China's Shadow Bankers and the Vampire Squid

"China is displaying the same three symptoms that Japan, the U.S. and parts of Europe all showed before suffering financial crises: a rapid build-up of leverage, elevated property prices and a decline in potential growth."  -- Zhiwei Zhang, Nomura economist

An uptick in manufacturing activity in March has eased fears of a hard landing, but China is not out of the woods yet, not by a long-shot. The industrial powerhouse has succumbed to the same problems as its trading partners in the West who were thrust into crisis by soaring real estate prices, reckless credit expansion, and an out-of-control shadow banking system. While government-directed infrastructure programs have helped to keep the Chinese economy chugging along at an impressive 7.5%, a growing number of experts believe that China's day of reckoning may not be far off. Here's an excerpt from an article in Emerging Markets:

"Worries that China's economy will slow down more abruptly than forecast have returned on the agenda, a fund managers survey shows. The survey, by BofA Merrill Lynch Global Research, showed that expectations for growth in the Chinese economy dropped sharply to 14% of participants from 60% in a previous poll. This is the lowest level since October last year and represents one of the biggest monthly falls in the reading in the survey's history.

"The analysts said that the 'significantly increased' fears of a hard landing in China are reflected in investors' moves out of stocks in emerging markets and into those of developed ones, especially the US and Japan"... ("China hard landing fears resurface in survey," Emerging Markets)

While exports remain the source of China's strength, 20 to 30 percent of GDP derives from domestic real estate development, much of which is financed by exotic wealth-management products that are subject to neither regulation nor disclosure. According to 60 Minutes news magazine, China's credit explosion has "created the largest housing bubble in history" which is "the main driver of growth." ("China's real estate bubble," 60 Minutes) Due to the unreliability of the data, it's hard for analysts to predict when the bubble will burst, but in a recent interview with Reuters, Gillem Tulloch, founder and managing director of Forensic Asia, had this to say:

"I've never come across a government that's managed to deflate a bubble gradually. What will likely happen is that confidence will suddenly go, and, yes, the bubble will pop. We think the bubble will pop in the second half of the year once they stop injecting ridiculous amounts of credit into the economy." ("China housing bubble will pop in second half of 2013: Forensic Asia," Reuters Staff)

Analysts are particularly worried about China's shadow banking system which Credit Suisse economist, Tao Dong, calls "a time bomb." Here's a brief rundown from the financial newsletter called The Asset:

"The bank estimates trust funds, wealth management products, and other components of the (shadow banking) sector to have grown to nearly...US$3.7 trillion or 44% of the nation's GDP at the end of 2012." Non-loan credit now comprises one-third of total credit outstanding in the financial sector, up from 15% in 2006."

"According to Tao, many products offered to retail investors in China increasingly look like collateralized debt obligations (CDOs) sold in the US before the financial crisis.

"'These products have little transparency and a complicated structure, seem tied to higher-risk underlying investments, are lacking a regulatory framework, and are vulnerable to tail risks,' he analyzes." ("Shadow banking casts gloom on China rebound," The Asset)

Sound familiar? China's shadow bankers have adopted the same flawed model as Wall Street. Leverage is building in dodgy debt instruments that have little or no capital supporting them and that are not subject to regulatory oversight. It's a prescription for disaster. Even a modest slowdown in expansion could lead to a credit crunch that could send the dominoes tumbling and push GDP below the 6 percent threshold.

China's growing middle class has boosted its investment in wealth-management products (WMPs) which offer a higher yield than bank deposits. But investors are unaware of how risky these products are. A significant amount of the money has been loaned to builders and developers who will never be able to repay the debt. Analysts fear that any tightening of monetary policy will trigger a series of defaults and bankruptcies that will ripple through the financial system leading to a contraction. Here's an except from a post by China expert, Michael Pettis:

 "It is difficult to measure the precise amount and value of WMPs".. According to a report by CN Benefit, a Chinese wealth-management consultancy, sales of WMPs soared 43 percent in the first half of 2012 to 12.14 trillion yuan ($1.9 trillion).  

"There are more than 20,000 WMPs in circulation, a dramatic increase from only a few hundred just five years ago. Given that the number is so big and hard to manage, China's shadow banking sector has become a potential source of systemic financial risk over the next few years.  

"Particularly worrisome is the quality and transparency of WMPs. Many assets underlying the products are dependent on some empty real estate property or long-term infrastructure, and are sometimes even linked to high-risk projects, which may find it impossible to generate sufficient cash flow to meet repayment obligations." ("Michael Pettis on China Reforms, Ponzi Schemes in Wealth Management Programs, Rebalancing Implications," globaleconomicanalysis.blogspot.com)

Chinese policymakers appear to be eager to follow Wall Street off the cliff using the same methods for boosting leverage through securitization, hypothecation, and derivatives. An article in the Wall Street Journal sheds a little light on recent developments: