Wednesday, January 29, 2014

Chinese banking pyramid scheme about to falter?

Image used with permission from Pixabay.
From China, the second largest economy in the world, comes mixed and often disturbing news. The latest macroeconomic figures indicate a declining growth of the world's largest trading nation. The growth GDP in 2013 was exactly the previously predicted 7.7 %, as in 2012. But this was 10 % the year before, so a much lower growth rate. Many analysts believe that growth in the coming year will slow down further to 7.4 %. This would be the lowest rate since 1990.

Unprecedented economic growth

China has seen unprecedented economic growth over the last thirty years. It has become a major exporter of many products such as electronics and clothing, as well as steel and plastic. Over the last 35 years, its economy grew about 9.7 % per year on average, though many think that this is unique in history, we all know this from the 60's era of the last century, when postwar "miracle economy" Japan had about the same growth rates. China's total debt rose from 130 % of GDP in 2008 to 200 % of GDP today. Most other countries almost always end up in a deep crisis when this happens.

However, the growth in China did not come without sacrifice. China is struggling with major domestic problems, both economically and socially. The environment is so heavily polluted that an estimated 2 percent of the arable land is too contaminated to grow anything, and then we’re not even talking about urban pollution.

Shadow Banking

But the biggest concern is China's rickety banking system, which Chinese capital providers have recognized since the outbreak of the global financial crisis. The amount of outstanding loans almost doubled. And even that was not enough for the huge demand for capital. As a result, it created an unofficial banking system: the so-called shadow banking system. In order to get money; capital is lent in foreign currency, converted into yuan and subsequently lent back to China again - of course - at significantly higher interest rates. The problem is that this is beyond the control of the Chinese government.

Due to this this vast shadow banking system there is little trust among Chinese banks, which regularly causes peak rates in the Chinese money market. The two co-existing systems, are connected to each other in a certain way. Over the final months of last year, the official rate also increased significantly on top of that. The risks taken in the shadowy system are unprecedented, and the Chinese government is slowly experimenting with more liberal interest rates to get the two systems closer together.

The People's Bank of China has to intervene regularly in order to keep interbank rates low. Last week, the central bank created an emergency fund of 255 billion yuan (US$42.7 billion) available for commercial banks and decreased the interest rate 88 basis points, to 5.4 %. This capital injection was to avert yet another potential banking crisis.

Consumer Driven Economy

Traders and investors fear that the Chinese economy can not evolve to a consumer driven economy in time. Prosperity has indeed increased in recent years, but this new-found wealth has ended up with a relatively small portion of the population. Chinese retail sales growth for December was positive with a growth of 13.6 %. In November, it even grew by 13.7 %. It looks like China’s economy is increasingly thriving on domestic demand rather than exports.

If the Communist Party maintains the high growth targets, even more money has to be pumped in the economy. Government projects will boost employment in the short term, but ghost towns and unused railroads contribute little or nothing to the economy. A more balanced growth, which is partly created by rising domestic demand, will ultimately reduce the risks. Then the highly anticipated consumer-driven economy can finally begin at a starting point. In March, the ruling party will release the official targets. Then investors can see what the government really intends to do with the excessive capital growth.

Important test

An important test of the Chinese banking system is this Friday, January 31st. Then a gigantic bankruptcy case will settle with coal miner Shanxi Zhenfu. Via a trust fund office, China Credit Trust, wealthy Chinese have invested almost US$ 500 million, and they won’t see back a dime. This is the first major Wealth Management Product (WMP) that collapses, and more are expected to follow. These WMP's form the ‘house the cards’ on which the credit of the shadow banking is based. Previously, the poor results of WMP were caught by newly issued WMP's, but this pyramid scheme is now starting to falter. It depends what is going to happen January 31st, but it could mean a huge run on banks by investors, to get their invested funds out, which in turn could lead to a collapse of the house of cards. For investors it's important to keep a close eye on this, as it could spark an economic ripple effect, which consequently could be felt around the world. 


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