown in the mix. The economic impact is forecast to be small and localized, and the bankruptcies may be considered special cases. However, if the corner is turned (and this is where the real question lies) and credit has indeed tightened for the riskiest part of the market, then the credit bubble has begun the process of unwinding.

So what is going on in the trust market? We now have some estimated data for February. The first chart shows newly issued trusts over the past 10 weeks, the second newly established trusts. The line represents the number of trusts, the bar indicates the total amount of capital raised or the size of the newly established trusts.

While there's a strong rebound in fundraising, it is only back to the levels seen in January, which represents a contraction in credit. The duration and yields on products are moving in two directions as the market bifurcates: riskier products have to shorten their duration and increase the yield, while safer products are seeing longer duration and lower yields. At the moment, credit continues to tighten for the riskiest of borrowers as lenders, individual Chinese savers, opt for safer products.

Here's a look at WMPs. Below is the average yield on an index created by 金牛理财.


According to the firm, yields for big banks declined, but yields at smaller banks increased. The spread between guaranteed and non-guaranteed products widened to 101 basis points.

Here is the spread between WMP yields from state-owned and large banks, versus small and medium sized banks. Yellow line is state owned, orange small and medium, blue area is the spread. The three figures across are the start of period, end of period and average.

Here's guaranteed versus non-guaranteed WMP yields. Yellow line is guaranteed, orange non-guaranteed, blue area is the spread. Notice the blowout in spreads around the time of the "Credit Equals Gold" default. These are WMPs though, not as risky as trusts, but investors are reacting similarly.

Here's the same setup again, this time with yields on short (yellow) versus medium to long (orange) duration.

The current shift in the market place can most definitely shift back to normal and there have been multiple head fakes before in this credit bubble. However, if this trend doesn't reverse, it doesn't matter how much credit gets pumped through mainstream credit channels. The most marginal of borrowers will default and that will push more investors (who are the lenders) into shorter duration, less risk and lower yields.

Meanwhile, the Chinese banking system continues to face pressure from the online money market funds.
Total social financing aggregate, a broad measure of liquidity including bank loans, trust loans and bonds, rebounded to 2.58 trillion yuan, almost doubling that of December.

Meanwhile, traditional bank deposits decreased by 940.2 billion yuan from 104.38 trillion by the end of December 2013, according to the PBC.

The decrease in deposits is partially due to corporate year-end bonus distribution, and as a result of intensified competition from high yield wealth management products including surging Internet financial products, Lian Ping, chief economist at Bank of Communications, told the Global Times.

Many commercial banks face increasing competition from Internet financing products led by Internet giant Alibaba, Baidu and Tencent.

Tencent's WeChat users reportedly transferred more than 800 million yuan to Licaitong - its first wealth management product - on the first day of its launch on January 22.

Alibaba's Yu'ebao, the first online wealth management platform released in June last year, reportedly raised funds of 880 million yuan within six minutes after it launched a new wealth investment product on Friday.

The impact of Internet financial products will narrow the profit margin for commercial banks, as it is getting harder and more expensive to attract new deposits to fuel traditional lending, Fan Jianping, chief economist at government think tank State Information Center, told the Global Times Sunday.

Money channeled to high yield wealth management products contains higher default risks for investors, and a high interest rate will also weigh on the economy as borrowers will have to pay higher funding costs for money raised by these products.
There are two trends at work. One is interest rate liberalization that allows investors to obtain higher yields for their money, albeit by taking on more risk. This is on net a good thing. On the other side, investors in the riskier end of the credit market are pulling back, which is on net a negative for the credit bubble. Economic reforms are very positive for China in the long-run, but people are rushing into higher yielding products near the end of the credit cycle.

I have been wrong before on the timing of when China's credit bubble will burst, but eventually it will burst. I'm keeping an eye on the trusts. If the current trends continue there will be more defaults because the speculative borrowers will be unable to roll over their debts.
The "hedge borrower" can make debt payments (covering interest and principal) from current cash flows from investments. For the "speculative borrower", the cash flow from investments can service the debt, i.e., cover the interest due, but the borrower must regularly roll over, or re-borrow, the principal. The "Ponzi borrower" borrows based on the belief that the appreciation of the value of the asset will be sufficient to refinance the debt but could not make sufficient payments on interest or principal with the cash flow from investments; only the appreciating asset value can keep the Ponzi borrower afloat.

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