China's Credit Dilemma
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China's Credit Dilemma

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The October monetary statistics for China, released last Friday by the People’s Bank of China, show the second consecutive month of an interesting phenomenon; normal bank loans, which in October amounted to RMB 505.2billion (U.S. $81.5 billion), made up less than half the total RMB 1.29 trillion of aggregate credit issued in China.  In September, bank loans totaled RMB 623.2billion, out of RMB 1.65 trillion of total credit. Two months do not constitute a trend, but there is mounting evidence, and solid theoretical reasoning, to support the idea that there are some shifts underway in China’s monetary environment.

The official banking sector is under a lot of strain after it proved unable or unwillingness to properly assess borrowers’ credit worthiness during the government mandated 2009-2010 credit backed stimulus period.  This investment heavy, bank backed reaction to the 2008/2009 global slowdown has undoubtedly created another non-performance loan (NPL) headache.  Astute readers will point out that NPL ratios remain low, but increasing amounts of overdue loans, and loans classified as “performing” but in the “special mention” category, suggest that there are indeed repayment problems simmering beneath the surface.

Whether or not a bank acknowledges a non-performing loan on its books openly, the problem loan will drag on the bank’s normal business.  A borrower’s failure to repay the debt, or a bank restructuring the loan to provide the borrower with easier repayment terms,  both constrain a bank’s ability to lend to new customers.  Absent another recapitalization of the banks, the overall choice for the economy is either to accept lower levels of credit creation (and thus slower growth), or find alternate, non-bank sources of financing. 

There is therefore strong theoretical support for the argument that China’s economy would increasingly turn to “non-bank lending” rather than the traditional model.  There is also a chicken-and-egg issue here – is the migration of funds from bank deposits to higher yielding wealth management products (WMPs) also pressuring the banking system’s ability to lend? Are banks unable to lend (as theorized here) or unwilling to lend due to the credit risk – in other words, are they finally applying good lending practices and resisting pressure to support the economy? Either way the impact on new loans would be the same.

Corporate bonds make up another piece of this confusing pie.  Traditionally the corporate bond markets in China have been “non-functioning;” with absurdly low trading volumes, no shape to yield curves, and banks directly making up the majority of bond investors.  Furthermore, to date there has still not been a single default in the bond market, and until a predictable and reliable procedure for such an eventuality can be drafted and proven in practice, many investors will stay away.

In September and October, corporate bond issuance came in at RMB 227.8billion and RMB 299.2 billion respectively.  There is some speculation that banks are now using funds raised through Wealth Management Products (WMPs), a low-risk high-return alternative to simply depositing one’s money, to fund their bond purchases, as mentioned in an excellent post from China Real Time explains.

China may be trying to attract more foreign capital into its sluggish equity and still-small bond markets, but the lack of any proven procedure for default will help dissuade foreign capital from entering the bond markets, while falling corporate profits growth will weigh down equity markets. 

The data in the coming months will demonstrate whether China’s financing model has indeed shifted away from normal bank lending. If this is the case, analysts need to consider the consequences of the shift. Responsibility for supporting the investment heavy growth model would have then shifted to private and retail investors. With it would come the risks associated with continued lending after overinvestment has already become problematic. While government news agencies may try to spin the change as a positive, many new questions arise:  What happens when some WMP borrowers are unable to repay their investors? If the borrowers are state owned entities (SOEs), will the courts allow investors to pursue their debtors effectively? Are banks liable for any of the losses? 

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