Contagion Risk Chinese Style: The Week’s Real Main Event
Think The FOMC Meeting & Taper Threat Is The Big Event Of The Week? A Chinese Style Sub-Prime Crisis Looms & Could Upstage It: Complete With Chinese-type CMOs, Dark Pools, Sleeping Regulators, And Contagion Risk For An Investment Class Worth 60% of China GDP, & Ramifications For Traders (Update: Add Deposit Withdrawal Restrictions)
The following is a partial summary of the conclusions from the fxempire.com weekly analysts’ meeting in which we share thoughts about key developments worth a special report – this one on ramifications of a potential China default threat this Friday by one of China’s largest banks
UPDATE: Add to the above sub-title: bank runs prevented only by withdrawal restrictions. Around 8pm EST, the BBC broke the news that HSBC had suddenly imposed restrictions on cash withdrawals over as little as 3000 Pounds, unless customers can provide written documentation of why they need to withdraw more of their own money. HSBC explained that it had a duty to prevent “lawless” use of money. It also claimed that the restrictions had been in place since November, ti just hadn’t notified depositors. Hmm.
Are you worried about a China slowdown, or rising geopolitical risk from that spat with Japan over some rocky Islands and their juicy mineral rights?
Here’s something to take your mind off of those. Something worse. Central banks like the PBOC usually can exercise ‘verbal intervention’ to calm markets because they have credibility stemming from both expertise AND (usually) ability to print cash as needed in emergencies.
However, as recent history shows, there a few things that can overpower even central bank’s ability to maintain calm – a major bank default that leaves those exposed to losses without any official guarantees of support or relief.
Where have we heard this story before?
- A new political order brings pro-market reforms, unleashing a wave of growth, a robust economy, and a strengthening currency used by such a huge chunk of the world’s population that many predict it could soon replace the US dollar as the global reserve currency.
- Alas, the good times were fueled by too much debt too willingly provided and taken because, hey, real estate/stocks/whatever are only going higher, right?
- Then, a seemingly small, isolated default suddenly casts doubt on the solvency of any bank or government that might be exposed to losses from that default. No one knows who is solvent and who isn’t and suddenly the one default metastasizes into a systemic banking crisis and credit freeze that threatens recession or even depression for the entire region if not the world. Markets aren’t thrilled, and promptly nosedive.
First the US, (or was it Japan?) then Europe, now China.
The story isn’t really new; mainland Chinese investors (versus the more overseas oriented Hong Kong index) have known trouble was brewing for over a year. Just look at any weekly chart of the Shanghai stock index.
SHANGHAI STOCK INDEX NOVEMBER 2012 – PRESENT
03 jan 27 1059
However, like those of the US and Europe, it takes time before it starts getting global attention.
Last week China reported continued declines in lending and money supply growth. This is part of an ongoing process as the central government tries to reduce debt levels without inflicting too much damage on growth and an economy too dependent on continued easy credit.
Part of this process involves reducing regional and municipal government debt, much of which is financed through private investment firms that sell wealth management products (WMPs) — which are securities comprised of a basket of other securities like trust products, bonds, stock funds that offer higher yields than bank deposits. Like the infamous CMO’s (collateralized mortgage obligations) that fueled the US subprime crisis and the Great Recession that followed, these are sold as low-risk investments when in fact this financial lunchmeat has riskier bits mixed in. How much? Which WMPs? Who knows?
So if even one or a few high profile WMPs default, guess what could happen to all the others, and anyone believed to have material exposure to loss from them?
Unfortunately, there is real risk of a wave of WMP defaults.
Bank of America’s David Cui reports that there might be a “wave of trust defaults” coming, and that the pace of these defaults “appears to be accelerating rapidly,” and he cites examples of coal or other mineral miners that at significant risk of default on their WMPs, worth a total of 1.6 billion yuan.
Ok, what’s 1.6 bln yuan here or there? No biggie, right?
No, but guess what would do for the confidence and market value of what he says are another 100 bln yuan in other mining related WMP due to mature this year? That’s just the mining related trust products.
The damage doesn’t end with those losses.
Unfortunately, untold numbers of local Chinese governments rely on these shadow bank sales of WMPs, for the financing that keeps them liquid.
The latest audit of Chinese government debt showed that local government debt is up to 17.9 trillion renminbi (about $2.8 trillion).
If the market for WMPs collapses, then Chinese local governments, banks, both shadow and official, and the businesses invested in them could all go down too.
Shadow banks offer loans to companies or individuals that may have trouble securing traditional bank financing. Often, the loans are then packaged and sold to investors looking for higher returns. There are no precise figures on how big the shadow banking sector is, but some estimates put its size at around 60% of China’s GDP.
Last Thursday Reuters reported that an official with the Industrial & Commercial Bank of China (ICBC) said the bank would not repay a 3 billion yuan ($495 million) trust product that is expected to mature on Jan. 31.
The ICBC isn’t some back-alley shadow bank. It’s China’s largest state-owned bank. It sold this WMP to raise funds for coal-miner Shanxi Zhenfu Energy Group. However as China’s economy slows and commodity prices fall, many miners are unable to repay the debt that funds the payments on that WMP.
It’s as if Bank of America announced it wouldn’t pay up on some debt it sold. How would you feel if you about the safety of your investments or the stability of your bank?
ICBC officials and the government are surely aware of the panic and collapse that could happen, so the first thought is that the Chinese banks or government ultimately offer to backstop these products to prevent panic, right?
However these are cash obligations that are NOT on the bank balance sheets. Who knows how much a given bank can backstop, or what is its exposure to these financial time bombs? Every bank is holding them, no one knows how much or which ones are problems. Surely their value, and thus bank balance sheets, will fall in value, but by how much?
In sum, there are all the ingredients for a systemic crisis. Even a small default can raise enough uncertainty to put an entire system at risk, so almost WMP becomes too big to fail.
Unless the Chinese government steps in like Bernanke did, ready to print unlimited yuan. Heck, isn’t China an export economy anyway? Cheaper yuan, more exports!
The Chinese can print their own money, so we expect they’ll prefer a lower yuan to economic collapse, just like the Fed, ECB (ex-Germany), Bank of Japan, etc.
Welcome to the rising risk of a new subprime crisis, Chinese style. Or will it just go straight to currency war? This potential crisis, given the Chinese economy’s size and importance, like so much else made in China, is ready for export.
A much cheaper yuan? Hmmm.
Good morning Vietnam (and Korea, Taiwan, etc.)! How does that affect the big Abenomics plan in Japan? Not well.
If the US was mad before about unfairly cheap Chinese exports, now what happens? China is one of if not THE biggest importer of US and European goods, so what happens if the yuan plunges?
That’s enough for now. This is usually where I try to slip in my plug for my book on the how and why of simple, safe ways to protect your portfolio from risks of currency debasement, at least once growth really returns. I’ll spare us both, given the stark realities of the above.
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DISCLOSURE /DISCLAIMER: THE ABOVE IS FOR INFORMATIONAL PURPOSES ONLY, RESPONSIBILITY FOR ALL TRADING OR INVESTING DECISIONS LIES SOLELY WITH THE READER.