More on China’s little financial crisis

Via the ABC comes a nice primer on China’s little financial crisis:

Up until a few weeks ago the Baoshang Bank’s prospects seemed bright enough.

According to Baoshing’s most recent regulatory filing, the smallish lender based in Inner-Mongolia, made a $600 million profit in 2017.

It had assets of around $90 billion, non-performing loans were modest — under 2 per cent — and its capital buffers would fit comfortably with the global demands of a Tier1 bank.

Then it collapsed.

That set off a series of events rarely, if ever, seen in Chinese banking.

A ‘Lehman moment’?

Regulators seized Baoshang, the first action of its type since 1998.

That may have shaken the foundations of Chinese banking, but of far greater significance was the collapse caused China’s first recorded interbank default.

It is yet to be a “Lehman moment” — where the credit market freezes, banks stop lending to each other and the economy teeters above the abyss —but it has, as Societe Generale’s Wei Yao noted, “triggered severe liquidity tensions in the interbank market”.

“Now that credit risks and counter-party risks have finally descended on this very core market in China’s financial system, all the key players in the system have to figure out how to price risks in the new paradigm, and quickly.”

Ms Yao said the understandable consequence was “a big and unpleasant wave of risk repricing”, with major banks shying away from doing business with smaller lenders.

And that’s a worry, as small-to-medium sized banks combined have balance sheets as big as the big banks combined, but are far more dependent on interbank funding.

The central bank (PBoC) immediately pumped around 600 billion yuan ($125 billion) into the system and halted a run on the banks by guaranteeing 100 per cent of all retail deposits.

It calmed nerves a bit, but credit has tightened and borrowing has become more expensive — not an ideal mix when the broader Chinese economy is slowing and under pressure from the ongoing battle with the US over trade.

Bad news for the Chinese economy is readily translated into worse news in Australia, given commodity exports to our biggest trade partner pretty well prop up otherwise rather uninspiring growth.

Whack-a-mole response

“Interbank borrowing rates for smaller banks rose after the Baoshang default, and China’s central bank has been busily playing whack-a-mole by injecting cash,” J Capital’s Anne Stevenson-Yang wrote in a recent note to clients.

Ms Stevenson-Yang says authorities are clearly spooked by the Baoshang default and reports about threats to the solvency of other banks.

For the record, the party line from Beijing is the collapse was an isolated case, with the Baoshang’s majority stakeholder using the bank’s funds illegally in another one of his investment businesses.

Economic slowdown

It might be just one bank (at the moment), but Societe Generale sees the real problem as the spill-over into the broader economy.

“While we think the PBoC can avoid a systemic liquidity crisis,” Ms Yao said, “we are becoming increasingly concerned that the economy may pay the price of a more intractable slowdown in the coming quarters.”

The central bank may still have some work to do beyond targeted cash injections in the financial system.

Interest rate cuts have been off the agenda, but are likely to be deployed if things turn ugly — such as a bad outcome in trade talks and another barrage of US tariffs heads China’s way.

“The central bank remains reluctant to step up headline easing, as it is probably waiting for the outcome of the G20 Summit,” Ms Yao said.

A brief interbank credit squeeze back in 2013 may be a useful template to map out what happens from here. Back then, the real pain was felt well down the track.

“Compared with the economic momentum before that liquidity squeeze, one can even argue that the economy is in a more fragile state amid the confidence shock from the tariff war, among other things,” she said.

“After this liquidity squeeze — even if it is over soon — financial institutions will keep adjusting to the new paradigm of non-zero counter-party risk in the interbank market, supposedly the safest segment of the financial system.”

Debt mountain

Perhaps the most positive spin that can be put on the Baoshang collapse is, if it is a step to eroding the mountain of problematic debt in the Chinese financial system and tempering the cavalier approach to risky lending, it is a step in the right direction.

Certainly, Societe Generale’s Wei Yao says China’s interbank market will never be the same after its first ever default.

She argues deleveraging will expose weak institutions along the way, and implicit interest rate guarantees need to be abandoned to learn the proper price of risk.

“Enduring such pain is the only way to improve the efficiency of credit allocation in the long run, making China less reliant on debt for growth,” Ms Yao said.

“We still think China has a chance to pull through without a financial crisis, given the Chinese Government’s control over many things.”

However, it is not yet out of the woods.

“When the deleveraging process enters the very core of the financial system, the risk of things going terribly wrong rises,” Ms Yao warned.

Something going terribly wrong in China is something Australia could ill-afford as it too battles with a slowing economy.

We are long past the point at which economic crisis can be averted. The only question now is does it happen quickly in a lending freeze? Or slowly via the middle income trap? I back the latter given China has repeatedly demonstrated its willingness and capability to force state owned banks to lend even when it makes no economic sense to do so.

David Llewellyn-Smith

David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal.

He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.

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  1. That’s a lot pressure ratcheting up on China. Is Trump dumb enough to blink and claim victory when he has the chance to really put the squeeze on?

    In his shoes i’d be stretching this out and cranking up tariffs, waiting for Brexit, helping Hong Kong troubles to mushroom and Italian banks to implode, not to mention force up the price of oil with some mischief re Iran

    • I am practically certain that the G20 will result in 100% of Chinese goods being tariffed.

      The bastard may even go a step further and put export controls on the things they desperately need – like pork.

      They’re facing the largest animal pandemic in history on their favourite meat.

      • HadronCollision

        Do they really need to eat pigs?

        What replacement food is there.

        Rice, legumes, carbohydrates, cake?

        [I am not being facetitous – I am geniunely asking to what extent they rely on eating pork so as to not starve]

      • Hadron:

        It’s not that they have to eat it. But imagine Straya day without Lamb.
        How do you think Strayan’s would take it? I’d put money on people who barely eat it joining in the protests.
        Now imagine Straya day is nearly every meal.

        They’ll go bonkers if pork prices keep rising. Possibly riot.

  2. Ronin8317MEMBER

    The bank collapsed due to too much bad debt. The 2% bad debt was a complete fabrication, so when the real number is discovered, it got forcibly taken over.

    The GFC was only 10 years ago, so I’m sadden that financial journalist can’t remember what is exactly the ‘Lehman moment’. The freezing up of the interbank lending is only the result, however the actual event is the Feb and US Treasury refusing to bail out Lehman Brothers after the deal for a UK bank (Barclay) to buy Lehman was blocked by the UK regulators. A takeover by the Chinese Central Bank is the exact opposite of a ‘Lehman moment’.

    • As you note, this is ALL about bad debts. Baoshang is closer to Bear Stearns, we’re yet to see the Lehman’s moment.

    • DominicMEMBER

      You can bet your bottom dollar the bank has been trading insolvent for years but eventually the parlous state of its balance sheet has come home to roost. It’s bad loans are closer to 50% than 2% I’ll bet. The entire Chinese banking system is like this — rotten to the core. They just keep rolling over and restructuring bad loans and crossing their fingers. I wonder sometimes if the CCP has any idea of the true state of things in the financial system — who’d want to deliver bad news to Xi and his henchmen? And face the gulag or even execution. It’s all blue skies ahead …

  3. Baoshang clearly demonstrated that the Chinese capacity to maintain accurate bank financial accounts is hopeless. How many more Baoshangs are already in the system? When are they going to break to the surface?

    • DominicMEMBER

      I can’t believe Western investors actually invest in listed Chinese stocks — the reporting standards are atrocious. There is fraud and dishonesty from top to bottom. Alibaba is meant to be a gigantic ponzi scheme — I read a hedge fund report recently on BABA’s accounts and they are almost impenetrable — a vast and complex web of legal entities around the globe with money being transferred between all these entities on a perpetual basis. The guy reckons a team of 20 forensic accountants wouldn’t be able to unravel it all.

    • Lots but they are kept on life support. Baoshang’s has political problems. This is significantly political.

  4. Lending to liars when you are a liar. What a surprise it imploded. This is so enjoyable.