Fitch Defies S&P on China’s Credit Bubble

Defying the consensus, US Credit rating agency Fitch ratings says China’s bubble is unsustainable.

From the Bloomberg: (bold mine)

Chinese banks are adding assets at the rate of an entire U.S. banking system in five years. To Charlene Chu of Fitch Ratings, that signals a crisis is brewing.

Total lending from banks and other financial institutions in China was 198 percent of gross domestic product last year, compared with 125 percent four years earlier, according to calculations by Chu, the company’s Beijing-based head of China financial institutions. Fitch cut the nation’s long-term local-currency debt rating last month, in the first downgrade by one of the top three rating companies in 14 years.

“There is just no way to grow out of a debt problem when credit is already twice as large as GDP and growing nearly twice as fast,” Chu, 41, said in an interview.

Usually I would take the opposite side of the fence vis-à-vis credit rating agencies, but in the case above, the Fitch analyst Ms. Charlene Chu resonates on my analytical methodology: She focuses on the trajectory.

China has implemented a massive RMB 4 trillion or $586 billion stimulus meant to shield against the US epicenter crisis in 2008. This serves as an aggravating or secondary cause. From the same article:

Amid the global credit crunch of 2008, China ramped up lending by state-controlled banks to prevent an economic slowdown. The assets of Chinese banks expanded by 71 trillion yuan ($11.2 trillion) in the four years through 2012, according to government data. They may increase by as much as 20 trillion yuan this year, Chu said April 23. That will exceed the $13.4 trillion of assets held by U.S. commercial banks at the end of last year, according to the Federal Deposit Insurance Corp.

Chu says companies’ ability to pay back what they owe is wearing away, as China gets less economic growth for every yuan of lending.

In short, the stimulus only created massive malinvestments or transfers of resources to wealth consuming activities. Thus the diminishing returns of credit. The payback from which is likely to come sooner than later.

The Chinese government’s denial:

China’s expansion of credit hasn’t caused a surge in the proportion of bad loans, data from the banking regulator show.

While loans overdue for at least three months have grown for six straight quarters to reach 526.5 billion yuan at the end of March, the ratio of nonperforming loans declined to 0.96 percent as of March 31 from 2.42 percent at the end of 2008, according to the China Banking Regulatory Commission.

As previously noted, Non Performing Loans (NPL) are coincidental or lagging indicators. They usually become apparent when the bubbles are in the process of reversing. 

Yet for as long as the bubble inflates, or for as long as housing prices moves up, the Ponzi financing scheme may continue to thrive.

When entities (private or public) can hardly finance principal and interests of outstanding loans from cash flows but increasingly depends on rising assets to cover funding requirements, through asset sales or as collateral for more borrowing such is called a Ponzi finance as postulated by economist Hyman Minsky.

China’s housing bubble continues to balloon even as the real economy has materially been slowing down, as shown in the chart from Wall Street Journal. Such is a sign of growing Ponzi finance.

In short, current inflationist policies by the Chinese government motivates the public to speculate on housing and other financial packages rather than invest on productive enterprises.

Such housing bubble has likewise drawn in hot money as shown by the chart from Zero Hedge

The Chinese government has recently moved to curtail hot money flows using copper imports to facilitate “carry trades” based on “interest rate arbitrages”.

Going back Fitch. Ms. Chu says China’s statistical data has been unreliable. Importantly she says that much of what I call Ponzi finance may have found a channel in the burgeoning “Shadow Banking Sector”

Chu, who has covered Chinese financial institutions at Fitch for seven years, says these figures are distorted. The ratio of nonperforming loans to total lending has declined mainly because credit has surged, she said. Moreover, the regulator’s data doesn’t reflect the real amount of debt because of the ways banks move loans off their books, Chu said.

Some loans, often for real estate, are bundled together and sold to savers as so-called wealth-management products, while other assets are sold to non-bank financial institutions, including trusts, to lower the lenders’ bad debt levels, according to Chu. Wealth management products and trusts are sold to investors eager to get more than the government-mandated benchmark of 3 percent annual interest on bank savings accounts.

“The data may be somewhat accurate for the on-balance-sheet loan portfolios of the banks, but banks have substantial off-balance-sheet positions for which there is no asset-quality information,” she said.

The Moody’s estimates that China’s Shadow Banking System have reached 29 trillion yuan or  $4.7 trillion  compared to 17.3 trillion yuan in 2010

Shadow banks are manifestations of regulatory arbitrages or the circumvention of regulations. China's shadow banks has been mainly through Wealth Management Products (WMP) which have mainly been about short term financing

Quoting Ms. Chu from another article:

WMPs are vehicles that can borrow/lend, and banks engage in transactions with their own and each other’s WMPs. This makes the pools of assets and liabilities tied to WMPs in effect second balance sheets, but with nothing but on-balance-sheet liquidity, reserves, and capital to meet payouts and absorb losses. These hidden balance sheets are beginning to undermine the integrity of banks’ published balance sheets.

The leverage being accreted can be seen in the accelerating growth of China’s bank assets as shown from the chart by Northern Trust. Bank Assets in the official sector have now topped 250% of GDP and excludes the shadow banks. Bank assets has spiked since 2008. 

Every bubble culminates with a mania phase, characterized by a blow off in the build up of debt which ultimately implodes

A jump in the ratio of credit to GDP preceded banking crises in Japan, where the measure surged 45 percentage points from 1985 to 1990, and South Korea, where it gained 47 percentage points from 1994 to 1998, Fitch said in July 2011. In China, it has increased 73 percentage points in four years, according to Fitch’s estimates.

“You just don’t see that magnitude of increase” in the ratio of credit to GDP, Chu said. “It’s usually one of the most reliable predictors for a financial crisis.”

I have previously shown this chart from Harvard’s Reinhart-Rogoff where debt build up leading to every crisis intensifies until this hits a certain debt intolerance level which may triggered internally or externally.

Fitch versus S&P

The nation is in a better position now to tackle nonperforming loans, said Liao Qiang, a Beijing-based director at S&P. In the past decade, China’s economy has quadrupled, the number of urban residents surpassed those on farms and policy makers allowed freer flows of its currency in and out of the country. Its foreign-exchange reserves surged fivefold from 2004 to $3.3 trillion at the end of 2012.

“Given that China’s credit is mostly funded by its internally generated deposits, I don’t think a real financial crisis, which is normally manifested in a liquidity shortage, will happen anytime soon,” S&P’s Liao said by phone. Local-currency savings stood at 92 trillion yuan at the end of 2012, according to the National Bureau of Statistics.

Again we see the conflict between analysis based on statistics and with that of economic logic.

Bubbles are symptoms of savings being squandered for yield chasing speculative wealth consuming activities.

With underdeveloped capital markets and as the Chinese government uses financial repression via negative real rates to confiscate people’s savings, real savings by the average Chinese are being transferred (to the government) and consumed (through speculations—housing and Ponzi Shadow banks). The implication is that real savings are being depleted. 

China’s stock market continues to languish since the 2007 top. This provides scant returns for the public (tradingeconomics.com)

And that’s why many Chinese gravitate to gold. The state of the Chinese yuan, like other fiat currencies, reveals of the "inflation tax" and continues to depreciate against gold as shown by the chart from GoldMoney.com

Surging bank loans

Chinese banks extended 2.8 trillion yuan of loans in the first quarter, 12 percent more than a year earlier and the second-largest quarterly total on record, government data show. Economic growth in the period slowed to 7.7 percent from 7.9 percent in the fourth quarter.

Only 29 percent of last year’s aggregate financing translated into economic growth, the lowest rate on record, as borrowers use more resources to finance outstanding debt and less for investment, Sanford C. Bernstein & Co. analyst Michael Werner wrote in January.

The reality is that the Chinese government has already launched a stealth stimulus since last year. 

This can be seen in the continuing credit growth in the Chinese banking sector as seen from ‘the chart from Dr. Ed Yardeni.

Most of the pick up in credit growth I believe has been directed to State Owned Enterprises (SOE). One must realize that Chinese economy remains heavily politicized where many firms are wards of the government. So Chinese policies can be coursed through them without official admission. 

And as a final note, the covert stimulus being reflected as credit boom is likewise manifested on money supply as shown by the chart from Zero Hedge

Denials will not assume away the effects of unsound policies.

At the end of the day: bubbles (something out of nothing) and Ponzi schemes will reveal of their true nature. 

This means I will not bet on the China led “Asian century” until we see significant liberalization of her economy and monetary system.