China Credit Growth and Risk of Financial Crisis

For many years I've been covering China's credit risk and the potential for a yuan devaluation. Back in 2011, when many companies were pouring capital into expanding natural resource production in anticipation of never-ending Chinese demand, I discussed how China was not planning a stimulus to boost demand. It was openly reported in Chinese media, but Western media stuck with the China-bull narrative.

Yuan depreciation/devaluation began as an academic exercise, to rebut the claims of China's currency taking over the world. As the case for depreciation began accumulating, I argued the yuan's most likely path was down. The depreciation of August 2015 was no surprise. I expect much more depreciation before the larger credit cycle completes (in contrast to the ~3 year cycles that began in 2008, 2011, 2015 and 2018).

The crux of the issue has always been China's credit growth and its ability to avoid a credit crisis. I believe they will not allow deflation and default, and instead create more credit that will be made possible by or cause a depreciation in the yuan. I have been wrong on timing because China has been able to defend its currency with draconian capital controls, but those controls are evidence that there is sustained depreciation pressure (outflow pressure) on the currency.

While China does print its own currency, it's citizens do not fully trust it. The yuan is not freely convertible on the world market. Rightly or wrongly, it's perceived value is highly tied to its FX reserves. China devalued the yuan in 1994 following a long period of high inflation. The financial system is still fundamentally tied to the US dollar. Until reserves peaked in 2014, China could let rising exports and dollar inflows provide liquidity for its financial system.

The U.S. dollar is at the center of this story because it is the global currency. When the U.S. dollar is depreciating, commodity prices rise. Agriculture and resource extraction enjoy booms. "Emerging" economies more reliant on those sectors boom. Capital flows in, their currencies rise, their financial and real estate sectors boom, and demand for Chinese imports surges. Chinese Belt & Road investments are profitable. If instead the U.S. dollar climbs higher, the entire system can run in reverse. A U.S. Dollar Index (DXY) breakout above 100 indicates deflationary pressure. If one or more dominoes tip over (the euro, a substantial emerging market currency, global trade, debt defaults anywhere), DXY could run to 110 or 120. Or vice versa. The global economic system does not anticipate a strong dollar and most companies and investors are betting against it.

Which is why I always have the caveat when speaking of China, that a major cyclical peak in the U.S. dollar, an end to the bull market, could alleviate much of the pressure on China's economy. On the flip side, a higher U.S. dollar driven by global deflationary forces could be the thing that causes something to break in China.

And now there are reports that Bank of Jinzhou is ready to blow. ZeroHedge has the hyperbolic headline:

ZH: Chinese Bank With $100 Billion In Assets Is About To Collapse

Reuters: Regulators in China discuss liquidity issues at Bank of Jinzhou - sources
Officials from the local branch of China’s central bank and other regulators recently met financial institutions in Liaoning province to discuss measures to deal with liquidity problems at troubled Bank of Jinzhou , sources told Reuters.
Bloomberg: China's Embattled Jinzhou Bank Courts Investors as Bonds Tumble
Bank of Jinzhou Co. said it is in talks to introduce strategic investors after a report that China’s financial regulators are seeking to resolve its liquidity problems pushed down the lender’s dollar-denominated debt.
Reuters: China Bank of Jinzhou says in talks with possible investors, renewing contagion worry

For full context, in 2014 I posted Liaoning Sounds Warning on Chinese Economy. In short, Liaoning (and the rest of Northeast China) relied on commodity production and related industries such as steel. As these sectors peaked around 2011, Liaoning began relying on real estate investment. By 2014, this model also reached its limit for GDP creation. The economy sank into recession and there was a real risk that the rest of China could tip into a major slowdown or crisis. A few WMPs and trust products defaulted. The yuan would depreciate in August 2015. China would unleash stimulus in 2015. By mid-2016, home prices were up 50 percent in some cities, SOEs were buying land hand over fist, and by late 2016 the decline in FX reserves would stabilize amid extreme capital controls.

At the end of 2015, Bank of Jinzhou IPO'd. Rubber Meets Road: Liaoning Bank to IPO in Hong Kong. From an FT piece linked in that post:
Could a banking crisis erupt in China? The commonly accepted answer among western analysts is no, for the simple reason that China has huge State owned banks that dominate the country’s banking industry. But dig a little deeper and a different picture emerges.

It turns out that within China’s smaller cities, the market share of the big banks fades away. Instead, local banks take over.

...In the city of Jinzhou, population 810,000, the state bank share drops by more than half to 19.4 per cent. Most of the slack is taken up by just one bank, the Bank of Jinzhou, with 62.6 per cent of assets.
I wrote:
My curiosity got the better of me when I saw the bank is growing 50%+ yoy. I want to see how the bank increased assets to over 300 billion yuan with only 90 billion in loans. What are these assets? They're listed as debt securities classified as receivables. A look at the notes: wealth management products. The bank, as of June 30, had 90 billion lent out in normal banking and 125 billion lent out through shadow banking. Also from the notes: the average yield on their assets rose from 6.04% in the six months ended June 2014 to 7.80% in the six months ended June 2015.

These WMPs and whatever else is lumped in here, have been driving profits. "Interest income from investment securities and other financial assets" constituted 19.5%, 27.4% and 42.6% of interest income in 2012, 2013 and 2014. Note that they're investing in these products, in addition to offering them. Page 28 lists risk factors associated with these products. As of June 30, 2015, these assets were almost 70% of total assets.
Bank of Jinzhou was operating a similar model to that of Baoshang Bank and many other smaller banks in China: lending in the interbank market, driving credit creation with "shadow banking" products such as WMPs. The risks of this model were well known years ago, to say nothing about where the money was going (such as real estate speculation).

Reuters: Fitch: Boom in WMPs a Key Risk for Some Chinese Banks
The continued rapid growth in wealth management products (WMPs) invested through Chinese banks could be a key source of credit and liquidity risk for certain financial institutions, says Fitch Ratings. The fast rise in WMPs is closely connected with the continuing growth in domestic credit, and they are accounting for an increasing proportion of funding at Chinese banks - especially mid-tier institutions. Recently released data showed the outstanding balance of WMPs rising to CNY23.5trn (USD3.6trn) at end-2015 from CNY15trn a year earlier, with an average of over 3,500 new products issued every week during the year. Nearly three-quarters of these are non-guaranteed WMPs; and over 60% of funds invested in WMPs come from retail investors, attracted by the higher rates of return than that for ordinary deposits. Importantly, they continued to grow faster than bank deposits, resulting in WMPs equating to 16.8% of system deposits at end-2015, up from 13.6% at end-1H15. As a result, banks with large sales of WMPs relative to deposits could face liquidity and funding pressures in the event of renewed market volatility. Fitch believes that the most common source of WMP repayment is through the issuance of new products, resulting in persistent rollover/payout pressure on banks.
The risks are well known, what was needed was the conditions for a credit event.

China doesn't need a major slowdown to have a financial crisis.

Back in 2015, Steve Keen published Get ready for an Aus­tralian reces­sion by 2017. He was off on the timing for the same reason China didn't end up with a crisis in 2017: global central banks were able to kick the can again. The article has a link to excel file which has a simplified debt model created by Keen.
The model combines credit growth with GDP to get total nominal demand. The economy produces a given amount of goods and services each year, and increased credit (from any source) represents additional demand in the economy. As credit grows in relation to GDP, small changes in credit have huge impacts on this nominal demand figure. If credit is 3X GDP, a 1 percent increase in credit creates as much demand as a 3 percent increase in GDP. If credit grows at 10 percent, that's equivalent to 30 percent of GDP. If GDP grows at 5 percent, the total nominal demand is 35 percent of GDP. Credit is 85 percent of new demand. Even a modest slowing of credit growth can have a huge impact on the economy. In macroeconomic terms, it is the failure of speculative finance.
Minsky argued that a key mechanism that pushes an economy towards a crisis is the accumulation of debt by the non-government sector. He identified three types of borrowers that contribute to the accumulation of insolvent debt: hedge borrowers, speculative borrowers, and Ponzi borrowers.

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" (named for Charles Ponzi, see also Ponzi scheme) 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.

If the use of Ponzi finance is general enough in the financial system, then the inevitable disillusionment of the Ponzi borrower can cause the system to seize up: when the bubble pops, i.e., when the asset prices stop increasing, the speculative borrower can no longer refinance (roll over) the principal even if able to cover interest payments. As with a line of dominoes, collapse of the speculative borrowers can then bring down even hedge borrowers, who are unable to find loans despite the apparent soundness of the underlying investments.
Fitch was warning that WMPs were paid back by new WMPs back in 2016. The Chinese financial system was showing clear signs of trouble. Since then, it accumulated 3 more years of bad debts.

For a U.S. example, here is total credit growth in the US economy (TCMDO) and total loans and leases at banks (TOTLL). Notice credit doesn't crater until well into the recession, when companies are defaulting. It only takes a small drop in growth to collapse the growth rate as speculative borrowers go bust.

When I run the numbers for China, the figure that tips the economy into recession is 9 percent credit growth. China's total social finance (TSF) growth slumped into the 10 percent range in 2019, down from low teens amid deleveraging efforts. Baoshang Bank went bust and Jinzhou Bank may or may not be on the precipice. Caixin: Exclusive: ICBC Subsidiary Will Lead Restructuring of Embattled Bank of Jinzhou
Troubled regional lender Bank of Jinzhou will attempt to restructure by introducing three strategic investors — China Great Wall Asset Management, and subsidiaries of Industrial and Commercial Bank of China (ICBC) and China Cinda Asset Management — Caixin can reveal.

If credit growth (TSF) slows towards 9 percent, there will be a great risk of financial crisis in China. It's possible officials cannot stop natural forces, but if they can, their most likely tool is more credit. Higher credit growth only makes the problem worse though, unless it accompanies much higher nominal GDP growth achieved through higher price inflation. China doesn't want uncontrolled inflation though. The simplest way to achieve a higher price level without risking spiraling inflation is a one-off devaluation in the currency. Exactly what was done in 1994. Or hope for a U.S. dollar bear market and boom in global credit growth.

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