China’s economy is still booming. Despite it’s worst growth in over a decade, the country’s economy expanded by 7.9% in 2012, and is expected to grow by a similar margin in 2013.

Despite some investor concerns, trust in the nation’s brand of Directed Capitalism and steady growth have made it a popular target for investors and companies looking to expand into new markets.

However, there may be trouble brewing in East Asia. If China undergoes a serious financial meltdown, the entire globe could enter into a second period of deep recession; According to some analysts another deep recession could  eliminate the gains made in the last five years. Where exactly could such a catastrophe come from and is there anything that can be done about it?

GMO LLC  recently created a A new white paper examining the country’s financial system and identifying its weaker points; the conclusions are worrying. One of the central points of the paper’s thesis is that our methods for predicting a bubble may be wrong and we may have learned the wrong lessons from the 2008 crisis. China may be on the very edge of collapse.

China Credit Bubble
China Credit Bubble

The paper, authored by Edward Chancellor and Michael Monnelly, draws parallels between China’s current position and U.S.’s financial position before the 2008 crisis; it also points out particular weaknesses in the country’s banking system. As can be seen from the chart above, the pattern across financial crises and their similarity to China’s current state, is chilling.

First off, it’s important to dispel some myths. China’s credit system is often considered safe because it is funded by domestic savings, rather than external funds and the country’s debt burden is relatively small by Western standards. The report, leaning on evidence from Japan in the 1980s, asserts that these two indicators are not significant enough to downplay the chances of a financial crisis.

Japan’s debt level before it’s crisis was similar to China’s, as can be seen from the chart. Japan’s banking  system was also funded by domestic debt. If the argument that China is not vulnerable to financial crisis relies on indicators that led to crisis in Japan twenty five years ago, it is surely  worth reexamining, if not discounting entirely.

In addition, it is wrong to compare debt levels in an emerging economy to those of a developed economy, contends the report. China is heavily indebted relative to the other countries designated as emerging economies. The chart below offers a graphical comparison.

The trend line may be a poor fit, but the ratios remain important. Mexico, Poland, Brazil, India and Russia have ratios well below China’s current level, and Japan’s 1988 ratio is more similar to China’s contemporary situation than many analysts would be happy to admit.

The numbers don’t give enough impetus to suggest a coming apocalypse, but they can help demonstrate the potential. There is a convincing thesis to go along with those numbers presented in the White paper. China’s financial system is weak, and there is every reason to expect it to show signs of stress going forward.

The value of unfinished housing stock in China has been estimated at 20%, and property, as collateral, secures much of the country’s debt. Though the reported value of property exposure in the Chinese banking system is just 22%, there is a great deal of property exposure hidden in the credit held by local government agencies.

Those agencies, funding vehicles directed from Beijing, are receiving loans from a banking system also directed by Beijing. Directed Capitalism may seem stable but this dynamic is unsustainable. Corruption is endemic to any system with such an incestuous design, local government funding vehicles accounted for 15-15% of credit in the Chinese banking system.

While the regulated state banking system has settled into a feedback loop, a second “shadow” banking system has emerged, making the situation much more complex and much more dangerous. This, asserts the white paper, marks a de facto liberalization of the banking system. The second banking system accounted for 60% of new lending in the fourth quarter of 2012.

These loans represent an unstable, and largely unaccounted for, mass of debt in unusual wealth management vehicles resembling the infamous CDOs that led to the 2008 crisis. A secondary, unregulated, banking system is not a good in general; in an economy lauded for its control of capital, it might be downright disastrous.

The difficulty of following the flows of capital in China make the system all the more threatening to the developed world. One of the more startling speculations in the white paper contends that a significant portion of the secondary banking system’s issuance may be financing property developers. That possibility is terrifying to any with knowledge of how bubbles work, or how the 2008 financial crisis arose.

When China’s economy began to wobble at the beginning of 2012, many members of the country’s establishment demanded a stimulus. That request was denied, but the Local Government Funding Vehicles were given a significant licenses. The controls on bond issuance were relaxed. The country’s corporate bond issuance jumped 64% between 2011 and 2012.

Many of these bonds are not being bought by banks, as had been the case in years gone by. Instead they were sold into wealth management funds and the like in the secondary banking system. The money from bond sales was then used, some research found, to pay off old bank debt instead of investing in infrastructure.

Wealth management products in China offer higher yields than bank deposits and are sold to retail investors as low risk, high performance assets. The entirety of the risk is placed on the investor, returns are expected, not guaranteed and investors are expected to take a loss if the assets do not perform. Chinese investors, according to the report, do not understand these risks, expecting the government and the banking system to cover them if there is a crash.

In simple terms, China’s wealthy are investing in Wealth Management Products, WMPs, that invest at least some of their capital in corporate bonds from the Local Government Funding Vehicle, LGFV sector, and some of it in the property sector. The LGFVs use the funds raised in bond sales to invest in infrastructure, and property, or in the worst of cases, pay back loans to banks.

The country’s regulated, state run banking system is making loans to the LGFVs, using property as collateral. As long as the property values continues to rise, and they are able to continue issuing bonds, this system will continue to produce excellent economic returns, and ultimately lead to a utopian ideal.

However, there is a chance that property values may not continue to grow forever, and in China it is possible that bond issuance will be arbitrarily caped. This means the interest would not be paid, and WMPs would not be able to deliver returns to their customers.

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