This Time is Different with Chinese Characteristics

Balding's World

The biggest incentive for banks to push WMP is not the lack of regulation but rather the Peoples Bank of China (PBOC) capital requirements.  As I noted earlier this week, the PBOC is generally regarded as high quality economists and technocrats.  They understand the risks and took a series of steps over the past few years to try and reduce bank risks.  This included raising the reserve requirement, which not coincidentally served the dual purpose of tightening money.  However, after lending tripled in 2009 and has actually declined slightly since, Chinese banks are facing both a large number of bad loans they need to get off their books and increased capital requirements.  New loans do not triple in one year without creating a large number of bad loans.

This is where WMP enter the picture.  Given increasing reserve ratios and an unofficially rising number of bad loans, Chinese banks were desperate to maintain credit growth if nothing else to roll over their bad loans, but still satisfy regulatory requirements and political pressure.  After the 2009 loan explosion new bank loans have remained relatively steady but shadow banking has exploded.  According to JP Morgan, shadow banking in China doubled from 2010 to 2012 from $3 trillion USD to $6 trillion USD.  In other words, right after traditional bank lending wen flat, shadow banking started exploding.  That means that shadow banking was relieving the pressure of making new loans from Chinese banks.

A WMP takes loans off the banks balance sheet and allows the official assets to make new loans rolling over the old lower quality loans solves the problem.  As long as it isn’t a straight trade of deposits for WMP, the banks are able to make new loans or roll over the old ones while moving problem loans off their balance sheet.  One report maintained that “issued urban investment bonds are actually designed to pay debts for last year’s projects under the name of a new, fake project.”  Though there is no reliable data on this yet, Chinese banks are probably mixing in a higher percentage of problem loans but not filling WMP with exclusively bad loans.

Second, shadow banking in its original form grew because banks in China heavily favor state owned enterprises.  It should come as no surprise that state owned banks favor other state owned enterprises.  In other words, the truly private sector in China is starved for capital.  One paper notes that “private Chinese firms are credit constrained while State-owned firms and foreign-owned firms in China are not…geographical and sectoral presence of state firms aggravates financial constraints for private Chinese firms (“crowding out”).”  Another paper found that “the findings suggest that less opaque firms and non-state-owned firms benefit more from foreign bank entry.”  Yet another paper writes “political affiliation contributes not only to alleviating individual firms’ financing constraints.”   Another paper unsurprisingly finds that “having the state as a minority owner helps firms obtain bank loans and this suggests that political connections play a role in gaining access to bank finance.” Consequently, shadow banking originally began when entrepreneurs would either guarantee loans for other entrepreneurs or make loans.

Beijing takes the primacy of state banks financing state owned enterprises so seriously that it has handed out death penalties, later reduced to life in prison, to entrepreneurs like Wu Ying in the finance industry.  It is worth noting that she was originally arrested for “illegal fundraising” and reportedly considered pleading guilty to a lesser charge of “illegally collecting deposits from the public.”  As it took two years for the charge to be changed to fraud for which she was later convicted, the veracity of the fraud charges against her is under serious debate especially considering that both investors and clients testified on her behalf.  Even the official news agency Xinhua noted that “Wu has drawn sympathy from the public, who have criticized a financing system that has made it difficult for small entrepreneurs to get loans from banks. These companies subsequently turn to underground lenders to finance their businesses, creating more problems.”  Shadow banking grew out of a system where state owned banks funneled credit to other state owned enterprises who used the capital poorly.  It is doubtful even Matt Taibbi would argue to execute Jon Corzine or Angelo Mozillo.

The major state owned banks started getting into the shadow banking game, not coincidentally, around the time the PBOC started raising the reserve ratio and about 1 year after the 2009 lending binge.  By moving loans off their balance sheet into WMP’s, they could continue to lend even as industrial capacity declined and apartment occupancy declined, keep their balance sheets healthy, and meet capital requirements.   It was no coincidence that the SHIBOR debacle coincided so neatly with the end of the official second quarter June 30 when Chinese banks have to meet capital adequacy audits.  Between loan targets and capital adequacy ratios, Chinese banks were under intense liquidity pressures and moving a lot of loans off balance sheet into WMPs.  If the deadline of capital adequacy ratios sound familiar, it should.  Think back to the Lehman Brother’s bankruptcy when they got in trouble for Repo 105 where they would move a lot of debt off balance sheet just before the end of the quarter in time to look good for investors.  Chinese banks are facing the same conundrum trying to move loans into WMPs.

These are not the hallmarks of a sound and healthy banking system.  Since the end of June liquidity crunch, one major lender, China’s Merchant Bank, has already been given the go ahead for a secondary offering after years of waiting.  Another bank, and the only fully private bank in the top 10 in China, is hearing chatter of needing $11 billion USD in capital.  Given the number of secondary offerings that have been conducted with the Chinese government as the main purchaser in the past couple years, Chinese banks appear to be sitting on a much larger number of bad loans than they are officially declaring.  You simply don’t have such frequent secondary offerings and regular liquidity crunches if your bank is healthy.

There are a couple of final points.  First, WMPs is the US mortgage bank model of originating the loan and selling it on with Chinese characteristics.  As we all know, this had disastrous financial consequences.  Research found that banks retained safer loans but sold on riskier loans.  There have already been small scale defaults on WMP’swith varying degree of guarantees and responses by the listed banks and regulators.  In short, given what we know about the track record of origination and distribute lending as well as the explosion of credit in China over the past few years, this alone should give anyone enormous concern about banks selling parts of their loan portfolio in WMP’s.

Second, many Chinese prognosticators have fallen into the same mentality that US bulls did prior to the 2008 financial crisis relying on asset prices to support debt levels.  The head of the China Banking Regulatory Commission recently said:

“Some people have compared our local government debt to European debt, but there’s a big difference — our debts are accumulated for production not for consumption — most of them have assets as guarantees and the overall risk is controllable…”

As long as asset prices remain high, then it remains semi-sustainable.  However, this is classic “this time is different” thinking depending on asset prices to support high debt levels that are not supported by cash flows.  Given falling demand, industrial production, and continued high loan growth to support asset prices seems like a bet with the devil at best.

There are however, two aspects of this process that are overlooked and that is the private sector and consumers.  The private sector started this because they were starved for credit and the private sector responded, even under threat of the death penalty.  The state owned giants with their size and need to move loans off balance sheet, jumped in and have been very aggressive.  Even now of the ten largest banks in China, only one Minsheng is a completely private enterprise, lending more to private small and medium enterprises, and relies more on short term borrowing than most other banks.  Financial consumers in China are much more savy than they are given credit for even if they don’t read all the fine print of financial products like many institutional investors.

The final point is the investment options of Chinese consumers. The stock market has been a losing proposition for many years and viewed as rigged.  Real estate has gone up by more than 300% as Chinese consumers sought a safe savings vehicle.  However, with new regulations with more teeth making it harder to buy multiple apartments, consumers have sought more outlets for savings and investment which WMP’s have handled.  Given the state of the stock market, no real bond market, capital controls, and regulation on real estate, WMP’s even with the risk represents one of the best available products for Chinese investors.  Furthermore, as bank deposits have not guarantee or insurance, WMPs are not necessarily a bad option for the portfolio constrained.  One has to wonder though if they will get left holding the bag for Chinese banks.