Fitch recently released an eye opening report on the staggering growth of leverage in the Chinese economy (h/t Bernard Hickey).
As many readers will be aware, the Chinese Government has been implementing policies aimed at curbing bank lending in order to slow inflation. However, as is often the case with regulation, these policies have shifted financing to unofficial sources (the ‘shadow’ banking system).
What makes the Fitch report unique is that it quantifies the amount of credit being issued via these informal channels, as well as through the official banking sector.
Fitch suggests that China’s credit expansion is unsustainable. While the credit boom has been a key to China’s GDP growth, it is achieving diminishing returns as its debt levels grow, suggesting high levels of malinvestment.
Below are some of the key extracts from the Fitch report (it is a few weeks old but is worth revisiting, find below).
Two years after the peak of the 2009 lending boom, credit levels in China remain elevated. Although bank lending has slowed, this moderation is being offset by a burgeoning of new credit channels both within and outside the banking system. Consequently, growth of leverage continues to outpace growth of the economy…
Fitch has developed an adjusted TSF [total societal financing] incorporating critical items currently omitted from the official gauge. The agency’s measure shows that China’s post‐crisis credit boom — often portrayed as a brief, isolated event in H109 — actually lasted two solid years, and is still running quite strong. With credit still so loose, it is difficult to foresee inflation moving off the policy agenda any time soon, and any premature easing could risk a quicker‐than‐expected re‐acceleration of price increases.
Fitch’s adjusted TSF shows that total financing is expected to exceed CNY18trn in 2011, or 38% of GDP, CNY3.5trn above the agency’s year‐end estimate for the official TSF and more than double its CNY8trn estimate for new loans (Figure 1)…
By end‐2011, total financing/GDP could reach 185%, up 61pp from 2007. Increases of similar magnitude have been seen elsewhere in the years leading up to banking stress, underscoring the agency’s cautious outlook on the sector.
That China’s economy is slowing while financing is still so abundant illustrates how dependent growth remains on loose financing (Figure 2). This is further highlighted by the continued low incremental economic return on new credit. Pre‐crisis, a CNY1 increase in financing yielded roughly CNY0.75 in new GDP, but in 2009 this plummeted to CNY0.18. The economic return on credit is slowly rising, but still has yet to fully recover…
Perhaps most strikingly, more than 55% of new financing is expected to come from outside bank lending, close to triple the level of 2006. This underscores just how rapidly off‐balance‐sheet and non‐bank financing has been expanding in China…
A key reason for Fitch’s concern about the medium‐term outlook for the Chinese banking system has been the large and rapid build‐up of leverage since the global crisis. Based on Fitch’s adjusted stock of credit 3 , the ratio of total financing/GDP in China rose from 124% at end‐2007 to 174% at end‐2010, and is on pace to rise by another 11pp to 185% in 2011.
Such a rapid run‐up in leverage relative to GDP is a sign that the incremental economic return on credit has declined, meaning that borrowers’ ability to repay is not keeping pace with the additional leverage being incurred. Over the medium term, this points to a potentially significant rise in loan delinquencies and pressure on Chinese banks’ earnings and capital.
Admittedly, the recent divergence between credit and GDP in China is not as blatant as some past extreme cases, e.g., the 310pp rise in credit/GDP in Iceland from 130% to 440% during 2003 to 2008. Nevertheless, increases of similar magnitude to that recently experienced in China have been witnessed in other countries in the years leading up to episodes of financial stress (Figure 14), underscoring Fitch’s cautious medium‐term outlook for the Chinese banking sector.