How China Could Start A Financial Crisis

He is looking at total debt to GDP which is more important for China as their state owned banks and corporations hold hundreds of billions or trillions of debt. It is public debt in all but name.

There certainly are a lot of similarities between 2008 USA and China. All the Chinese who put their life savings into buying apartments/buildings into what was expected to be future cities are probably sick to their stomachs right now. Ironic many Chinese are buying into the American SW right now which was the epicenter of our 2008 woes.

While I don't know much about credit (yet) I think a number of things besides credit and macro Econ are also happening simulataneously which are really hurting China. For one, companies and consumers are starting to realize China isn't good for business. While cheap labor is incredibly attractive the fact the regime is, for example, totally conducive with Chinese entities reverse engineering goods and then becoming competitors is cause for concern. Another draw for China is the size of its consumer base (+1.2bn people). Yet, how many people can truly be considered consumers? There's more people living in poverty than there are in the U.S. (prima facie estimate but you get the picture). Many got excited about China's growth rate and economic potential and it was the it place for a good while. But +8% growth is easy when you start from nothing. Textiles, simple widgets, and some manufacturing will remain but many processes are being brought back to the West as compamies have found it cheaper, safer, and just as competitive. That or move to friendlier countries that offer the same package like Vietnam, Laos, or the Phillipines.

Is China over? No, not at all. It will no doubt continue to be a leading world economy. I'm just a bit more pessimistic than most for the next 10-15 years because I foresee more volatility outside the economy. The Chinese are getting a taste of modernity, high quality goods, democracy, etc... As more people enter the middle class, become more educated, and experience a better lifestyle they will demand more from their government (I.e.representstion). With the economy slowing down they won't want to regress socio-economically either. I'm not suggesting a revolution but discontent is already foaming. Traditionally the government has funneled sentiments against the U.S., Japan, or S. Korea but how long will this work? While the countries huge labor force is its best asset it is also it's Achilles heel. How do you keep so many employed, fed, healthy, and happy?

I had the chance to speak to a CEO of the IBD/ECM department of a top 5 Chinese SOE "Investment Bank" (the IB model is obviously somewhat different from western institutions, they partake in IPOs and reverse mergers like the west and debt-side is obviously different and derivs/any sophisticated products are non-existent). He mentioned a few key points when I probed him on an overall view.

1) Currently, there is a lack of any innovation overall in capital markets that is not directed from the VERY top due to huge political risk. i.e. could result in very negative impact on political standing, which is critical in Chinese insert any industry here. The regulators are of course encouraging innovation on paper, but everyone knows how to read between the lines.

2) The reason why so much leverage exists in the first place is that credit is fundamentally different. China, as we all know, is run by the Party and thus most credit is credit OF the Party. You wouldn't dare oppose the party now would you as a financier?

3) Regulation is very hard to understand unless you understand the history of markets (despite really only ~22 years in China), as many policies are reactions to past market events / bubbles / arbitrages like the west, except they are still a developing nation when it come to financial markets and mistakes are inevitable.

For example, the IPO process is one of the most stringent in the world as it imitated and encompasses various requirements from the US, Taiwan, Hong Kong, Singapore, etc. and this stringency was introduced as a reaction to problems in the 90s which are seldom talked about, i.e. retail brokers took available client cash, then invested in the stock market using the money despite illegality. When this phenomenon became widescale and some brokers went under citizens were outraged and so the Party had to react accordingly with policy. The result is many more IPOs of Chinese companies going to the US or HK.

While I agree with the OP and the CEO started with presenting similar numbers as well, I don't see a strong enough catalyst to provoke a crisis. What I'm trying to say and the points above suggests is that in China markets can become much, much more inefficient before a crisis, as the Party controls credit, regulation, and even the press. Small and slow crises, even if it is a crisis on paper by western standards, would be stopped in its tracks and covered up to be seldom known.

Not saying it's not possible but if a crisis does occur it would be a smaller tail with a larger negative "payoff" to the economy. Also, taking advantage of the situation and actually extracting your money might be very, very hard.

If the actions of the Fed and ECB has told us anything in the past few years, it's that you can print trillions of dollars + euros and monetize poor credit underwrites and no one really cares. I apologize. I meant quantitative easing is a viable strategy to prop up declining economic growth and empower consumers.

China's government has to perform a balancing act at the moment. Currently it is trying to keep its growth target above 7%, which means stimulating the economy via monetary and fiscal policy. But China is also facing an increasing debt crisis from its local/provincial governments and state owned enterprises (SOEs) due to its huge stimulus package to avoid contagion during the 08-09 financial crisis. The real estate bubble has been deflating since 2011, but this means that people's wealth is also decreasing; most individuals get a negative effective interest rate on their bank deposits so they invest in real estate instead.

China's financial market is not deep or mature; it does not have a true floating currency, its capital account is closed, there are limited investment options available to individuals, there are interest rate restrictions on deposits. The People Bank of China (PBOC) has monetary policy tools, but there are not as effective as they would be in say, the US due to the financial restrictions listed above.

Recently the government announced they would move forward with plans to fully liberalize the interest rates that banks could charge by the end of 2015, but this would mean that all the debt that has been accumulated by local/provincial governments and SOEs would start to grow as well (as interest rates would rise from their artificially low levels). Also, the government would like to open its capital account, but is afraid that money would start to flow out of the country due to the economic slump it is facing. The poor interest rates that are currently offered, the falling real estate prices, and the overall economic slump means Chinese investors are looking to put their money somewhere else.

My prediction - China has to reform its financial system, which means that debt will likely grow to higher levels. But this will give the PBOC more tools to combat the current and future economic slumps. I think China is going to get lower growth levels, and perhaps a bit of unrest from citizens, but nothing major. As far as a financial crisis, I think the government still has enough influence over banks and institutions that even if interest rates were liberalized, they could keep things under control. As long as the anti-graft campaign continues I think Chinese citizens will feel as though the members of the government is not (too) much better off than the rest of them, and be alright during the economic slowdown. Crisis? Probably not. Slowdown? I would say absolutely.