A crisis forming at China right now

We spent last week taking a small group of clients on a tour of China. We met a central bank researcher, an oil company executive, a 12th Five-Year planner, an urbanisation specialist, a leading local real-estate researcher, a China politics professor, a coal executive, a World Bank economist, a base metals trader, some bond market regulators, a pessimistic bank analyst, three local real-estate companies, a stock-market regulator, an academic working on industrial capacity, and Standard Chartered staff from across our China private equity, financial markets and research platforms. And that was just in Beijing.




On local government debt, one speaker made the important point that local governments are forced to seek offbalance- sheet solutions, since their formal fiscal resources are extremely limited. Central and local governments each receive roughly 50% of total taxes, but local governments have nearly three-quarters of all spending responsibilities. This, combined with “draconian” (our speaker’s word) rules on local governments’ ability to raise debt or borrow formally, means they have no choice but to set up investment companies and leverage up informally.



Our banking analyst friend had become more pessimistic about the sector’s prospects as a result of continued super-strong credit growth and the off-balance-sheet activities of local banks. Total on- and off-balance-sheet assets are now probably 150-160% of GDP. Banks are selling loans to trust companies, which wrap these assets up and sell them on to individual and corporate investors as wealth management products (WMPs). There is very little transparency on the volumes and quality of these WMPs. Middle-class households are buying these products in their tens of thousands.



In 2009, at least CNY 1trn of bank debt was sold off the banks’ balance sheets (a conservative estimate), and more is being sold in 2010. The banks have an incentive to push more of the assets of local government investment vehicles off their balance sheets now, as the bank regulator is forcing them to provision for these loans by the end of July (though we do not know how this provisioning will be organised).



The trigger for a mini-bank crisis could come from a liquidity problem in one of the loans that back a WMP. Say an infrastructure project cannot meet its interest payments and/or principal repayment – in theory, the investors who hold the WMPs would take the hit. There is no trading in these products, and the banks say that they have no liability for them. Once one instrument goes bad, everyone will be worried about these products, and banks will be under pressure to bring these assets back onto their balance sheets and provision for them.



We then debated the seriousness of a possible crisis. One speaker argued that carving out the non-performing loans (NPLs), dumping them into the asset management companies, injecting FX reserves onto the banks‟ balance sheets and issuing official debt (both at home and overseas, where there would be big appetite), meant that these problems could be solved without hitting growth. The banking analyst argued that crises are always hard to control, that there are always unforeseen and damaging feedback loops, that the current batch of officials had not dealt with a major crisis before, and that once retail investors in the WMPs realise there is a problem, worry would spread quickly – and that this could happen soon, given the slowdown in credit growth.