Shadowy Problems With the Global Banking System

The market is still floundering from last week’s selloff. The Dow, for instance, is down over 500 points since last Tuesday.

Commentators blame a weak Chinese manufacturing survey, but I think it has more to do with the imminent test of China’s shadow banking sector…

As a reminder, Chinese shadow banking refers to loans outside the official state-controlled banking sector. When bank loan growths slowed a few years ago, shaky borrowers were desperate to find new sources of funding. Most were borrowing in a Ponzi fashion; the use of borrowed funds didn’t provide the cash to repay loans, so new loans are needed to repay old loans. Shaky borrowers found high-interest, short-term funding from “trust” companies. Trust companies match savers looking to earn high interest rates with desperate borrowers.

Trust loans, like payday loans in the U.S., have short maturities. Trust lending has become so big it has the potential to impair the banking system.

On several occasions over the past year, Chinese banks have demanded higher interest rates to lend to each other. When one bank fears another bank might have exposure to dodgy trust companies, it requires a higher interest rate to compensate for risk. The Shanghai Interbank Offered Rate (SHIBOR) — the rate banks charge each other for loans of various maturities — has spiked again in 2014, despite huge central bank liquidity injections.

This situation parallels Citigroup’s implosion in the 2008 crisis, when its exposure to structured investment vehicles (SIVs) left other lenders with the impression that they shouldn’t loan overnight money to Citi. The Fed had to step in and lend to Citi against its shaky collateral, because other banks wouldn’t loan at rates it could afford.

The global monetary system is fragile and volatile. It’s undergoing a harsh test.

Ultimately, the Chinese central bank will step in and flood the system with liquidity, alleviating the cash crunch. But in the near term, as part of its “reforms,” the government wants to purge speculation from the system.

By next Friday, we’ll find out how far the Chinese government will allow stress in the shadow banking sector to spread. The state-controlled press reported on China Credit Trust’s warning to investors: They may not be repaid when a 3 billion-renminbi trust product (with a yield approaching 11%) matures on Jan. 31.

Trusts and wealth management products (WMPs) are parts of the shadow banking sector. Banks and brokers sell WMPs to clients looking for high interest rates, with or without credit guarantees. They’re like U.S. money market funds (only riskier). Funds from WMPs are invested in a range of instruments including corporate bonds, trust loans and securitized loans.

CLSA strategist Chris Wood expands on the imminent test of WMPs in his Greed & fear letter:

“If there was ever a time to try to clean up what many, including Greed & fear, would view as the escalating risk of a Ponzi scheme in the trust and wealth management product industry, this would surely be it. The [China Credit Trust] WMP in question stems from a loan to an unlisted coal company. It is also the case that this WMP appears to be owned by about 700 relatively wealthy investors with an average holding worth over [4 million renminbi]. The Industrial and Commercial Bank of China, which acted as distribution agent for the WMP, has also made it clear via public statements that it does not consider itself primarily liable for the product…

“The risk facing the authorities is that a default in which holders are not bailed out in full might precipitate panic outflows across the trust and related WMP asset class, triggering a liquidity crisis, a liquidity crisis which would also ricochet into Hong Kong given the growing evidence of a carry trade funded out of Hong Kong in renminbi-denominated mainland products, a carry trade which has attracted more interest as the renminbi has continued to appreciate and as average yields on WMPs have risen.” [Emphasis added]

Wood includes the following chart:

Hong Kong Banks' Net External Claims on Mainland Chinese Banks, 1991-Present

The chart shows a rise in Hong Kong claims on mainland Chinese banks to a record HK$1.9 trillion. It’s a telltale sign of hot money flows into China, which ultimately leak into the shadow bank sector.

Hong Kong is overflowing with liquidity, having tied its monetary policy to that of the Federal Reserve. So banks are able to borrow cheaply in Hong Kong dollars and lend to Chinese banks at higher interest rates. The Chinese banks turn around and funnel liquidity to the shadow banks (although the Chinese banks, including the aforementioned ICBC, don’t issue blanket guarantees for WMPs).

Let’s trace our way back to the source of this corrosive behavior: zero interest rates and money printing. Without these two factors, none of these bubbles would have been inflated. The Chinese misallocation into infrastructure and buildings could have been only a fraction of its current size. Now that bubbles are starting to deflate in China, investors will discover that easy money is both necessary and permanent to prevent reversals of hot money flows and credit crunches.

Outside the stress in Chinese credit, emerging-market currencies crashed last week. Declines in currencies like the Turkish lira, South African rand and Argentine peso spark the unwinding of Japanese yen-funded carry trades, which in turn strengthens the yen and depresses overnight futures in the S&P 500.

The global monetary system is fragile and volatile. It’s undergoing a harsh test. The carry trades wrought by central bank policy may continue unwinding. Central banks will soon feel market pressure to remain permanently easy. And the need to hold some gold as insurance against this system will re-enter many investors’ minds.

Best regards,

Dan Amoss, CFA
for The Daily Reckoning

Ed. Note: So there you have it. The cracks in the global banking system begin and end with Fed monetary policy. But what does that mean for you? Well, it means you should be prepared for anything, even in the unlikely event of a catastrophic collapse in the global monetary system. Sign up for the FREE Daily Resource Hunter to find out specific ways you can diversify and gain exposure to the best, most secure investment opportunities you can have, regardless of what happens. Click here now to get started for free.

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