Earlier in the week, Société Générale’s economist Wei Yao had a striking note about China’s shadow banking problem (h/t Also Sprach Analyst), which she and her team estimated to be worth Rmb14,000bn – 15,000bn:
Yao has a neat, if rather sombre, indicator of trouble in China, and it relates to that black piece of pie:
Since the rise of China’s private sector in early 1990s, the correlation between the frequency of news reports on corporate bankruptcies in Zhejiang province and the occurrence of macroeconomic difficulties in China in following months has been, at least, as robust as that between inverted yield curves and recessions in the US.
Troubled enterprises are usually heavily involved in underground banking, which is basically direct and informal lending and borrowing between family members, friends, and people from the same community or locality. These unnerving stories always begin with PBoC’s lending curbs on formal banks, followed by surging underground banking, and then at some point – there is always such a point – inevitable and abrupt breaks in liquidity chains, and ending finally with run-away business owners or their suicide.
Yao says there have been 19 such bankruptcies reported since the beginning of the year — of which, nine were in September. The prefecture-level city of Wenzhou is probably worst, he says.
According to the PBoC’s Wenzhou branch office, the size of the underground banking in the city is estimated to have reached CNY 110bn, equivalent to 18% of Wenzhou’s CNY 602bn formal bank loans. The central bank also estimates that close to 90% of households and 60% of local enterprises are participating in this credit boom.
Scary stuff, especially when the interest rates are estimated to range from 20 to 180 per cent. So who would be willing to borrow on such extreme terms? Well, usurers and speculators, for sure. Yao says they account for almost half the Zhejiang bankruptcies picked up by news reports. (There were also some companies that were struggling anyway.)
And on that front, it’s not such a bad thing from the point of view of policymakers who were, after all, trying to rein in a credit boom and cost of living pressures. For example, Chinese officials spoke to the the FT last week:
In interviews with the Financial Times, two officials said that tightening measures over the past year had been aimed at choking off credit flows to poorly managed developers in China’s unruly housing market.
“There are some developers who are facing funding pressure or have even been cut off. This is something we are happy to see,” said one of the officials, who asked not to be identified. Developers were like “dragons and fish jumbled together”, he added, referring to a mixture of high and low-quality companies for whom a consolidation process was “very necessary”.
However, unjumbling the dragons and fish isn’t easy. Yao says some of the bankrupt businesses appear to have been “innocents”: SMEs frozen out of the formal credit system while banks favour big companies and state-owned enterprises. Not so great, that. And especially when “other” loans are becoming a bigger source of funding for the property developers than banks:
So it’s a big old mess. The formal banking sector is exposed through secondary lending — letters of credit and the like. And if the household sector is as heavily involved as underground banking as the PBoC estimates, there is a recipe for discontent. Especially if property prices fall *too much*.
But Yao believes if that happens — meaning, say, a property price fall of more than 10 per cent — things may get rough, but the government will take action, and not just in the form of loosening the reserve requirements that have been hiked in the past year:
Banking regulators are reportedly saying that banks should be more tolerant of SME defaults in order to help them through difficult times. Initiatives, such as collective issuance of SME bonds, are also seen as offering increasing scope. Further steps may follow; regional credit quotas and relaxing reserve requirement ratios seem possible avenues. As for more general easing, the probability of RRR cuts in this quarter will rise significantly if the property market takes a sharp turn.
SME bonds? Credit easing? Some of that sounds oddly familiar.