A few weeks ago I was challenged to produce a 'bull case for China'. It's a tough ask, and the best I could do was show how we can expect that profits growth will be strongly leveraged to the recovery, (when it arrives). This is because the efficiency gains (efficiency of finance, of asset-usage, and of labour productivity) which were won in the early stage of the credit squeeze will endure for at least the early stages of the recovery (when it arrives). (This is despite the evidence that the continued squeeze is, right now, eroding those initial gains.)
But when will it arrive? The belief that recovery will arrive sooner rather than later is made tougher by the run of data, as October's monetary, industrial and demand data showed this week.
Not that any of October's industrial or demand data was exceptionally grim. Rather, it was just uniformly disappointing: industrial output rose 5.9% yoy (0.3SDs below trend), electricity output rose 4.8% (0.5SD below trend) and exports (in Rmb and volume terms) came in 0.1SD below trend. For demand indicators, retail sales rose 8.6% yoy (0.8SDs below trend), auto sales fell 13% (0.6SDs below trend), urban investment rose 5.7% ytd (0.3SDs below trend), PMI employment indexes were 0.7SDs below trend, and only the real estate climate index managed a positive result (0.2SDs above trend). Industrial indicators have leaked momentum for four of the last five months; demand indicators for the last two months.
But then there's October's monetary numbers. Interpreting China's monthly monetary and finance data is becoming a bewildering puzzle, because although we know that great efforts are being made to scale back or close down the 'shadow banking' sector, we have no way really of telling how this is affecting banks' ability to lend, companies' ability to get credit from the banking system, and, moreover, how it is affecting government finances.
The key point is this: whilst the 'shadow banking system' of wealth management product, trust loans and entrusted loans started out with a good claim to be vehicles which could usefully circumvent interest rate ceilings for savers and institutional credit hurdles for companies, they morphed into something quite different.
In recent years, 'shadow banking' operations have tended instead to act primarily as ways in which certain types of commercial banks could sidestep overall credit limits, essentially by offloading loans to special vehicles (such as trust companies) in exchange for participation in 'Trust Benefit Receipts' which count as investments rather than loans. Over time, this has developed into a series of tightly interlocking financial relationships between various parts of the banking system and parts of the 'shadow banking system' which are very largely opaque.
To get a really good idea of the issues involved, I can recommend the BIS Working Paper No 701 'Mapping shadow banking in China: structure an dynamics.' This is a brilliant paper, and, if nothing else, one should take a look at the BIS's schematised map of China's shadow banking system, starting with the 'easy' map on p4.
BIS writes: crucially, 'direct shadow credit to ultimate borrowers has slowed considerably in recent years, whereas the volume of shadow funding as well as structured shadow credit intermediation has grown at a fast pace.' I think this is BIS being diplomatic: what it means is that in recent years, the principal driver for 'shadow banking' activity has been the need or desire to circumvent banking regulations by converting 'expensive' on-balance-sheet loans into 'investment receivables' from the trust company in which those loans have been parked.
That's good news and bad news. The good news is that winding down the 'shadow banking activity' as seen in the monthly aggregate financing numbers probably hitting banking operations more than credit creation. In other words, the slowdown in total aggregate financing probably overstates the slowdown credit created for ultimate users. The bad news is that we simply have no idea how those 'tight interlinkages' are going to be unwound, and what 'unknown unknowns' will make themselves unavoidably 'known'.
However, one conclusion - and no conclusions in this case are 'obvious' or even certain - is that during the expansion of the shadow banking system, the monthly scores of total aggregate financing are likely to have been inflated by an unknown degree of double counting. If so, it is quite possible that the current slowdown in total aggregate financing (just Y729bn in October, with bank lending accounting for Rmb714bn) with the contractions consistently recorded in trust loans and entrusted loans, is correspondingly less dramatic than it seems. Quite how the dis-integration of the shadow banking system and the banking system will affect, or is affecting, final credit provision is, I think, impenetrably obscure.
However, some light is shed by the inclusion this year of 'special local government bonds' as a separate line-item in total aggregate financing. What seems fairly obvious is that these bonds have been issued at a pace directly to offset the fall in the 'shadow banks' trust and entrusted loans.
During Jan-Oct this year, there has been a net repayment of Rmb1.847tr of trust and entrusted loans. Since trust and entrusted loans were the favoured vehicle for local governments to finance themselves, it looks like it is local governments which have been doing the repaying: during the same period, the issuance of 'special local government bonds' has amounted to Rmb1,782tr. The high-interest rate (and for banks' customers, high-risk) trust and entrusted loans are being repaid by the proceeds of the local government bonds.
But whilst these bonds are looking after the interests of local government finances, it is far less clear what the knock-on effect on final credit provision for other economic entities must be.
Nevertheless, it has the further consequence that we are getting a less unrealistic picture of the state of China's government finances. Consider, for example, that the total published fiscal deficit for Jan-Sept 2018 came to Rmb1.749tr, whilst the new local govt bond issues for Jan-Oct came to Rmb1,782tr. At some point we should start counting these new debts as evidence of previously unregistered deficits (rather than assuming they represent current fiscal gaps).
For those with long memories, the rather baroque system of 'tight interlinkages' which now characterise China's shadow banking system is reminiscent of S Korea's financial system prior to its 1997 crisis. There, the fundamental problem the system was trying to solve (or evade) was that the legacy of a command-banking system meant not only that credit where available was mispriced, but also that great swathes of S Korea's commercial economy couldn't access official credit markets at all. For small companies, the problem wasn't the price of credit, it was the lack of all access to official credit, whilst for chaebol, credit was price too cheaply. There are distinct echoes of this in the difficulties China's major banks still have in the preferential lending to SOEs and similar.
In S Korea, the financial system first developed derivative-institutions which attempted to address this problem. However, whenever economy-wide cashflows faltered, those institutions tended to fail, because a) they were not yet good at credit-pricing; b) they tended to have major liquidity mis-matches, and c) when cashflows into the financial system got crimped, these derivative institutions would be banks' first to get their lines cut. In one form or another, this sequence of events was repeated about three times before S Korea began to solve the underlying problem.
In China's case, the two underlying problems are the unacknowledged fiscal problems at local level, and the dominant giant banks' historic mistrust of lending outside the traditionally favoured areas. The blooming of the shadow banks represented a dangerous attempt to solve (or evade) those problems. Even if the current efforts to de-fang the mistakes doubtless made by the shadow banking system are successful, we should expect some sort of re-iteration until the twin problems are solved.