Worries of a Chinese Banking Crisis Are Highly Exaggerated Financial media were buzzing last week with news about troubles in China’s unofficial, or “shadow,” banking sector.
Stories that the sky is falling are useful to grab readers’ attention, and there was plenty of reporting suggesting that a Chinese financial catastrophe was in the works. They implied severe repercussions for global financial markets and for the global economy.
We believe these fears are very overblown, and we’ll explain why below.
We’ve Watched China for a Long Time
We’ve been China-watchers for decades, and besides our own observations, we also have a set of analysts whose work we have come to respect because of their insights and their track records. Based on this analysis, we don’t believe that the sky is falling.
While pursuing these goals, China’s current leadership has spent the last year and a half consolidating its power. Many observers believe that under Xi Jinping, the central government has become more capable of implementing reform than its predecessors. In fact, it has been said that Xi Jinping has greater personal power as a leader than anyone since Deng Xiaoping. This encourages us in believing that under Xi’s leadership, China will continue to make progress towards its medium- and long-term reform goals.
What Prompted Last Week’s Worries -- And Why We Think They’re Inaccurate
Last week, news broke of the potential default of a Chinese investment vehicle known as a “trust product.” With official bank lending skewed steeply towards big state-owned enterprises, and with many of China’s newly wealthy citizens looking for better returns than they could get from bank deposits, there has been a rapid growth in unofficial, “shadow” lending.
This sector provides several different kinds of investment vehicles. What they have in common is high promised returns, high leverage, and a lack of official guarantees and protection to investors. However, since they are typically sold to investors through banks, there is a sense among investors that they enjoy an implicit guarantee from the government -- and that investors will be made whole in the event that the investment vehicle goes bust.
This is the familiar issue of “moral hazard,” in which the market does not properly price risk when that risk is supposed to be backstopped by a bomb-proof guarantor -- such as a country’s central government. We had a taste of this in the developed world during the 2008 financial crisis.
Central Government Leans on Shadow Banking
For some time, the Chinese authorities have been aware that unofficial lending has been expanding too fast, and they have leaned on it in various ways to deal incrementally with the risks. At first, a lot of vehicles sold to wealthy investors -- “trusts” -- were tied into property markets. In 2011, the government responded by restricting trusts’ lending to property developers. That pushed trusts to lend to another highly-levered sector -- mining.And the pressure of the global slowdown quickly reduced the cash flow of many mining operations -- making the more highly levered ones vulnerable to default.
It was a mining company that caused the stir last week. Hit by the slowing economy, slumping demand for coal, and the arrest of one of the owners on financial corruption charges, Zhen Fu Energy went bankrupt. Some 700 wealthy investors had contributed an average of $700,000 each to a trust product invested wholly in the defunct company -- and it looked like the principal repayment, due on January 31, would not be happening.
Default Would Have Been Good News?
The bank that sold the product to investors quickly made it clear that they had no legal responsibility and would not undertake to make investors whole. Some analysts believed that a default would actually be good for the Chinese banking system, because it would remove moral hazard and cause the market to price risk more accurately. As it played out, a mysterious source of funds appeared (of unspecified origin) to make investors whole on their principal -- although they will lose out on a portion of the last year’s interest payment. It’s a light slap on the wrist -- a first gentle reminder that the government is not responsible for making investors whole.This was a disappointment to many observers, who were hoping for a harsher default -- but they stress that another default is very likely to occur this year, as a large tranche of principal repayments from stressed products is due to occur in 2014.
The Central Government’s Strategy
It is important to remember, first of all, that the Chinese banking system is very largely closed. Therefore the risk of direct contagion of any crisis to wider global financial markets is minimal. This is not another 2008 in the making.Second, it is important to remember that the Chinese government has sufficient reserves (presently an estimated $3.8 trillion) to contain almost any crisis. They are picking their battles, and the analysts we follow believe that they intend to let some trust products fail -- to instill some discipline in the markets -- while they backstop others. In other words, some trusts such as the one that lent to Zhen Fu Energy will probably be allowed to partially default -- but the trusts that lend to “local government financing vehicles” (LGFVs), a kind of unofficial muni bond, will not. In this way, local governments will gradually be deleveraged -- and the central government will take on some of that leverage. And the central government certainly has a war chest of reserves adequate to this task.
China’s Many Worries
While we and the analysts we follow believe that the Chinese government has a plan, and has the firepower to execute on that plan, there is always the potential that a crisis could emerge if they get something wrong or if they are hit by unexpected developments as they work to implement shadow banking reforms and restrictions.
In that event, any effects on the global economy will come not from direct financial contagion, but from the economic effects of a sharp Chinese slowdown. Obviously, such a slowdown would have its harshest effect on markets and companies with heavy China exposure. The fear of such an event may generate periodic volatility -- and if it does, we will use this volatility to take advantage of buying opportunities in the markets we favor.
In short, among our worries about China, we don’t see a banking crisis as a major concern. We are more concerned about corruption, and about progress in reliable, transparent accounting standards in Chinese corporations. Until we see more progress on that front we will not be eager to own China.
But we’re pretty sure the sky isn’t falling.
With the government now hoarding its dwindling reserves to try to pay its debt, hyper-inflation looks likely to take hold again (inflation is now estimated to run at 28 percent, twice the officially stated rate).
We do not believe that Argentina is a bellwether of the emerging markets as a whole. We do believe, however, that it is another example of the disastrous effects of economic populism -- like those we’ve seen in spades in Venezuela and elsewhere in the developing world. Usually, these crises are long in the making, and can be seen coming -- analysts have been describing the endgame of Argentina’s current policies for years.
Kirchnerismo is the populist doctrine of Argentina’s current president and her late husband. It’s a rebranding of the “third way” philosophy of Juan and Evita Perón. It is fundamentally hostile to free trade and to free enterprise, and the economic consequences are plain to see.
It is not our intention to condemn Argentina, but only to observe that global investors should be very wary when certain populist politicians come to power. To us, this type of populism is a big, flashing “danger” sign that warns us to steer clear of exposure to a country’s economy. Caveat emptor.