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China: Increasingly Fragile Economy and Financial Markets

March 31, 2014
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“When you see an asphalt roller (compactor) rolling down hill, what do you do? Step aside and let it hit the guy behind you”. –  Jay Charles Goodgal, 1982, Question/Comments to the Assistant Treasurer of Ingersoll-Rand, A solution for the Chairman of Ingersoll-Rand when Company learned of major loss as a result of a currency devaluation – “Aim the compactor at the Vice Chairman”. 

The Chinese economy and its financial markets are becoming increasingly fragile. Total debt, including public, central and local governments, public and corporate debt, to Gross Domestic Product (“GDP”) has risen to 230%. At the close of 2012, total debt to GDP was 215.7%, up from 125% at the end of 2008. Given that the Chinese economy has slowed from 10.3% in 2010 to 7.5% in 2013, with expectations that 2014 will be lower than 2013. In fact, it appears that first quarter GDP statistics may show an economy growing at its slowest rate since 1990.

For 2013, the five largest Chinese banks more than doubled the level of bad debts they wrote-off. The five largest banks in the country account for more than 50% of all loans in China. In 2013, Rmb 59 billion (US$ 9.5 billion) of bad debt were written-off, an increase of 127% from 2012. The write-off was the largest in over a decade for the banks which were rescued by the People’s Bank of China (“PBoC”) from insolvency, recapitalized and then publicly listed.

And if the amount of bad debt being written-off by the five largest banks weren’t problem enough, the non-performing loan ratio ((“NPL”) at Chinese banks rose to the highest level in two years by the end of 2013 (i.e., 1%). At the end of September 2013, the NPL ratio was 0.97%. Non-performing loans in Chinese commercial banks amounted to 592.1 billion Yuan (US$ 97.7 billion) as of the end of 2013, up 0.05% from the end of the third quarter last year, according to the China Banking Regulatory Commission. Many analysts believe China’s true NPL ratio is higher than the official figure, as banks can disguise bad loans by rolling them over.

It is expected that given slower economic growth in China, increased defaults and deferred loan payments by lenders will cause a rise in bank write-offs and a worsening of NPLs. The huge increases in bank lending and the expansion of the shadow banking system in China following the global financial crisis, along with a slowing of the Chinese and the global economy, is now causing a fragile economy and weak financial markets to teeter. “We believe Chinese banks’ loan quality will deteriorate noticeably in 2014,” Liao Qiang, senior director at ratings agency Standard & Poor’s.

Economic change is on the horizon. Li Keqiang, China’s Premier, stated in a recent speech, “Increasing downward pressure on the economy should not be neglected. We have policies in store to counter economic volatility”. In time, we expect the PBoC to counter the slowing of economy growth with another economic stimulus program. The problem is that such a increased monetary accommodation will further burden the economy with debt. This is a viscous cycle. “The treadmill to hell”, as stated by Jim Chanos, the Chief Investment Officer and founder of Kynikos Associates Ltd. At some point, the “Piper will need to be paid”.

It is unlikely that China will be able to navigate its way though these challenges without a shock to the financial system and further slowing of its economy. This is a economic and financial system that has been debt-driven. A hard landing resulting from credit contraction is not out of the realm of possibility. The economic system is rife with industrial overcapacity, excess of built infrastructure (i.e., “Ghost Cities”), most of it the result of debt-fuelled growth. Furthermore, the rapid increase and opacity of financial system’s shadow banking network is now crumbling due to the inability of lenders to repay and the excess amount outstanding. The situation has turned from being one where a “Black Swan” is imagined to where a “Grey Swan” hovers. Stresses in the Chinese economy and financial system have become more evident. In the interbank market, the recent default of a shadow banking market bonds, the weakness in the Renminbi, the recent run on two provincial banks are warning signals of a potential implosion.

The one thing that holds in politics and is nearly assured, being Xi Jinping, the President of the People’s Republic of China, is better than being the second in command, Li Keqiang, the Premier of China (i.e., the guy behind the President).

Addendum: If funding the Chinese banking system requires the sale of U.S. Treasuries, the U.S. can expect to see higher interest rates. Contagion is not a good thing for the global economy.

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