Chinese Growth: An Unstable Financial System Upon Which a Shipping Recovery is Based
The shipping recovery that is currently be discussed and propounded by analysts, shipowners, private equity investors and bankers is based upon an unstable financial system in China. China’s financial system is under significant stress as a result of excess credit availability and debt held by its banks and corporate entities. Should the People’s Bank of China (“PBOC”), the central bank of China, not be able to engineer a soft-landing, the impact on global financial markets, let alone the shipping markets, will be significant.
China is straining to maintain its GDP growth rate. The GaveKal Research chart, China Quarterly GDP Growth, on a year-over-year basis, shows the economy has been slowing since 2007. It is clear that China has spent the last few years focused on managing aggregate demand and to-date the PBOC has been successful in cushioning the slowdown in trend GDP growth. The PBOC is aware that the benefits of removing the fat tail threat of some kind of investment bubble that would end in tears vastly outweighs the costs of slower Chinese growth over the next couple of years. However, the poor returns on State Owned Enterprises (“SOE”) investment and spiraling debt are warning signs that the economy’s growth potential is being undermined. High debt levels among SOEs and private corporate entities levels means there is little room for another government or SOE led stimulus.
The Telegraph reported that Bank of England Governor Mark Carney warned the global financial crisis is rotating from West to East, and particularly focused his comments on China, with its “Shadow Banking” excesses posing the biggest threat to the international economy. In addition to central government and local government debt, the “Shadow Bank” market in China has substantially expanded credit in lieu of cash being available. Chinese bankers are resorting to issue Banker Acceptance Notes (“BANs”), which are nothing more than a post-dated check with a bank guarantee. In a BAN transaction, for example, a bank receives Rmb 100 deposit in hard currency by an SEO or corporate entity and issues to the depositor Rmb 200 loan. Effectively, the SEO or corporate entity then purchases assets of Rmb 200 with the BAN, bank guaranteed paper. In effect, the bank has given its customer a 200 RMB loan without using a cent of cash and the economy has experienced a massive expansion of leverage.
In theory, BANs are issued to support trade and represent short-term transactional risk as they are backed by assets to be sold to third parties. However, most BANs are not used in this manner and merely circulate as a secondary currency. In effect, BANs represent a issuance of credit/debt that is substantially uncollateralized to high-risk industries. For the banks, this also represents an off-balance sheet financing scheme that is then rehypothecated through the Chinese financial system allowing other SEOs and corporate entities to executed transactions that are high-risk, non-trade oriented. Furthermore, “There is a risk of banks and Local Government Financing Vehicles (“LGFVs”) colluding to fake security deposits and print BANs with no underlying trade,” warns a Ministry of Finance. This type of financing allows local governments to effectively print money and bypass the PBOC. According to the PBOC, almost Rmb nine trillion of BANs are in circulation out of a total monetary base of Rmb 107 trillion [Source on BAN: thediplomat.com, China’s Shadow Currency].
We expect the PBOC will continue to carefully slow the trend of growth in the Chinese economy as it seeks to raise interest rates, impacting the BAN market and reducing the credit expansion of the “Shadow Banking” system. If the controls being instituted by the PBOC causes a financial failures that spread beyond what the central bank can control, the growth rates anticipated by analysts and others to propel a recovery in the shipping markets will be fantasy. At the very least, a further slowing of Chinese GDP growth rate is not what shipping analysts and others related to industry are banking.
The expansion of Chinese credit /debt needs to be addressed and reduced substantially. The challenge for PBOC is daunting. The risks are clearly evident.
Jay Goodgal can be reached via email at [email protected]
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