When we discussed the latest monthly Chinese credit data reported by the PBOC, we pointed out something which to most pundits was broadly seen as success by the Politburo in its deleveraging efforts: for the first time in 9 months, debt within China's shadow banking system - defined as the sum of Trust Loans, Entrusted Loans and Undiscounted Bank Loans - contracted. These three key components combined, resulted in a 64BN yuan drain in credit from China's economy, the first negative print since October 2016, and rightfully seen by analysts as evidence that Beijing’s campaign to contain shadow banking and quash risks to the financial system, is starting to bear fruit.

Offsetting this unexpected decline in shadow bank credit (if not Total Social Financing) was a greater than expected increase in traditional yuan bank loans. As we observed last Tuesday, both corporate loans and household loans increased greater than last year; new corporate loans advanced to CNY354bn from a decline of CNY3bn a year ago, with long-term corporate loans contributing CNY433bn (a year ago: CNY151bn) and short-term loans adding CNY63bn (a year ago: CNY-201bn). New household loans registered CNY562bn, compared with CNY458bn a year ago.

So far, so good: after all a transition from the largely unregulated, and speculative shadow bank issuance to conventional bank issuance is just what the PBOC, China's regulators and most importantly, Xi Jinping want ahead of this year's all important Congress. Furthermore, the fact that China's economy continues to grow at a healthy pace, even if it means creating the occasional industrial metals bubble...

.... thanks to healthy bank loan creation, is good for both China and the rest of the world, and suggests that despite the sharp drop in China's credit impulse, there is more where it came from.

There is just one problem: there very well may not be much where it came from. In fact, according to analysts, there may be almost nothing left.

Reuters reports that following 7 months of blistering credit creation in terms of both new Loans and Total Social Financing, Chinese banks are set to see a slowdown in lending growth in the second half of the year, having exhausted most of their annual credit quota, in the process raising the spectre of corporate defaults as financing costs climb further in the world’s second-largest economy. The math is disturbing: only six months into 2017, banks have already used 80% of their yearly credit quota over January to June, versus the usual 60%, amid the abovementioned regulatory push to bring shadow financing activities to the main loan book, and Beijing’s crackdown on riskier lending.

While "loan demand is strong throughout the whole year”, as the second chart from the top shows, “the core conflict in the second half is loan quota – whether banks will be able to extend more loans than they originally planned" said Ma Kunpeng, chief financial industry analyst at China Merchants Securities, quoted by Reuters.

While it remains to be seen if Beijing will allow banks to breach their quotas, a sharp slowdown in new loan issuance is expected in either case: as reported last week, China saw a 12.9% growth in outstanding yuan loans as of the end of June. Nomura China economist Wendy Chen expects this to slow to 12.6% in Q3 and to 12.4% in Q4, more than 1% decline from 13.5% in 2016: a substantial hit to China's overly credit-reliant economy.

Adverse impact on the economy aside, the sharp contraction in bank loans in Q3 and Q4 means that “corporate defaults will rise if the availability of finance is further restricted. This could become a threat to economic growth ... especially if defaults are concentrated in labor-intensive segments like steel and coal,” Moody’s said.

While China’s commercial banks have been seemingly impervious to China's credit bubble, reporting higher first-half profits, while overall non-performing loans in Q2 remaining unchanged from Q1 (even if some analysts believe the real number is orders of magnitude higher), analysts cautioned that slower credit growth would eventually take a toll on banks’ profit margins. Just like in the US, net interest margins in China have fallen sharply in the past quarters following six successive benchmark interest rate cuts in 2014 to 2015.

For China’s top lender ICBC, the margin is forecast to narrow to 2.13 per cent in 2017 from 2.21 per cent last year, while China Construction Bank could report a drop of 27 basis points to 2.09 per cent in 2017, Thomson Reuters data shows.

Compounding the NIM decline and collapsing margins is Chinese banks' move to increase deposit interest rates this year to as much as 40% above central bank benchmark rates to lure depositors, statistics compiled by Reuters showed.

Part of the higher costs has been passed on to corporate borrowers. The price of loans as measured by the weighted average of loan interest rates rebounded to 5.67 per cent in June, from 5.22 per cent in September. But that will not be sufficient to cushion the impact on near-term profits.

“The most direct impact of the regulatory crackdown is on liquidity and profitability,” said Alicia Garcia-Herrero, chief Asia Pacific economist at Natixis. “Chinese banks will find themselves in a dilemma ... with more doors shut in the shadow banking, which has been a source of profits to offset the impact on net interest income.”

As a reminder, China’s economic growth has already been showed signs of fading in July when key economic indicators from retail sales, to industrial production to capital spending all declined while lending costs rose, but a hard landing is unlikely with Beijing keen to ensure stability ahead of a once-in-five-years Communist Party leadership reshuffle later this year.What happens after, however, is very much an open question. Meanwhile, if Chinese banks only have 20% of their annual loan issuance quota left for the entire second half of the year, and if Beijing refuses to boost these quotas, the next global economic shock may be just several months ahead.