There is nothing simple about China. Perhaps its complexities arise out a 5000-year-old culture or perhaps it is because of the Chinese Communist Party (CCP). I will leave that discussion for another time. To put it simply, everything in China is complex and nothing more so than the Chinese economy.
In my previous post, China – An Inevitable Economic Disaster, I had explored the debt crisis in China. The CCP has been buying time to stave of the inevitable. However, there is an even bigger economic calamity that looms over China – Shadow Banking.
UNDERSTANDING SHADOW BANKING
Shadow Banking is not unique to China, it exists everywhere. In fact, it was Shadow Banking which caused the 2008 financial meltdown on Wall Street, which triggered a global recession. Like everything else, China copied the Shady Side of Shadow Banking from Wall Street and habitually it cut corners, over-scaled it, and made it off even more inferior quality.
Shadow Banking is not all about shady backroom financial jugglery by shady bankers. It does have its use and is necessary for the economy to leverage non-bank credit. And when it is tightly regulated and monitored, it can become a strong leverage to boost economic growth. In fact, all economies across the world have Shadow Banking in their systems. Pozsar (2012) provided a refined description of shadow banks, defining them as “financial intermediaries that conduct maturity, credit, and liquidity transformation without explicit access to central bank liquidity or public sector credit guarantees.”
The core premise of Shadow Banking is extending credit to people or businesses which are not all that creditworthy, or as they say sub-prime. This does not necessarily mean that all such people or businesses are not good for the loan they take, it just means the bankers think they constitute a higher risk to lend to them.
So, the bankers came up with an ingenious way of serving two needs, giving loans to people and businesses which are deemed sub-prime and not giving the loan with their own money. The ingenious bankers created something called a Wealth Management Product (WMP). Which to put it simply the bankers would get others with capital to invest in these WMP for a better return on investment than bank deposits.
Now that the bankers were able to get investors to give them money for these WMP, they lent that money to sub-prime businesses and people at higher interest rates. So, people who needed credit and did not qualify for a traditional loan were now able to get credit. The interest rates were higher, so the banks made more money and they passed on this extra money to the investors of the WMP.
Theoretically this works fine. The interest rates are high enough to cover for the losses which may occur due to a few loans going into Non-Productive Asset (NPA) category. Everyone comes out a winner, especially the bankers, who end up making lots of money without investing a single paise from their side. And it is even more brilliant that these WMP can be kept of the balance sheets of the bank, as they are not transactions which are core to the banks.
However, fairy tales are not true. And greed does make people do the most hideous things. The bankers got greedy. Since they realized the WMP were not regulated by the Central Banking system of most countries, they could completely hive of the WMPs into new companies which were not banks. These companies exist everywhere and are called Non-banking Financial Companies (NBFC) or Merchant Banking Companies (MBC).
The bankers then realized that they could make more money from these WMPs. They figured out that they could club a bunch of small and midsized WMPs into one larger WMP. And this larger WMP could then be resold to other investors. It made sense to club smaller WMP into one large WMP product to de-risk it. Most investors never knew what they were investing in or how risky or how good the WMPs were as the banker sold and re-sold these WMPs. The complexities of these transactions are equivalent to impenetrable financial Chakravyuh.
The system works fine as long as the people who get loans keep paying their EMIs. The problem starts when there are events which makes the economy tank. Its the sub-prime people and businesses, which are the first to get affected and they begin to default on their loans. This is called the Minsky Moment – a sudden collapse of asset prices sparked by debt or currency pressure, after a long period of growth. This is exactly what happened in 2008 on Wall Street.
This elongated explanation of how Shadow Banking works globally was important to understand the extent of the Shadow Banking problem in China. And how the Chinese Communist Party (CCP) has misused Shadow Banking to prop up a massive debt crisis bubble.
IN THE SHADOWS OF A LOONY DRAGON
In 2018, Torsten Ehlers, Steven Kong and Feng Zhu published a BIS Working Paper on Mapping shadow banking in China structure and dynamics. The study was limited to the declared Shadow Banking sector by the CCP.
Torsten, Kong and Zhu plotted the complex Chinese Shadow Banking system in a flowchart.
In conclusion, they found that the Chinese Shadow Banking system as the most complex maze of financial jugglery. Unravelling this puzzle will be a near impossible task.
There is a particularly good reason for the Chinese Shadow Banking system to be the most complex. It helps the CCP obfuscate shady deals and camouflage the bloated and weak bearing of the Chinese economy.
The 2008 Wall Street crash was caused by murky dealing within the US Shadow Banking system. Post the collapse, while the world began to clamp down and regulate this in their economies, the Chinese Communist Party (CCP) did the exact opposite. The CCP actively encouraged Shadow Banking to boost liquidity into the Chinese economy.
Official estimate of the Chinese Shadow Banking Industry is currently at 51 Trillion Yuan, which is 31% of formal Chinese banking assets (loans given). But as we know from past experiences, the CCP and any data from China are extremely suspect.
A forensic estimate of the Chinese Shadow Banking industry pegs its currently at 80 to 87 Trillion Yuan, which is at 66% to 68% of formal Chinese banking assets. Experts who have conducted their forensic studies on the Chinese economy believe that the Chinese Banks are sitting on piles of Non-performing Assets, which have still not been cleaned of their books and that the informal Shadow Banking in China is far greater than what is officially reported.
A recent study by French investment bank Societe Generale indicates a staggering 8 Trillion Yuan losses which has already accumulated in Chinese Banks. This mean that 60% of all capital in all Chinese banks are at huge risks.
Essentially the Chinese banking system and Shadow banking have been used by the CCP to create massive debt-based GDP growth. Officially the CCP has been creating 4 Yuan of debt for 1 Yuan of GDP growth. When the official debt is combined with Shadow banking debt, this ratio balloons to 8½ Yuan of debt for every 1 Yuan of GDP growth.
In the wake of the 2008 global financial crisis, Chinese economy which was dependant on exports was severely affected. The CCP realized that it had to transform the Chinese economy from export dependant to a domestic consumer-oriented model. To generate higher GDP growth rates, the CCP unleashed a large-scale fiscal stimulus program.
While this had the intended effect of insulating China from the full force of the economic slump, the longer-term and unintended impact was to expand and solidify China Inc., the sprawling system of state-owned enterprises and quasi-private companies that are sustained by the CCP’s management of the economy. The quasi-private companies are mostly owned by CCP members via their proxies.
To generate a quantum leap in the Chinese economy, the CCP unleash massive infrastructure projects across China. To fund these projects, the CCP turned to “printing money”. Essentially, the CCP induced gigantic proportions of debt through its state-owned banks and passed them of to state-owned enterprises and quasi-private companies to construct these new infrastructure projects. The official debt to GDP ratio grew exponentially from a manageable 50% to 300% from 1992 to 2018.
Resultant to this infrastructure push by the CCP, Chinese GDP grew at an astonishing pace. This was called the Chinese miracle. Also resultant to this was an out of control over supply of infrastructure across China and hedonistic consumerism by the Chinese people. My previous post, China – An Inevitable Economic Disaster, has detailed the resultant debt bubble and the consequences Chinese economy is currently facing.
Fundamentally the CCP had a Hobson’s choice. The only way it could control the Chinese people was by convincing them that the CCP’s governance model was the best in the world and that the Chinese people were richer and better under the CCP’s leadership. “Growth at any cost” and “make money, forget politics” was the message the CCP drilled into the Chinese people.
And the CCP members had a finger in every pie. Officially CCP members are not permitted to own or participate in any private enterprise. But it is openly acknowledged by the Chinese people that the CCP members own and operate most Chinese companies. Corruption is rampant in the CCP. In China corruption by the CCP is institutionalized.
2008, was also the year when CCP realized that creating money to fund growth via traditional banking would not provide the capital required for its growth plan. CCP could not keep printing the Yuan without the consequences of hyper-inflation and devaluation. The world always knew the Yuan value is artificially sustained by the CCP. For the CCP, there was no choice but to encourage shadow banking activities. Xi Jinping’s accession to power in late 2012 solidified this trajectory.
CHINA MAKES BAD COPIES OF EVERYTHING
The scale of shadow banking in China is gigantic. The Chinese have created their own versions of shadow banking and they call it “Social Financing”. Majority of shadow banking activities are structured to keep them out of the purview Chinese regulators. For the CCP, it is particularly important to show to the global community its commitment to financial transparency. The CCP has a slew of regulators who keep up the pretence. The CCP has no desire to regulate the shadow banking activity.
Broadly we can classify Chinese shadow banking into ten categories.
1. Off-Balance-Sheet lending: Most of China’s commercial banks, including the big four Chinese state banks, offer a variety of services that do not fall into their balance sheets. These include letters of credit, loan commitments and guarantees, entrusted loans, and asset supervision. These activities are not recorded on banks’ balance sheets; however, they are disclosed to regulators and therefore are supervised to some extent. These banks also engage in activities that are not fully disclosed to regulators. These activities include informal securitization of loans and Banker’s acceptance bills (undiscounted), as well as the ever-growing variety of wealth management products.
2. Trust Companies: I have explained this in detail when dealing with Wealth Management Products (WMP). Trust companies are WMPs and play an important role in off-balance-sheet lending done by banks. Trusts purchase loans from banks, take them off the bank’s balance sheet, package them together, and then sell these loans to other financial institutions and private individuals. The primary function of trust companies is to act as third-party wealth managers. These companies pool capital from investors and then channel these funds into a variety of sectors like real estate, infrastructure, financial instruments, and private equity. The bulk of Trust companies in China are heavily invested in the oversupplied real estate sector.
3. Microfinance lenders: The microfinance industry in China, often called small loan companies, is a growing source of finance for small and medium enterprises. These companies are prohibited from taking deposits from the public and may not loan more than 5 percent of their capital to a single borrower. These lenders primarily offer unsecured loans, meaning that the losses they face from nonperforming loans are potentially extremely high. Small loans companies can charge interest rates up to four times the benchmark rate and earn additional revenues through fees.
4. Company-to-Company Finance: Another channel for financing during periods of tightened credit is direct loans between nonfinancial companies. Corporations flush with cash are reluctant to put all their surplus funds in bank accounts because of negative real interest rates on deposits. Instead, these companies take their excess funds and make loans directly to companies that are unable to receive credit from the banks. These loans are offered at much higher interest rates than bank loans. The risk analysis and mitigation performed by the lending company is likely to be much less sophisticated than that performed by banks.
5. Underground Banks: Underground banks are unregulated and often unregistered financial organizations that offer many of the same services as traditional banks. These banks tend to proliferate in areas where there are large numbers of small and medium private enterprises, such as Zhejiang Province. Underground banks have attracted a lot of attention recently as many have become swept up in the credit crisis that has engulfed Wenzhou, a city that is a bellwether for China’s private sector. To attract deposits, underground banks offer savers interest rates as high as 20 to 30 percent and then loan out funds at even higher rates. Underground banks are often quite aggressive in their marketing of loans and are believed to be much less sophisticated in their analysis of risk than traditional banks.
6. Peer-to-Peer (P2P) loan Websites: I call it the Chinese Tinder for Money. There are over 4000 P2P lending online platforms in China. These websites eliminate the middleman by using online platforms to directly connect lenders and borrowers. The websites profit by charging a small commission for each loan. Rates offered through P2P networks are significantly higher than traditional banks. The industry is totally unregulated and is so new that it is in many ways the Wild West of lending. Some websites perform a basic level of scrutiny of both borrowers and lenders and require some reserve capital. Others throw all safeguards and directly connect individuals. Some websites to attract businesses have started offering principal guarantees in the case of loan defaults. The financial risk present in these operations is relatively high.
7. Pawnshops: Pawnshops are a refuge for small and micro enterprises that have been denied credit from traditional financial institutions. Pawnshops typically offer short-term credit to businesses that need working capital or bridge loans. In exchange for quick access to credit and limited credit checks, pawnshops often charge steep interest rates and have hefty collateral requirements. Due to these high collateral requirements, the pawnshop loan industry is relatively low risk.
8. Leasing Companies: In the wake of credit restrictions, leasing companies have become an important source of medium-term financing for small and medium enterprises. Leasing companies effectively provide loans for investment in fixed assets, renting equipment to businesses (often with ownership transfer at the end) in exchange for a series of payments. Because many enterprises are borrowing money to purchase equipment in the first place, leasing companies can provide an effective substitute to loans. Many leasing companies are subsidiaries of banks.
8. Loan Guarantee Companies: Many enterprises with surplus cash have entered the loan guarantee business. In exchange for a percentage of the principal, these companies guarantee the repayment of a loan. Loan guarantee companies are an extra level of risk mitigation which encourages large banks to lend to smaller businesses. These companies often take relatively risky positions, guaranteeing the entire amount of a loan while only putting a precautionary fund equal to 10 percent of the principal on reserve with the banks.
10. Offshore Borrowing: Many Chinese enterprises have turned to lenders abroad to get access to additional credit. Enterprises borrow, often through their subsidiaries, in the offshore renminbi markets located primarily in Hong Kong. These funds are then remitted back to their operations on the mainland. Not only is credit more available in the offshore markets, but often the rate is lower because of the dearth of investment opportunities.
ARMAGEDDON AROUND THE CORNER
The tell-tale signs of the Looney Dragon economy is beginning to unravel. The CCP’s bluster and propaganda has taken shrill proportions. CCP wolf-warriors have already declared the old “enemy foreign hand” responsible for all of China’s woes. Old foes in the CCP are sharpening their Knives for Xi Jinping. China is in economic and political turmoil.
SHADOW BANKING: The once fast-growing Shadow Banking Trust Funds has 5.4 trillion yuan ($766 billion) which are coming due this year. These are all high-yield products backed by loans that are sold to banks, institutional investors, and wealthy individuals. Due to the impact of the Wuhan Coronavirus pandemic on the economy, Beijing’s Reality Finance Research estimates that 300 Trust Fund products will go into default in 2020. 118 Shadow Banking Trust funds went burst in 2019, totaling 2 Trillion Yuan.
China Trust Association estimates more than 1,500 trust products valued at 577 Billion yuan were designated as risky in 2019, up from about 870 Trust products in 2018. In the last 12-months a slew of the Largest Chinese Trust Funds have gone rogue. China Everbright Trust Co., Jic Trust Co., Zhongtai Trust Co., Anxin Trust Co., Sichuan Trust Co., Guizhou Trust Co., Dongguan Trust Co., Minsheng Trust Co., etc. have all defaulted in payment. Anxin’s shares are now suspended in Shanghai Stock Exchange, after plunging 80% from a peak in 2017.
CLSA estimated China’s shadow banking could lead to losses of $375 billion. According to their 2016 study, the potential bad debt ratio for “bank-related shadow financing” was at 16.4 percent, or 4.2 Trillion Yuan. Assuming a 40 percent recovery rate left a potential loss of 2.5 Trillion Yuan.
SHRINKING GDP, DEBTs AND NPAs: The Chinese economy has been contracting since 2018. A forensic examination of the Chinese economy estimates the actual GDP growth at 1.67% in 2019. The onset of the Wuhan Coronavirus global pandemic has pushed the Chinese economy into recession. S&P Global estimates the Chinese Banks could face as much as $800 billion in loans going NPA due to the Wuhan Coronavirus Pandemic.
China’s external debt was estimated at between $3 trillion and $3.5 trillion by Daiwa Capital Markets in a recent report. In other words, total foreign liabilities could be understated by as much as $1.5 trillion
SAVINGS: In a span of 8-years, the Chinese household savings rate has dropped to 25% from its high of 50%. Partly due to unhinged consumerism encouraged by the CCP and primarily because the CCP needed this money to fund China’s infrastructure boom. The CCP actively encouraged the Chinese people to invest in real estate and Shadow banking products.
REAL ESTATE: The bubble has burst. The CCP will not admit it, but the evidence if there for everyone to see. Over 50 million homes are lying unoccupied. Hundreds of Ghost Cities dot the Chinese hinterlands. 100 Builders are likely to go bust in the next few months. Another 500 Builders have sought loan moratorium.
FOREIGN EXCHANGE: Chinese Foreign Exchange reserves fell from high of $ 4 Trillion in 2013 to $ 3 Trillion in 2019. China lists its outstanding external debt at $1.9 Trillion. For a $13 trillion economy, that is not a major amount. But numbers significantly understate the underlying risks. Short-term debt accounted for 62% of the total as of December 2019, meaning that $1.2 Trillion will have to be rolled over in 2020.
Xi Jinping’s Belt and Road Initiative have exacerbated the build-up of foreign debt. China has been borrowing US Dollars on international markets and lending it around the world for everything from Kenyan railways to Pakistani business parks. With this year and 2020 being the peak years for repayments, China faces dollar funding pressure.
To repay their dollar debts, Chinese firms and Banks will have to draw from the central bank’s foreign-exchange reserves (which the CCP is unlikely to allow) or buy dollars on international markets. This creates a new set of problems. There are only 617 Billion yuan (US $90 Billion) of offshore renminbi deposits in Hong Kong available to buy dollars. If he CCP were to push China Inc. to bring debt back onshore, this would necessitate significant outflows that would push down the yuan’s value against the US Dollar
FAKE GOLD: As recently as June 2020, Kingold Jewellery which is owned by a prominent CCP member Jia Zhihong had pledged 83 tonnes of fake Gold bars to secure loans from the Chinese Trust Fund (Shadow Banks). Kingold Jewellery was affiliated to the People’s Bank of China (PBOC). Prior to 2002, Jia Zhihong managed gold mines owned by CCP’s private militia the PLA. The fake gold fraud amounted to 22% of China’s annual gold production and 4.2% of the state gold reserve as of 2019.
Analyst do not expect this to be a one-off case. Some estimate that over 25% to 30% of China’s Gold reserves could consist of fake Gold. The CCP leadership through its proxies have been swapping real Gold with fake bars and have been funnelling this out of China via Macau. The CCPs top leadership are expecting an economic meltdown and has been funnelling Gold out of China to save their personal wealth.
Zero Hedge investigative report stated that the Kingold Jewellery scam exposes just how multi-faceted fraud is in China: capitalizing on pre-existing cronyism and connections with CCP and PLA. China’s fake Gold has been unfolding since 2016. In the northwest Shaanxi province and neighboring Hunan, regulators found adulterated gold bars with 19 Trust Funds backing 19 Billion Yuan (US $2.5 billion) of loans.
We have certainly not heard the last of China’s Fake gold.
The complex lending hidden in the Shadow banking sector compounds the threat posed by China’s rapid accumulation of core banking debt. Economic pain from a string of defaults presents a challenge for the CCP regime that draws its legitimacy from the promise of prosperity.
Every economic indicator points out the severe strife in the Chinese economy. Runaway debt crisis, of-the-books Shadow banking NPAs, an oversupply of real estate, overcapacity within all industries, aging population, fake Gold reserves, rampant corruption, declining household savings, declining forex reserves, artificially propped up currency and hyper-consumerism.
Using the data model from IFARA and extrapolation of the current economic scenario with the deep impact on the Chinese economy of the Wuhan Coronavirus pandemic and trade wars which China is now facing from all major global economies, we see a frightening scenario. The model predicts the Chinese economy imploding within the next 18 to 24-months.
The belief within the Chinese people is that the Chinese economy is far too big for it to be allowed to fail. The Chinese people believe the CCP will bail them out – eventually. Like they have in the past. The only question to ask now is does the CCP have the money or rather will it be able to print more money to bail out the Chinese economy?
I doubt the CCP will be able to contain the situation, the Looney Dragon has already escaped, and it will burn down the Chinese economy. For cues to the impending collapse of the Chinese economy, keep a close watch on the CCP’s actions in Hong Kong, its belligerence with neighbors, and what it does to counter trade wars. And finally, how Xi Jinping fares over the next 6-months.
Postscript - My next post will deal with the cosy relationship between the Chinese Communist Party and Chinese Organized Crime Networks – The Triads.
DISCLAIMER: The author is solely responsible for the views expressed in this article. The author carries the responsibility for citing and/or licensing of images utilized within the text.