Charlene Chu is a Senior Director in the Financial Institutions Group at Fitch Ratings, based in Beijing. She oversees the credit ratings of Chinese banks and other financial institutions. Before joining Fitch, Ms. Chu was a Senior Analyst in the emerging markets group at the Federal Reserve Bank of New York. Below she shares her concerns about China’s rapid credit growth.
Charlene Chu who was called a hero by SocGen analyst, Albert Edwards, was recently interviewed by Allison Nathan of Goldman Sachs.
Below is a transcript of the interview with Charlene Chu.
H/T Alex Frangos of WSJ (and related article: Charlene Chu Is the ‘Rock Star’ of Chinese Debt Analysis)
The views stated herein are those of the interviewee and do not necessarily reflect those of Goldman Sachs.
Allison Nathan: How large has the recent credit expansion in China been and how worrisome is it?
Charlene Chu: Most people who look at China are aware that there has been a credit boom underway since 2008, but it’s been going on for so long that people often forget the scale, which is important because the numbers are really off the charts, beyond anything we’ve seen for such a large economy. Our measure of credit-to-GDP showed that we were at close to 200% at the end of 2012. That’s up over 70 percentage points in four years, from the end of 2008. You don’t
see increases in that ratio of that magnitude in such a short amount of time without there usually being some sort of asset-quality problem in the financial sector.
If you look at what happened in the UK or the US from 2002 to 2007 or at Japan in the late ‘80s or South Korea prior to their crisis in the ‘90s, the increases in their ratios were all roughly 40 to 50 percentage points. So the sharp
and rapid increase in the ratio in China, which continues to climb this year, is sending a very cautionary signal. I think people also forget the scale in nominal terms. From the end of 2008 until the end of 2013, banking sector assets will have increased about $14 trillion. That’s the size of the entire US commercial banking sector.
So in a span of five years China will have replicated the whole US banking system. What we’re seeing in China is one of the largest monetary stimuli on record. People are focused on QE in the US, but given the scale of credit growth in China I believe that any cutback could be just as significant as US tapering, if not more.
Allison Nathan: How vulnerable is China to a banking crisis?
Charlene Chu: When you look at crises elsewhere, a lot of the same precursors are present in China. I just highlighted one, in terms of a large run-up in credit that is not matched in GDP growth. Others include a very aggressive expansion of shadow credit, massive investment in property leading to a bubble in some locations, weak risk management at banks, and heavily state directed
financial and corporate sectors.
Another very important issue in China that isn’t cited often enough is moral hazard. There is tremendous confidence in the ability and the willingness of the Chinese Communist Party to bail everyone out. But as the system gets bigger and bigger, there are more questions about how feasible that is. On top of all of these financial system issues, China’s growth model is peaking out. A few years ago nominal GDP growth in China was in the mid-teens. In that type of environment, problems can easily get papered over. It’s only when growth slows that the challenges really start to surface. That’s essentially where we are in China right now. In Fitch’s view, all of this does make the country much more susceptible to a crisis.
Allison Nathan: Are there any differences between China today and crisis-stricken countries in the past that make China less vulnerable to a crisis?
Charlene Chu: A crisis is certainly not pre-ordained. China has some unique features that mitigate some of these risks and contribute to a more stable environment than in other emerging markets. Specifically, China’s financial sector is funded primarily by domestic deposits, so there isn’t that reliance on overseas or FX funding that exists in Eastern Europe or was present in some of the Asian countries in the ‘90s. China also has a closed capital account, which means that savings are captive in the domestic financial sector.
In addition, we have a system dominated by state owned banks lending to state-owned companies. In that climate, everyone is part of one big family, so there’s more tolerance for non-payment, forbearance, etc. The Chinese government also is very active behind the scenes – both at the local and central levels – whenever small fires appear to prevent them from spreading, for example, a guarantee company blowing up or a trust product defaulting. In the end, all of this contributes to a more stable financial environment. That’s the advantage. The disadvantage is it allows this unhealthy, imbalanced dynamic to go on longer and further than it would in other countries.
Allison Nathan: Could there be a crisis in 2013?
Charlene Chu: These things are difficult to predict and even more so in China. Even though we have features that contribute to greater stability, the underlying characteristics that have preceded other crises are present. On a day-to-day operational basis, we’ve got a growing amount of questionable transactions taking place within shadow banking, in terms of both non-bank credit extension as well as bank issuance of wealth management products (WMPs; essentially, the informal securitization of bank assets into a second balance sheet).
In Fitch’s view, there’s absolutely the potential for a surprise from these areas because we don’t have enough visibility and the numbers aren’t small – about 50% of all new credit extended in China in 1H13 came through non-loan channels.
Allison Nathan: What role does shadow banking play and how risky is it?
Charlene Chu: Shadow finance is very risky in our view. There are only two real upsides to shadow finance in China – providing access to credit to small- and medium-sized enterprises (SMEs) that have a difficult time getting bank loans, and offering savers a higher real savings rate that, in turn, will hopefully lead to more consumption and greater rebalancing of the economy over the long term.
But beyond these two advantages, this is quite risky business. That’s because we have very little information about who the lenders and borrowers are, what the quality of the assets is, or what’s being transferred by banks onto their second balance sheets. When it comes to non-bank credit extension, the players are usually quite small institutions with unsophisticated risk management. Many of their credit decisions are relationship-driven, and there’s often heavy political influence in that process.
You can see how you could quickly start to have widespread misallocation of capital through that channel. On top of these concerns, the proliferation of shadow banking is leading to more decentralization of the financial sector. If you go back a decade ago, 80 to 90% of all intermediation was taking place through the banks. The government had very open and direct lines of communication with those banks and, when they made a policy decision, the banks would fall into line pretty quickly. Now, you’ve got tens of thousands of guarantee, leasing, and finance companies, as well as countless informal financial institutions that don’t really report to anyone.
This is undermining the effectiveness of China’s traditional monetary policy tools. Also, a very critical, but often
overlooked, risk from shadow finance is how it is undermining the accuracy of the data that everyone looks at to assess the health of the financial sector. As shadow banking gets bigger, we have more and more activity taking place in this black box where nobody really knows what’s going on.
This is starting to lead to a significant divergence between the picture that’s portrayed in bank financials/ macro indicators and reality. How much signaling value does a 1% NPL ratio have when more than one-third of all credit now resides outside banks’ loan portfolios? This creates a lot of potential for policy missteps and misjudgments by investors and analysts.
Allison Nathan: Would trouble in the shadow banking sector necessarily negatively impact the formal banking sector?
Charlene Chu: There is a misconception in the market that the banking sector and the non-bank sector are separate, and therefore that banks are insulated from what happens in the nonbank sector.
In reality, banks tend to be involved in about 75% of all of non-loan credit extension. So there’s no way that a major problem in shadow credit wouldn’t have a very significant impact on the banking sector itself.
Allison Nathan: What actions, if any, are authorities taking to get a better handle on shadow banking?
Charlene Chu: There have been a number of new rules and regulations this year aimed at addressing the rapid growth in
shadow credit. We’ve seen these measures begin to take a toll on the amount of credit being extended. But it’s still too early to tell if that’s just temporary because banks and borrowers have generally been very creative in finding ways around these kinds of rules. If the authorities truly want to rein in shadow credit, there will likely be a significant hit to overall credit 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?
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.
