Finance

Andy Mukherjee is a Bloomberg Gadfly columnist covering industrial companies and financial services. He previously was a columnist for Reuters Breakingviews. He has also worked for the Straits Times, ET NOW and Bloomberg News.

Chinese banks be warned: Idle cash with your customers is the devil's workshop. When there's already unease about mounting corporate debt, lazy money can light a fire under speculative assets, particularly property. That could add a headache to the lenders' migraine.

These risks are currently off investors' radar because on the face of it, the Chinese economy isn't doing badly. But GDP growth of 6.7 percent doesn't mean all is well.

To see why companies hoarding cash is a problem, start with the difference in year-on-year growth rates of M1 and M2. The former is a narrow measure of money supply, mainly cash in circulation plus corporate deposits waiting to be liquidated. M2 includes M1 and household deposits. When M1 expansion starts exceeding that of M2, it usually means firms are getting war chests ready for new projects. As those come to fruition, household savings and M2 rise, and banks make money. During the past 16 years, a widening M1-M2 gap has typically led to a rally in the shares of large Chinese banks:

A Toothy Gap
When M1 growth outpaces M2, shares of Chinese banks usually perform better
Source: Bloomberg
*Market-cap weighted index of 13 largest Chinese lenders

This time may be different. When the M1-M2 gap blows up without any sign of a corporate investment revival, and when even tourists' behavior seems to suggest capital flight, it could imply that companies are keeping money ready to move out of the country at short notice.

Schroder's emerging market economist Craig Botham has uncovered evidence that the yuan is weakening in lockstep with the M1-M2 gap. Even if a big chunk of the idle money isn't poised to cross the border, it's still available to dabble in "entrusted loans," a form of inter-corporate lending that lets state-owned companies charge high interest rates to desperate borrowers as their core business dawdles. When cash that would otherwise buy new machines stays in current accounts to repay older debt, M1 jumps.

Nothing Sweet About This Parting
The M1-M2 gap* in China has diverged from the U.S., lending credence to the "liquidity trap" hypothesis in which monetary easing is increasingly toothless
Source: Bloomberg
*Difference between year-on-year growth of narrow and broad money.

With doddering debtors funded by companies, commercial banks must find new customers. Their dalliance with wealth-management products is well known. Lately, home buying has been the big opportunity. Banks tracked by Nomura put half of their new loans in the first six months in mortgages. Developers got just 1 percent.

Home Run
The recent rally in Chinese banks has been strongest for lenders with large mortgage exposure
Source: Bloomberg
*Market-cap weighted average of top 13 lenders.

Property-related lending still has room to grow, says Nomura, which estimates the current exposure of publicly traded banks at 18 trillion yuan ($2.67 trillion). Still, the frenzy may be unsustainable if home prices keep surging irrationally. Any reversal would expose the banking system to debris from a housing collapse.

A hard landing may look remote with an official GDP growth rate of 6.7 percent. If it happens, however, that M1-M2 divergence will come back to haunt China. As commentators including Sanford Bernstein have warned, the gap raises the risk of a "liquidity trap" in which the central bank's efforts to stimulate a swooning economy become ineffective.

So far, the authorities have played down the risk, explaining the difference between narrow and broad money growth as a technical problem. But the stubbornness with which idle cash appears in the data month after month suggests investors should at least consider a more devilish interpretation.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Andy Mukherjee in Singapore at amukherjee@bloomberg.net

To contact the editor responsible for this story:
Paul Sillitoe at psillitoe@bloomberg.net