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China’s Financing Is Growing Pretty Circular, Deutsche Bank Says

Less money supply, more problems.

“Lend, lend, lend!” commanded Chinese regulators.

“To whom, whom, whom?” asked Chinese banks.

“To yourselves, selves, selves!” suggested no one in particular.

China’s attempts to revive its flagging economy with a credit boom may have provided an unexpected boost to its first-quarter GDP, but a new report from Deutsche Bank AG analysts casts doubt over the sustainability of the move.

They point to a widening gap between money supply and credit growth, “suggesting current stimulus through credit expansion did not fully transmit into lending to firms and households.” More worryingly, expanded credit may be finding its way into the financial system instead of emanating from it.

“The conventional wisdom focuses on debt in the non-financial sector and the potential non-performing loans problem in the banks. Such risks may take many years to fully materialize,” analysts Zhiwei Zhang and Li Zeng write. “What we highlight is a new source of risks. It comes from the financial sector itself," they said. If it continues to grow without proper regulation, "it may lead to disruptive adjustment.”

Deutsche Bank AG

Such a mismatch would be reminiscent of the credit boom experienced by Thailand, South Korea and the U.S. before their respective financial crises in 1998 and 2008, the analysts added.

“How could M2 growth be so much weaker than credit? The answer is that a large part of bank credit is circulated back to the banking system via non-deposit channels,” the analysts add, using the acronym for a common measure of money supply.

At issue is the way in which banks may be self-dealing as a way to make up for declining profit margins. Instead of simply lending directly to a company, banks may opt to do their corporate lending via non-bank financial institutions as a way of boosting their returns.

Deutsche Bank AG

Such round-about financing would boost credit to a greater degree than money supply, but could mean a banking system more exposed to collapse than one that is ‘just’ exposed to unprofitable investment projects and soured loans.

“On the one hand, the banking sector has been pushing out new lending aggressively, partly reflecting the government’s will to support growth, and partly driven by the needs to leverage up to offset narrowed profit margin and maintain returns. On the other side, many borrowers are reluctant to invest the credit from banks into real economy. Rather, they try to seek financial investment opportunities,” the Deutsche Bank analysts conclude. “With real returns coming down and the amount of financial assets chasing those returns going up, it should not be surprising if they turn to financial leverage to boost returns.”

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