Let’s Buy Sweden and Put it on our Front Lawn

Or rather, let’s not. As Bloomberg reports, the officially admitted to amount of bad loans in China’s banking system has by now swelled to approx 4 trillion yuan, or $628 billion, which is roughly equivalent to Sweden’s total economic output per year.

Sweden is a small, but highly developed country which exhibits astonishing rates of monetary and credit inflation at present. It has slightly less than 10 million inhabitants, and its “GDP per capita” on a purchasing power parity basis amounts to approx. $44,000 compared to $12,600 in China. We are mentioning this to make clear that such comparisons have to be put into proper perspective.

Annualized loan growth of China’s banking system. After the huge post GFC surge in bank lending (the government essentially ordered the large state-owned banks to expand credit willy-nilly) it has slowed to a still quite extraordinary 14.4% as of October.

In short, bad loans equal to the GDP of Sweden still represent a very low NPL ratio of just 5.5% – and this is including so-called “special mention” loans, which are dud loans that are held not to be complete write-offs just yet, primarily based on assorted extend & pretend schemes. In China this method of masking the extent of bad loans is called “evergreening” loans. Naturally, everything is done to hide the true extent of deterioration, but this is by no means unique to China.

For instance, the successfully “stress-tested” banking systems of Europe’s peripheral countries are weighed down by staggering amounts of dud loans as well, but extend & pretend is the order of the day everywhere these days. Based on official data and the relative sizes of their economies, the banking systems of countries like Spain and Greece are for the time being in a far worse position than China’s. In Sweden the credit bubble sun is still shining, but when (not if) its credit and real estate bubbles burst, it is highly likely to become the next Spain.

But what about China? Chinese data generally have to be taken with a big barrel-full of salt. A great many ancillary data that describe economic activity, such as electricity consumption, cargo traffic or steel prices belie official GDP growth rates. In fact, if all we knew were those ancillary data, we would never suspect GDP to be growing at all, let alone at a rate of 6.9%. Of course, one must never lose sight of the fact that GDP is a quite useless statistic to begin with. We have discussed this on several occasions (readers may want to check out “The GDP Illusion” and “The Mirage of Economic Growth” for details). In the words of Oscar Morgenstern: “[T]here is real trouble with the basic underlying notion of GNP. It is not an acceptable scientific concept for the purposes it is used”.

According to Bloomberg, another large corporate borrower has recently keeled over in China, with its debt abruptly joining the collection of dud loans in the banking system:

“Chinese banks’ troubled loans swelled to almost 4 trillion yuan ($628 billion) by the end of September, more than the gross domestic product of Sweden, according to figures released by the industry regulator. Banks’ profit growth slumped to 2 percent in the first nine months from 13 percent a year earlier, according to data released on Thursday night by the China Banking Regulatory Commission.

The numbers come as a debt crisis at China Shanshui Cement Group Ltd. prompts lenders including China Construction Bank Corp. and China Merchants Bank Co. to demand immediate repayments and as weakness in October credit growth shows the risk of a deeper economic slowdown. While the official data shows non-performing loans at 1.59 percent of outstanding credit, or 1.2 trillion yuan, that rises to 5.4 percent, or 3.99 trillion yuan, if “special mention” loans, where repayment is at risk, are also included. The amount of bad debt piling up in China is at the center of a debate about whether the country will continue as a locomotive of global growth or sink into decades of stagnation like Japan after its credit bubble burst.

It is a good bet that several more large borrowers will be going belly-up in the not-too-distant future. China has been home to twin real estate and infrastructure construction bubbles that are dwarfing anything seen before. Entire cities built for millions are ghost towns that are already crumbling before anyone has settled in them. It is malinvestment on a truly gargantuan scale, essentially Keynesian pyramid building to unbridled excess. All the economic activity associated with this waste of scarce capital was of course recorded as “growth” in the GDP accounts.

It may seem surprising that China’s bank lending growth is still so strong in light of these dangers. However, if one looks at the effect bank lending growth has recently had on money supply growth on a net basis, we can see that it remains quite muted. China’s domestic money supply growth partly depends on foreign exchange reserves accumulation, resp. decumulation, and the minimum reserve requirement set by the PBoC to offset the effects this has on its balance sheet and money supply growth.

China – annualized growth rates of the money supply aggregates M1 and M2. Current growth rates are at the very low end of a multi-year range and the slowdown from the 2009/2010 peak has been quite dramatic – click to enlarge.

Keep in mind that there is actually a difference between money and credit, even if they are closely linked in a fractionally reserved banking system. China’s current money supply growth rates strongly suggest that an economic bust should be expected.

China’s Opaque Shadow Banking System

A recent report by CLSA on China’s “total social financing” and the shadow banking system (in which so-called investment trust companies are playing a prominent role) noted that the more closely one looks at this system, the more one realizes how opaque it actually is. The trust system has been used by banks to circumvent lending restrictions, which may inter alia explain why bank lending growth has remained fairly strong. A lot of it seems to involve financing the activities of trusts.

Not too long ago, people were quite worried about the many real estate-related white elephants funded by China’s trusts. It appeared as though major trouble was just around the corner, but miraculously, nothing really spectacular has happened so far. Apparently, a three card Monte trick routinely employed by China’s authorities to sweep such problems under the rug has been used in this case as well. It consists of moving bad stuff around within the system, as a result of which it is no longer in focus. Many of the real estate-related trust products were reportedly simply shifted to insurance companies, which don’t mark them to market; as a rule they are simply held to maturity.

A similar trick was used in the US in early 2009, when FASB was pressured to abandon sound accounting principles and replace them with a method that allowed banks to hide problematic assets by simply excluding them from mark-to-market requirements. Sound conservative accounting principles demand that an asset should either be valued at cost, or at its market price, whichever is lower. Everything else is simply pulling the wool over the eyes of investors, i.e., it serves to hide the truth. Yes, we are well aware of all the well-reasoned rationalizations that have been put forward in favor of adopting these new rules, but the facts are not altered by this.

China’s total “social financing”, bank loans and shadow banking activity combined, via CLSA – click to enlarge.

Since many of the real estate bombs in China’s trust universe have thus been swept under the rug by simply moving them to different agents with different reporting requirements, the trusts have continued to grow. There was a tiny hicc-up in their growth rate in Q1 2015, but just one quarter later, their assets under management reached a new record high as a percentage of total bank loans outstanding (data for Q3 were not available yet in early November when the following chart was made):

Assets under management (AUM) of China’s trust companies as a percentage of all outstanding bank loans are at a new record high – click to enlarge.

Whenever there is a bubble in China – and there always seems to be one, in one sector or another – the trust companies are closely associated with it. The most recent prominent bubble was the one in the stock market, which has in the meantime been replaced by bubble-like growth in corporate bond issuance. The trusts have been and remain major players in financing both. The corporate bond issuance boom involves products that are using leverage of up to 1:10 – and the leverage component is of course funded by banks.

The Shanghai stock market index – the bubble was helped along by trust companies, which issued a plethora of products linked to equity market performance – click to enlarge.

The concrete data (which are once again only showing the trend until Q2, so the most recent developments are not yet captured) show that only infrastructure investment has declined. After a small pause, growth in real estate investment by the trusts has accelerated again, but the the biggest growth has been recorded in the “capital markets and financial institutions” segment. As you will see further below, this includes major funding efforts tied to the recently (temporarily?) expired stock market bubble.

Investment product categories the trusts are focusing on. The capital markets segment has seen explosive growth – click to enlarge.

Next comes a chart showing the types of capital market investments. It should be noted in this context that the bond financing component is said to actually exceed the growth in stock market investment products by now, which still represented the undisputed leading category as of Q2.

Capital market products issued by trust companies – at the end of Q2, the stock market category still led the charge. In the meantime, bond products have reportedly grown to such an extent that they are exceeding equity-linked investments – click to enlarge.

We should also note here as an aside that a lot of new credit issuance in China serves to support existing credit in what is essentially Ponzi-like fashion. This is part of the extend & pretend strategy pursued by banks; new loans are issued for the express purpose of servicing old ones before the latter have a chance to become delinquent and join the “special mention” brigade.

The recent surge in corporate bond issuance seems to have the aim of replacing a planned IPO issuance boom that was pole-axed by the stock market crash this summer before it could be put into operation. So instead of issuing equity instruments, companies are now issuing debt instruments. Investors can lose money in both, but since bonds are fixed income instruments, there is a limit to the gains that an be achieved with them, a limit that becomes more obvious as interest rates decline (the PBoC is on a rate cutting spree). As a result, a lot of leverage tends to be employed in bond market products to spice up returns.

Corporate bond issuance has begun to soar again this year, after a brief pause in late 2014/early 2015 – click to enlarge.

More and more of this bond issuance seems to be funded via trust products – and the associated leverage creates the obvious (one would think) danger that yet another bubble is forming that will eventually burst.

Pressure on Money Supply Growth

As noted above, China’s domestic money supply growth is closely tied to foreign exchange flows, due to the closed capital account and the “managed” yuan exchange rate. The main instrument with which the PBoC tries to either limit or boost domestic money supply growth is the minimum reserve ratio, which has recently been cut to 17.5% (after a peak of 21.5% reached in 2011). This is a fairly blunt instrument, as it depends on the banks increasing credit creation in commensurate fashion. How the banks react to lower reserve requirements can however not be predicted with certainty.

China’s foreign exchange reserves have begun to decline, which is putting pressure on domestic money supply growth under the current monetary regime.

When looking at bank loan growth in absolute terms, it can be seen that in spite of the still brisk annualized growth rate discussed further above, it has actually declined rather noticeably in recent months. The cuts in reserve requirements (which accelerated beginning in H2 2014) have boosted bank lending growth for a while, but this no longer seems to work.

China – bank balance sheet/ loan growth in yuan terms. This is a volatile series, but recently there has been a fairly steep decline.

The continued growth in trust products and the increased use of leverage by such products suggests that lately, an ever greater proportion of new bank loans must have gone toward providing financing to these products. A large gap has opened between settled and newly issued trust products, so this form of funding continues to grow by leaps and bounds, even as money supply growth keeps slowing down. The problem with credit and asset bubble type activities is however that they need inflationary money supply growth in order to be sustained.

Trust product settlement vs. new issuance – net exposure keeps growing – click to enlarge.

Conclusion

Opinions over China and the potential dangers from its real estate bubble and the huge amount of increasingly dubious looking outstanding credit are actually quite divided. As far as we are concerned, the most positive factor China can point to is the enthusiasm and well-developed entrepreneurial spirit of its population. Many people in China are reportedly not at all averse to taking risks. Other observers are stressing that China’s central planners have proven extraordinarily adept at juggling assorted bubble activities and keeping the show on the road – if need be by imposing quite drastic measures (such as ordering the burst in credit growth in 2009/10 or their recent effort to keep the stock market from falling further by hook or by crook).

However, the limit to all such interventions is always given by the real world. No matter how much money is printed or to what extent credit expansion is egged on, capital is scarce and tends to be consumed during the boom phase of the business cycle. Eventually, the associated losses will have to be recognized. The question then is how significant these losses will turn out to be relative to the size of China’s economy. This is a country of 1.36 billion people, hundred of millions of whom have moved from a state of poverty and deprivation to middle class status within just the past two decades. In a capitalist economy, even a hampered one, as a rule more wealth tends to be accumulated during boom periods than is consumed. The impoverishment of the boom-bust cycle is usually (though not always) a relative one: as Ludwig von Mises points out in Human Action, it merely means that a better state of satisfaction would have been achieved without it:

One must guard oneself against a misinterpretation of this term impoverishment. It does not mean impoverishment when compared with the conditions that prevailed on the eve of the credit expansion. Whether or not an impoverishment in this sense takes place depends on the particular data of each case; it cannot be predicated apodictically by catallactics. What catallactics has in mind when asserting that impoverishment is an unavoidable outgrowth of credit expansion is impoverishment as compared with the state of affairs which would have developed in the absence of credit expansion and the boom.

The characteristic mark of economic history under capitalism is unceasing economic progress, a steady increase in the quantity of capital goods available, and a continuous trend toward an improvement in the general standard of living. The pace of this progress is so rapid that, in the course of a boom period, it may well outstrip the synchronous losses caused by rnalinvestment and overconsumption. Then the economic system as a whole is more prosperous at the end of the boom than it was at its very beginning; it appears impoverished only when compared with the potentialities which existed for a still better state of satisfaction.”

Nevertheless, an extended boom will eventually be followed by a bust – this is unavoidable. The more distorted the economy’s production structure becomes, the more difficult it will be to bring into line with actual consumer wishes. Consequently, the longer the boom is kept on artificial life support, the greater and more harrowing the bust will turn out to be.

We have little doubt that the recent growth spurt in leveraged trust company investments in China has added to the risks, while only superficially “buying time”. China’s real estate bubble specifically has become so large that a painful denouement seems certain. Now a boom in financial assets has been added on top of it; this cannot have done anything but make the economy even more vulnerable. Since money supply growth continues to be feeble in spite of the growth in shadow system financing, one should expect these risks to become manifest sooner rather than later.

Charts by: TradingEconomics, CLSA, St. Louis Federal Reserve Research