GMO on China's subprimey financial innovations A new and scary note is out about China's risk from GMO's Edward Chancellor and Mike Monnelly, who make a good argument that China's financial system is showing many of the hallmarks of a not-too-distant bubble: China's thriving shadow banking system has much in common with the American version, which thrived before Lehman's collapse: 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. Much of it our readers will have heard about before, but it's put together in an elegant way and highlights especially the prevalance of the originate-to-distribute model, and of assumptions that the government is backing every investment product. Chancellor and Monnelly have included some interesting figures relating to China's total debt levels: It has also been argued that China has nothing to fear because total non-financial credit, at roughly 200% of GDP, is relatively low by comparison with the U.S. and other developed economies. Yet the total stock of credit is less predictive of future problems than its rate of growth. Furthermore, mature economies appear to have a greater capacity to shoulder debt. In economists" parlance, "financial deepening" is correlated with the level of economic development. As this chart shows, the 200 per cent-ish of GDP ratio is much higher than its nearest peers: Then there's public sector debt: Because the main banks are state-controlled and most of their lending is directed at state-controlled entities, a great deal of bank lending is quasi-fiscal in nature. In order to get a proper picture of China's sovereign liabilities we must add back the loans to local government infrastructure projects, policy bank debt (issued by the likes of the China Development Bank), borrowings by the asset management companies (which acquire non-performing loans from banks and others), and debt issued by the Ministry of Railways to fund the roll-out of the expensive high-speed rail network. This seems a logical way of estimating government debt; and it's one that Chancellor and Monnelly say would total 90 per cent of GDP. Moreover, this level has increased rapidly: Higher levels of public debt are associated with a prolonged decline in economic growth. Economist Andrew Hunt estimates that China's true public debt has increased by around 60% of GDP since 2007. If Beijing were to attempt to repeat the credit-fuelled stimulus package of 2009, its true debt-to-GDP ratio would exceed that of Greece. And finally, banks: Bank loans are officially around 130% of GDP; add on interbank assets, other assets held on balance sheet, and various off-balance-sheet exposures, and the banks" total credit exposure is close to 300% of GDP. GMO points out that the PBoC made net injections of about Rmb1.4tn into the country's banking system last year through its liquidity operations. Furthermore, the WSJ says that nearly two-thirds of that took place in the second half of 2012 - that is, the rate almost doubled. This all hints at stress, but it also partly reflects the PBoC's move away from its more traditional and slightly clunkier tools such as reserve ratio requirements and lending/deposit rates. And as we wrote last year, the PBoC can probably carry on with this just fine for a while, but if these trends continue, along with rising capital outflows, its ability to remedy the liquidity stress could run into inflationary problems. It's difficult to tell when this all might become a problem. However there are other ways that authorities are trying to ensure liquidity and stave off any panic from investors; Anne Stevenson-Yang of J Capital Research says at least two of the asset management companies are actively preventing defaults among property developers by assuming their obligations in return for equity stakes or "covert agreements." On a recent trip around China, she wrote some astounding observations and accounts of the bankers" acceptance notes, guaranteed, securitised pre-IPO shares, high return private equity debt instruments, and so on. She concluded: The pace of "financial innovation" in China now is far faster than any analyst's ability even to understand what is happening. Poorly trained auditors and poorly motivated regulators are playing against a stacked deck. The gray market is exploding in a chain reaction. No matter how determined authorities may be to funnel money into the defaults, there is no telling when, but the flood of "innovation" will overwhelm them. Related links: China's two-way liquidity risk: Shadow banking - FT Alphaville Chinese banks" Weapons of Mass Ponzi - FT Alphaville This header is a reference to the excellent documentary mini-series, "Welcome to India" and "Welcome to Lagos." A similar project showing life in the Chinese shadow finance world would be brilliant...