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The Chinese Shadow Banking Market: One Failure to Financial Crisis

March 5, 2014
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The Chinese Shadow Banking System (“CSBS”) has evolved over the past three years from an underground lending network among individuals and small companies into a complex and interconnected financial web. It is estimated by JP Morgan Chase to be valued at US$ 7.7 trillion. The CSBS is an integral financing sector of China’s financial system that includes the Chinese mainland’s biggest banks, state-owned firms, local governments and millions of households, involving trillions of Yuan trust products. This is an unregulated lending system that threatens the financial stability of China and global markets.

In 2013, 3.5 trillion yuan matured and in 2014 5.3 trillion yuan of trust products will mature. According to a report in the South China Morning Post (“SCMP”), at least 20 trust products have run into difficulty making payments since 2012 (Source: China Securities, Beijing). Investors were bailed-out and default was avoided as issuers/third parties, such as state-owned bad-loan managers and guarantee firms, eventually repaid investors in full.

Up until now, the financial risk of such investment products has been underwritten by implicit guarantees, which can no longer be relied upon to provide sufficient capital to bail-out investors. Clearly, systemic financial risk is evident. Christine Kuo, an analyst at Moody’s Investors Service was quoted in the SCMP, “The failure of one product could lead to defaults of many others in a chain reaction”.

While Xu Gao, Beijing-based chief economist at Everbright Securities believes, “China needs a default, but not now. A default would lead to an exodus of capital from similar financial assets, followed by a bank run, as liquidity is quickly drained in the financial system. Nobody will be willing to lend to each other – just like what happened when Lehman went bankrupt”.

A default in the CSBS is just the type of catalyst that can have a significant impact in the global financial market as well as the financial system and industrial complex of China. It is a “Grey Swan” that is hovering as a result of excess lending to non-investment grade companies and to investors reaching for yield. It is little discussed in the U.S. and European press and for the most part dismissed as investors’ to-date have received bail-outs by issuers/third parties.

For those shipowners/investors increasing capital investments based upon the Chinese economy, Caveat Emptor. The underlying financial system, supporting the Chinese industrial complex upon which the shipping industry relies is fragile. Shipowners/investors will be significantly impacted as the shipping industry is still after years of deleveraging represented by overcapacity, with a large orderbook, and excessive leverage, a severe problem during any financial crisis.

For investors in U.S., the “Butterfly Affect” may be stronger than one imagines. Defensive investments in agricultural products and land as well as water resources, while impacted on a relative basis, should be expected to outperform other types of securities as these investments are required for sustenance.

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