Charlene Chu Interview with Goldman on China’s Credit Bubble

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growth, and, ultimately, economic growth.

So the real question is not, “what are the authorities doing about shadow finance?” But rather, “what is their appetite to take the pain that will come with cracking down on it?” That’s the real unknown. We can see that they are
aware of the issues and have a willingness to do something about it, but we don’t know what their threshold for pain is.

Allison Nathan: Has the recent volatility in interbank rates been related to the government crackdown on shadow credit?

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Charlene Chu: Yes. There is always seasonal tightness in liquidity in June. But this year, rather than inject liquidity to keep interest rates steady, the central bank chose to hold back. That decision was partly aimed at reining in shadow finance by constraining the liquidity available to fund new credit. It was the ambiguity surrounding this change in central bank behavior that created so much uncertainty and drove interest rates up.

In the past, the PBOC could always be relied upon to inject enough liquidity to maintain financial stability, but suddenly they seemed to have a new, competing policy objective – cracking down on shadow finance. It really caught people off guard, and there was uncertainty as to how far they were willing to go.

The events of June highlight just how tight liquidity has become in the Chinese banking sector. Before the global financial crisis, liquidity among Chinese banks was abnormally strong. You had a banking system that was funded almost entirely by domestic deposits that were abnormally sticky because there was nowhere else for depositors to invest their money, while the fixed deposit-rate regime meant depositors gained nothing from moving their money from one bank to another. That created an environment where banks essentially had no liabilities.

In that kind of climate, it doesn’t matter what your asset quality is because you never really face any cash payout obligations, so you can carry a 40% NPL ratio for years and it doesn’t matter. That was one of the secrets to stability in China through past asset-quality problems.

However, since the global crisis, the liquidity position of Chinese banks has deteriorated as large amounts of liquid assets were deployed into credit, and as deposit growth has slowed in tandem with GDP growth and the narrowing trade surplus. Depositors also are becoming more mobile as new investment options open up. The result is that banks have growing amounts of liabilities to meet, but a dwindling amount of liquid, cash-generating assets to draw on. Banks have increasingly filled this gap by borrowing from the interbank market. But when that market shut down in June, rates spiked and smaller banks found themselves in very stretched positions. Deterioration in bank liquidity has been one of the most significant developments in the Chinese financial sector in decades, almost as significant as the current credit boom itself.

Allison Nathan: Do you agree with the PBOC’s actions here?

Charlene Chu: Given the lack of success with the rules and regulations-based approach, using interbank liquidity is more effective because it immediately reduces the funding available for all types of new credit, including shadow credit. But this tool is blunt and can have immediate, dramatic effects, which I think the authorities underestimated. There was also some misjudgment as to how tight liquidity already was.

Allison Nathan: Is there any near-term risk to further changes in Fitch’s sovereign or bank ratings for China?

Charlene Chu: Following our sovereign local currency downgrade in April, we left the outlooks on the local and foreign currency ratings of the sovereign on stable for the coming rating horizon, which is essentially one year. We felt we had seen enough deterioration to warrant a downgrade, but that the situation was unlikely to get really out of control over the coming year since the authorities have a fair amount of firepower to deal with short-term problems.

On the bank side, in February we downgraded three banks’ viability ratings, which are the intrinsic financial strength
ratings of the banks, independent of any state support. There is continuing downward pressure on the viability ratings of Chinese banks, in particular the mid- and lower-tier banks, which have been growing more aggressively, have large off-balance-sheet exposures, and have much thinner liquidity. So, yes, there could be more negative rating action on the bank side over the coming year.

Allison Nathan: What would make you more positive?

Charlene Chu: Until we can get out of this destructive dynamic where credit to GDP is already 200% and the numerator is growing twice as fast as the denominator, it’s very hard to get more positive on China. That means that at the top of my list is stabilization in the credit-to-GDP ratio. In my view, what we have in China is really a growth problem that is manifesting itself in financial sector issues.

Since 2008, the financial sector essentially has been stepping in to hand out a bunch of credit to paper over a structural decline in external demand and to inflate domestic demand for infrastructure and property. China must to get to a point where it can get back on a healthy growth path that is not dependent on massive amounts of credit every year. Absent this, everything else is secondary, including policies to improve the soundness of shadow finance or financial sector liberalization.