Another tumultuous year for ChinaThe unwinding of America’s mega-size and prolonged stimulus by scaling down monthly quantitative easing has dealt an immediate blow to the Chinese financial market. After the U.S. Federal Reserve announced plans to reduce its multibillion-dollar purchase of government and mortgage bonds by $10 billion starting in January, China’s money market rates went up to nearly 10 percent at the year’s end. It is the second spike in Chinese interest rates from the impact of the U.S. tapering news for the past year.
The seven-day repurchase rate - the gauge of funding costs among Chinese banks - jumped by more than double from their normal levels of 3 percent to 4 percent and briefly hit as high as 9.9 percent in the last weeks of December on a credit-squeeze scare that gripped the Chinese money markets in June. The People’s Bank of China interfered with open-market operations. But the volatility in the bond market again underscored the fragility of the Chinese financial system. The Chinese money markets are huge and dynamic, reflecting its staggering economic growth and colossal trade surplus, but why then all these concerns and talks about the credit crunch and bubble burst?
The centerpiece of a brewing credit crisis is a mismatch in liquidity. China’s total debt - including liabilities of companies and households that stood at 130 percent of its gross domestic product when the United States first went on quantitative easing to combat a financial meltdown five years ago - is estimated to have surged to 200 percent.
Debt by households, companies and local municipalities surged with the burgeoning shadow banking sector whose lending practices are unregulated by Chinese financial authorities and the central bank. This off-the-radar segment of Chinese finances is estimated to have accounted for about 35 percent of new loans at the end of last month. The Economist reported in June that shadow lending has reached 17.5 trillion yuan ($2.1 trillion) by the end of 2012.
Shadow lending is the fallout of China’s strict control on money markets. Traditional Chinese banks - mostly state-owned - put caps on lending rates at below 3 percent. The money mostly goes out to giant state-owned companies. But banks with ample money supplies cannot sit around watching so many money-making opportunities go wasted amid a real estate boom and a gluttonous investment appetite. So they spawned off-balance-sheet activities. Banks collaborated in creating trust companies, which are unrestricted in lending money directly to real estate developers and local governments and offer so-called high-return and high-risk wealth management products.
The off-balance-sheet debt went to finance private companies and local governments in their ambitious business and long-term pork-barrel projects. Liquidity risk is inevitable because of different durations of the WMPs and trust loans. The WMPs have a short duration of three months or less while trust loans to real estate developers and local governments often go as long as a few years. Banks find themselves in a liquidity squeeze due to a mismatch in maturity repayment until the central bank bails them out with emergency liquidity supplies. Bad debts are inevitable if property projects or business deals flop. A liquidity crisis is, therefore, brewing, and many believe that some midsize banks and trust companies would go under this year.
A mismatch in currency also poses a simmering problem. The loose liquidity unleashed from advanced economies during the easing cycle swarmed into emerging markets in the form of portfolio investment in securities and bonds instead of traditional financial loans. Of an estimated $5.9 trillion in hot money, more than 50 percent headed to China. According to the Financial Times, outstanding foreign-denominated debt issued by Chinese companies totaled $240 billion versus yuan-denominated debt at $50 billion at the end of 2013. Chinese companies could raise dollar-denominated debt at low interest rates of 4.5 percent to 5 percent in Hong Kong and convert them into local currency.
International trust management companies invest in these cheap foreign-denominated debt, and borrowers hold liabilities in local currency. Naturally, there is a mismatch in currency between debt issuer and borrower. The question is: Can Chinese corporate debt issuers cover the losses for their investors when they want to cash out during the tightening cycle? It could be another tumultuous year for China and other emerging debt markets. In other words, a new round of turmoil can sweep across international capital and the foreign exchange market. Authorities and investors alike should brace up for repercussions in the local market as well.
Translation by the Korea JoongAng Daily staff.
*The author is a visiting professor at KAIST College of Business. He previously served as chairman of the board at the Korea Exchange and president of Daewoo Shipbuilding and Maritime Engineering.
By Hong In-kie