The Shadow Cast Over China’s Banking System

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Today’s tour of the global struggle against financial tyranny will take us on a slight detour. We’ll look at Saudi Arabia and the threat shale gas plays to all oil producing nations (and their political elites). Nothing much is going on in the stock market, by the way. The S&P 500 had its first positive day of the year and precious metals got whacked. It was a little like 2013, in other words.

Before we get to the Saudis, a follow up on China’s shadow banking system. You may have missed it, but China had no less than three minor liquidity crises last year. Interbank lending rates spiked to 9.39% in June. They rose again in October. And in December they spiked yet again to 8.95%.

What banks charge each other for overnight loans is a measure of the soundness of the financial system. If banks don’t trust one another, if they doubt the quality of each other’s assets or collateral, then credit stops flowing in the economy. And if that happens in a place like China’s economy, then growth stops too.

It’s pretty obvious what this means for Australia. Take a look at yesterday’s worst performing stocks. Three of them were iron ore companies. Fortescue Metals (ASX:FMG) fell by 4.73%. Mount Gibson Iron Ore (ASX:MGX) fell by 6.47%. And Atlas Iron Limited (ASX:AGO) fell by 8.49%. Any time there is a hint of doubt about the durability of China’s growth rate, the Aussie miners are going to cop it.

The People’s Bank of China has responded to each spike in overnight borrowing costs by promising the market liquidity. ‘Don’t you worry, shadow bankers! There’s plenty of money to go around for everyone. If you run out, we’ll just make more.’ Each time, the actions were sufficient to return things to normal (or what passes for normal in the Chinese financial system).

But what’s normal in China now? The central government wants to tighten credit in order to rein soaring land prices and soaring local government debt. But when it dialled back the stimulus program of 2009, shadow bank lending to local governments nearly doubled in the space of two years to almost 36 trillion yuan (AU$6 trillion).

There are two issues at stake. First, unregulated lending can lead to an awful lot of dodgy risk taking. Not all debt is bad. But borrowing money to speculate on land prices is a recipe for a bubble. It has been throughout history, from the Mississippi Bubble to the South Sea Bubble to the US sub-prime mega bubble.

The second issue is collateral. Quality collateral is in scarce supply all over the globe. It’s no different in China. The shadow banking system is really about using any kind of non-traditional asset as collateral for more credit, since the central bank creation of credit has been slowed down.

What is collateral? Well, your editor doesn’t want to wax too philosophical. But this is precisely the kind of issue that we expect to be front and centre at the World War D conference in late March. Quality collateral used to be cash, or gold, or real estate. In the global financial system, the US Treasury bond has long been considered the most secure collateral in the world.

The trouble, as usual, is debt. Worry about sovereign debt levels may seem like a quaint little fetish in 2014. After all, the stock market is on a high. As Dick Cheney once said, ‘Deficits don’t matter.‘ Surely governments have proved that since 2009. They’ve assumed the liabilities of the banking system and central banks have become lenders of all resort to any loss-making venture with enough shamelessness to beg for a handout.

But deficits DO matter. They matter because borrowed money has to be paid off. To pay it off, you need an income stream, preferably from the productive asset you built with borrowed money. If you’re borrowing money just to pay off the interest on money you’ve already borrowed, you’re engaged in what Minsky called ‘Ponzi Finance.

The chart below shows that our situation has not really improved since 2009, when it comes to government debt levels as a percentage of GDP. The prospect of a sovereign debt crash, and then a sovereign debt depression, remains as dangerous now as it was five years ago. More dangerous, in fact.

a
click to enlarge

No one likes a Danny Sovereign Debt Depression Downer, of course. But it needs to be said. The reason it isn’t being said more is that governments have used their central banks to engineer a giant distraction in the stock markets. Asset market inflation is the way to conceal the demographic deterioration of the sovereign balance sheet. The crisis is still coming.

But since it’s not here yet, you still have time to prepare for it. And in the classic way of turning crisis into opportunity, let’s close with the Saudis.  New shale oil and gas discoveries are, ‘a threat to any oil producing country in the world,‘ Saudi Prince Alwaleed bin Talal told Canada’s Globe and Mail

Saudi government finances, along with many other petro-powers, are heavily dependent on a high oil price. Anything that threatens oil’s global supremacy, then, is an existential threat to governments whose main source of cash is oil. Thus, the Saudi concern with shale.

This is shaping up into a great contest between technology and scarcity. The technology behind shale oil and shale gas is the marketplace response to high prices (an incentive to increase supply and grab market share). The scarcity argument is that the bloom of the shale boom will quickly wilt with high depletion rates and increasing drilling costs. In other words, it’s going to be a very short golden age for shale gas.

Tell that to the people in North America currently freezing their toes off. Tomorrow, we’ll look at whether Australia will ever have a real energy policy that produces lower electricity and gas prices. The opportunity is there, with companies like Santos willing and able to increase the production of unconventional natural gas. But will it be prevented from happening?

Regards,

Dan Denning+
for The Daily Reckoning Australia

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Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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6 Comments on "The Shadow Cast Over China’s Banking System"

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Ross
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Thomas Kent
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Dear Mr. Denning, while I have enjoyed reading your past articles, I noticed in the article “The Shadow Cast Over China’s Banking System” the currency pictured is a Japanese 10,000 Yen note and not Chinese Rembi. Just a heads up, please keep writing.

Sincerely,

Tom

ram
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“…able to increase the production of unconventional natural gas…” Nearly all those schemes are scams. The major petroleum companies throughly investigated such potential resources years ago. Note how they avoid them today, I don’t think their research, exploration, and production departments were totally stupid. Coal seam and shale gas take alot of energy to extract, produce high levels only for a short time, and then fall off precipitously. The net energy extracted is usually negative, let alone enough to pay off the debts incurred in producing it. However, if your “business” is selling securities to naive investors, then “unconventional natural… Read more »
Harquebus
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The shale revolution is one gigantic ponzi scheme. The high depletion rate of these wells is only now starting its effect. Increasing production is getting harder and will continue to do so.

ken
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The whole debts must be eventually paid line is a lot none sense! It simply doesn’t!! Central bankers lend non existent money, supposedly backed by a ratio of 1 to 10 with real collateral. Assuming that ratio is true & adhered to, still it means that if central bankers agree to a 80% haircut in case of a bankruptcy (e.g. Cyprus) then they’re still doubling their “collateral”. Even in case of an insolvency of one of their little branches (Lehman brothers) only 10% is their own outlay, the other 90% is imaginary money they’d lent out! That’s fractional reserve banking…or… Read more »
zeehan
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I ain’t crying for the Saudis.

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