Victor Shih says a surge in leverage to over 300% of GDP have transformed the Chinese economy into a “Ponzi unit” that is highly vulnerable to financial catastrophe in the medium-term.
In a study published by Merics China Monitor entitled “Finance Instability in China: Possible Pathways and Their Likelihood,” Shih, an associate professor of political economy at UC San Diego, estimates that China’s total credit hit around 254 trillion yuan as of May this year, or 329% of 2016 nominal GDP, on the back of double digit increases in key credit categories during the preceding year and half period.
Total shadow banking assets surged by 35.1% to 106.946 trillion yuan from 79.168 trillion yuan, while on-balance credit leapt 20.1% to 147.75 trillion yuan from 123 trillion yuan.
Certain key shadow banking segments saw declines during the period from end of 2015 to May 2017, such as undiscounted bills and interbank loans, which fell by 24.8% and 4.7% respectively.
All other categories posted double digit increases, however, led by credit held by funds, which skyrocketed 116.2% to reach 18.970 trillion yuan, followed by non-bank non-bank bond balances, which surged 80% to reach 17.619 trillion yuan.
Should the interest servicing for this leverage exceed nominal incremental GDP growth, borrowers will need to service their debts by obtaining new credit, which would make “China more of a Ponzi unit, [requiring] new credit to service interest payments,” and lead to further acceleration in debt growth.
While the other alternative would involving the servicing of interest via a rising share of income for households, firms or government, Shih says that this would be “tantamount to a massive tax which will slow growth for an extended period.”
Shih sees the first scenario playing out in China, with incremental nominal GDP growth lagging total interest service on credit by a wide margin since 2012.
“Chinas a whole is a Ponzi unit,” writes Shih. “Total interest payments from June of 2016 to June of 2017 exceeded increment increase in nominal GDP by roughly 8 trillion RMB.
“This was not always the case…prior to 2011 incremental nominal GDP roughly matched or even exceed interest payments.
“The advent of high-yielding shadow banking led to the explosive growth in interest payments, and thus the need to capitalise interest payments, starting in 2012.
“To be sure, the Chinese government has succeeded in avoiding the bursting of the asset bubble, but this has been achieved by a greater degree of leveraging.”
Shih highlights four factors that could serve as potential triggers for a financial crisis on the back of China’s precarious debt quandary – a household sector crash, a shadow banking panic, capital flight, and an abrupt suspension of international credit.
According to Shih a household sector crash and shadow banking panic are both unlikely causes of calamity, given that they comprise only a modest share of total credit.
“Chines household debt is still a relatively small share of GDP and of banking sector assets,” writes Shih. “The sudden appearance of a large amount of distressed household debt by itself will not impact the financial system significantly.”
In addition to this property controls such as heavy down payment requirements are preventing a rise in loan-to-value ratios for new real estate purchases.
With respect to the much-discussed shadow banking sector, Shih points out that shadow banking assets comprise only a modest volume of total banking assets, while the sector remains propped up by the state-controlled banking system via interbank lending.
“Shadow credit has seen explosive growth in recent years, growing from nearly zero to a 50 trillion RMB phenomenon.
“Even at 50 trillion RMB, however, shadow credit still pales in comparison to assets held by the formal banking system, which had 240 trillion RMB in assets at the end of June 2017.
“As long as the flow of loans continues, shadow finance should not be the source of a financial panic.”
Capital flight is a far more likely culprit for financial catastrophe in Shih’s opinion, given a decline in foreign exchange reserves of nearly 1 trillion used between the middle of 2014 and the start of 2017.
Foreign exchange reserves have fallen from over 20% of money supply and 55% of household saving deposits as of mid-2014 to around 10% of money supply and 30% of household savings.
“Given the enormous trade flows that go through China and China’s large monetary base, China remains highly vulnerable to another bout of capital flight.
“If households and firms were to move just 10% of money supply overseas, China’s FX reserves would basically be depleted. The need for China to increase its money supply directly links its domestic credit bubble to a potential crisis triggered by capital flight.”
A sudden cessation of international credit is also a likely potential trigger of financial collapse, despite official Chinese external debt remaining modest as a percentage of GDP.
Shih points out the official data is disingenuous, because Chinese firms and financial institutions engage in profligate overseas borrowing via Hong Kong.
If Hong Kong is included, Chinese external debt is in excess of 1.9 trillion dollars as of Q1 2017, more than a trillion of which is short-term interbank borrowing.
Suspension of international credit is an especially worrying as a potential trigger of financial crisis for China, given that it lies beyond the purview of the heavy central government control that can be used to extinguish domestic panics.
“Analysts of past bubbles underestimate the extent to which the ruling Chinese Communist Party controls nearly every aspect of the financial system through party committees in every financial institution in China,” writes Shih. “This control decreases the chance of panic selling, often the trigger of a crisis.
In the case of a staunching of international credit, however, “PBOC will be powerless to stop many of of the deleterious consequences.”