China has passed many reforms aimed at easing capital controls. But these are being rolled out slowly. A meager deposit interest rate has forced people to turn to wealth management products and other risky investments. And the recent credit crunch forced many into the unregulated shadow banking system.
China has created too much credit too quickly - The last big surge of credit came in 2009 when China unleashed 4 trillion yuan to help spur economic growth and employment. "Since that date, China’s economy has become a credit junkie, requiring increasing amounts of debt to generate the same unit of growth. Between 2007 and 2012, the ratio of credit to GDP climbed to more than 190%, an increase of 60 percentage points." In 2012, new credit to the non-financial sector totaled 15.5 trillion, that's equivalent to 33 percent of 2011 GDP.
China also has significantly more debt than its emerging market peers.
A lot of debt is sustained by real estate which is offered as collateral, and credit booms end when property bubbles burst. - A lot of China's debt is supported by real estate which is put up as collateral for the loans. Banks' official exposure to property is listed as 22 percent of the loan book. But that doesn't account for exposure to real estate through their loans to local government financing vehicles (LGFVs) and off-balance sheet credit instruments.
Moral hazard is a major issue in China's banks b ecause of heavy state controls.- Moral hazard is a real issue in China, since the state controls not just the biggest banks but also the recipients of credit, the state owned enterprises (SOEs). "These arrangements have encouraged crony lending practices and the concealment of non-performing loans." Moreover, since local governments can't borrow directly from banks for their own use, they have had to create local government financing vehicles (LGFVs). These LGFVs account for between 15 - 25 percent of outstanding loans and often offer land, marked above market value, as collateral. Other guarantees are also questionable since they depend on land sales which could leave local governments shy when real estate prices fall.
There has been a surge in shadow banking. - Shadow banking, which involves lending that is kept off the balance sheets has surged, in particular, the wealth management products. In Q4 2012, non-bank lending accounted for 60 percent of new credit. China's shadow banking system is reminiscent of what we witnessed in America before Lehman's fall. "Trust loans that finance cash-strapped property developers have a whiff of the subprime about them; wealth management products that bundle together a miscellany of loans, enabling the banks to generate fees while keeping loans off balance sheet, bear a passing resemblance to the structured investment vehicles and collateralized debt obligations of yesteryear; while thinly capitalized providers of credit guarantees are reminiscent of past sellers of credit default insurance.
Banks refused to lend to local government financing vehicles, so local governments turned to the corporate bond market.
Wealth management products (WMP) - An increasing number of bonds are being packaged and sold to banks' clients through risky wealth management products (WMP).
Because of higher returns people are also flocking to risk real estate trusts.
These trust products are the Chinese equivalent of subprime mortgage-backed securities. Chinese savers that are chasing yields and LGFV's are the dominant borrowers from trust companies. The Chinese trust industry has more than doubled in the past two years to about 6 trillion yuan by the end of September 2012. Trust operators are "highly leveraged" and because these trust products are low quality and have broad exposure to real estate, they are seen as the Chinese equivalent of subprime mortgage-backed securities (MBS).
WMPs have been the most popular investment for Chinese savers
Some argue that WMPs are ponzi schemes
The WMP's asset and liabilities have differing maturities (i.e. duration mismatch) which makes them much more risky.
China has an extensive credit guarantee system, but many of these are "thinly capitalized and poorly regulated".
Collateralized lending is extremely popular - Since Chinese banks aren't allowed to charge for risk, banks ask for collateral. More than 40 percent of all bank loans are collateralized. In China, commodities like steel and copper that were part of the residential housing bubble were often used as collateral. What's more? Often the steel or copper offered as collateral doesn't actually exist.
The banking sector is also vulnerable to capital flight.- Because of its trade surplus and capital inflows in the last decade China has had to print new yuan for every dollar entering the country and control the value of its currency. Naturally, capital inflows have seen a rise in lending and have helped fuel a credit boom. Moreover, the wealthiest Chinese control the equivalent of two-thirds of the country's foreign exchange reserves, and they have ample reason to move their money out of the country. "If the wealthiest Chinese were to move a significant portion of their money offshore, liquidity in the banking system would be drained.
China's credit expansion relative to GDP is much larger than the credit booms experienced by the U.S. ahead of the financial crisis and Japan in the late 1980s.
6 - China Hard Landing
BANKING CONSOLIDATION - Assets versus Derivative Liabilities
As of this morning Tim Geithner is no longer Treasury Secretary. And while Tim Geithner's reign of clueless pandering to the banks has left the US will absolutely disastrous consequences, an outcome that will become clear in time, the most ruinous of his policies is making the banks which were too big to fail to begin with, so big they can neither fail nor be sued, as the recent fiasco surrounding the exit of Assistant attorney general Lanny Breuer showed. Just how big are these banks? Dallas Fed's Disk Fisher explains.
It is important to have an accurate view of the landscape of banking today in order to understand the impact of this proposal.
As of third quarter 2012, there were approximately 5,600 commercial banking organizations in the U.S. The bulk of these—roughly 5,500—were community banks with assets of less than $10 billion. These community-focused organizations accounted for 98.6 percent of all banks but only 12 percent of total industry assets. Another group numbering nearly 70 banking organizations—with assets of between $10 billion and $250 billion—accounted for 1.2 percent of banks, while controlling 19 percent of industry assets. The remaining group, the megabanks—with assets of between $250 billion and $2.3 trillion—was made up of a mere 12 institutions. These dozen behemoths accounted for roughly 0.2 percent of all banks, but they held 69 percent of industry assets.
What does this mean numerically?
As the most recent weekly H.8 statement shows, there was $11.25 trillion in total assets at domestically chartered commercial banks. Which means that just 12 banks now control some $7.76 trillion.
And that is Tim Geithner's true legacy: the "0.2%" now control 69% of everything.
But wait, this is just the asset side. What about the liabilities that these assets support, and especially the over the counter derivative side?
Well, according to the latest Q3 OCC report, the total amount of derivative exposure at just the Top 4 banks is now some $212 trillion, or 93.2% of the total $227 trillion in outstanding US derivatives.
To summarize: the top 12 banks control 69% of all financial assets, some $7.8 trillion yet just the top 4 are responsible for 93.2% of all derivative exposure.
A job well done, Mr Geithner.
And now, can you please head the Federal Reserve when Bernanke retires in one year to finish your job of completely dismantling these here United States and destroying the country's middle class?
As we recently noted, the US Macro picture is considerably less sanguine than every talking head would have you believe. Not only are earnings for Q4 coming in notably weak, but the top-down macro picture is its worst in almost five months - and turned negative this week. Of course, the fact that our 'market' is dislocated from any sense of reality will come as no surprise to anyone; but, the chart below provides some, perhaps useful, insight into how to trade this disconnect (and its inevitable convergence). To add a little more impetus to this decision, the past two weeks have seen the US macro picture drop at its fastest rate since June 2011 - right before the last debt-ceiling debate, which was followed by a quite notable decline in stocks.
While not perfect, the combination of the 20/100 DMA with the fact that US ECO has turned negative is a strong indication of a short-term correction in stocks
What could generate a correction now? We see the following near term concerns:
1. A complacent ECB. Whereas the Fed and BoJ are adding to asset purchases, and the BoE may do so soon judging by the King Speech Tuesday night, the ECB will likely (continue to) contract its balance sheet as LTROs are repaid and does not seem in the mood to cut rates either. This might present most problems via the currency. But if the ECB makes the same mistakes by tightening policy as under Trichet in mid 2011, European stocks could really suffer. Since our economists expect instead further cuts eventually, and OMT activation could generate balance sheet expansion, our base case is underperformance, not Armageddon, in European equities. But it is worth noting that a theme in meetings in 7 European financial capitals over the past couple of weeks has been: why shouldn’t European equities do better this year? This suggests that investors are already positioned for gains/ outperformance.
2. Another concern is Japan. Well before Elections in Japan on 16 December last year, aggressive investors built short JPY (and long NKY) positions anticipating pressure for easier monetary policy from Japan. While the Election outcome and subsequent BoJ decisions (more QE, higher CPI inflation target) have to a large degree validated these expectations, we think this move might have run its course for now. In part this reflects the slightly disappointing BoJ decision to postpone further balance sheet expansion to 2014. And in part recent official comments that JPY rapid depreciation may have downside risks. There may be pressure from trading partners if Japanese government spokesmen return to too explicit a policy of talking the JPY lower. The JPY/ NKY move may have another leg when the BoJ Governorship changes on 8 April but we have cut our tactical position to zero for now. If the market confuses JPY short term strength/ NKY weakness for a general risk off move, this could also cause near term volatility more generally.
3. Another investor focus is the recent softness of the data, particularly in the growth outperformers. In very recent days, better than expected European data have kept our G10 ESI from falling further though zero. But the US index remains soft and so does the EM overall index. On the US ESI, after 4.5 months in positive territory, the index has moved negative, partly because of the way it is designed to mean revert over time. Positive surprises last year decay out of the index over 3 months and at an accelerating rate. This may lead to some participants citing ESIs as a concern for risk assets. Our own Risk-On/ Risk-Off (RORO) rule for markets based on ESIs was triggered on 17 January - as seen above.
Of course, there is all the other usual stuff too such as the debt ceiling deadlines, politics in Europe and elsewhere, deleveraging etc. However, the three concerns listed are where we would see a more serious setback coming if it did.
ICELAND - We didn't follow the prevailing orthodoxies of the last 30 years in the Western world
"Why do we consider banks to be like holy churches?" is the rhetorical question that Iceland's President Olafur Ragnar Grimson asks (and answers) in this truly epic three minutes of truthiness from the farce that is the World Economic Forum in Davos. Amid a week of back-slapping and self-congratulatory party-outdoing, as John Aziz notes, the Icelandic President explains why his nation is growing strongly, why unemployment is negligible, and how they moved from the world's poster-child for banking crisis 5 years ago to a thriving nation once again. Simply put, he says, "we didn't follow the prevailing orthodoxies of the last 30 years in the Western world." There are lessons here for everyone - as Grimson explains the process of creative destruction that remains much needed in Western economies - though we suspect his holographic pass for next year's Swiss fun will be reneged...
MOST CRITICAL TIPPING POINT ARTICLES THIS WEEK - Jan 27th - Feb. 2nd, 2013
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