China’s credit problem is rooted in its very rapid growth over the last six years in the shadow-banking sector, shorthand for a mélange of lightly regulated special-purpose financing vehicles, wealth management products and trusts. These products have given local governments and small companies that lack access to institutional credit a way to borrow substantial sums of money. And they have done so: Credit Suisse’s Head of Non Japan Asia Research Dong Tao noted in a report this month entitled “Embracing Higher Risks” that “shadow banking counts for more than 40 percent of total lending and is the key credit channel for marginal lending.” Last year, Tao estimated the size of non-bank debt financing in China to be 22.8 trillion yuan ($3.7 trillion) – equivalent to 44 percent of China’s GDP.
After years of pretty much zero defaults, problems are emerging. A 3 billion yuan ($480 million) loan originated by the China Credit Trust Co. for a coal mining company narrowly escaped default in January when an unknown third party took over the debt. Investors recouped their principal, but had to forfeit the final interest payment. In late February, Shanghai Chaori Solar Energy Science & Technology Co. became the first Chinese company to default on corporate bonds onshore. And they are unlikely be the last: Credit Suisse’s Tao told investors on a conference call earlier this month that markets could be seeing a dozen defaults a week come summer.
Credit Suisse does not believe these anticipated failures pose a systemic threat to either the Chinese or global financial systems. But the bank’s fixed-income strategists cautioned in a note this month called “To Blink Or Not To Blink” that liquidity could decline significantly if private investors begin to shun the wealth management products that provide the lion’s share of funding for the corporate bonds and trusts that accounted for 21 percent of new credit issued in 2013. And that, in turn, would pose a significant threat to economic growth.
As with many things China-related, it is not exactly clear what the country’s leaders intend to do about the debt problem, if anything. The People’s Bank of China clearly wants the economy to deleverage, Tao says, having twice issued repurchase agreements this year to drain liquidity from financial markets. The Chinese authorities have also been trying to shift the economy from near-total dependence on exporting goods and building infrastructure – a model that requires gobs of credit – to a heavier reliance on domestic demand.
Officials set on deleveraging are not likely to be particularly keen to step in if local governments that used shadow banking products to raise money for infrastructure projects—many of which were not economically viable in the first place—are unable to pay their bills. Local government debt now stands at 10.9 trillion yuan ($1.76 trillion), 3.5 trillion yuan ($560 billion) of which is maturing in the second half of 2014. Credit Suisse’s Tao sees higher-than-usual risks in a particular 2.3 trillion yuan ($370 billion) batch of trusts created in 2012 that is maturing in the second half, and he noted on the investor call that “the prevailing sentiment in the central government is that local governments need to be taught a lesson.”