Why Failing Chinese Banks Could Bring Down the World

News in the last couple of months of the Chinese government having to bail out 2 collapsed financial institutions, Baoshang Bank Co. Ltd. and Anbang Insurance Group Co. Ltd. sent shockwaves through the Chinese financial system seeing interbank lending rates spike as much as 1000%.  As ABC reported after the Baoshang collapse at the end of June:

“It is yet to be a "Lehman moment" — where the credit market freezes, banks stop lending to each other and the economy teeters above the abyss —but it has, as Societe Generale's Wei Yao noted, "triggered severe liquidity tensions in the interbank market".

"The Baoshang incidence has challenged one fundamental belief of China's financial system; interbank defaults are not possible thanks to 100 per cent implicit guarantees," Ms Yao said.

"Now that credit risks and counter-party risks have finally descended on this very core market in China's financial system, all the key players in the system have to figure out how to price risks in the new paradigm, and quickly."

Ms Yao said the understandable consequence was "a big and unpleasant wave of risk repricing", with major banks shying away from doing business with smaller lenders.

And that's a worry, as small-to-medium sized banks combined have balance sheets as big as the big banks combined, but are far more dependent on interbank funding.


The central bank (PBoC) immediately pumped around 600 billion yuan ($125 billion) into the system and halted a run on the banks by guaranteeing 100 per cent of all retail deposits.

It calmed nerves a bit, but credit has tightened and borrowing has become more expensive — not an ideal mix when the broader Chinese economy is slowing and under pressure from the ongoing battle with the US over trade.

Bad news for the Chinese economy is readily translated into worse news in Australia, given commodity exports to our biggest trade partner pretty well prop up otherwise rather uninspiring growth.”

Now we have reports yesterday from Bloomberg that a much bigger bank, Bank of Jinzhou, is looking like it will join these shortly.  It is in talks with creditors and the government and their auditors, Ernst & Young, have quit in protest as: “the bank refused to provide E&Y with documents to confirm the bank's clients were able to service loans, amid indications that the use of proceeds of certain loans granted by the Bank to its institutional customers were not consistent with the purpose stated in their loan documents.”

These may well be just the early signs of things to come from the world’s 2nd largest economy and biggest pile of debt.  In the same Crescat Capital investment update from which we sourced those 9 ‘must see’ charts yesterday, China is top of their list of concerns.

“We have written extensively about China’s currency and credit bubble in past letters. China was responsible for over 60% of global GDP growth since the global financial crisis. The country’s massive investments in non-productive infrastructure assets was financed on credit and created high GDP growth but failed to add wealth or debt-servicing capacity. China has created an enormous currency and credit bubble in the process. The problem is that its central planners accomplished this incredible economic growth through an unsustainable growth in fractional reserve bank credit. Since 2008, China’s banking system assets have grown 400% to USD 40 trillion!”

China's banking asset growth

“This insane level of expansion for a large economy was made possible because China’s communist leaders mandated high lending growth from its state-owned banks. At same time, they ignored the true write-down of non-performing loans.

As a result, we believe the value of China’s banking system today is grossly mismarked. The Chinese financial system in our view is a Ponzi scheme poised to unravel and is likely to be a major contributor to the coming global economic downturn. The Chinese citizens are the primary creditors who could be on the line, but the rest of the world that has invested in China will almost certainly suffer with them.

We believe the Chinese government will be forced to print money to recapitalize its banks and bail out its citizens to attempt to quell social unrest. The massive monetary dilution could lead to a currency crisis which is the lesson of almost every emerging market credit bubble in history from Latin America to Asia. Currency crisis is also the ultimate consequence of economic failure of centrally planned communism as we have learned from the Soviet Union to Venezuela.

Our outlook for both the Chinese yuan and Hong Kong dollar is extremely bearish and we are positioned accordingly in our global macro fund. The warning signs of the coming Chinese crisis are everywhere from the Trump administration’s year-long hardball on Chinese trade, to the recent Chinese government seizure of failed Baoshang Bank, to the current mass anti-Chinese Communist Party protests in Hong Kong.”

Hong Kong yield inversion

China is of course not alone in this quickly overwhelming sea of debt.  

“Because the US dollar is the largest fiat reserve currency, the Fed’s past accommodative policies has allowed other countries to pursue their own easy money schemes and accumulate record levels of debt. Across the globe, these levels are higher on average than they were prior to all major credit busts of the last 30 years.”

Global Debt Imbalance

Noting the chart above is 2018 data, one can safely assume that things are even worse now, half way through 2019.

Whilst many point to the Lehman Brothers bailout as the beginning of the GFC, nearly a year earlier French bank PNB Paribas suspended redemptions for three mutual funds with sub-prime mortgage exposures.  That was the real start of what would become one of the worst financial crises in history.  In hindsight these relatively small Chinese banks could well be the PNB Paribas’s of this next crisis.  When you have behemoths like Deutsche Bank with $49trillion in derivatives literally on the rails and who knows what next from China, our “Lehman Moment” may be closer than you think.