In Pursuit of Performance.

by David Franklin, dfranklin@sprott.com

Shanghai Surprise

The Economist recently reported that The Industrial and Commercial Bank of China (ICBC) displaced Bank of America to become the world’s biggest bank in 2012, marking the first time in history a Chinese bank has reached this pedestal. China now has four of the world’s ten biggest banks.1

Together, these Chinese banks have a combined market capitalisation of close to $1 trillion Canadian dollars, or three times the market cap of the Canadian banking sector. ICBC alone has 393 million individual customers, which according to the Telegraph is the equivalent of a single bank managing the bank accounts of every man, woman and child in Western Europe.2 In fact, Chinese banking sector assets have increased by $14 trillion since 2008, which is the entire size of the US commercial banking sector. China is a global banking force to be reckoned with.

From the outside, however, observing the Chinese banking system can be “like watching two dogs fighting under a carpet.” It's clear that something is happening, but it’s hard to tell exactly what .3

June 19, 2013 will go down in Chinese banking history as the day that overnight borrowing rates hit a record high 25%, thus effectively freezing the Chinese credit market.4 Under normal market conditions, the SHIBOR - which is the rate at which Chinese banks are willing to lend to each other for short periods of time – is typically less than 3%. Expert opinion is sharply divided over both the causes and implications of these skyrocketing lending rates.

In one corner we have Charlene Chu from Fitch Ratings, who evoked memories of Lehman Brothers and Northern Rock when she suggested in the Telegraph that an extreme spike in the SHIBOR is an indication that China is wrestling with ‘the worst ever credit bubble’.5 At the heart of this credit bubble is the opaque shadow banking system of trusts, wealth-management funds and offshore vehicles that allows companies to avoid regulations and hide large amounts of debt.

Echoing the same sentiment, China watcher Gordon Chang, known for his book “The Coming Collapse of China”, sees the country on an economic decline and views the current interbank lending stress as further support for his position. Chang describes a timeline of key events leading to the jump in interbank lending rates:

“The crisis began in the first week of May when the state administration on foreign exchange issued that rule cracking down on fake export invoicing. That triggered a $40 billion outflow from the banking system and in the month of June we saw two failed central government bail auctions, two spikes in interbank rates, and two waves of default in the interbank markets. Each crisis is getting worse than the previous one.”6

Both experts suggest that skyrocketing interbank rates signify the dire state of the Chinese banking system. They point to a credit bubble that has gotten out of hand and portends a collapse of the economy.

Surprisingly, other experts suggest that there is nothing to be concerned about. Earlier this month Liao Qiang, a Beijing-based director at Standard & Poor’s, argued that “Given that China’s credit is mostly funded by its internally generated deposits, I don’t think a real financial crisis, which is normally manifested in a liquidity shortage, will happen anytime soon”.

Adding support to this view, the Peoples Bank of China (PBOC) stated in a letter published Monday, “At present, the overall liquidity of the banking system [is] at a reasonable level”, and further suggested that lenders should better manage their own balance sheets.7 The PBOC also soothed concerned markets this week when it assured that it would provide cash to institutions that need it.

In summary, both Standard & Poor’s and the PBOC are saying to us “nothing to see here folks, move along”.

These divergent quotes highlight the huge contrast of opinions when it comes to the SHIBOR spike. But whether investors believe in the ‘utter collapse’ or a ‘business as usual’ scenario, they are not waiting around for the winner to emerge from ‘under the carpet’. Investors are selling Chinese banking shares - the Shanghai financial sub-index lost as much as 22% in the month of June and has yet to recover, according to data compiled by Bloomberg.

Investors have clearly chosen their ‘dog’ in this fight by voting against the banks. Regardless of which scenario ultimately plays out, the fact that expert opinions are so divergent on such a critical issue at such a sensitive time is the real surprise.

 

1 World's biggest banks. 
2 Chinese banking: a Wild West in the Far East?
3 While this expression has been attributed to Winston Churchill, historian Richard M. Langworth had these comments “We searched my digital canon: fifty million published words including Churchill’s own fifteen million words—all his books, articles, speeches and published papers. “Dogfight” gets ten hits, all referring to aerial warfare. “Carpet” has 264 hits but none close to this quotation and “under the carpet” draws a blank. Without further information, we have to conclude this is unsubstantiated. http://richardlangworth.com/dogfight-under-a-carpet
4 China Panic: Overnight Rate Hits 25%. 
5 Fitch says China credit bubble unprecedented in modern world history. 
6 Forbes Columnist Gordon Chang Predicts Chinese Economy’s Catastrophic Failure.
7 General Office of the People's Bank of China on commercial banks' liquidity management issues letter (translation).
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