China: Dried Kindling in the Shadows

I have long been a China bear, even before the financial crisis.  (Bearishness here means that I believe China has many structural weaknesses that make it highly unlikely it will achieve the  prodigies that China bulls predict.)  A major reason for this bearishness has been the Chinese financial system.  For years, bad loans have been buried. More recently, the combination of financial repression and the need to get bad loans off bank balance sheets have encouraged the development of a shadow banking system that makes the West’s look positively staid and stable by comparison.

This is illustrated quite graphically in an excellent special report on Reuters.  Do read the whole thing, but here are my takeaways.  First, as just noted, financial repression which depresses returns on bank accounts encourages savers to look for higher return-and higher risk-alternatives.  Second, shadow banking mechanisms such as “Wealth Management Products” are being used to fund very dodgy assets and get them off bank balance sheets.  Third, these shadow banking products involve maturity, credit, and liquidity transformation.  In many cases, the degree of transformation is extreme, with very short term liabilities (as little as a few weeks) used to fund long maturity, non-performing, extremely illiquid assets  Fourth, the degree of disclosure about these products is appalling.

In brief, there are all the ingredients of a run present there.  Indeed, if the Reuters characterization is correct (and I have heard the same or worse from those who have major skin in the game), this system is far more fragile than the web of ABCP, SPVs, liquidity puts, subprime MBS and CDOs and CDO squareds that collapsed in the US in 2007-2008.

Woefully uninformed investors have no ability to discriminate between good and bad trust companies, wealth management products, etc.  Bad news about a few, or a big one, quite likely would lead to a spike in suspicion about all of them: given the highly dubious quality of the underlying assets (resulting to a considerable degree to the malinvestment caused by the government’s stimulus efforts in 2008-2009), such bad news is quite likely to arrive.  This would spark a run on the entire shadow banking sector (because investors cannot discriminate given the near complete opacity), which given the extreme maturity mismatches and the illiquidity of the underlying assets would lead to a collapse in short order.  Some of this would blow back onto banks, threatening their solvency.  But even if banks walk away from related trust companies, etc., investors in the shadow banking products would be ruined.  This could have social ramifications that no doubt petrify the ruling Communist Party.  Even absent social disturbances caused by infuriated investors seeing their wealth evaporate, and the associated potential for a government crackdown, the decline in wealth would lead to a sharp reduction in consumption, slowing Chinese economic growth; putting a drag on the world economy (especially commodity producing countries); and exacerbating the already unprecedented imbalance between investment and consumption.

The heavy hand of the Chinese government has contributed mightily to this state of affairs.  Distortions of prices (notably interest rates) and misallocations of capital through a banking system that favors state owned enterprises and forces entrepreneurs who generate the real growth to rely on shadowy sources of capital, currency management, the focus on export and investment oriented growth, all exacerbated by the response to the 2008-2009 crisis have led to the development of a warped financial system that is extremely fragile.  More fragile, almost certainly, than the one that imploded in the US and Europe 4-5 years ago.

When will a collapse come?  The coordination game, multiple equilibrium nature of these things makes that very hard to predict.  A small change can lead to a jump to a run equilibrium.  The risk is there, just as a huge pile of dead underbrush in a forest poses the risk of a conflagration at any instant.  When the spark or the carelessly discarded cigarette or the lightning strike will set it off is impossible to predict.  But one must be very lucky indeed to avoid a big fire when the conditions are so favorable.

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