World financial markets have been rocked again in recent days. First came the US Fed’s announcement last Wednesday (19 June) that it could start to unwind its cheap credit policy of ‘quantitative easing’ by year-end. The following day financial markets were stunned as a liquidity crisis gripped China’s state-owned banking system, with major banks all but refusing to lend to each other. This ‘credit crunch’ reflects growing fears over the unsustainable surge in debt levels across the Chinese economy, and its growing reliance on the opaque and unregulated shadow banking sector.
The Washington Post saw “an unnerving parallel to the first days of the US financial collapse,” as China’s money markets froze, with the overnight interbank lending rate shooting to record levels. “Until a few days ago, the notion that China might face an imminent financial crisis was a prediction that only the bravest of bears dared make,” commented Simon Rabinovitch, Shanghai correspondent of the Financial Times (21 June 2013). “But when short-term money market rates soared to 28 per cent on Thursday, forecasts of a crisis no longer seemed so outlandish,” he added.
While subsiding from this peak, following central bank intervention, the cost of interbank lending remained at punitive levels on Monday 24 June, unleashing new steep falls on global stock markets. The Shanghai stock market slid by 5.3 percent on 24 June, making for a market slump of almost 20 percent over the past four weeks. Steep drops were also recorded on global bourses. China’s economy has been the main engine for global growth in the past five years, supporting high world prices for energy and commodities and offering a counterweight to the recession in older industrialised countries.
Downgrading GDP forecasts
Since the onset of the global crisis five years ago, capitalism on a world scale has become dependent on an unprecedented flood of cheap credit for ‘life support’. The prospect of central banks now reining in this monetary stimulus has panicked financial markets. The latest financial turmoil in China follows weeks of bleak economic data confirming an accelerating economic slowdown in the world’s second-largest economy. All major forecasters, including the IMF most recently, have downgraded their estimates for China’s GDP growth this year. Last year’s GDP growth of 7.8 percent was the slowest for 13 years, but figures for the first half of 2013, to be published later this week, are likely to show a further softening. Many analysts now doubt China will reach the government’s target of 7.5 percent GDP growth in 2013. Volatility in the banking sector adds far greater uncertainty to this picture, with potentially dire implications for the global capitalist economy.
Several factors explain the liquidity crisis that sent interbank interest rates shooting upwards. Banks in China are scrambling to dress up their balance sheets for end-of-quarter audits. In addition, around 1.5 trillion yuan worth of so-called wealth management products come due by the end of June. These complex and in many cases ‘subprime’ financial products have proliferated in recent years as banks have invented new ways to get around government credit limits. The central bank refused on this occasion to come to banks’ rescue by increasing liquidity in the system.
While this situation appears to have been engineered by the government and central bank (PBOC), in what the BBC called “a kind of state-sponsored credit crunch”, the question is why such a drastic approach has been adopted? “Chinese leaders seem to be trying to prevent a disaster by basically popping the bubble, a kind of controlled mini-collapse meant to avoid The Big One,” noted Max Fischer in the Washington Post (20 June 2013). In particular the government has taken several measures recently to try to rein in the growth of wealth management products, a major category of shadow financing, now estimated to be worth 13 trillion yuan (US$2.1 trillion).
If so, the PBOC has adopted a high-risk strategy. While this is not entirely analogous to the collapse of Lehman Brothers in 2008, which triggered a worldwide credit crunch and financial crash, that too was caused by politicians and central bankers refusing a ‘bailout’ in an attempt to instil discipline in financial markets. As Craig Stephen of the Wall Street Journal commented on Beijing’s stand, “At the very least, this appears a reckless way to instil market discipline: It risks one default or rumour triggering unintended, wider systematic problems.” The Economist described it as “a terribly clumsy way to curb credit growth”.
The notion that China’s ‘communist’ (CCP) rulers are ‘in control’ has been dealt a serious blow. As Rabinovitch of the Financial Times also noted, “a third conclusion from the ructions of the past week is that Beijing is far from omnipotent in its management of the Chinese economy.”
In the past ten days, China’s state-run media has been rife with rumours of the failure of a mid-sized bank and a string of defaults by local government entities linked to ‘ghost city’ investment projects in provinces including Shandong and Inner Mongolia. The intensity of the rumour mill forced the Bank of China, one of the ‘big four’ banks, to issue a denial that it had defaulted on one of its loans. More ominously, a Bloomberg News report on 20 June said the central bank had intervened with US$8.2 billion in “relief” to the Industrial and Commercial Bank of China (ICBC), which is the world’s largest bank.
While the murky nature of China’s banking system lends itself to all kinds of rumours, and a clear picture may never emerge, it seems the central authorities are involved in a game of brinkmanship with the banks nominally under their control, turning off the liquidity tap last week as a warning in their efforts to curb runaway credit expansion and the banks’ increasing recourse to shadow banking channels.
Whatever the immediate outcome, the drama of recent days is a clear warning of the massive and unsustainable financial imbalances that have arisen in China.
“I think what people don’t really grasp is the extent to which this is not a liquidity crisis – it’s a debt crisis, so it’s not something that can go away,” argues Beijing-based economist Anne Stevenson-Yang. “They have a situation now where they’re running the whole economy on debt.”
While China has its own special features due to the high degree of state ownership in its banking system and economy and a dictatorship running the state, this does not allow it to defy economic gravity. A financial crisis is only a matter of time in China, given the massive levels of debt accumulated especially since the regime’s monster 4 trillion yuan (US$650 billion) stimulus package of 2008. This headline sum – huge in itself – was only the tip of the iceberg in terms of the subsequent credit expansion which was “unprecedented in modern world history”, according to a recent report from Fitch, the ratings agency.
The Fitch report says outstanding loans by Chinese banks and shadow financial institutions rose to 200 percent of GDP at the end of 2012, from around 125 percent of GDP in 2008. The state-run China Securities Journal has published an even higher figure, putting total credit in the financial system at 221 percent of GDP. Overall credit jumped from US$9 trillion to US$23 trillion in 2008-12. “They have replicated the entire US commercial banking system in five years,” said Fitch’s senior director in Beijing, Charlene Chu.
The central authorities lost control over this credit expansion, with earlier government attempts to slam on the brakes proving ineffective. In the first quarter of 2013 alone, China generated 7.5 trillion yuan (US$1.2 trillion) of new credit. As Tom Holland in the South China Morning Post (25 June 2013) pointed out, “That’s more new credit than China created in the whole of 2007 at the height of its Olympic investment boom”.
Huge new injections of credit have become necessary to prevent old loans from souring and triggering a wave of company failures and defaults among China’s heavily indebted local governments. According to a study by Société Générale, the combined interest repayments of Chinese companies will total US$1 trillion this year – more than any other economy.
With massive overcapacity in industry squeezing profits, much of the new credit has been ploughed into speculation – in property, commodities, or new forms of shadow finance – fuelling a financial bubble. China’s housing market is history’s largest property bubble, with vast swathes of completed housing lying empty and ‘ghost cities’ littering the landscape.
Growth of shadow banking
Between 2010-12 the shadow banking sector doubled in size to 36 trillion yuan worth of loans (69 per cent of GDP), according to JP Morgan Chase. Shadow finance is mostly comprised of ‘off balance sheet’ loans and investment products created by the state-owned banks to get around government controls and hide non-performing loans. Chu of Fitch estimates that about three-quarters of shadow banking transactions are directly or indirectly related to the mainstream banks. This is about creating a second – unofficial – balance sheet for the state-owned banks, she says.
The growth of shadow banking shows the extent to which China’s economy has become a “credit junkie”, to quote a recent Bloomberg report, getting fresh credit fixes via the ‘backdoor’ whenever government policies restrict access to official banking channels. In recent months the growth of shadow finance has accelerated, accounting for the majority of new lending.
In the first five months of 2013, total social financing – which is a measure of all credit in the economy – grew by 52 percent from 2012, with two-thirds of this originating from shadow finance. This is a sure sign of crisis ahead, and explains the central bank’s drastic actions of the past week.
Economic pain ahead
The credit squeeze comes on the heels of a stream of bleak economic data. Statistics published last week suggested Chinese manufacturing activity for June fell to a nine-month low. HSBC’s preliminary purchasing managers’ index (PMI) sank to 48.3 for the month, from 49.2 in May (readings below 50 indicate negative growth). Manufacturing is not the only sector in the doldrums. The China Beige Book published this week reports the “economy is weakening across the board, with the previously robust retail and services sectors now starting to see slippage in revenue growth”.
The mini-stimulus programme (worth around US$160 billion) injected last summer to prop up economic growth in the run up to the 18th CCP Congress, has clearly already worn off. This underlines a further serious problem – that fresh doses of credit are producing diminishing economic returns. “The extra GDP growth generated by each extra yuan of loans has dropped from 0.85 to 0.15 over the last four years, a sign of exhaustion”, says Ambrose Evans-Pritchard in The Telegraph (16 June 2013).
The Financial Times interpreted the central bank’s tough stance as “both good and bad news”, hoping this will head off a more serious credit collapse at a later stage. But the newspaper added, “taming a credit boom is always risky, especially as, in China’s case, much of it lurks off balance-sheet, often in Ponzi-type layers of transactions, and subject to uncertain liquidity conditions. The combination of regulatory tightening and restricted liquidity in these markets raises the risk of miscalculation or an accident that might trigger the instability the authorities want to avoid.”
Even if China’s central bank ‘wins’ its current standoff with the banks and succeeds in instilling greater credit discipline, this will push up the cost of loans meaning painful medicine for the economy as a whole, and a further slowdown in GDP growth. The corporate bond market has already been hit, adding to companies’ borrowing costs. As Japanese bank Nomura warns, “we expect a painful deleveraging process in the next few months. Some defaults will likely occur in the manufacturing industry and in non-bank financial institutions.”
While a full-blown financial crisis may be averted for now, the current unprecedented levels of debt will weigh like an albatross on the whole economy. As Chu of Fitch warns, “There is no way they can grow out of their asset problems as they did in the past. We think this will be very different from the banking crisis in the late 1990s.”
In a majority state-owned system the Chinese regime will not stand by while banks collapse, but will step in to bailout distressed entities as it did in the 1990s. But even with banks on government ‘life support’ – which today will be much a more costly proposition than it was 15 years ago – this can act as a gigantic drag on future economic growth. It also means huge costs will be passed on to the Chinese people – especially workers, farmers and the poor – through inflation, higher taxes and neo-liberal ‘restructuring’ of the public sector. China risks “becoming dangerously like Japan in the late 1980s – an economy in which a massive investment bubble deflates to stymie growth for a generation”, warns the BBC’s Business Editor, Robert Peston.
The central bank’s current gamble fits in with the PR image of the new CCP leaders, Xi Jinping and Li Keqiang, who want to show they ‘mean business’ early on in their rule. According to media reports they are planning a major programme of pro-capitalist economic reforms for this autumn’s Central Committee plenum (perhaps today’s banking mayhem is an example of the greater role for ‘market forces’ they want to promote). But more than anything the regime fears political instability and the prospect of the masses taking to the streets – a now familiar sight in other ‘BRIC’ economies, as exemplified by Brazil’s huge protest movement, which the Chinese leaders are undoubtedly watching. The current financial volatility is conclusive proof that China’s ‘miracle’ years are behind us and the CCP dictatorship faces a turbulent and uncertain future.