Meanwhile, in the domestic banking scene… [See part 1 on capital outflows here.]
China’s financial system stability is increasingly intertwined with its shadow banking system — which is big, according to various tallies. Bank of America Merrill Lynch says it accounts for a quarter of all bank loans, with the biggest segments being wealth management products or WMPs (8 per cent) and trust companies (8.9 per cent). Fitch Ratings says that WMPs now account for about 16 per cent of all commercial bank deposits; KPMG says trust companies will overtake insurance to become the second-biggest component of the financial sector.
China’s increasing use of both these types of products keeps lots of people happy: it gives a higher yield for depositors looking for a positive return in real terms (which conventional deposits do not offer); banks can increase their spread; and it helps businesses who need credit but lack access to traditional bank loans, which historically tend to be directed towards large, state-owned firms. In theory banks are not liable for the trusts and WMPs they facilitate, but they are still at risk, as BAML’s David Cui wrote earlier this month:
Even commercial banks’ normal lending business may be disrupted if something goes seriously wrong in the shadow banking sector. When a loan expires, banks often do not roll it over straight away. A common practice is for the borrower to repay full principal plus interest on the due date and then the bank will grant it another loan over the next two to three days. As a result, many borrowers resort to underground banks for a bridge loan to cover this brief period (An interview on SME loans, May 11). If there is a seizure in this market, commercial banks will have a tough decision to make as to whether to roll over those loans without an upfront full repayment first.
Charlene Chu of Fitch Ratings explained the mechanics of the WMPs in her very interesting note on China’s banks last December. It shows how vulnerable these products make banks owing to poor asset-liability management:
If WMPs were structured so that investor payouts were evenly matched with the assets underlying the products, meeting these obligations would be relatively straightforward. However, most asset-backed WMPs, which have made up 99% of all products issued by domestic banks thus far in 2011, are not linked to any specific asset, but rather to a pool, whose cash inflows often do not match the timing of WMP payouts.
When they can’t liquidate those assets to pay out the investors, she says, they have three options:
draw on their on-balance-sheet assets, resulting in an erosion of on-balance-sheet liquidity;
use money raised from new WMP issuance to pay off old issuance, which is the most popular option, but which is highly dependent on confidence, market conditions, and interest rates;
borrow the funds in the interbank market, which covers the immediate product payout but creates a new future liability. While banks generally prefer the first two options, as liquidity has tightened there has been a growing reliance on interbank borrowing to repay product investors. Because a large share of WMPs are structured to mature at month-end – thereby allowing the money to be brought back on-balance-sheet – there has been an intensifying month-end scramble for cash to cover product payouts and the additional RRR allocation.
Chu wrote last week that these risks are increasing because WMPs are increasingly becoming the domain of smaller banks that are less well-equipped to cope with mismatches.
These issues are particularly relevant for small, non-state banks, whose narrower deposit bases, more limited access to interbank credit, and thinner liquid assets make them more susceptible to WMP repayment and rollover issues.
Chu’s newer note warns that the liquidity risk from WMPs is now “paramount”, and says banks are relying on WMPs for as much as half of their deposits.
And here’s where the potential trigger comes in…
Anne Stevenson-Yang of J Capital Research says most of those deposits come from state-owned enterprises and large corporations, who are seeing their own cash flows dwindle (look at the steel mills, for example). And that could mean they stop ploughing so much money into the WMPs. This is a problem given the tendency to “pool” WMP assets in a Ponzi-like way — a practice pointed out by every financial analyst we’ve cited here.
What next? Stevenson-Yang explains it could be rather tricky:
If the WMPs stood alone, the banks could just buy their assets and close them down. But the WMPs have become a key tool to generate interbank liquidity. Now, some 50-80% of underlying assets are interbank loans. That means that WMPs are a channel for financial contagion. Were any bank to fail to meet its interbank obligations, its creditor banks would lose out. They might just extend more credit, but the retail investors who purchase WMPs would presumably not be so forgiving.
Fitch Ratings’ Chu says the precise amount of WMPs backed by interbank loans is difficult to determine, but it’s definitely growing. In fact the interbank loans could just be a cover story for even more risky assets:
In 2012, a growing share of funds raised through WMPs have been invested in interbank assets, giving the impression that liquidity and credit risk of products has declined. However, this can be misleading. Many interbank assets of Chinese banks actually represent corporate credit disguised as interbank claims. Meanwhile, banks occasionally conduct “interbank” transactions with their own WMPs, meaning that some of these assets could be claims on themselves that are not backed by any real cash flow.
Stevenson-Yang points out that forced rollovers might help, but they do not solve the fact that the banks are not really recouping their loans:
Of course, it’s all in the way you count. In early winter, regulators quietly deleted about 12 trillion RMB from potential NPLs by extending the terms of loans to the local government financing platforms. Changing these to long-term loans, though, does not change the fact that banks are not getting paid. When they don’t get paid, they need to find liquidity elsewhere.
Opportunities for liquidity scrambles come up quite frequently: the tenor of most new WMP issuance remains very short, despite a successful crackdown on WMPs of 30 days or less, notes Fitch:
Did we mention that WMPs suffer from a lack of transparency? Fitch Ratings says there are no disclosure requirements, no central catalogue of issuance, and no way to even identify WMPs.
Sooo… the question is, to what degree has the reliably high foreign capital inflow been compensating for domestic liquidity problems?
One of our readers who wanted to remain anonymous summed it up very succinctly, we think:
And associated discussion:
I guess the best way to interpret this orange line is that it shows the massive monetary influence of China’s f/x reserves. Fundamentally, the trade surplus is the fuel which powers this machine. Interestingly, China started to have problems in 2008 when the ratio did not increase and again in 2011 when the ratio decreased. This is why capital flight is such a core concern for China. Let’s pretend that $1 trillion wanted to leave for whatever reason (this is Victor Shih’s number). The PBOC coughs up the $1 trillion and must fund this by selling RMB 6.3 trillion domestically. This would push the “RMB reserves % GDP” to about 25% and be massively contractionary. Of course, that’s not going to happen. But we are seeing a slow bleed of capital each month which I estimate to be about $50 billion. It won’t take too long at that rate for this capital flight to add up to meaningful figures. For an economy necessarily reliant on continued capital inflows – importantly, a stable capital position is insufficient to continue powering the current Chinese macroeconomy – this is an absolute red warning light flashing.
Indeed it is… because the capital inflows are (or have been) to some extent enabling the PBoC to provide sufficient liquidity. Of course, as our reader points out above, the levels of outflow we are seeing to date aren’t going anywhere near disaster levels.
The risk, if we follow Shih’s argument, is if sentiment among the wealthy elite becomes rapidly more negative. By “wealthy elite” think princelings with lots of Rmb who decide it’d be much better to have foreign currencies and the assets to go with.
As Michael Pettis wrote to us by email:
The nightmare scenario is one in which slow growth and worries about risk in the financial system cause money to pour out of the country, which causes a contraction in credit, which causes growth to slow even more and financial risk to increase, which causes even more money to leave, so on. This is one of those deadly “positive feedback loops” which always cause good times to be better than expected and bad times to be worse.
Another pro-cyclical risk… just what the world needs, huh?
China’s two-way liquidity risk: capital outflows – FT Alphaville
The framework of China’s FX flow – China PBOC Watcher
China’s disappearing bank deposits – FT Beyondbrics
China’s financial slowboat speeding up – FT
The ultimate guide to China’s monetary policy – Also Sprach Analyst
Undoing China’s bank reforms – Patrick Chovanec (also in WSJ)
Victor Shih on the dangers of capital fleeing China (video) – Institute for New Economic Thinking
Carl Walter and Victor Shih on the Chinese banking system (video) - Gplus
China’s dollar shortage is an aspect of the global shortage - Tim Congdon of ING via FT AV Tumblr