Last April, I warned that China is about to suffer the mother of all banking crises, caused by wildly aggressive expansion of bank lending. Now that vicious inflation has forced the communist authorities to slam the brakes on the economy, short term interest rates in China vaulted to 25% and the People’s Bank of China had to bail out one the nation’s banks.
Fear that China may be on the verge of a crisis similar to the collapse of Lehman Brothers in September 2008 caused panic across the globe, sending the value of every stock, bond, and commodity market on earth plunging. But after 5 years of risky lending practices, China seems doomed to suffer a grim period of economic payback.
From a distance, China’s economy seemed to be the poster child of sustainable growth. Government reports showed consistent 9% expansion, double digit retail sales growth, $3 trillion in foreign reserves, and inflation less than 5%. But these statistics masked a dark side as the government instructed banks to finance state-owned enterprises to sell at subsidized producer and consumer prices. Over the last two years, artificial subsidies restricted increases in retail food prices by 24% and retail gasoline prices by 20%.
The real secret-sauce of the “China Economic Miracle” is that although there are 3,800 banks in China, the country’s four largest state-owned banks (Industrial and Commercial Bank, Agricultural Bank, People’s Bank of China and Construction) control two thirds of all bank deposits and loans. Since the Chinese government does not provide adequate social welfare programs and restricts its citizens’ investment options to bank accounts, about 40% of Chinese household income is deposited in these four state-owned banks each month.
The banks then leverage the deposits by 45 times and lend 75% to state-owned enterprises and 25% to real estate development at extremely low interest rates. Although China generated huge exports as the “world’s largest manufacturer” and built impressive infrastructure, the growth is one giant Ponzi scheme where companies are highly leveraged and sell their products below their costs.
As Lee Adler at the Wall Street Examiner artfully pointed out, China “has been undergoing a massive liquidity crunch in recent days as the central bank there maintains a tight monetary policy that has drained reserves from the system this year” to try “to cool massive speculative bubbles.” He points out that the People’s Bank of China injected $240 billion into the banking system in 2012 and then drained only $33 billion so far this year. But with banking leverage of 45 times, China state-owned banks would need to shrink their lending by $1.5 trillion, or 25% of the nation’s annual GDP.
Lee advises that with Chinese companies and banks highly leveraged and desperate for cash, they are selling their foreign stock, bond, and commodity assets to raise cash to meet bank margin calls at home. He warns this selling may send asset prices crashing around the world, triggering more margin calls and sending prices spiraling even lower.
On June 19, Chairman Ben Bernanke surprised analysts when he indicated that the U.S. Federal Reserve may “taper” its efforts to stimulate the American economy through $85 billion in bond purchases each month. With U.S. inflation low and unemployment still over 7%, most analysts were surprised that Bernanke would chose to slow credit expansion. But his real motive is to prevent the U.S. dollar from strengthening if the Chinese currency weakens from an extended liquidity crisis. A stronger U.S. dollar would devastate American competitiveness and cause significant job losses.
In April, Fitch Ratings for the first time since 1999 downgraded China’s credit rating from AA- to A+ as their debt had ballooned to 200% of GDP. Two weeks ago, China’s Everbright Bank defaulted on a $940 million inter-bank loan due to tight liquidity conditions. Charlene Chu, Senior Director at Fitch Ratings commented: “We have not seen increases of credit to GDP of this magnitude in a large country, in a short amount of time, since data has been kept.”
“So usually when we see expansions of this magnitude, it does lead to banking sector problems at some point,” she said.
China achieved spectacular economic growth by exponentially spiking risky bank lending, while shielding their citizens from inflationary price increases through subsidies, paid for with more bank lending. As government tried to shrink lending, it should not be surprising for stocks to crash, real estate bubbles to burst, banks to default, and interest rates to surge. As the people suffer, the flames of social protest may soon ignite.