As China’s economic growth has continued apace, so has the size of its financial sector. Similar to the the energy sector I looked a few weeks ago, finance is a cornerstone of any modern economy and if it runs into poor health or worse a major crisis (as we saw a decade ago in the West) the ramifications for the economy and politics are monumental.
Economists and policy makers have been concerned about China’s credit growth and the financial sector as a whole for a long time, the explosion in the so called shadow banking sector has led to a opaque and poorly regulated financing channels which have helped many access credit, but at a cost, which is a poorly understood structure of credit intermediaries, which some fear could undermine the country’s overall financial standing.
The other big worry is the number of non-performing loans, as much as 15% of the Chinese loan book is less than premium, banks are forced to extend or roll over loans to over-indebted companies which are no longer making enough money, but the government does want to see them go out of business because of the losses (confidence and job) wise that would ensue.
This situation looks like a recipe for chaos – but in China the government still holds a lot of cards, namely 60% shares in all the key banks, such as ICBC and Agricultural, Bank of China and Communications Bank, the remaining 40% floats on stock markets.
As well as the government backing, foreign exchange controls means that China retains significant capital controls which in turn means a rapid outflows of funds from the country is restricted, which has been the downfall of other Asian economies in the past.
However the fact that the government is a backstop and can bail the banks (and they know that) out creates a massive moral hazard because it incentivises Banks to take greater risks in the knowledge they can never really fail.
I chatted with Brandon Emmerich from Granite Peak Advisory – a firm which crunches often difficult to fathom Chinese financial data to get the latest on the health of the Chinese financial sector.
His long experience analysing the Chinese economy and financial sector and unique approach to interpreting information and data provide him with some fascinating insights.
Brandon disagreed with the assumption that government guarantees and foreign reserves are enough to contain any Chinese financial crisis or deleveraging of the economy, instead he shed light on the high proportion of assets tied up in risky financial products with odd acronyms like DAMPs, TRBs & WMPs, these often promise higher returns but represent much greater risk to clients and the wider economy.
These financial instruments have evolved to avoid regulatory oversight and are often clustered around smaller weaker banks and then channelled through non-bank financial institutions, such as Trust companies, Wealth Management firms and others who repackage finance in way to avoid market scrutiny and the regulators. While much of this funding supports solid businesses, but in other cases it is used for property speculation, rolling over of debt and other uses which are not healthy in the long term.
Granite Peak utilised a unique methodology to identify China’s weakest Banks. A league table of China’s Banks was developed based on available data for non-bank credit intermediation, funding stability (with estimates of inter-bank borrowing), and asset quality (estimate by asset growth).
The model also looks at regional exposure as a proxy for unreliable non-performing loan data, as many provinces economies are centred around mineral extraction (particularly in the West of the country) and are relatively poor economic performers.
The lowest firm in the league table, Bank of Jinzhou is confined to Liaoning Province in the sluggish North East, while the strongest regional performer was the Jiangsu Zhangjiagang Rural Community Bank, based in the prosperous Jiangsu Province in between Shanghai and Beijing.
Interestingly while Brandon doesn’t predict financial armageddon he does point out that in the event of a liquidity crisis the Chinese government would allow listed banks to be priced by the market (and therefore see the weaker ones fail) or provide liquidity which would then pressurize the RMB and hit the state’s much prized currency reserves.
Brandon also points out that the authorities have not been idle, they have been pushing weak banks to recapitalise and have been active in reforming the regulatory regime but it is not clear whether they have done enough. Only some kind of financial crisis will really tell us for sure.