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Sub-prime Lending

The Chinese Credit Crunch

China’s local government debts, while colossal, are at least under scrutiny from national regulators. The massive, shady trade in over-the-counter credit, however, may pose a more serious risk to the country’s financial and social stability

December 2011 Issue | by Li Jia

“While the US subprime crisis resulted from mortgages is­sued to insolvent individu­als, the Chinese subprime credit has been cre­ated by banks loaning to financially unstable local governments,” said Cheng Siwei, presi­dent of the International Finance Forum, a discussion platform for financial leaders, on September 16 at the World Economic Fo­rum in Dalian, Liaoning Province.

The three international credit rating agencies, Moody’s, Fitch and Standard & Poor’s, have all issued stark warnings on China’s banking system. Fitch even threatened to downgrade China’s sovereign credit rating if the asset qual­ity of Chinese banks worsened in the next 12 to 24 months.

There is, however, an even bigger threat to China’s financial stability than the build-up of bad bank loans. Only half of the loans in China show up on banks’ balance sheets, which then come under the scrutiny of regulatory authori­ties. The other more dangerous half are provid­ed through banks’ off-sheet operations, or else by loan sharking companies or individuals with idle money. All this has combined to create a storm of so-called “shadow banking.”

In an exclusive interview with NewsChina in October, Mr Geoffrey Choi, the Banking and Capital Markets Leader for Ernst & Young in Greater China, talked about the massive social and financial risks China faces from shadow banking, and how foreign banks can grab a bar­gain by buying Chinese.

NewsChina: The US financial crisis in 2008 was blamed on “shadow banking.” Will China’s shadow banking, which is growing exponentially, trigger a Chinese subprime credit crisis?

Geoffrey Choi: I believe shadow banking is creating an even more severe problem than the problem of local government debt in China. Nobody knows how big this black hole is. Based on data from the central bank, credit from shadow banking reached 3.6 trillion yuan (US$563bn), or 46 percent of the total, in the first half of 2011. But no accurate figure is avail­able so far due to a lack of a standardized statis­tical approach. Regulators are not as confident in their understanding of the scale of shadow banking as they are on the local government debt problem.

Worse still, the China Banking Regulatory Commission (CBRC) has little surveillance power over banks’ off-balance sheet operations. What they can do is to ask the banks not to give loans to projects that have no clearly defined purposes, as borrowers of those loans could be­come sub-lenders to reap higher interest rates, rather than investing in the projects.

Massive capital subject to weak oversight carries not only financial risks, but also risks of social instability. A huge number of Chinese individuals have invested in wealth manage­ment tools recommended by banks. Although those products are off-balance sheet by nature, the banks cannot expect investors to take all the losses. A big lesson can be learned from the case of mini-bonds, a type of derivative sold by the US investment giant Lehman Brothers through Hong Kong banks. Under the pressure of protests and petitions of the investors falling victim to the collapse of Lehman Brothers, the Hong Kong government stepped in to mediate a solution under which the Hong Kong banks had to shoulder some of the losses. That shows that a financial problem can evolve into a social problem and banks are not immune from losses from their off-balance sheet business.

NewsChina: Outside banks, loan sharking is a problem. Why is the practice so popular?

Choi: Under the current tightening monetary policy, private companies have no choice but to turn to usury loans for help, whose interest rate can be as high as 50 percent. At the same time, high inflation is reducing the value of bank deposits. As a result, small private compa­nies thirsty for capital and non-banking entities with access to idle money, companies providing guarantees or small loan services, for example, fit in readily. But how could the borrowers sur­vive such predatory interest rates? The recent re­ports of borrowers disappearing or committing suicide do not come as a surprise.

In fact, there is widespread expectation among shadow bankers that the government will eventually have to bail them out when the problem escalates to the point where it threat­ens financial and social stability. This belief in itself proves the risk of social problems, making shadow banking all the more dangerous.

NewsChina: Many experts are calling for a more market-based interest rate pricing re­form to solve the shadow banking problem. What do you think?

Choi: That reform is one of the goals of China’s 12th Five-Year Plan (2011-2015). It will cer­tainly create more competition between the banks, but will that solve the shadow banking problem? I doubt it.

We need to look at the issue from a more long-term perspective. China has always pledged to further boost its domestic consump­tion. But the existing social security and health care systems give people more incentive to save than consume. The huge amount of idle money sloshes around and finally finds its way into the shadow banking domain. So the key question is how to give people the confidence to spend money. The solution to shadow banking must come through social policy.

NewsChina: Given all the warnings from international ratings agencies and senior Chinese political figures, is China’s banking sector on the threshold of systematic risks?

Choi: There is currently no solid evidence to support that view. Some countries have suffered from systematic risks because they ignored early signs of the crisis. But the CBRC is paying very close attention to local government loans. More accurate information has been made available over the past few months due to the introduc­tion of more inclusive statistics standards; the latest figures released by the Chinese banks in their half-year reports are much higher than be­fore. The CBRC has made it clear that no new loans are allowed to cover old ones. As long as China’s economy does not slow down drasti­cally, systematic risk is not a likely scenario.

However, the banks stressed their high cash flow coverage, which is estimated revenue to be generated by local infrastructure projects built with loans. The CBRC should check how ac­curate their forecast is – in the coming months when those loans mature, the situation may not be as rosy as the banks are depicting.

Also, some of the repayments are financed by local governments’ fiscal revenue, which is largely backed by the volatile land transfer mar­ket, and the risk of default is much higher at the county and municipal levels than provincial. If slower-than-expected economic growth and heavy reliance on land transactions occurs in too many places, then there is systematic risk.

NewsChina: Has the debt crisis in Europe and the US undermined cooperation be­tween Chinese banks and their foreign coun­terparts?

Choi: It is true that we are no longer seeing the surge of foreign banks acquiring stakes in Chinese banks that we saw a few years ago. But many foreign banks remain positive about investing in the Chinese banks with good as­set quality and corporate governance. Canada’s Bank of Nova Scotia, for example, declared in early September its deal worth US$722 million with the Bank of Guangzhou. Ernst and Young are helping some Chinese urban commercial banks secure foreign investors.

Some Western banks are still doing well despite the financial crisis. Many in Canada, Germany and Australia are strong enough to get a foothold in China. Now is a good time for them to do so. Many Chinese banks register as low as around 1 percent price-to-book value ratio, indicating the huge potential for revalua­tion. It is a real bargain to get on board now.

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