“Replacing Old Impaired Debt with New One Does Not Generate Growth, It Will Not Reverse Financial Death Spiral” – By Charles Hugh Smith

A decade later scars of US led 2008 financial crisis are still visible and have led to massive rise in global debt across geographies (refer to our report titled ‘Deficit + Debt = Death’). Off late with China cracking down heavily on shadow banking industry1 which was posing a potential systemic risk to the financial system, China’s private sector which contributes most to China’s GDP is facing huge cash crunch resulting in surge in bond defaults. We in this note try to understand tools used by China to overcome the problems caused by a cash-squeezed private sector, upcoming bond maturity wall and likely impact of bond defaults on the Chinese economy.


The Chinese regulators are making progress to tame down the $10trillion shadow banking industry1 which posed a serious threat to the Chinese financial system. After a yearlong squeeze on the riskiest areas of the industry, China’s economic growth continues to decline. The rising prospects of bond defaults have started emerging thereby increasing the risk to economic stability of the country. China’s private sector reeling from a surge in bond defaults is unlikely to get a respite anytime soon, as record amount of notes are due to mature in the next couple of quarters. Chinese regulators have put forth some 30 new rules since March’18 to speed up deleveraging drive. This has led to a liquidity squeeze in the market especially in private sector who are finding it hard to make profits in current economic slowdown. This has led to increase in Chinese bank loan provisions for losses. The picture would only worsen with ongoing trade war between US and China and huge upcoming bond maturity wall in H1’19.


After explosive growth between 2010 and 2016 in shadow bank financing products mainly wealth management products (an off-balance sheet item) once sold by banks have barely increased in 2017 and 2018. A key element of the campaign against asset management products is a ban on providing implicit guarantees for the riskier offerings to Chinese savers. Instead,

banks have boosted their issuance of structured deposits with derivative features, many of them with embedded options that are unlikely ever to be exercised, as a way to attract yield-hungry Chinese savers. A typical structured deposit offers a guaranteed return, normally in line with regular bank deposits, together with the potential for a higher yield depending on embedded derivative contracts, which are often linked to currencies, commodities or stock indices.

Example of Structured Product:

“A 91-day structured deposit from Weihai Blue Ocean Bank, promising to offer 5.28% a year in interest if gold prices stayed between $300 and $2,200 an ounce until maturity”. Such deposits are meant to tickle customers’ desire for gambling and are seeking high returns on their deposits. With Chinese regulators trying to slow down the expansion of financial sector and are tightening liquidity, state banks are facing huge pressures to secure funding as they continue to reduce off-balance sheet products, hence resorting to issuance of structured products. Structured deposits have proven especially attractive as a funding source for China’s smaller banks, which don’t have the huge branch networks of big lenders like Bank of China, and have been hardest hit by the shadow banking clampdown. But China’s structured debt isn’t immune from the defaults and could very well cause crisis in long term.


Fall in issuance of shadow banking products and rise in structured products is nothing but pulling out money from left pocket and putting it back in right pocket in a structured manner. The inherent assumption of a structured product is that the investor has an intention of holding till maturity. While, this sounds good in theory, the credit worthiness of the note’s issuer could very well be compromised. As with any IOU, loan or other type of debt, you bear the risk that the issuing investment bank might get into trouble and forfeit on its obligation. The biggest problem is ‘a structured product adds a layer of credit risk on top of market risk.’ China known for its opaque financial markets, could only add to problems once the hunger for such high-yield product catches up further. Structured products rarely trade on the secondary market after issuance and thus pose serious liquidity problems in times of default. Moreover, these structured products are no more off-balance sheet items, meaning the products are covered by the central bank’s 14.5% Reserve Requirement Ratio (RRR) on savings instruments. That requirement, combined with the average yields of 4-4.5% on structured deposits, is likely to accelerate pressure on banks’ funding costs. This is predominantly one of the reason for recent decline in China’s RRR along with central banks aim to ease liquidity pressure faced by banks and corporate sector.

The People’s Bank of China last week announced a 150 billion-yuan ($21.5 billion) increase in financing as part of plans to support privately owned enterprises. The central bank also plans to give 10 billion yuan to a state-backed insurer to provide credit support for debt sales by private firms. China’s leadership hinted that further stimulus measures are being planned and the government will help resolve difficulties prevailing in the private sector. If the banks’ ability to extend loans gets hampered significantly, their support for real economy shall erode and this could very well derail the China’s economic growth.


We believe the seeds of next financial crisis are being sown and could very well come from China and spread across global financial markets. The China’s accommodative monetary policy shall fail to spur economic growth and keep the markets on the edge. China is expected to take necessary steps to boost the economy through monetary and fiscal support along with some tax cuts. The ongoing trade war between the US and China (assuming it grows worst) shall increase liquidity pressure among Chinese private firms if their ability to make profits decline. This shall further result in increase in bond defaults rate and decline in China’s GDP to 6% (y/y) in 2019 from ~6.5% this year.


1The shadow banking industry consists of off-balance-sheet funds provided by banks and other financial institutions. The funds are lent at rates higher than standard bank loans, often to companies without ready access to the conventional banking sector.

Sachin Nimkar | Market Intelligence, Swiss Singapore

Published by Swiss Singapore Overseas Enterprises PTE Ltd. The material contained herein has been obtained from sources believed to be reliable but is not necessarily complete and cannot be guaranteed. Any opinion expressed is subject to change without notice. All information is for the private use of the person to whom it is provided without any liability whatsoever on the part of Swiss Singapore Overseas Enterprises PTE Ltd. or any associated company or any employee thereof.

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