Shanghai-based Jonathan Anderson has been described by the Financial Times as “one of the most thoughtful China analysts”. In recent years he has been cautiously optimistic about the Chinese economy. But earlier this month his research firm Emerging Advisors Group published a report that predicts China could face a banking crisis in five years. Here Anderson explains his reasons for that call.
You’ve turned more bearish on China, after being sanguine on its prospects for many years. What was the tipping point?
To be fair, for years my view has been that the debt bubble would result in crisis if the government just let it run to the bitter end.
But until very recently I also took the view that the authorities understood the problem and wouldn’t let it get to that point. Instead, they would quickly turn to serious tightening, cutting back on credit growth and allowing local government finance vehicle platforms and indebted firms to go bankrupt.
This would mean much weaker growth, of course, probably down to 2-3% for a couple of years from today’s 6% range, but surely the government could explain to the public that China had to go through a period of necessary pain in order to stabilise balance sheets, deleverage the economy and prevent a more serious credit problem down the road?
This is what I told clients in every one of the past four years. But it never happened. China never stopped levering up. Overall debt ratios have spiralled non-stop since 2012, and are now 100% of GDP higher than where we started in 2008.
So I am not saying the same thing anymore. It’s now clear that in spite of skyrocketing debt numbers, the government is not really interested in a meaningful tightening – in fact, just the opposite. Since last summer the credit numbers have jumped in a big way once again and the PBoC [the central bank] has lowered interest rates and pumped lots of liquidity into the system. There is no sense at all that the authorities are trying to rein in a debt bubble. This winter President Xi Jinping himself announced an average annual growth target of 6.5% for the second half of the decade, which really implies growth no lower than 6% in any given year, and he also said that fiscal and monetary policy will be kept as “supportive” as needed to achieve that growth. Meanwhile, you hardly see any discussion of rising debt levels, not at the PBoC, the DRC [the Development Research Centre of the State Council], nor in any of the senior leadership forums.
The bottom line for us is that official policy is now to simply “kick the can down the road”, regardless of the longer-term consequences.
This probably means that things will be okay for the next few years, as the government will do what it takes to keep growth at or around 6%. But it also means that China is heading directly for a much bigger crisis in perhaps five or six years’ time.
How do you arrive at your estimate that there will be a crisis within that time period?
I’m not saying there will definitely be a crisis in five years. Rather, the point is that within five years China will be crossing the threshold point where crisis risks become much larger, with a real possibility that the liquidity buffers and other constraints that China has put in place to protect the financial system could be overwhelmed.
How do we know? In every global example of credit crisis, whether in emerging markets or developed economies, the trigger has always been an unsustainable buildup of risky funding on the liability side of the financial system balance sheet. In simple terms, it’s not so much the size of the debt but rather the funding of that debt that leads to a meltdown.
And the best way to measure this in any country is the aggregate credit to deposit ratio, which compares the amount of total credit being pumped into the system to the traditional safe deposit base. This shows how far the system as a whole is “gearing up” on the liability side of financial balance sheets.
Sure enough, in every historical case of crisis we have seen a sharp increase in this credit/deposit ratio.
You can see this in the chart; the vertical axis is the peak credit/deposit reading over the 12 months prior to the onset of the crisis for major emerging market countries over the past 20 years, and the horizontal axis shows the foreign component of this, i.e. the peak net foreign liability position of commercial banks as a share of assets. The blue points in the top left quadrant show exactly where crisis “tipping points” occurred.
And the exposure numbers are rising in China. The yellow points in the chart show China in 2009 and again in 2015, and you can see that the Chinese economy is rising slowly but inexorably toward the threshold point – the red dotted line that marks the beginning of where other emerging markets fell apart.
At this pace it will be there within five years. This doesn’t mean that China faces a crisis the moment it crosses the line, but the risks start to rise very rapidly once it does.
How will that crisis play out, i.e. what might trigger it?
Good question. What are the specific stresses that lie behind these ratios we’re measuring? In the case of China, what we’re really talking about are rising banking system exposures to non-bank “shadow” firms such as trust, finance and securities companies – institutions that are inherently much more unstable and volatile.
Remember that the non-bank financial system doesn’t have mandatory reserves, stable deposits or access to emergency lending facilities. It’s a hodge-podge of firms outside the formal safety net and without the kind of buffers that help banks withstand shocks to the system.
Today the size of that “shadow” system is still moderate compared to the banks themselves, so that even if you get a wave of bankruptcies and illiquidity it wouldn’t be enough to seriously impact banks.
But consider this. Five years ago gross claims and liabilities vis-à-vis non-bank financial institutions were only around 5% of commercial bank balance sheets. Today the number is 16%, a dramatic increase, and the share is still growing rapidly.
So fast forward another half-decade – with total debt outstanding in the system increasing from 240% to 340% of GDP in the process – and suddenly you’re talking about exposures that could truly overwhelm even the formal banking system.
How would it occur? An obvious trigger would be a wave of trouble in heavily geared trusts, finance companies or securities firms, probably in conjunction with a renewed property market recession or a stock market downturn.
And if you double today’s exposure ratios into the formal banking system, defaults and bankruptcies in the non-banks would easily take out some smaller and medium sized banks as well.
Liquidity locks up. You get a wave of panic. Credit activity falls, corporates hoard funds and the economy goes into recession. This is just your classic “Minsky moment” once again.
Of course the PBoC would be quick to respond by issuing massive amounts of new liquidity and backstopping larger banks in the system, but as we learned in 2008 this doesn’t stop the initial crisis from occurring and doesn’t prevent a big economic downturn, one that could lead to protracted deleveraging pressures as well.
What about the argument that capital controls ought to protect against a yuan-based financial crisis?
Yes, this is an important point. In most emerging markets crises you have a big currency component as well; just think of the Asian financial crisis of 1997. And China doesn’t have anything like the same external exposures that these economies had; it runs trade and current account surpluses, it doesn’t have massive foreign borrowing and it still has very high reserves as well. So you don’t necessarily have the renminbi “exploding” and my guess is that the PBoC could prevent that from happening.
But I want to stress that you don’t need to have an FX crisis to have a financial crisis. The US meltdown in 2008 had nothing to do with foreign exposures, and the dollar actually strengthened. The US savings and loan crisis in the 1980s was entirely domestic as well. So were some of the other examples of banking crises in the UK and Europe. Even in the widespread Central and Eastern European crises in 2008-09 most countries kept their currencies pegged to the euro throughout – but still had horrific banking system collapses and years of lost growth.
So in China’s case we’re not necessarily talking about the exchange rate. But that may not matter much in terms of the potential for domestic pain.
Looking at more immediate signals, the Chinese bourses are arguably a speculative irrelevance. But what does recent volatility in the currency tell us?
In part what’s happening with the renminbi can be viewed as a symptom of the debt spiral – but in part it’s also a different and distinct phenomenon.
With regard to debt, China is creating a lot of credit today. Deposit growth in the banking system is running at 16% year-on-year and M2 is growing at 14%, while nominal GDP growth is only 6%. So implicitly a lot of “excess” financial assets are being created (money that is not needed to facilitate underlying activity) and these sums are as high as $1.5-2 trillion per year. So the fact you have large capital outflows is to some degree due to financial balance sheets growing very quickly and some of this wants to diversify out of the renminbi.
But there are other factors that have nothing to do with Chinese debt creation. One is the rapid strengthening of the dollar against all currencies, at the same time that the PBoC has moved to manage the exchange rate against a trade-weighted basket. So for nearly a decade the renminbi was seen as a one-way positive trade against the dollar, and now suddenly it’s not. There’s no surprise that local households and firms have started to switch out of the renminbi to hold dollars instead.
And the other, to be honest, is the lack of transparency in renminbi policy. The PBoC is allowing the currency to bounce around against the basket in small but unpredictable ways, with no real explanation for why the renminbi suddenly moves on any given day. The message to markets is not only that the renminbi is no longer appreciating. It’s also that you probably should sell the currency and buy dollars quickly, because you just don’t know if there’s a bigger devaluation looming next week. So this is more about communication and confusing signals.
This week there were reports and then denials that CSRC boss Xiao Gang had resigned. Is this another instance of China’s regulatory elite looking less surefooted (and less in control) than previously?
Are we seeing a big deterioration in the quality of Chinese policymaking? I think the answer is no … and yes.
No, because the toolkit used to manage growth, the stock market or the currency is pretty much the same as 10 or 15 years ago.
Just to use the A-share market as an example, when stock prices were falling sharply in the early 2000s or again in 2008-09, the government rolled out precisely the same bunch of measures to try to prop up the market that we have today – and with precisely the same lack of effect.
The trouble, though, is that the underlying environment has changed. China’s asset markets and financial balance sheets are a lot bigger than they were a decade ago. The economy is more open and is also more complicated and technologically advanced as well. Which means that when you’re using the “same old toolkit”, you can run into much bigger problems.
Back in 2000, for example, if the currency moved by 1% in one direction or another it wouldn’t generate big external capital flows. But now, with far bigger liquidity and assets in the system, and a more integrated global economy, the same uncertainties around exchange rate policy have much greater ramifications.
This applies to money and credit policy. Turning on the credit taps to hit 8% GDP growth was fine when the economy was not so levered and when the global economy was booming. But trying to rely endlessly on domestic credit tools in the face of a long global export recession and debt ratios that are already sky-high has essentially brought us to where we are today.
For those interested in subscribing to Anderson’s research, they can find more information at his firm’s website: www.emadvisorsgroup.com
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