- Rhodium Group’s China research head speaks in interview
- Things that aren’t sustainable will end, says Logan Wright
The shadow financing that is fueling China’s economic growth is unsustainable and “eerily similar” to developments in the U.S. before the global financial crisis, says Logan Wright at research firm Rhodium Group.
The nation has at most about 18 months before this funding -- derived largely from wealth-management products offering higher returns on riskier underlying investments -- hits a wall, says Wright, director of China markets strategy for New York-based Rhodium. Banks will then be unable to generate new credit needed to maintain the current pace of economic growth, which is likely to slow to a range of 5 to 5.5 percent for about two years, he says.
“It’s pretty shocking just how important this has become and how the funding structures for this type of asset creation have changed,” he said. “Everyone assumes it’s a stable system, it’s deposit-funded. It’s just not true any more.”
The financial engineering being employed to generate credit needed to fuel growth is reminiscent of the notorious structured investment vehicles and special purpose vehicles that played a central role in triggering the U.S. and global financial crisis in 2007-2008, said Wright, who has covered China since 2006. Still, the equally notorious credit default swaps that were also a key factor in the financial crisis are largely absent in China, which indicates any future shock may not be so short and sharp.
Here are excerpts of the conversation:
Why do you think China can’t keep muddling through for more than another 18 months?
Because of the financial imbalances that are building and the impact that will have on asset growth should they start to unwind. Back in 2011-2012, whatever you wanted to say about the Chinese financial system, it was pretty stable. It was largely deposit funded, its assets were largely loans even though there were a lot of them. There were pretty steady balance of payments surpluses for years, basically about $30 billion a month in reserve accumulation from 2003 to 2011.
Starting at the end of 2011, with European bank deleveraging, you saw a reversal in China’s financial account that went into deficit. You saw the emergence of pressure on the currency and you no longer had these very steady balance of payments surpluses. Now, you still have this political pressure to generate assets, but the banks already have pretty stretched balance sheets so they can’t expand assets based on their own loan volumes.
They’re not getting the returns out of banks to recapitalize out of retained earnings because return on assets for the whole system is around 1 percent. So therefore you have to restructure assets into different non-loan forms in order to grow assets at the same rate. And at the same time you no longer have the steady source of deposits externally so you have to keep issuing wealth management products and use riskier forms of liability structures to continue to attract funding, which appears fine because everything looks guaranteed. What has happened is that the funding rate for the system has increased and the assets that it’s chasing are increasingly speculative and based on returns that can’t be justified in the real economy. So these are big shifts.
Isn’t the central bank well-equipped to keep the party going?
For the banks that’s plausible, but the question is: Can you really get liquidity in the right place and do you know that that’s the case? What’s really changed in the inter-bank market is who’s borrowing and lending and small banks aren’t really borrowing in any size any more. It’s largely non-bank financial institutions that are borrowing.
What does that mean for the assets that they are generating? What kind of assets are being funded by that bank financial engineering, which is very similar to SIVs or SPVs during the global financial crisis where banks are basically levering up via their issuing wealth management products, promising rates of return, moving assets off balance sheet and they are providing additional leverage via the pledged repo market to deliver these returns. So it’s a question of which assets are being used and it does seem that corporate bonds are very central to that.
The PBoC can certainly liquefy the banks and maintain liquidity to any institution it wants to. The question is: Does that deliver the stabilization that they need in asset prices, in asset markets, and in the health of the broader financial system in terms of its ability to keep generating assets because it’s not that this is froth that they can easily skim. This is the key story of how assets are being created.
How will this unfold?
Things that are unsustainable will eventually stop. The real question is exactly how they do so. What happens is hard to say but the reason we talk about that kind of time frame is because you do compress portfolio spreads on some of these investments to such a range that they can’t go much lower. Sure, bond prices can keep trending higher for quite some time, but ultimately if it’s not justified by the underlying fundamentals we will see a market reversal. The corporate bond market should be the center of that thinking because spreads to government bonds are narrowing further and yet at the same time, demonstrably, credit risk is higher than it was previously.
What impact will there be on the macro economy? It brushed off the equity market collapse last year while barely breaking stride.
The equity market was kind of a sideshow. Very few households are invested in the domestic equity market and it was primarily among the very rich who don’t have a high propensity to consume. But there was also a pretty massive liquidity injection that really helped to mitigate those losses. The corporate bond market would be far more central given the dependence upon short-term interest rates and risk premiums for the overall health of the financial system.
This is a huge banking system with $33 trillion in assets and half those are short term in nature, which means short-term interest rates really matter if you are essentially re-creating over 150 percent of gross domestic product in assets every year. If you get a sudden reversal in corporate financing conditions that way, or a sudden reversal in these asset markets, that’s a concern.
One difference with the U.S. is there are no credit default swaps betting on the other side. So a shock in China may not be so short and sharp as it was in the U.S.?
It’s very hard to say exactly how this would shake out but I definitely do think that’s a meaningful distinction. It could be a more gradual process, absolutely. The concern is just what kind of assets are these structures funding and what will happen to those markets. Credit growth in the non-bank financial sector might fall and that could create additional pressure on asset markets that have been bid through that process even if there’s no one bidding on the other side.
— With assistance by Kevin Hamlin