GMO: China's  Marching Toward A Massive Credit Crisis

China has passed many reforms aimed at easing capital controls. But these are being rolled out slowly.
A meager deposit interest rate has forced people to turn to wealth management products and other risky investments.  And the recent credit crunch forced many into the unregulated shadow banking system.
In a new report, GMO's Edward Chancellor and Mike Monnelly warn of "acute fragility" in China's financial system, and write, "the public appearance is of a banking system with negligible levels of bad debts, ample liquidity, and low leverage. The reality, on closer inspection, looks rather different".

China has created too much credit too quickly.

Job seekers queue for a job fair in China's Shaanxi Provinc

The last big surge of credit came in 2009 when China unleashed 4 trillion yuan to help spur economic growth and employment.
"Since that date, China’s economy has become a credit junkie, requiring increasing amounts of debt to generate the same unit of growth. Between 2007 and 2012, the ratio of credit to GDP climbed to more than 190%, an increase of 60 percentage points." In 2012, new credit to the non-financial sector totaled 15.5 trillion, that's equivalent to 33 percent of 2011 GDP.
Source: GMO

China also has significantly more debt than its emerging market peers.

Source: GMO

A lot of debt is sustained by real estate which is offered as collateral, and credit booms end when property bubbles burst.

"Recent research suggests that credit booms are more likely to end in severe busts when they coincide with property bubbles."
A lot of China's debt is supported by real estate which is put up as collateral for the loans. Banks' official exposure to property is listed as 22 percent of the loan book. But that doesn't account for exposure to real estate through their loans to local government financing vehicles (LGFVs) and off-balance sheet credit instruments.
Sudden drops in real estate prices caused a jump in debt problems and non-performing loans.

Because of heavy state controls, moral hazard is a major issue in China's banks.

Moral hazard is a real issue in China, since the state controls not just the biggest banks but also the recipients of credit, the state owned enterprises (SOEs). "These arrangements have encouraged crony lending practices and the concealment of non-performing loans."
Moreover, since local governments can't borrow directly from banks for their own use, they have had to create local government financing vehicles (LGFVs). These LGFVs account for between 15 - 25 percent of outstanding loans and often offer land, marked above market value, as collateral. Other guarantees are also questionable since they depend on land sales which could leave local governments shy when real estate prices fall.
Source: GMO

There has been a surge in shadow banking.

Man dressed as Chinese god of fortune distributes coupons

Shadow banking, which involves lending that is kept off the balance sheets has surged, in particular, the wealth management products. In Q4 2012, non-bank lending accounted for 60 percent of new credit.
China's shadow banking system is reminiscent of what we witnessed in America before Lehman's fall.
"Trust loans that finance cash-strapped property developers have a whiff of the subprime about them; wealth management products that bundle together a miscellany of loans, enabling the banks to generate fees while keeping loans off balance sheet, bear a passing resemblance to the structured investment vehicles and collateralized debt obligations of yesteryear; while thinly capitalized providers of credit guarantees are reminiscent of past sellers of credit default insurance.
Source: GMO

As banks refused to lend to local government financing vehicles, local governments turned to the corporate bond market.

Source: GMO

And an increasing number of bonds are being packaged and sold to banks' clients through risky wealth management products (WMP).

In the past Chinese banks bought corporate bonds, but increasingly they have been pooled into wealth management products (WMPs) and sold to clients.
While banks have been able to lower their exposure to LGFVs, there is a chance that they will have to payout losses that investors may face.
Source: GMO

Because of higher returns people are also flocking to risk real estate trusts.

Source: GMO

These trust products are the Chinese equivalent of subprime mortgage-backed securities.

Chinese savers that are chasing yields and LGFV's are the dominant borrowers from trust companies. The Chinese trust industry has more than doubled in the past two years to about 6 trillion yuan by the end of September 2012.
Trust operators are "highly leveraged" and because these trust products are low quality and have broad exposure to real estate, they are seen as the Chinese equivalent of subprime mortgage-backed securities (MBS). 
Source: GMO

Still, WMPs have been the most popular investment for Chinese savers.

But some argue that WMPs are ponzi schemes.

Charles Ponzi, the original Ponzi schemer

There were reportedly over 13 trillion yuan (or around $2.1 trillion) of WMPs outstanding at the end of 2012, a 50 percent year-over-year increase, according to Fitch.
These WMPs are sold as low risk investments and stay off the balance sheet since returns aren't guaranteed. Often people that sell the WMPs can't explain how the money is used and frequently it is put in shadow finance, and often the property sector. 
Bank of China's chairman Xiao Gang has said, "when faced with a liquidity problem, a simple way to avoid the problem could be through using new issuance of WMPs to repay maturing products. To some extent, this is fundamentally a Ponzi scheme”.

The WMP's asset and liabilities have differing maturities (i.e. duration mismatch) which makes them much more risky.

Over two-thirds of WMPs mature in under three months but the money is invested in assets with longer maturities, like trust loans that can often span several years.
"This asset-liability mismatch makes it crucial for the banks to be in a position to roll over the loans. The numbers are enormous and getting larger by the day – every quarter around RMB 3 to 4 trillion of wealth management products need refinancing.
"The banks have been forced to turn to the interbank market to finance the roll-over…The dubious creditworthiness of many WMP assets means that defaults are an ever present possibility. A loss of confidence in China’s shadow banking arrangements could threaten a full-blown credit crunch. China’s shadow banking system has grown too big to fail, but it may also have become too big to control."
Source: GMO

China has an extensive credit guarantee system, but many of these are "thinly capitalized and poorly regulated".

25 percent of all bank loans in China have some form of guarantee, and the country has an extensive network of credit guarantees."These guarantees may come in the form of a mutual guarantee, where one company guarantees another’s debts against default. Alternately, a guarantee can be purchased from a dedicated guarantee firm."
The 2011 credit crisis in Wenzhou was sparked by a collapse in this system and the guarantee firms had to be bailed out by the government.

Collateralized lending is extremely popular.

Since Chinese banks aren't allowed to charge for risk, banks ask for collateral. More than 40 percent of all bank loans are collateralized. In China, commodities like steel and copper that were part of the residential housing bubble were often used as collateral. What's more? Often the steel or copper offered as collateral doesn't actually exist.
Source: GMO

The banking sector is also vulnerable to capital flight.

Because of its trade surplus and capital inflows in the last decade China has had to print new yuan for every dollar entering the country and control the value of its currency. Naturally, capital inflows have seen a rise in lending and have helped fuel a credit boom.
Moreover, the wealthiest Chinese control the equivalent of two-thirds of the country's foreign exchange reserves, and they have ample reason to move their money out of the country. "If the wealthiest Chinese were to move a significant portion of their money offshore, liquidity in the banking system would be drained. "
Source: GMO

China's credit expansion relative to GDP is much larger than the credit booms experienced by the U.S. ahead of the financial crisis and Japan in the late 1980s.