It's getting increasingly more difficult for China to deny its massively overindebted reality.
The latest striking confirmation that things in the world's former growth dynamo are deteriorating rapidly, come yesterday from none other than PBOC advisor Huang Yiping, who during a speech in Beijing said that China's "deleveraging isn't making progress" and that the "high leverage ratio is becoming a big financial problem for the country" noting that the household leverage ratio has "surged sharply in China." Adding something ZH readers have known for the past year, Yiping said that "mining and property sectors have the highest leverage ratio" in the country and while the M2/GDP ratio is "not the best gauge to measure leverage for China" he notes that the "leverage ratios in state-owned companies have kept growing since 2008."
None of this is a secret: one look at the chart below from the IIF according to which China's gross leverage is now roughly 300% of GDP, confirms just that.
Worse, in a troubling report by SocGen from September 21, the French bank found that depository banks’ claims on the government are surging, up 80% and nearly CNY7tn yoy. As SocGen notes, the simultaneous and rapid rise in the PBoC’s claims on domestic banks has raised questions as to whether China is conducting a modified form of quantitative easing.
SocGen's explanation is partial affirmation of this question:
"In our view, the surge in banks’ claims on the government is because of the debt-to-bond programme for local governments. These claims only include banks’ holding of central government bonds (CGBs) and local government bonds (LGBs). Any borrowing of quasi-government institutions from banks in the form of either loans or (corporate) bonds was and is still categorised as corporate borrowing.
The National Audit Office conducted two nation-wide audits on local government debt in 2010 and 2013, and the State Council finalised the count of local government debt at CNY16tn as of end-2014, on which the swap programme was based, designed and kicked off in 2015. However, the label was never changed in creditors’ record despite the formal recognition. Only when local government bonds (LGBs) are issued and banks buy them do banks’ claims on the government increase.
Even if the proceeds of LGBs issued under the swap programme have not gone to repay the borrowing of quasi-gove rnment institutions, banks’ claims on the gove rnme nt still increase nonetheless as long as banks buy up the LGBs.
This means that it is the rapidly expanding swap programme that enables local governments to issue so many LGBs so quickly.
The programme commenced in May 2015 and reached over CNY3tn by the end of 2015. In the eight months this year, the stock of LGBs under the programme added another CNY3.6tn. Along with the increases in budget bonds issued by central and local governments, the increases in government securities are in line with the increase in banks’ claims on the government.
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Of course, this massive transfer of obligations to the government should mean that the local banks are more stable as a result of their liabilities being effectively insured by the government. Well, not necessarily.
As it turns out, while China's big banks, most of which are state-owned enterprises already, may indeed have become inextricably interconnected with the fabric of China's own sovereign stability, China’s smaller banks have never been more reliant on each other for funding, prompting rating companies to warn of contagion risks in any crisis.
"Contagion risks are definitely rising," said Liao Qiang, Beijing-based senior director for financial institution ratings at S&P Global Ratings. "The pace of the development is concerning. If this isn’t stopped in time, the central bank will lose some control and flexibility of its monetary policy."
According to Bloomberg, wholesale funds - notably those raised in the interbank market - accounted for a record 34% of small- and medium-sized bank financing as of June 30, compared with 29% on Jan. 31 last year, Moody’s Investors Service estimated in an Aug. 29 note that analyzed central bank data. Shanghai Pudong Development Bank Co.’s first-half earnings showed its short-term borrowings and repurchase agreements surged by 75% in the past three years, while its consumer deposits rose just 24% .
As Bloomberg adds, "policy makers have sought to sustain an economic recovery by keeping the seven-day repurchase rate at round 2.4 percent for the past year, a level that has encouraged borrowing for investment in property, corporate bonds or risky loans, often packaged as shadow banking products. CLSA Ltd. estimates total debt may reach 321 percent of gross domestic product in 2020 from 261 percent in the first half, while the Bank for International Settlements also warned lenders are at risk from surging leverage."
What China's attempts to stabilize its financial system have achieved is forced banks to rely not on deposits as sources of funds, but intermediaries such as the dreaded shadow banks, aka WMPs, and worse, other banks: a precarious balance which threatens a domino-like effect should even one counterparty fail.
Shanghai Pudong Development Bank told Bloomberg in an e-mailed response on Sept. 24 it has been using appropriate financing and its regular deposits and interbank borrowing have been developing properly and in synchronization. Total liabilities will be kept under control in the long run and all liquidity gauges meet regulatory requirements, it said. Rising short-term borrowing doesn’t mean its risks have climbed as well, the bank said.
Meanwhile, as reported previously, the PBOC resumed longer-term reverse repos to boost borrowing costs in August and deputy governor Yi Gang said in a television interview earlier this month that the nation’s short-term goal is to curb leverage. The benchmark 10-year government bond yield climbed slightly, to 2.75% from a 10-year low of 2.64% on Aug. 15, effectively setting a rate floor for China's plunging sovereign bond yields which recently also hit an all time low. Interbank market stability only makes it more appealing for traders to borrow money and invest in illiquid assets of longer tenors, S&P and Moody’s warned.
The good news - for now - is that a worse case scenario would likely be cushioned by depositor bail-ins. China’s financial system is backstopped by some 148.5 trillion yuan ($22.3 trillion) of savings, even though regulators removed a rule that limited loans to 75 percent of deposits in 2015. Industrywide, the ratio was 67% on June 30, up from 64% five years ago, China Banking Regulatory Commission data show. Including shadow banking, it is closer to 100 percent for some lenders, such as Shanghai Pudong, Moody’s wrote. The rating company said the big four state banks still have "strong deposit franchises and a more prudent growth strategy."
Of course, the rapid flight of deposits offshore is the biggest risk that has been facing China, and is why the PBOC has spent hundreds of billions in reserves over the past 18 months trying to stabilize the Yuan, which has been hit as a result of depositors rushing to park their savings abroad, aware that it is only a matter of time before China's banking syste, suffers a major crisis.
Meanwhile, China's shadow banking problems continue to grow: short-term borrowings and repos accounted for 37% of Industrial Bank Co.’s total liabilities as of June 30, up from 34% three years ago, according to its filings. The lender’s loan-to-deposit ratio rose to 73.8 percent, from 67.8 percent at the end of 2015. The ratio for Hong Kong banks’ local currency business was 78.2 percent on June 30, while that for Australian lenders was 114.9 percent, according to official data.
Why is this a danger? As Christine Kuo, a Hong Kong-based senior vice president at Moody’s said, the higher the reliance on wholesale funds, the greater the risk of a liquidity crunch.
"When banks face fund withdrawals by other financial institutions, this will in turn prompt them to call back their own funds," she said. In other words, just as the "breaking" of money markets in the aftermath of Lehman is what many say catalyzed the freeze of interbank funding as a result of virtually no regulation of shadow banking in the US, it is now China's turn to aggressively rely on short-term and even overnight sources of funding.
It gets worse: in a sign that China's financial system has already moved beyond the Ponzi point on its way to the inevitable Minsky moment...
... banks are also buying each others’ wealth-management products and accounting for the transactions as investment receivables.
As a reminder, the "Ponzi finance" stage in a financial regime, is where borrowers have insufficient cash flows to pay either principal or interest and therefore must either borrow or sell assets to make interest payments. This is where China finds itself now. As Bloomberg writes, a record 26.3 trillion yuan of WMPs were outstanding as of June 30, doubling over two years, China Banking Wealth Management Registration System data showed. Investment receivables at 25 listed Chinese banks grew 13.4 percent in the first half to 11 trillion yuan, earnings reports show.
- China Minsheng Banking Corp.’s receivables surged 77% in the first half, while its short-term borrowings and repos more than doubled in the past two years, company filings show.
- Industrial Bank declined to comment and China Minsheng didn’t reply to an e-mail seeking comment.
As He Xuanlai, a Singapore-based analyst at Commerzbank AG, says "banks’ use of wholesale funds to buy WMPs only makes the contagion risks higher."
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We anticipate that all of the above warnings, as has traditionally been the case, will be ignored until it is too late to engage in proactive damage control, instead forcing China to "fix" a problem of massive leverage by throwing even more debt at the problem as the country joins the rest of the "developed" world in doing "whatever it takes" to keep its insolvent financial system alive by kicking the can as far as it possibly can.