The $15 trillion shadow over Chinese banks
China analyst Charlene Chu explains why the nation is on the verge of crisis
Charlene Chu is adamant that a Chinese banking collapse of some description is a certainty Photo: Bloomberg
9:30PM GMT 01 Feb 2014
http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/10611931/The-15-trillion-shadow-over-Chinese-banks.html
Drawing attention to the problems at an individual bank is never likely to
make you popular, but calling time on an entire financial system is another
thing entirely.
For eight years, until her resignation last month, Fitch banks analyst
Charlene Chu has done just that, warning of the impending collapse of
China’s debt-fuelled bubble.
Born and raised in America and a graduate of Yale, she has claimed in painful
detail that China has embarked on an unprecedented experiment in credit
expansion that far exceeds anything seen before the financial crisis that
rocked Western markets six years ago.
Working out of Beijing, Chu has developed a reputation that has seen her
hailed by some of the world’s most important money managers as a “heroine”
and treated as a pariah by some within China’s financial elite.
In a country where the banks, even the largest, are not known for openness,
Chu has warned since 2009 about a rapid expansion in lending that has seen
something close to $15 trillion (£9.1 trillion) of credit created, fuelling
a property and infrastructure boom that has no equal in history.
To say her warnings have been unusual is to underestimate quite how important
her contributions have been. Chu has explained the creation – from a
standing start just five years ago – of a shadow banking industry in China
that today is responsible for as many loans in terms of volume as the
country’s entire mainstream financial system.
Speaking for the first time since her departure from Fitch last year, Chu, who has taken a new job at Autonomous, the respected independent research firm, says she remains adamant that a Chinese banking collapse of some description remains not just an outside chance, but a certainty.
“The banking sector has extended $14 trillion to $15 trillion in the span of five years. There’s no way that we are not going to have massive problems in China,” she says.
Behind these problems lie a baffling range of “trusts”, “wealth management products” and foreign-currency borrowings that have allowed indebtedness to expand even as the authorities have attempted to clamp down on mainstream lending by the big banks.
Chu’s warnings have carried particular weight in recent weeks as the Industrial and Commercial Bank of China backed away from a 3bn renminbi (£297m) trust it had sold to its customers. The move prompted fears this could become China’s “Bear Stearns moment”, a reference to the abandonment by the defunct US broker of several sub-prime funds in the early stages of the West’s 2007 credit crisis.
In the event, a default of the ICBC trust was averted, but Ms Chu remains clear that the linkage between the official banking system and its shadow twin remains a threat.
“Banks are often involved behind-the-scenes in a lot of this shadow product,” she said. “It’s one reason why I am always emphasising this idea that is often pushed by Chinese economists and academics that the shadow banking sector and the formal banking sector are separate and therefore, if the shadow banking sector falls apart, it does not matter.
“I just don’t agree with that because there is so much inter-linkage between the formal banking sector and the shadow banking sector and this product [the ICBC trust] is a good example.” Many take comfort that foreign currency reserves, estimated at close to $4 trillion, could be used to rescue the financial system in a crisis. Chu says such optimism is wishful thinking.
“The FX [foreign exchange] reserves cannot be used nearly to the extent that people think they can. There are some analysts that think they can’t be used at all, but I disagree with that.
“I believe they can’t be used in their entirety by any means because they are offset by the other side of the balance sheet of the PBOC [People’s Bank of China]. Because of that, you can’t just run down one side of the balance sheet, the asset side, and not deal with the liability side of the PBOC balance sheet.”
However, while Chu questions the ability of the authorities to throw money at the problem, she also says there are several reasons to think a Chinese crisis would not take the form of that seen in the West. “This is going to be different from other markets where market forces are allowed to play out. Here the authorities get involved and that means these kind of defaults can remain one-off and isolated for quite a while,” she says.
“The critical question is that, at some point are these one-off issues going to turn into a very big wave of defaults? That is going to be very difficult for the authorities to manage in the same way that they have been able to manage the one-offs.”
Taking such a pessimistic view of China’s banks has not made Chu popular either with the authorities or the lenders. Her previous employer, Fitch, last year became the first of the three main ratings agencies in 14 years to cut China’s credit rating, largely based on her analysis.
Fitch and Chu both remain circumspect about how her exposure of the problems of the banks has affected business.
Chu admits that her views have made her job harder, in particular the effort to uncover decent data on what is going on inside the system. On the other hand, she adds that not being beholden to the “party line” has enabled her to analyse China more dispassionately than others.
“I still feel like, in the end, being on the outside has not hurt me too much in terms of what is going on.” Not following the party line has seen Chu travel to China to inspect first-hand the building of “ghost cities” that developers claim are fully occupied, but that appear to be deserted except for a scattering of maintenance staff and increasingly despondent “entrepreneurs”.
“The odd thing is that you will certainly encounter some developments that appear to be totally empty and yet they are totally sold out,” says Chu. “It is a very mixed picture, but I do feel in the end that the amount of real estate building that has gone on over the last few years is substantial, yet there are
still a lot of projects in the works. There is definitely reason for people to be worried that we have got a real estate bubble.”
The popping of this bubble could leave behind a very different China, and it is the post-crisis economy that is Chu’s biggest concern.
Like the West, which has implemented an array of new regulations in the wake of the crash, Chu worries that China could find it difficult to adapt to a slower pace of growth.
“This isn’t a developed market with a very strong social safety net. If we get to a situation where we are having severe financial sector problems, the chances are GDP growth is much slower than it is now for a prolonged period of time,” she says. Adding: “I think that really is where the cost of a financial sector crisis comes in. To me, it’s much less about how much the sovereign issues in terms of debt to bail out the financial sector. It comes down to how much of a hit does growth take and what is the impact of that on the populace and do we start to have any other issues that arise from that?”
Chu says that many in China’s policy elite realise the Faustian pact the country has made but, with the economy and political system so dependent on maintaining a 7pc rate of growth, there is little will to take away the punchbowl any time soon.
And that is the problem. While a crisis now would be bad, allowing the current situation to persist will only make the final reckoning that much worse, particularly for the wider international financial system.
Warnings have already been raised about the increased use of offshore dollar funding by mainland Chinese borrowers. The Hong Kong Monetary Authority has pointed to the growth of foreign currency funding of China, which is believed to have more than quadrupled in the past three years to in excess of $1 trillion.
Chu says that this remains a side issue, arguing that the longer the credit boom is allowed to continue the bigger the international leg of the crisis will become.
“One of the reasons why the situation in China has been so stable up to this point is that unlike many emerging markets there is very, very little reliance on foreign funding,” she said.
“As that changes it obviously increases the vulnerability to swings in foreign investor appetite. I do think, in the end, you look at the exposure numbers from the BIS [Bank for International Settlements] and the Hong Kong banks and you’re going to encounter a few institutions that are going to have a sizeable exposure to China.”
As the problems in the Chinese financial system become harder to ignore, it is likely Chu’s opinions are going to be increasingly sought as investors look for insight on what is going on in the world’s second-largest economy.
Speaking for the first time since her departure from Fitch last year, Chu, who has taken a new job at Autonomous, the respected independent research firm, says she remains adamant that a Chinese banking collapse of some description remains not just an outside chance, but a certainty.
“The banking sector has extended $14 trillion to $15 trillion in the span of five years. There’s no way that we are not going to have massive problems in China,” she says.
Behind these problems lie a baffling range of “trusts”, “wealth management products” and foreign-currency borrowings that have allowed indebtedness to expand even as the authorities have attempted to clamp down on mainstream lending by the big banks.
Chu’s warnings have carried particular weight in recent weeks as the Industrial and Commercial Bank of China backed away from a 3bn renminbi (£297m) trust it had sold to its customers. The move prompted fears this could become China’s “Bear Stearns moment”, a reference to the abandonment by the defunct US broker of several sub-prime funds in the early stages of the West’s 2007 credit crisis.
In the event, a default of the ICBC trust was averted, but Ms Chu remains clear that the linkage between the official banking system and its shadow twin remains a threat.
“Banks are often involved behind-the-scenes in a lot of this shadow product,” she said. “It’s one reason why I am always emphasising this idea that is often pushed by Chinese economists and academics that the shadow banking sector and the formal banking sector are separate and therefore, if the shadow banking sector falls apart, it does not matter.
“I just don’t agree with that because there is so much inter-linkage between the formal banking sector and the shadow banking sector and this product [the ICBC trust] is a good example.” Many take comfort that foreign currency reserves, estimated at close to $4 trillion, could be used to rescue the financial system in a crisis. Chu says such optimism is wishful thinking.
“The FX [foreign exchange] reserves cannot be used nearly to the extent that people think they can. There are some analysts that think they can’t be used at all, but I disagree with that.
“I believe they can’t be used in their entirety by any means because they are offset by the other side of the balance sheet of the PBOC [People’s Bank of China]. Because of that, you can’t just run down one side of the balance sheet, the asset side, and not deal with the liability side of the PBOC balance sheet.”
However, while Chu questions the ability of the authorities to throw money at the problem, she also says there are several reasons to think a Chinese crisis would not take the form of that seen in the West. “This is going to be different from other markets where market forces are allowed to play out. Here the authorities get involved and that means these kind of defaults can remain one-off and isolated for quite a while,” she says.
“The critical question is that, at some point are these one-off issues going to turn into a very big wave of defaults? That is going to be very difficult for the authorities to manage in the same way that they have been able to manage the one-offs.”
Taking such a pessimistic view of China’s banks has not made Chu popular either with the authorities or the lenders. Her previous employer, Fitch, last year became the first of the three main ratings agencies in 14 years to cut China’s credit rating, largely based on her analysis.
Fitch and Chu both remain circumspect about how her exposure of the problems of the banks has affected business.
Chu admits that her views have made her job harder, in particular the effort to uncover decent data on what is going on inside the system. On the other hand, she adds that not being beholden to the “party line” has enabled her to analyse China more dispassionately than others.
“I still feel like, in the end, being on the outside has not hurt me too much in terms of what is going on.” Not following the party line has seen Chu travel to China to inspect first-hand the building of “ghost cities” that developers claim are fully occupied, but that appear to be deserted except for a scattering of maintenance staff and increasingly despondent “entrepreneurs”.
“The odd thing is that you will certainly encounter some developments that appear to be totally empty and yet they are totally sold out,” says Chu. “It is a very mixed picture, but I do feel in the end that the amount of real estate building that has gone on over the last few years is substantial, yet there are
still a lot of projects in the works. There is definitely reason for people to be worried that we have got a real estate bubble.”
The popping of this bubble could leave behind a very different China, and it is the post-crisis economy that is Chu’s biggest concern.
Like the West, which has implemented an array of new regulations in the wake of the crash, Chu worries that China could find it difficult to adapt to a slower pace of growth.
“This isn’t a developed market with a very strong social safety net. If we get to a situation where we are having severe financial sector problems, the chances are GDP growth is much slower than it is now for a prolonged period of time,” she says. Adding: “I think that really is where the cost of a financial sector crisis comes in. To me, it’s much less about how much the sovereign issues in terms of debt to bail out the financial sector. It comes down to how much of a hit does growth take and what is the impact of that on the populace and do we start to have any other issues that arise from that?”
Chu says that many in China’s policy elite realise the Faustian pact the country has made but, with the economy and political system so dependent on maintaining a 7pc rate of growth, there is little will to take away the punchbowl any time soon.
And that is the problem. While a crisis now would be bad, allowing the current situation to persist will only make the final reckoning that much worse, particularly for the wider international financial system.
Warnings have already been raised about the increased use of offshore dollar funding by mainland Chinese borrowers. The Hong Kong Monetary Authority has pointed to the growth of foreign currency funding of China, which is believed to have more than quadrupled in the past three years to in excess of $1 trillion.
Chu says that this remains a side issue, arguing that the longer the credit boom is allowed to continue the bigger the international leg of the crisis will become.
“One of the reasons why the situation in China has been so stable up to this point is that unlike many emerging markets there is very, very little reliance on foreign funding,” she said.
“As that changes it obviously increases the vulnerability to swings in foreign investor appetite. I do think, in the end, you look at the exposure numbers from the BIS [Bank for International Settlements] and the Hong Kong banks and you’re going to encounter a few institutions that are going to have a sizeable exposure to China.”
As the problems in the Chinese financial system become harder to ignore, it is likely Chu’s opinions are going to be increasingly sought as investors look for insight on what is going on in the world’s second-largest economy.
