Is the Chinese credit bubble starting to unravel?


Vivek Kaul
One of the fundamental rules of forecasting is to make as many forecasts as possible and then publicise the ones you get right. A little over two weeks back I wrote a piece titled “Is China getting ready for the next big financial crisis?
On June 24, 2013, the Shanghai Composite Index,
China’s premier stock market index fell by 5.3% to close at 1963.22 points. The fall continued on June 25, and at one point of time the index reached a four year low of 1849.65 points. Though by the end of the trading day, the stock market had managed to recover the losses and was quoting at around 1960 points.
The stock market plunged in response to the Shanghai interbank offered rate (or Shibor) going up dramatically towards the middle of last week. Shibor is the interest rate at which banks lend to one another. It had spiked to 25% on June 20, 2013.
Despite this rapid rise in Shibor,
the People’s Bank of China, the Chinese central bank, refused to intervene. In fact in a statement dated June 17, 2013 (but issued only on June 24, 2013) the central bank said “current liquidity in our country’s banking system is overall at a reasonable level.”
This statement was what caused a panic in the stock market on June 24, 2013. The interpretation was that the People’s Bank of China was sending out a message that the days of “easy money” in China are over and the central bank would now get into a tightening mode as far as the easy availability of credit was concerned. If one were to use the language of those who follow every move that a central bank makes, the central bank had just turned hawkish. The stock market falling was a response to that.
Loans given by banks and other financial institutions have grown at a very rapid rate since 2007. As Edward Chancellor and Mike Monnelly of the global investment management firm GMO point out in a white paper titled
Feeding the Dragon: Why China’s Credit System Looks VulnerableBetween 2007 and 2012, the ratio of credit(i.e. loans) to GDP climbed to more than 190%, an increase of 60 percentage points. China’s recent expansion of credit relative to GDP is considerably larger than the credit booms experienced by either Japan in the late 1980s or the United States in the years before the Lehman bust.” As of the end of 2012, the total lending by banks and other financial institutions as a proportion of the GDP ratio stood at 198%. And this growth in loans continued unabated even in 2013. During the first three months of the year, the loans grew by 20% in comparison to the same period last year.
Ambrose Evans-Pritchard of The Daily Telegraph comes up with a very interesting data point in a recent blog which shows very clearly how big the Chinese credit bubble really is. As he writes “China has increased credit from $9 trillion to $23 trillion since late 2008. The increase is equal to the entire US commercial banking system.”
This lending by banks and other financial institutions is reflected in the rise of private sector debt in China.
A recent World Bank report puts the ratio of private domestic debt to GDP at 160%. This is the highest among all the nations categorised as emerging markets. The credit rating agency Fitch puts this ratio at 200%.
This rapid increase in credit, which has had the blessing of the People’s Bank of China, has been a major reason behind China continuing to grow at a very high rate even though economic growth all over the world has slowed down.
But the trouble is with so much money being lent, the efficiency of lending has broken down i.e. more money has to be lent now to create the same amount of growth, in comparison to the past.
As Wei Yao of Societe Generale writes in a report titled China’s missing money and the Minsky moment “a fast rising debt load of an economy suggests either deteriorating growth efficiency or high and rising debt service cost, or in many cases both. There is clear evidence that China is suffering from both of these.”
Wei Yao estimates that China has “a shockingly high debt service ratio of 29.9% of GDP, of which 11.1% goes to interest payment and the rest principal….At such a level, no wonder that credit growth is accelerating without contributing much to real growth!”
In fact so much money has been lent that ghost cities where no one lives have been built. “
Miles upon miles of half-completed apartment blocks encircle many cities across the country. Official data suggest that the value of the unfinished housing stock is equivalent to 20% of GDP and rising..Developments in the infamous “ghost city” of Ordos, in Inner Mongolia, reveal the vulnerability of China’s credit system to an overblown housing market. The Kangbashi district of Ordos is a totem for China’s property excesses. Kangbashi has enough apartments to shelter a million persons, roughly four times its current population,” write the GMO authors.
A lot of these loans have (and continue) to be made in the shadow banking system.
As an article in The New York Times points out “Banks borrow at the low interbank rate, then lend to trust companies and smaller banks who in turn make riskier loans. The fear among some analysts is that the vast amount of bad debt and hidden liabilities the shadow banking system masks could start sinking banks. Those excesses could start a chain of other economic setbacks.”
Money raised and lent by the shadow banking sector has also been responsible for the massive property bubble in the country.
As an article in the LA Times points out “Chinese authorities are trying to rein in the nation’s so-called “shadow banking” sector, in which smaller banks and trust companies borrow from bigger state-run banks with easy access to credit. Those entities relend money at high interest rates to property developers and businesses, often with tight connections to the Communist Party, driving speculation and asset bubbles.”
And the People’s Bank of China cannot let this run forever. Hence the recent statement is being seen as a warning to banks and other financial institutions to go slow on lending money.
Also Shibor, acts as a benchmark interest rate to other kind of loans from home loans to credit cards. And a rise in Shibor could slowdown lending further. As Goldman Sachs said in a recent note “The recent tightening of the interbank market has sent a strong policy signal that the strong credit growth earlier in the year will likely not continue.” For any bubble(and China has a huge property bubble that is currently on) to sustain itself it is important that money keeps coming in. And the Chinese central bank seems to have turned the tap off as far as “easy money” is concerned.
Another possible explanation is being offered for the recent hawkish statement made by the People’s Bank of China. The new Chinese President
Xi Jinpingand Premier Li Keqiangare said to be interested in initiating financial sector reforms by opening up the Chinese bond markets and also freeing up the interest rates.
The Forbes quotes Carl Walter, who has spent 20 years working in Chinese banking sector as saying “There is a political message to all of this, which is don’t mess with the banking system…I think the People’s Bank of China and the big four banks are telling the new leadership to keep its hands off this sector.”
By letting the Shibor to rise, the banking interests want to show the new Chinese leadership of what is likely to happen if the interest rates are set free. As Walter puts it “By playing with Shibor, letting it go sky high, and watching these small banks squeal then politically you show strength…They are saying, ‘you want to liberalize interest rates, go right ahead, look what at what is happening to these smaller banks. We are too big to fool around with.”
Either ways, there is trouble ahead.
The article originally appeared on on June 26, 2013 

(Vivek Kaul is a writer. He tweets @kaul_vivek)