Summary
Since 2008, substantial debt-financed stimulus investments and repeated rounds of monetary easing led to a sharp increased in the debt stock and issuance of new credit. Total new lending in 2012 increased 22.8 % compared to 2011. The majority of this increased is not due to bank loans as in the past but to the proliferation of unconventional financing channels. The increase in lending by non-banking institutions is a response to the overly regulated banking sector, which favors certain sectors to the detriment of others in terms of capital allocation. There is ample room for policy response on the part of the government and the central bank, which mitigates the risk of a credit crisis.
A very high investment rate and savings rate (especially private) is a characteristic feature of the Chinese economy. According to official data, savings have increased in recent years to over 50 per cent of GDP, while investment consistently accounted for over 40 per cent of GDP. While these figures are likely overstated, these ratios are still considerably higher than the OECD average, and well above the level of other large developing countries. China has been running a sizeable current account surplus. The capital account still remains largely closed, preventing excess domestic capital from being invested more productively overseas, and resulting in the build-up of foreign currency assets on the balance sheet of the People’s Bank of China (including large amounts of US treasury Securities). These trends are changing as authorities are starting to ease some of the existing capital controls and consumption is expected to take on a more prominent role in the economy. Nevertheless, these factors all contribute to both a high supply and a high demand for capital. In fact, China’s credit sector is very sizeable when compared with other countries, both in absolute terms and as a percentage of GDP.
Over the past two decades, credit sector reform in China has proceeded steadily, allowing the country to transition from total government control of lending to a more and more market-based system. Large, wholly state owned policy banks and smaller local credit cooperatives alike have been partially privatized. Fully private commercial banks have proliferated, and foreign banks have been allowed to open branches and affiliates in the country. Similarly, the bond and money market has been liberalized, and authorities have started to remove some of the controls on interest rated and lending quotas. Despite the progress made, spearheaded by the Pubic, government hierarchies still maintain a large measure of control over banking practices of man of the major credit institutions, through formal channels such as majority shareholding, and informal, such as widespread revolving door practices between regulators, political bodies and bank officials.
According to reports made recently by IVA, in order to fend off the negative effects of the global financial crisis in 2008, the Chinese government enacted a very sizeable stimulus package, which took the form of a vast campaign of debt-financed investment (infrastructure and housing projects) on the part of local administrations across the country. The nearly $ 0.5 trillion (Yuan 3.2 try) in stimulus money contributed to a further increase in investment to 48 per cent of GDP from 43 per cent a year earlier. Despite weathering the impact of the global recession in 200, the Chinese economy has struggled to gain traction since then. Starting in early 2011, GDP growth slowed down for 7 consecutive quarters, giving rise to fears that a ‘hard landing’ was on the way. The yearly growth rate of 7.8 per cent in 2012 was the lowest since 1999. These conditions encourage the Pubic to its its focus towards growth and loosen monetary policy. The benchmark interest rate was cut in mid-2012 (for the first time since 2008) by a total of 60 basis points. Reserve requirements were also reduced twice freeing up large amounts of capital, and more liquidity was injected in the system through open-market operations by the PBoC. This was accompanied by another wave of public investment. The combined effects of these repeated rounds of deficit spending and loose monetary policy has been the rapid increase in public and private debt levels and total credit issuance. Today, while public debt remains low at 20 per cent of GDP, the stock of private debt (which in China is considered to include debt of local government entities) has swollen to 180 per cent of GDP, a 50 per cent increase since 2008. Local administrations have proven unable so far of reducing this debt stock, as old debt keeps on getting rolled-over. This brings total debt to over 200 per cent of output, a very high ratio by developed country-standards, and even more unusual, to say the least, for a developing country. Issuance of new credit in 2012 reached $2.53 trillion (Yuan 15.75 trl), up 400 per cent from the same period in 2007, and a 22.8 per cent increase from 2011. This rapid credit growth outpaced the growth in Yuan bank lending, with new Yuan bank loans up only 15 per cent over 2011. This is the latest indication of the increasing size and rapid growth of alternative financing channels in China, commonly referred to as the shadow banking system. While banks have traditionally dominated the credit sector in China, accounting for over 90 per cent of lending up to 2004, non-banking financing has grown exponentially over recent years, and since July 2012 has accounted for the majority of all new capital issuances in China. This parallel system is legal (for the most part) but is not subject to the same rules and regulations as banks. It includes direct lending between companies, online ‘peer-to-peer’ lending platforms, loan sharks, investment companies such as trust funds, and off-balance-sheet lending on the part of banks.
This rapid growth of credit provided by non-banking institutions can be explained by several factors. The large banking sector, still suffering from a certain degree of government influence and collusion, has been historically skewed towards providing credit to certain sectors rather than others, namely, local administrative bodies, infrastructure developments and large state-owned enterprises, which play a dominant role in the Chinese economy. In spite of the far-reaching reforms to the banking sector, which have led to the adoption of market practices in bank activities, these sectors continue to enjoy preferential financing, often leaving small and medium enterprises in desperate need for resources. Furthermore, authorities have tended to preclude or limit bank financing from real-estate developers and investors, in an effort to deflate the bubbles generated by fast-rising real-estate prices. At a more general level, the banking sector still remains highly regulated. Rigid interest margins, while accounting for 80 per cent of bank profits, are one of the preferred tools of monetary policy. This system
encourages investors to search for higher yields that bank deposits do not provide, which in turn opens up financing new options for borrowers.
The 22.8 yearly increase in new credit refers to total social funding, a new measure of credit supply the PBoC devised in 2011, to better capture liquidity provided through non- banking institutions. It is defined as the total funds the real economy obtained from the financial system over a period of time. When broken up into its 6 components (Yuan bank loans, foreign currency loans, trust loans, bank acceptance bills, corporate bonds and non-financial equity sales) this measure gives a good sense of the pace at which non- bank lending has been growing. Bank loans counted for 92 per cent of new credit in 2002 but only 52.1 per cent in 2012. That percentage was down to less then 40 in the last four months of the year and decreased to 28 per cent in December. Trust loans have witnessed an upsurge, on the other hand, increasing 8.2 per cent from 2011. Perhaps the more worrisome development in the shadow banking system has been the proliferation of wealth management products, which did not exist until 2006 and now account for $1.2 trillion (Yuan 7.4 trl) of lending, and are expected to become the second largest financial sector after bank loans surpassing insurance. These instruments are administered by trust companies but are often marketed by banks, without appearing on their balance sheets. They offer higher returns than regular deposits, but are perceived to be entirely safe by investors. Banks and trust companies often guarantee the returns by investing in risky real estate development projects or in high-yield local government bonds. In the very competitive WMP market, so far banks have avoided letting investors incur any losses, but exceptions are starting to emerge. In addition, maturity mismatches may be building up in this system funds from WMP (typically with short maturities) are channeled primarily towards long-term projects, thus needing to be constantly rolled- over.
The growth of shadow banking could be seen as the sign of strong credit demand, a response to rigidities in traditional credit sector institutions and excessive regulation, and the simmering of a more dynamic financial sector. But the sharp increase in credit issuance, accompanied by very high private debt levels, can be worrisome. Several studies initiated in the aftermath of the global financial crisis have tried to established indicative danger thresholds for credit growth. China appears to trigger all early warning indicators.
Chinese regulators seem to be aware of these potential threats. Despite arguing that the sector is sufficiently regulated, especially in comparison to non-bank lending in developed countries such as the Unite States, authorities have moved to curb the credit boom in several ways. The PBoC’s monetary policy stance has changed sharply since the last quarter of 2012, as fresh expectation of a rebound in growth in 2013 prompted to shift the central bank’s focus from growth to inflation targeting. Aggressive open market operations have been undertaken to absorb excess liquidity. The PObC has already absorbed over $88 billion from the economy (Yuan 548 bln), a clear change from the previous year, during which the bank injected a net $232 bln (Yuan 1.438 trl) in new liquidity. In addition, several new measures have been introduced to increased transparency in the shadow banking sector. Starting in the spring, for instance, new disclosure requirements will be put in place for wealth management products in several pilot-regions, including Shang-Hai. Additional, direct limits on off-balance-sheet activities of banks have been proposed but have not yet been enacted, such as introducing caps on the percentage of WMP inflows over assets or over deposits.
The Chinese government is widely expected to stand behind struggling local authorities in the event of a default. This greatly reduces the risk that a local deb-crisis would pose to the banking sector and the wider credit sector. In addition, China’s central bank has large amounts of reserves that it could use to shore up struggling institutions in the event of a crisis. Growth in China is expected to rebound in 2013 to over 8 per cent. Similarly, housing market concerns have eased as the housing market (which accounts for about 10 per cent of GDP) has resumed strong growth, pushed by the upsurge in capital, ublic investment and continued internal migration. These factors combine to reduce the chance of a severe banking crisis in China, or to mitigate the impact such a crisis would have on the real economy. Nevertheless, there is potential for a severe disruption in the financial system. The credit crisis that hit Wenzhou in 2010 is a good reminder of the dynamics that could lead to a credit event of this type. A credit crisis would hurt growth in he short-to-medium term, as it did in the aftermath of the Asian credit crisis when authorities were forced to intervene by relieving struggling banks of large amounts of non-performing assets. Today, however, China is not growing at the same pace as in the mid-nineties, while the Yuan’s ambitions as a global currency are much more significant. If this downside risk were to materialize, the impact would be more severe on financial, banking and real-estate stocks. Repercussions for the world economy would be significant, especially for commodity exporters.
