A senior director from Fitch Ratings warned that the banking system in China is out of control and it could face a Japanese-style deflation due to massive problems such as lack of transparency and increase of systemic risk, according to a report from Ambrose Evans-Pritchard of The Telegraph.

China

Charlene Chu’s Observation

Charlene Chu, senior director of Fitch Ratings observed, “The credit-driven growth model is clearly falling apart. This could feed into a massive over-capacity problem, and potentially into a Japanese-style deflation.”

“There is no transparency in the shadow banking system, and systemic risk is rising. We have no idea who the borrowers are, who the lenders are, and what the quality of assets is, and this undermines signaling,” added Chu.

According to the report, concerns regarding China increased after a series of distress situations in various areas such as Qingdao, Ordos, and Jilin in trust products, a $.4 trillion segment of the country’s shadow banking system.

Chu cited that Fitch Ratings already observed defaults in trust products, which is a signal that China is starting to experience stress. She emphasized, “Typically stress starts in the periphery and moves to the core, and that is what we are already seeing with defaults in trust products.”  Ten days ago, Bank Everbrite defaulted an interbank loan amid the rising short-term borrowing rates at Shibor.

According to Chu, banks are able to circumvent loan curbs and avoid the initiatives of regulators to stop the overload because of the so-called “hidden balance sheet,” wealth products worth $2 trillion of lending. She cited that the segment is the center of the risk, and 50 percent of loans should be rolled over every three months and an additional 25 percent in less than 6 months, which is similar to what happened to Lehman Brothers Holdings Inc. (OTCMKTS:LEHMQ) and other banks on short-term liabilities.

Chu said banks were required to set aside more than $3 trillion in reserves at the Central bank, providing a “massive savings account that can be drawn down” in the event of crisis. However, the available funds may not be enough to prevent a problem due to the large scale of the lending boom. The credit in surged from $9 trillion to $23 trillion. “They have replicated the entire U.S. commercial banking system in five years,” said Chu.

China’s Credit Ratio to GDP

China’s credit ratio to GDP increased by 75 percentage points to 20 percentage points. The credit ratio to GDP is higher than 40 points surged that happened in the United States over five years that led to the subprime bubble in the country, or in Japan before the Nikkei bubble burst in 1990.

Chu stated that rapid increase in China’s credit ratio to GDP is “beyond anything we have ever seen before in a large economy. We don’t know how this will play out. The next six months will be crucial.”

Furthermore, according to Fitch Ratings, “There is no way they can grow out of their asset problems as they did in the past. We think this will be very different from the banking crisis in the late 1990s. With credit at 200 pc of GDP, the numerator is growing twice as fast as the denominator. You can’t grow out of that.”

Chinese Currency Ratings Downgraded

In April, Fitch Ratings downgraded China’s long-term currency rating to AA-. Back then, the agency still believes that the Chinese government is capable of handling any banking crisis.

On the other hand, We Yao of Societe Generale commented Chinese companies reached a debt service ratio of 30 percent of GDP, which is the common trigger for a financial crisis. He said that many will not be able to pay interest or repay the principal. According to her, China could face a “Minsky Moment,” when the debt pyramid collapses on its own weight. Yao said, “The debt snowball is getting bigger and bigger, without contributing to real activity.”

In a previous interview with Hugo Scott Gall of Goldman Sachs Group Inc (NYSE:GS), Stan Druckenmiller, chairman and CEO of Duquesne Family Office said that China’s problem is the growth in credit at a time when GDP is slowing. He believes that the country is experiencing the same situation that happened in the United States wherein credit growth outpaced economic growth.

Albert Edwards of SocGen praised Chu’s warning regarding China nearing the abyss.