Perverse Incentives, China And You

Detroit Publishing Co. “Loop the Loop at Coney Island, New York” 1903

Since I wrote “The Taper And The China Credit Power Struggle Squeeze” on Dec 29, I have of course kept on reading up on China, and thinking about what I read. And I got to say, it keeps getting murkier and scarier at the same time. What I suggested in that article is that, although nobody I’ve seen talks about it, I’m convinced there’s a political struggle afoot in China that may shake the country to its foundations. And I don’t see how the western world would not be affected by that, possibly quite severely.

That is to say, while everyone still holds on to the notion that the Communist Party and the – central – People’s Bank of China (PBOC) have near absolute power over the Chinese economy, I think power over the shadow banking system has been relinquished. The size of that shadow banking system was estimated by JPMorgan at $5.86 trillion, or 69% of GDP, in May 2013, and that’s an in your face indication of what powers the “official” leadership still has.

There’s a lot of talk of Beijing and the PBOC curbing lending through the shadow banks, but if you count for over 2/3 of the economy, it’s an obvious choice to just stare them down. In the same vein, Beijing wants local governments to show responsibility for their debt, but that will only drive local officials even deeper into the shadow system. These officials first of all get judged on their accomplishments, such as the infrastructure they get built and the jobs that are created in their region, and they’re probably covering one hole with another already, so there’s no way back.

Which, incidentally, is one of the main reasons why a annual growth rate of 7% or more is so crucial for China: it allows for cover-ups of everything that’s gone awry. Local officials would rather pay loan shark interest rates than fess up to the mess they’ve made. All they’re looking for is opportunities to keep rolling over the debt. They’re not interested in paying it off, they’d rather use the cash to build another bridge or highrise, because that’s good politically.

Reuters reported on Monday that Beijing issued a whole new set of rules:

China issues fresh curbs on shadow banking

China’s cabinet has issued new rules to strengthen regulation of the shadow-bank lending that has helped fuel an explosion in debt levels since 2008, in the latest effort to address growing financial risks, sources told Reuters on Monday.

Another way to read this: a very, capital V, substantial part of China’s growth since 2008 has been financed by an explosion in debt levels. And that’s helped push up growth a lot. Which in 2013 at an estimated 7.6% was already the lowest since 1999.

The wide-ranging new rules issued by the State Council, China’s cabinet, say that shadow banking is a “beneficial” and “inevitable” consequence of financial development and provide an official definition of the term, according to a copy obtained by Reuters.

It’s interesting to note that Beijing finds it necessary to acknowledge shadow banking’s role in its economy by providing an “official definition”. And we all understand that if any boss you’re working for ever labels you “beneficial” and “inevitable”, and puts it on paper, you know you’re good, and you’re not about to be made redundant.

The regulations contain new restrictions on banks’ cooperation with trust companies, securities brokerages and other intermediaries with whom banks have cooperated in order to carry out off-balance sheet business.

Authorities also attempt to address the problem of banks’ exploiting regulatory loopholes by clarifying the responsibilities of various regulators, the People’s Bank of China, the China Banking Regulatory Commission, and the China Securities Regulatory Commission. The rules also address internet finance, micro-lending, and informal lending by friends and family members.

The Chinese government would love to get a clear picture of what goes on underground in its own economy, but it must have understood by now that it can no longer simply demand to be given the numbers. To get that picture, it’s at the mercy of the very people it seeks to regulate more strongly. And then it becomes a straightforward negotiation: if I give you this, what will you give me?

The government did try, though, with an official audit. Or was it just going through the motions? You have to wonder about all the numbers the audit reported, since there’s no telling what was left out. This is how Bloomberg put it over the weekend:

Shadow Banking Risks Exposed by Local Debt Audit

China’s audit of local governments exposed an increased reliance on shadow banking, swelling the risk of default on 17.9 trillion yuan ($3 trillion) of debt.

Bank lending dropped to 57% of direct and contingent liabilities as of June 30 from 79% at the end of 2010, while bonds rose to 10% from 7%, National Audit Office data show. Trust financing surged to 8% from zero, while other channels that sidestep loan curbs accounted for the remaining 25%. The yield on five-year AA notes, the most common rating for local government financing vehicles, jumped by a record 158 basis points last year to 7.6%. That exceeds the 5% on emerging-market corporate notes, Bank of America Merrill Lynch indexes show.

“As banks tightened their purse strings, local governments had no choice but to resort to shadow banking and incur more expensive borrowing costs,” said Tang Jianwei, a Shanghai-based economist at Bank of Communications Co., the nation’s fifth-largest lender. “That will further constrain their repayment ability and eventually overwhelm some lower-level entities which have borrowed way beyond their means. I won’t rule out some defaults in 2014.”

Premier Li Keqiang is cracking down on less-regulated shadow banking activities, estimated by JPMorgan Chase & Co. at $6 trillion in May last year, while the central bank engineered a cash crunch in June 2013 to push deleveraging in the world’s second-largest economy. China’s borrowing spree since 2008 has evoked comparisons to debt surges that tipped Asian nations into crisis in the late 1990s and preceded Japan’s lost decades. [..]

Local government debt overdue at the end of June was 1.15 trillion yuan, or 10.56% of borrowings, the audit report showed. That compares with the 1.3% overdue ratio in the banking system, reflecting the practice of rolling over regional debt instead of classing it as delinquent, according to Barclays Plc.

“Rapidly rising local-government debt poses the biggest medium-term fiscal risks,” Chang Jian, a Hong Kong-based economist at Barclays, wrote in a Dec. 31 note. “Intertwined with the under-regulated and poorly managed shadow banking business, slowing economic growth and more liberalized markets, systemic financial risks are increasing.”

The China Banking Regulatory Commission estimated in 2010 that about half of the bank loans to LGFVs were being serviced by secondary sources including guarantors because the ventures couldn’t generate sufficient revenue, according to a person with knowledge of data collected by the nation’s regulator. In 2012, the agency suggested banks cap loans to such vehicles to levels reached at the end of 2011. CBRC Chairman Shang Fulin reiterated the limit last month.

As a result, growth in bank loans to local governments slowed to 19% to 10.1 trillion yuan from the end of 2010 to June 30, 2013, compared with a 67% jump in total debt, audit data showed. Trust financing to LGFVs surged to 1.4 trillion yuan from zero and bond issuance more than doubled to 1.8 trillion yuan.

To summarize: in just 2.5 years, total debt went up 67%, and since official banks lent less, almost all of that rise came from the shadow system. Bond issuance doubled, and the “invention” of WMPs, or Wealth Management Products, put trust financing on the map for the first time. Question: where would China’s GDP growth level have been without shadow banking? Dare we even ask?

China’s local governments are responsible for 80% of spending while getting about 40% of tax revenue, the legacy of a 1994 tax-sharing system, according to the World Bank. Local governments have set up more than 10,000 financing vehicles to fund projects such as subways and airports because regulations limit their ability to borrow money directly. [..]

Trusts typically get people to invest at least 1 million yuan in alternatives to bank accounts linked to the PBOC’s 3% benchmark deposit rate. They had 10.1 trillion yuan of assets under management as of Sept. 30, an increase of 60% from a year earlier, according to the China Trustee Association. About 26% of their proceeds were invested in infrastructure projects.

The National Development and Reform Commission will work to prevent default, fiscal and financial risks in LGFVs as 100 billion yuan of debt is estimated to come due this year, according to a statement posted on the agency’s website on Dec. 31. The special vehicles will be allowed to sell bonds at lower costs to refinance higher-cost borrowings, and the NDRC can approve new debt to finish projects short of funding, according to the statement.

The yield on China’s 10-year sovereign bond surged about 100 basis points, or 1 percentage point, last year to 4.6%. The seven-day repurchase rate jumped to an unprecedented 10.77% on June 20, pushing the average rate in 2013 to 4.09%, up from 3.50% in 2012. The one-year interest-rate swap, the fixed payment needed to receive the repo rate, reached an all-time high of 5.38% on Jan. 2, 2014.

In order to maintain their hold on power, Communist Party big wigs need high growth numbers. The more they come down on the risk-laden shadow banking system, the more they need that system to finance that growth. And the system knows it. That’s a rock and a hard place in Chinese: attempt to take back power from the shadows, and see your economy dwindle, a politically very risky move because defaults are a certainty, or let the shadows finance ever more of the economy, let them grab ever more political power away from the Party, and forget a stable economy. More numbers from Bloomberg yesterday:

China Crisis Risk Flagged by Haitong as Debt Snowballs

China’s second-biggest brokerage said record debt threatens to trigger a financial crisis as borrowing costs jump to unprecedented highs despite a cooling economy.

Liabilities at non-financial companies may rise to more than 150% of gross domestic product in 2014, raising default risks, according to Haitong Securities Co. The ratio of 139% at the end of 2012 was already the highest among the world’s 10 biggest economies, according to the most recent data. That compares with 108% in France, 103% in Japan and 78% in the U.S., figures from the Bank for International Settlements and the World Bank show.

“We are concerned that the debt snowball may get bigger and bigger and turn into a crisis,” Li Ning, a Shanghai-based bond analyst at Haitong Securities, said in an interview on Jan. 3. “Default probabilities from next year may rise because more and more Chinese companies depend on new borrowings to repay old debt.”

Premier Li Keqiang has driven up money market rates to help deleverage the economy, as Moody’s Investors Service warned this week that credit expansion could spark a financial crisis. Companies must repay a record 2.6 trillion yuan ($430 billion) of borrowings this year even after bond yields surged and economic growth slowed to the weakest in more than a decade. [..]

China’s aggregate financing, the broadest measure of new credit, climbed 14% to 16.1 trillion yuan in the first 11 months of last year from the same period in 2012, central bank data showed. Total debt of publicly traded companies in China and Hong Kong has surged to the equivalent of $1.92 trillion from $607 billion at the end of 2007, according to data compiled by Bloomberg.

China’s shadow banking system is opaque, built on risk, and extremely leveraged. China holds $1.3 trillion in US Treasuries, and that’s just the official number. So I wonder things like: what have these Treasuries been purchased with? Leverage? What if they dump them to pay off liabilities? Another question: how deeply are Goldman Sachs, Blackrock, JPMorgen involved in that shadow system? It seems easy enough: they have the cash, there’s little or no control, and if you thought US subprime was the ultimate stage for bigtime gamblers, you stand corrected.

And so yes, perhaps the real prize is control over the Forbidden City after all. But a growth rate of over 7% cannot be sustained by leverage levels of 100:1. Moreover, a battle for power at that scale never ends well for the people, neither in China nor in the west. Too big to fail banks can risk all they want, they’re not on the hook for the losses. That’s what you call a perverse incentive. Which exist in the US, in Europe, and, as we now know, also in China.

China’s economy is somewhere in the middle of a roller coaster ride, and the cars need to keep going at high speed, because if they slow down, they will derail. And we will all go down with them. Or do you think, or hope, that the world’s second largest economy, and its biggest supplier of gadgets and trinkets, will implode without you noticing?

Nicole will be teaching, along with Albert Bates, Marisha Auerbach and Christopher Nesbitt, on a Permaculture Design Certificate course in Belize in 2014. The course will be the 9th annual event held at Maya Mountain Research Farm between Feb 10-22nd. Click here for details and registration.

This article addresses just one of the many issues discussed in Nicole Foss’ new video presentation, Facing the Future, co-presented with Laurence Boomert and available from the Automatic Earth Store. Get your copy now, be much better prepared for 2014, and support The Automatic Earth in the process!