© AFP/File / by Benjamin Carlson | Debt owed by Chinese households in the world’s second largest economy has surged from 28 percent of GDP to more than 40 percent in the past five years
BEIJING (AFP) – Chinese household debt has risen at an “alarming” pace as property values have soared, analysts say, raising the risk that a real estate downturn could send shockwaves through the world’s second largest economy.
Loose credit and changing habits have rapidly transformed the country’s famously loan-averse consumers into enthusiastic borrowers.
Skyrocketing real estate prices in major Chinese cities in recent years have seen families’ wealth surge.
But at the same time they have fuelled a historic boom in mortgage lending, as buyers race to get on the property ladder, or invest to profit from the phenomenon.
Now the debt owed by households in the world’s second largest economy has surged from 28 percent of GDP to more than 40 percent in the past five years.
?The notion that Chinese people do not like to borrow is clearly outdated,” said Chen Long of Gavekal Dragonomics.
The share of household loans to overall lending hit 67.5 percent in the third quarter of 2016, more than twice the share of the year before.
But this surge has raised fears that a sharp drop in property prices would cause many new loans to go bad, causing a domino effect on interest rates, exchange rates and commodity prices that “could turn out to be a global macro event”, ANZ analysts said in a recent note.
While China’s household debt ratio is still lower than advanced countries such as the US (nearly 80 percent of GDP) and Japan (more than 60 percent), it has already exceeded that of emerging markets Brazil and India, and if it keeps growing at its current pace will hit 70 percent of GDP in a few years.
The ruling Communist party has set a target of 6.5 to 7 percent economic growth for 2017, and the country is on track to hit it thanks to a property frenzy in major cities and a flood of easy credit.
But keeping loans flowing at such a pace creates such “substantial risks” that it could be a “self-defeating strategy”, Chen said.
– Transferring risks –
China’s total debt — including housing, financial and government sector debt — hit 168.48 trillion yuan ($25 trillion) at the end of last year, equivalent to 249 percent of national GDP, according to estimates by the Chinese Academy of Social Sciences, a top government think tank.
China is seeking to restructure its economy to make the spending power of its nearly 1.4 billion people a key driver for growth, instead of massive government investment and cheap exports.
But the transition is proving painful as growth rates sit at 25-year lows and key indicators continue to come in below par, weighing on the global outlook.
Authorities “desperate” to keep GDP growth steady have turned to consumers as a source of finance because “many of the sources of capital through the banks and corporations are essentially used up”, Andrew Collier of Orient Capital Research told AFP.
Individuals have turned to pawn shops, peer-to-peer networks and other informal lenders to borrow cash against assets such as cars, art or housing, he said, to spend it on consumption.
Banks are also driving the phenomenon, Andrew Polk of Medley Global Advisors told AFP.
“Banks have been pushing people to buy houses because they need to make loans,” he said, as corporate borrowing has dried up.
Combined with a rise in peer-to-peer lending, with over 550 billion yuan borrowed in the third quarter of 2016, the risks of speculative investment have risen, S&P Global Ratings said.
Some analysts argue that China is well positioned to manage these risks, and has plenty of room to take on more leverage as families still save twice as much as they borrow, with some 58 trillion yuan in household deposits, according to Oxford Economics.
“From an overall perspective, household debt remains in a safe range,” Li Feng, assistant director of the Survey and Research Center for China Household Finance in Chengdu, told AFP, adding that risks over the next three to five years were modest.
But Collier said that credit-fuelled spending was a “risky game”, because when capital flows slow, property prices are likely to collapse, particularly in China’s smaller cities.
That could lead to defaults among property developers, small banks, and even some townships.
“That will be the beginning of a crisis,” he said. “How big this becomes is unclear but it’s going to be a difficult time for China.”
A systemic financial “bomb” that won’t detonate
Despite its high debt level, China’s financial risk is still localised in nature rather than systemic, though this will change as China continues to liberalise its financial sector and capital account. However, as long as the current system set-up remains, or changes very slowly, an increase in bad assets per se is probably not enough to trigger a financial crisis. This is because the government still owns the major banks which are funded by stable retail deposits. Its implicit guarantee policy is the linchpin that holds the system together by, ironically, distorting creditors’ behaviour.
If China were an open and mature market and given its NPL problem, the creditors would lose faith in the debtors and cut funding, leading to a systemic collapse in the form of a debt-currency crisis. However, the majority of the creditors in China are the households, who are ultimately backed by the government’s implicit guarantee policy.
So long as there is no loss of public confidence, the creditors in China will not cut off funding to the banking system which, in turn, will not cut off funding to the corporate sector. This “irrational” behaviour suggests that no one could pull plug on China’s financial system easily, so there would not be a financial crisis or capital flight or a collapse in the renminbi exchange rate. Meanwhile, China’s closed capital account helps lock up domestic liquidity and keep the banking system whole.
What about China’s surging debt-service burden, which is now the highest among the major economies (Chart 1)? The Bank for International Settlements (BIS) argues that when a country’s private-sector debt-service ratio rose to above 25% of GDP a year, a financial crisis would follow later, citing the experience of the high-profile financial crises in Finland in 1991-92, South Korea in 1997-98, the US and the UK in the early 1990s and more recently in 2007-08. Some market estimates have put China’s non-public sector debt-service ratio at over 30% in 2015, higher than the BIS’s estimate of 20%. However, the crisis triggers, namely a deregulated financial system, a heavy foreign debt burden and an open capital account which pushed these countries over the cliff, are not present in China.
Thus, focusing on China’s high debt level and poor asset quality is exaggerating the fear about a systemic blow-up. Generally, banks do not fail because they have bad assets. They fail when they cannot fund themselves either through deposits (as in a classic bank-run case) or the wholesale market. The trigger for a banking crisis lies on the liability side of the bank balance sheet; a rise in bad assets per se does not necessarily bring down a financial system.
Chinese banks may have bad assets, but they have stable funding from domestic deposits. Despite years of gradual increase, the system’s credit-to-deposit ratio is only 100% (Chart 2). This is less than half of the ratios seen in many other countries. Foreign creditors play no role in funding Chinese banks, so the system is not susceptible to withdrawal of foreign funds.
The risk lies somewhere else
All this is not to deny any financial risk in China. There is indeed a rising risk of some localised financial failures, thanks to the rapid expansion of small and regional banks (Chart 3) many of which have engaged in regulatory arbitrage through opaque and complex financial activities funded by wholesale funding. To see this, note that interbank borrowing by small and regional banks has risen from 12% of their total funding sources in 2015 to 15% in 2016, compared to about 2% by the large commercial banks and the Big Four (Chart 4). Bottom-up data from 26 listed Chinese banks shows that almost every small and regional bank had increased their reliance on interbank funding between 2013 and 2015, with the share of interbank borrowing ranging between a quarter to half of their funding sources. The big Chinese banks are well funded through their deposit networks and their relationship with the government and SOEs. However, small banks lack this advantage and have, thus, become more reliant on wholesale funding.
Normally, an increase in reliance on wholesale funding raises systemic risk because when the interbank market seizes up, as it typically does during times of financial stress, these small banks would be vulnerable to funding squeeze which could, in turn, create a domino effect on the system. In the developed markets, this could lead to a systemic collapse. But the situation in China is different. The People’s Bank of China (PBoC) would most likely step in either to keep funds flowing or force the major banks to take over the small troubled ones, as it did in 1998 when it asked the Industrial and Commercial Bank of China to absorb all the liabilities of Hainan Development Bank.
How do they cheat?
The weakest link in China’s banking system is the increasing complexity of credit creation, which involves multiple layers of transactions between banks and non-deposit-taking financial institutions (NDFIs) aiming at eschewing regulatory constraints on lending. Bank lending to NDFIs has grown at an annual average rate of 35% since 2011, even when other types of bank loan growth has remained relatively stable at around 14% (Chart 5).
Trust companies play a central role in this bank-NDFI nexus, which emerged in 2009. Being NDFIs, trust companies cannot take deposits but are allowed to make loans and invest in real estate and securities. They package their investments or loans into wealth management products (WMPs) and sell to banks, which may re-sell them to their clients or keep them as investment. Since 2014, other NDFI players, including fund managers, asset management companies and brokerage firms, joined the game, adding many layers to the credit creation process.
In a stylised example (Chart 6), a company approaches Bank A for a loan. But the Bank’s lending ability is restricted by some regulatory constraints (see below). So it makes the following arrangement for its client: It buys a WMP from Bank B, which uses the proceeds to buy some packaged assets from an asset manager. The asset manager uses the funds to buy loans from a trust company, which then uses the proceeds to lend to Bank A’s client. In the end, the company gets a loan via this complicated credit creation process without having any connection with Bank A who is the de facto lender by eschewing the regulatory lending constraints. All the other players are, arguably, rent-seekers in facilitating this regulatory arbitrage process.
The credit risk of the final borrower does not change regardless of how many layers of credit creation are added. But complicating the credit creation process increases systemic risk: if any one of the players defaults, it will set off a domino effect by triggering counter-party risk. According to industry estimates, two-thirds of the credit created by this complicated process ends up as loans to the real economy.
Why do they cheat?
The innovative credit creation process is indeed regulatory arbitrage. Under Chinese regulations, a corporate loan carries 100% risk-weighting for capital adequacy purposes. An indirect loan routed through a NDFI counts as an interbank claim and carries only a 20% risk-weighting. So the process lowers the banks’ capital charge and allows them to expand their loan books by breaking the regulatory constraints but not breaching the regulations. But it also encourages rent-seeking and financial excess to build up.
Banks also exploit this multi-layer process to dress up their sickly balance sheets. For example, Bank A might sell a bad loan to an asset management company, which then sells the cash-flow rights of the loan to a brokerage, which packages them in a WMP and sells it to Bank B. Bank B then repackages the WMP into a new investment product and sells it to Bank A.
In this transformation, Bank A “magically” turns a bad loan into a “safe” interbank claim on Bank B, which is recorded as investment in A’s balance sheet. The “paper” risk of Bank A disappears, but the underlying risk from the bad loan is still there. Most importantly, the process has increased systemic risk.
Not yet a dire problem
Such regulatory arbitrage activity funded by the wholesale market looks similar to the situation in the US before the subprime crisis in September 2007, leading many observers to fret about a financial meltdown in China sooner or later. However, the comparison with the US situation is not appropriate at this stage. This is because the majority of the Chinese banks do not rely on wholesale funding, which is a major determinant of bank vulnerability during the US subprime crisis. In China, wholesale funding accounts for only 14.5% of total funding, according to the PBoC, compared to 75% at the peak in the US system.
Furthermore, virtually all banks in China are owned (directly or indirectly) by the government. There are only five private (small) banks, and foreign banks account for less than 1% the banking market share in China. All the major NDFIs are also majority-owned by the government. The point is that the state is behind the Chinese financial system. The US crisis was triggered by private creditor decision to cut off funding for over-extended firm such as Bear Sterns and Lehman Brothers. In China, the state ownership and implicit guarantee policy distort rational creditor behaviour which, in turn, helps preserve the system. In the event of defaults by small institutions, the government can also order the big state-owned banks to keep the credit lines open.
There is certainly risk in the Chinese financial system, but it is not systemic yet.
Chi Lo, Senior Economist, BNP Paribas Investment Partners (Asia) Ltd. (BNPP IP), and author of “The Renminbi Rises: Myths, Hypes and Realities of RMB Internationalisation and Reforms in the Post-Crisis World”
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