In my view it is all about property prices. This is a bubble by any name and the reasons for the bubble would take many a blog post but I am convinced that this bubble is there and it is large. The other problem is "bad loans". There are a lot of them, a real lot of them.
This very recent Wall Street Journal article saves me the time of writing up my worries.
It is impressive that Fitch Ratings have shown some balls to make this call.
A 60% chance of a banking crisis by 2013 seems pretty darn high to me actually (and fairly accurate. It is therefore important to understand exactly what the implications would be.
Fitch’s Bold Call on China Banking-System Risk [WSJ]
Fitch Ratings has developed a strong record on China’s banking sector in recent years, thanks largely to the perspicacious analysis of its lead banks analyst in Beijing, Charlene Chu. She was one of the first observers, back in 2009, to flag how Chinese banks were moving loans off their balance sheets to lightly regulated trust companies to avoid government lending caps. This past December, she and her colleagues published a report estimating that China’s banks had used trusts and other tools to blow past the government’s 7.5 trillion yuan ($1.14 trillion) quota for new yuan loans 2010 to the tune of an additional three trillion yuan not recorded on their balance sheets.
Last month, the People’s Bank of China effectively validated Ms. Chu’s analysis, saying that its longstanding measure of new bank lending failed to capture actual credit flows, and that the banks were responsible for creating around 11.5 trillion yuan of new credit last year.
So it turned a few heads Tuesday when an analyst elsewhere at Fitch was quoted saying that China has a 60% probability of experiencing a banking crisis by 2013. Ms. Chu’s analysis had pointed to significant flaws in China’s banking system, but this call put Fitch out there toward the Jim Chanos end of China Cassandra spectrum.
The analyst, Richard Fox, a London-based senior director at Fitch, told Bloomberg News that Fitch sees risks of “holes in bank balance sheets” should a property bubble burst.
The jarring assessment was based on the Macro-Prudential Risk Monitor, a sort of analytical tripwire system that Fitch developed in 2005 to flag potential bank crises. Using a formula based on credit-growth rates and asset-price increases, Fitch places national banking systems in three categories based on their “Macro-Prudential Indicator” scores, with MPI 1 being the least risky and MPI 3 the most.
As noted by Bloomberg, which said it interviewed Mr. Fox by phone on March 4, Fitch actually assigned China to the MPI 3 category back in June. But the move went largely unnoticed.
According to Fitch, an emerging-market economy like China has a 60% chance of experiencing a banking crisis within three years of being designated MPI 3. Thus it would follow there’s a better-than-even chance that D-Day will dawn for Beijing sometime before mid-2013.
Fitch bases that assertion on surveying almost 40 past banking crises. It says that a combination of abnormally fast growth in credit, assets prices, and the real effective exchange rate is a solid predictor of ill fortune for countries’ financial sectors.
Some countries enter MPI 3 and are removed without undergoing banking crises, among them, in the last three years, are Brazil, France, Denmark and New Zealand. On the other hand, according to Bloomberg’s interview MPI 3 correctly sounded the alarm for countries including Ireland and Iceland.
“We look at indicators and conditions which have preceded past crises,” Mr. Fox said in an email exchange with The Wall Street Journal on Tuesday. “MPI 3 shows these are present in China. Past evidence suggests there is therefore a 60% chance of a crisis in three years.”
If China does indeed fall into a banking crisis in the next 28 months, Fitch’s prediction will be lauded for its prescience—though it would also be grim news for the world economy. It’s safe to say that few experts in China who follow the banking system closely think there is a probability of a crisis in such a short period of time—including those who agree that China’s lending binge since 2009 has inevitably created a mountain of new bad loans that will someday have to be reckoned with.
News of the Fitch assessment apparently infuriated Ting Lu, China economist for Bank of America-Merrill Lynch, who blasted the 60% assessment in a note Wednesday. “Being cautious is one thing, exaggerating risks is quite another,” he wrote.
A Fitch spokesman declined to comment on the remark.
Certainly China’s loan growth is worrisome. The volume of outstanding yuan loans in the banking system has jumped by more than half in just the past two years. It’s almost impossible to imagine such a flood of credit being issued without sizeable mistakes. Indeed, regulators are clearly aware of the problems and have already been working to ensure that the banks hold sufficient collateral for loans made to infrastructure investment platforms backed by local governments, a group of borrowers deemed most worrisome.
Still, it could be a stretch to put a numerical probability on something as uncertain as the timing of a financial crisis in China, especially if it’s based on a one-size-fits-all model applied to diverse economies across the globe.
The Fitch model says four conditions have to align before it’s time to sound the alarm. Real private-sector credit growth must exceed 15% a year, sustained over two years. Property prices need to grow more than 5% a year and the real effective exchange rate (that’s a measure of the currency on a trade-weighted basis, adjusted for the effects of inflation) must appreciate by more than 4% a year over the same two-year period. And finally, equity prices need to gain more than 17% a year over the preceding two year period. China has fulfilled the credit and property-price conditions for most of the decade, but a stock market bubble in 2006-2007 and strong yuan appreciation pushed it over in 2008.
China’s government is far from omnipotent, but it does have significant ability to mitigate or delay a crisis—not least because the state is ultimately the owner of both the banks and most of the big borrowers they lend to. And given that the once-a-decade transition in China’s leadership, which begins in the autumn of next year and runs through early 2013, there will be a serious political imperative to paper over problems in the economy. It could be a while yet before the big cracks start showing in the banking system.
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