Chinese Banks Push Back On Shadow Banking Regulations - Expose "Catch-22" For Financial System

In November, we discussed how the post-Party Congress measures to deleverage and crackdown on the worst abuses in China’s credit bubble took an important step forward with the announcement of a new era of regulation for China’s $15 trillion shadow banking and asset management industry. See "A New Era In Chinese Regulation Means Turmoil For $15 Trillion In China"s Shadows". In particular, the authorities turned their sights on wealth management products (WMPs).

On the way out are “guaranteed returns” and “capital pools” which had turned the $4 trillion sector into a leveraged Ponzi scheme. We joked that in a “radical and shocking” departure from the norm, financial institutions would have to offer yields based on the risk and returns of the underlying assets. Paying out guaranteed returns with new funds from depositors would no longer be allowed.

Commentators at the time described it as “a new era of regulation” which would lead to tighter risk control and slower but higher quality growth in the Chinese economy, blah, blah. However, our interest was piqued by the implementation date for the new rules. This is slated for the end of June 2019, providing Chinese banks and the entire shadow banking system a grade period to get their house in order. As we suggested.

We can only guess the delay reflects the enormity of the problems discovered by China’s regulators when they finally looked under the hood.

We didn’t have to wait long for confirmation that our cynicism was justified. It turns out that there was a “closed-door meeting” last week during which Chinese banks laid out the systemic risk if the regulators pursue their reform plan. According to Reuters.

Ten Chinese banks have raised strong objections to the central bank’s recent move to tighten rules on the asset management sector, saying it may cause a rush of redemptions among other risks, three sources with knowledge of the matter told Reuters.

Senior executives from the joint-stock banks said during a closed-door meeting in Shanghai last week that the rules would have a big impact on financial markets and could even “trigger systemic financial risks”, according to the sources, who declined to be identified due to the sensitivity of the matter. The executives also said the new rules on removing implicit guarantees for wealth management products (WMPs) could spark liquidity risks and increase market volatility, the sources said late on Thursday.

Unlike the Big Four state-owned banks, the smaller banks have limited scope to increase lending in the absence of WMP funding...and that"s ignoring the "black holes" hidden beneath the surface.

In short, the entire Chinese financial system, from depositors to banks to asset management companies, has become addicted to the WPM model. Reforming it will only advance the crystallization of losses and bankruptcies, never mind largescale protests from investors who have always assumed that, somehow, the banks would make good on their promises. On a small scale, the clearest example of the near-impossibility of reforming WMPs without threatening China’s financial system, was the example of Foresea Life Insurance in May this year. This report from Fortune captured Ponzi nature and risk of civil unrest.

A Chinese insurer has warned the country’s regulators of defaults in the billions and possible unrest unless it is allowed to launch new products again. Foresea Life Insurance asked the China Insurance Regulatory Commission (CIRC) in a letter dated Apr. 28 to lift its ban, “in order to avoid inciting mass incidents by clients and localized and systemic risks, producing greater damage to the industry,” reports the Financial Times. It further warned that, with an expected redemption of $8.7 billion this year, the insurer might not be able to meet payouts without selling new products.

The Bloomberg article portrays the feedback they gave to regulators on the new regime as “a rare protest by Chinese bankers as pressure mounts amid a government campaign to de-leverage and de-risk the country’s massive and increasingly complex financial system”. However, it’s much more than that, it’s essentially a plea for the survival on the part of smaller banks. Without large pools of deposits, smaller banks have relied on WMP and other shadow banking conduits for funding. In the absence of guaranteed returns, leverage and fraud, that might not have been a problem.

The new rules will pose a direct challenge to a business model that small- and mid-tier banks have been relying on to drive asset expansion and profit growth, bankers told Reuters earlier. “Every time when the regulators announce tighter regulations it would almost always benefit the large state banks and hurt the smaller ones, because they (the latter) are taking much bigger risks,” said a senior executive at one of the country’s big four state-controlled lenders.

The joint-stock banks, which are unable to compete against large state banks for public deposits, have depended on selling WMPs with implicit guarantee of fixed returns to attract retail funds. In turn, they invest the money they manage into stocks, bonds and non-standard debt assets to generate profit. Bank executives said at the meeting the 28.38 trillion yuan of banks’ WMPs, part of the so-called shadow banking sector, have allowed them to bypass regulatory restrictions on credit expansion and capital constraints.

The problem for Xi Jinping and his cronies is that they left the situation to fester for way too long before attempting to intervene. In an effort to dissuade the authorities, here is Reuters on more warnings from the threatened banks.

If the current draft of the rules takes effect, banks will be forced to offload assets beforehand, including selling bonds, stocks and other liquid assets at a discount and asking clients to repay loans before time, the sources said. “No matter which solution we choose, it will hit financial markets,” they added.

The banks also said rules on strictly limiting bank WMP investments in non-standard debt assets and private equities would reduce their support for the real economy and increase financing costs for companies, the sources said. They also suggested the central bank remove certain rules and extend the transition period for the new rules - currently up to June 2019 - to three years to smooth the impact, the sources said.

…which basically amounts to a “Catch-22” situation for China’s financial system.

Meanwhile, it’s worth highlighting a (very) recent example of fraud in the Chinese banking system which encompassed the WMP sector. Last Friday, the South China Morning Post (SCMP) reported on the 722 million yuan ($109 million) fine – the industry’s biggest penalty - served on Guangfa Bank, the largest bank in Guangzhou city. The bank covered up the default of two bonds issued by phone maker, Cosun Group, which had ben sold on an Ant Financial Holdings’ WMP platform. As the SCMP explains.

Ant Financial and 10 other banks sought compensation for investors from Zheshang Property and Casualty Insurance, which had provided insurance coverage on the debt, only to discover that the insurer had been issued fake letters of guarantee by Guangfa’s branch in Huizhou city. The fraudulent documents were created using counterfeit corporate seals made by branch staff. The case involved as much as 12 billion yuan, as the bank tried to channel money to cover its mounting bad loans and operational losses.

“Guangfa did everything that regulators hate the most,” said Chen Shujin, chief financial analyst at Huatai Securities. “They gave an under-the-table guarantee, and made illegal interbank investments to cover up a non-performing loan.”

The epidemic of fraud across China’s financial system has been obvious for years. The Catch-22 situation faced by the Chinese authorities boils down to a timing preference. With Xi’s position cemented for the next five years, the authorities can bring on the “Minsky moment” adjustment, knowing that the economy can recover by 2022. Or they can postpone it, leading to a truly catastrophic collapse down the road.
 

China's Shadow-Lending Ecosystem Could Be As Large As $40 Trillion, PBOC Guesses

Authored by Deep Throat at Deep Throat Blog

Today, I"d like to take some time to revisit a couple of related topics that we first started discussing a few years ago. I am, of course, referring to the burgeoning increases in China"s Debt levels, Shadow Bank Assets (loans) and M2, along with a high-level analysis of the most recent PBOC Financial Stability Report and FSB Global Shadow Bank Monitoring Report. (No!....please don"t click this page closed....I promise this will eventually get interesting...)

As a starting point, let"s begin by reviewing the February, 2015 McKinsey report  Debt and (not much) Deleveraging .  I first referenced the report in this blog in March of 2015. The report focused on the world"s, and particularly China"s, rapidly building debt/leverage phenomenon (2014 Year End Data).  I encourage you to re-read the entire report, but for those of you who are pressed for time, I"ll give you the executive summary bullet-points right here:

• Debt continues to grow  


• Reducing government debt will require a wider range of solutions


• Shadow banking has retreated, but non?bank credit remains important


• Households borrow more


• China’s debt is rising rapidly

I"m hoping that the McKinsey authors will consider updating the report, bringing the figures current, as I believe these observations, figures and analysis are even more pertinent today than they were back in 2015.

China"s Debt

So now, using McKinsey as a reference point, let"s take a look at where we are today, via the FRED (St. Louis FED)data below.

The FRED (Federal Reserve Economic Data - Citations below) Chart below represents US Core Debt (as defined and provided by the BIS - Bureau of International Settlements) compared to China Core Debt, as a percentage of GDP.  The third (bold Red) line represents China"s debt levels adjusted for a "what-if" constant I"ll explain shortly.

Lets dig into the numbers.  We see from 2006 thru 2016 US Core Debt increased modestly from roughly 220% of GDP to 250% of GDP.  However, China"s Core Debt, relative to GDP nearly doubled during the same period, to roughly 260% of GDP.

Before we discus the above, let"s talk about what GDP is (and isn"t).  GDP is:

C+I+G+(NX) or:

(Consumption + Investment + Government Spending + (Exports-Imports)).  

First, it"s important to understand that increased GDP does not necessarily increase wealth or improve quality of life.  A GDP calculation is measuring-stick for economic activity....nothing more.  A GDP figure makes no representations as to the quality, efficiency or economic utility of the activity producing the GDP.  i.e.) When my Dad was in the Army (WWII....the "big one") he talked about "practicing" digging fox holes.  He and thousands of other soldiers would be told/ordered to dig holes and fill them in.....for no apparent reason other than to keep them busy.  This activity, since he was being paid to do it, would increase GDP, even though it accomplished nothing more than wear them out and keep them out of the English pubs.

That said, here are a few examples of things that would significantly increase GDP.

• Building a Superhighway, Bridge or Bullet Train connecting two uninhabited deserts or islands. (I+G)


• Building a Ghost City. (I+G)


• A military build up. (I+G)


• Producing millions of tons of steel and cement held in a developer"s CIP inventory. (I+G+C)


• Creating even more manufacturing capacity (factories and mines) for steel, cement, etc.(I)


• Building infrastructure.  i.e.) Public works, water, power plants, tunnels, wells, utilities etc. (I+G)


• Manufacturing phones, computers, clothing and consumer goods for export. (C+NX)


• Buying tons of eCommerce stuff. (C)


• Tearing down an abandoned building/high rise. (C+G)

Here are a few more you might not think about.....again, these are events/activities that increase GDP but don"t necessarily increase wealth or quality of life.

• A hurricane....all of the destruction has to be financed and rebuilt. (C+I+G)


• Public Welfare and Housing Assistance Checks (C+G)


• Single Payer Health Care (C+G)


• Paying 10x as much for a medical procedure as you might pay in other countries (C)

So you get the point.....although it looks good on paper, incurring debt to build/finance things that aren"t economically viable, produce little (or no) economic utility or fail to generate earnings and cash flow doesn"t work too well over the long haul.  At some point, the lenders won"t be paid back.....or, as should happen in a free-floating world, if they are eventually paid back, they"ll be paid back with a currency having a fraction of the purchasing power of the currency they initially loaned out to finance the activity.

China"s "Productive GDP"

Now, let"s get back to the bold Red line on the chart above and take some time to coin a phrase. We"ll call it "Productive GDP" or PGDP.  As any economist will tell you, desperate times call for desperate measures.....and new terminology!  Let"s say that China"s "Productive" GDP, for lack of a better term, is defined as GDP excluding all of the over-building, non-productive excess capacity and accounting games created simply to hit the arbitrary 7%, etched in stone, silly, CCP mandated GDP growth target.

So let"s further say that rather than the published, rock solid, 7%, annual NBS GDP growth rate, the "Productive", un-fudged, non-incentivized, PGDP growth rate is only 4.6%, (2/3rds of the published/reported rate), but still a remarkable number for an economy the size of China"s.  Extrapolating the bold Red Line above, if GDP is "overstated" by a third, we illustrate/conclude that the ratio of Core Debt to "Productive" PGDP explodes to nearly 400%, much higher than the current G20 average of 240%.

Author"s Note:  You math aficionados out there might be observing that the bold red line doesn"t consider the compounding impact (i.e. reducing the GDP growth rate in a prior year impacts the current year starting point).  So the method illustrated (multiplying GDP by a constant) actually overstates GDP.  That"s absolutely correct.  However, since I have no actual data to base my adjustment on, it"s a guess, an arbitrary adjustment, so the compounding doesn"t matter.  Besides using a constant was just simply easier than trying to program the FRED model to compound the change.  In any case, I"m just illustrating a point.

So far so good?

Shadow Banking

Now lets revisit the 2015 McKinsey Report (2014 data) bullet points above.  Specifically:

• Shadow banking has retreated, but non?bank credit remains important

Unfortunately, per the People"s Bank of China (PBOC), Shadow Bank lending has reversed course abruptly and skyrocketed since the 2015 McKinsey report.  Nobody really knows how big China"s Shadow Bank ecosystem is, but the PBOC recently offered a rather shocking guess in their 2017 Financial Stability Report (pg.48).  China"s Off-Balance-Sheet, un-regulated, "Shadow" loans have grown to nearly US $37 Trillion (RMB 252.3 Trillion) and have surpassed China"s US$34 Trillion, "On-Balance Sheet" bank assets as of the close of 2016.  They also restated the 2015 numbers, increasing the 2015 figures to US$ 28 Trillion (RMB 189 Trillion), roughly doubling the 2015 figure.

Keep in mind, the PBOC estimating Non-Bank Shadow loans is a bit like the local Sheriff estimating "unreported financial crime".  He doesn"t have authority over the mechanics of the activity, lacks enforcement resources and therefore can"t do much about preventing the crime(s).  Even if he had authority and resource, he"d have a hard time zeroing in on the metric....criminals generally don"t respond to surveys or self-report their schemes.  Moreover, the Sheriff would have an incentive to under-estimate the problem and hope everything works out, since, at some point, someone is going to be held accountable.  As history shows, and Chinese Bankers are well aware of this, financial scoundrels are normally exiled to horrific disgrace on a private tropical island with access to boatloads of Cayman Islands money.....so it goes.

Again, based solely on the usual, limited transparency inherent in PBOC reporting (good things are trumpeted and bad things are swept under the rug), a disclosure like this would indicate that the problem is potentially much larger than they are letting on.  In the 2017 Financial Stability Report (an oxymoron if I"ve ever heard one) the PBOC restates the Shadow Bank Assets for 2014 and 2015 (as shown by the dotted line in the chart below). To my knowledge, no other major economy has ever experienced an acceleration anywhere near these levels of Non-Bank, Shadow debt relative to GDP, much less restated it in a gigantic "ooppps....our bad" buried in a couple of paragraphs in the bowels of a report.  In China....they do things big.  The bigger the better.  The two Charts below, prepared by Capital Economics illustrate that we"ve apparently entered uncharted waters.

Although the fiercely independent citizens, politicians and bankers of Hong Kong and Singapore might disagree, we can generalize that the leverage in those economies (tall bars on the left of the chart) is inextricably linked to the Chinese financial system. If there were ever a potential "ground-zero" for a default-induced financial contagion Shang-Hong-apore would be it.

Moreover, when we examine the PBOC/CE Charts above, it wouldn"t be much of a reach to conclude that Shadow/Non-Bank Credit has become an absolutely essential tool for keeping all of the financial balls in the air. As reported by Ambrose Evans-Pritchard in a piece for the Telegraph:

Jahangir Aziz and Haibin Zhu from JP Morgan said the debts of the state-owned entities (SOEs) have alone reached 90pc of GDP or $13.3 trillion.  

Nearly 60pc of new credit this year is being used to repay old loans. It takes four times as much new credit to generate a given amount of extra of GDP as it did a decade ago. “China’s rising indebtedness has come to represent all that is disconcerting about their economy,” they said in a report entitled “The Sum of All Fears”.

Hmmmm....."The Sum of All Fears"....catchy little title for a financial/policy report!  Tom Clancy would be proud....

Viewed another way, when we add the current, 2016 BIS figure, roughly US$28 Trillion of China"s Core Debt plus the estimated US$37 Trillion +/- of Shadow debt (RMB 253.5 Trillion), we have a Debt/PGDP ratio approaching 900% of "Productive" PGDP.  The Comparable, relatively constant, US ratio (250% +/-) is shown in blue below.

"Total Social Financing" (TSF)

Total Social Financing (TSF), a term of art the Chinese government introduced a few years ago to track the leverage in their economy, grew to RMB 155.99 trillion RMB (US$ 23 Trillion),  up 12.8 percent from 2015, per the PBOC Report. (Pg. 28)  The intent of this statistic is to track the "total financing" required by households and businesses.  The process goes awry when we try to decipher exactly what"s included in this metric and how the data is collected.  There are numerous articles written on this topic and I"ve listed a few of them in the citations below.  Suffice it to say that the consensus is, that a significant amount of Non-Bank Shadow financing is excluded from TSF.  Interestingly, this metric, intended to show changes in the composition of how economic growth is financed, is actually misleading, since significant Shadow risk is omitted from the calculations.

Some Verifiable Numbers.....Bonds

As difficult as it is to measure China"s fragmented Shadow Financial System, there are a few reported metrics which are presumably more reliable than others.  China"s bond markets are one such example.  In the last two years (2015 & 2016) the value of new "Major" Chinese Bond issues (below) has actually exceeded the total amount outstanding of America"s Corporate Bond market (about US$ 8.6 Trillion).  Why is all of this new debt necessary?  Again, most (60%?) of the new issues are used to roll over other bonds/debts/financing coming due.

Continuing the theme, Non-Performing Loans (NPL"s) have somehow remained relatively constant, hovering just under 2% since 2011 as shown below.  (pg. 44 of the PBOC Report)

How can this be?  Perhaps it"s just little old skeptical me, but usually, when borrowing skyrockets like this, underwriting is lax and bad loans go bad much quicker.  The universally accepted game bankers play to keep a bad loan from being reported as non-performing is to refinance it and change the terms....and (drum roll please....) ....like magic, it"s a performing loan again!  In all likelihood, that"s what"s happening with this fake NPL statistic.  It"s hard to believe that China"s financial system hasn"t already broken its economic foot as a consequence of kicking all of these NPL cans down the road, but somehow it just keeps chugging merrily along.  As my favorite Irish pub drinking song goes...."Roll me over in the clover.....roll me over lay me down and do it again...this is number one....we"ve only just begun....."

The Chinese Economy's Fatal Flaws

Dr. Per Bylund’s recently published article poignantly states one of the core problems in the Chinese economy and its the state-manipulated Keynesian foundation. I do agree with his opinion. And if we dig deeper into the exact situation of Chinese economy, we will find that it’s a typical failing of the Keynesian, cronyist system.

By using the perspective of Austrian business cycle theory, lets take a look at China’s real estate industry, which is suffering more and more painfully from artificial credit issued by China’s central bank, the People’s Bank of China (PBC).

During the 2008 global economic crisis, China’s central government issued the famous RMB 4 Trillion Stimulus Package Plan (equaling to $586 billion).

Since 2009, the Chinese real estate economy has already suffered from three small economic cycles. As it is becoming more difficult for real estate companies to live on artificial prosperity, the duration of every business cycle has become shorter than the previous one. We also see more and more ghost cities because of the economic boom in every sub-economic cycle. There were at least 12 ghost cities founded in 2013, and the number of them jumped to at least 50 in 2017! Bankruptcy is happening more frequently among Chinese real estate enterprises. Since 2016, at least three real estate companies — with a combined debt of at least RMB 763 million — have gone bankrupt. The story of bankruptcy is continuing, with one of the biggest real-estate-driven enterprises, Wanda Group, facing financing problems. If Wanda no longer has access to cheap debt, it might not be able to refinance or roll over all its debt again. If Wanda has to face bankruptcy, it could possibly accelerate an end of the the current Chinese boom. 

The data from the Chinese local governments is also not optimistic; their debt levels have reached almost RMB 25 trillion (US$ 4 trillion) at the end of 2014. In 2015, even the PBC admitted in one of its annual reports saying that China’s financial system is facing higher instability and uncertainty.

The above evidence is not a surprise. All these are the consequence of artificial bank credit created by central banking and central planning.

In China, the loans are easy to get from the State Owned Enterprises (SOEs) or the businessmen who are the friends of the politicians in the Communist Party. China’s real estate industry is also the ally of the state and only the people who are friends of those in authority can participate in housing programs. 

Besides the SOE economic system, what we should worry more about is how the Keynesian and crony system hurts small and private businesses in China, who are driving the economy of this country. Compared with the SOEs, and the businessmen who are the close allies of some influential politicians, it is harder for ordinary entrepreneurs who are running small businesses to get loans. Moreover, the recent market squeeze makes it harder for Chinese small business to survive. These entrepreneurs are not only facing an unfriendly bank credit situation, but also the threat of having to bribe the government to circumvent the massive scale of governmental economic regulations.

Consider the story of a small business boss Li Lang, who is a typical Kirznerian alert businessman in China. Several years ago, he observed a shortage of moving companies in the Southwest Chinese town of Chengdu. He started his business to serve the local people. The business is not easy, not only because it requires hard work, but Li also must bribe and maintain good relations with the local politicians to let them “protect” his business and help him introduce some business opportunities. According to Li, if the local bigwigs in the crony system had already discovered the opportunity of earning a fortune by managing a moving company, it wouldn’t have been possible for him to enter the business. Though now that he has earned a lot of money, he still has to carefully maintain the relationship with the politicians to "protect" his business. His is not an isolated case. In China, the less connections you have with the cronyist system, the less business opportunity you have. And even if you become successful in your business, be careful, the state has eyes on your wealth.

Though we know that the private sector is driving the Chinese economy and has improved the living standard of many Chinese individuals despite state economic manipulation, we still have to emphasize that the nature of the Chinese economic model is dominated by Keynesianism and cronyism.

Otherwise, the false prosperity would make us misread what is happening in China.

*  *  *

In other words - don"t start believing.

Analyst Lays Out China's "Doomsday" Scenario

The first time we laid out the dire calculations about what is perhaps the biggest mystery inside China"s financial system, namely the total amount of its non-performing loans, by former Fitch analyst Charlene Chu we called it a "neutron bomb" scenario, because unlike virtually every other rosy forecast the most dire of which topped out at around 8%, Chu argued that the amount of bad debt in China was no less than a whopping 21% of total loans.

Corporate investigator Violet Ho never put a lot of faith in the bad loan numbers reported by China’s banks: crisscrossing provinces from Shandong to Xinjiang, she’s seen too much - from the shell game of moving assets between affiliated companies to disguise the true state of their finances to cover-ups by bankers loath to admit that loans they made won’t be recovered. The amount of bad debt piling up in China is at the center of a debate about whether the country will continue as a locomotive of global growth or sink into decades of stagnation like Japan after its credit bubble burst. Bank of China Ltd. reported on Thursday its biggest quarterly bad-loan provisions since going public in 2006.

Charlene Chu, who made her name at Fitch Ratings making bearish assessments of the risks from China’s credit explosion since 2008, is among those crunching the numbers. While corporate investigator Ho relies on her observations from hitting the road, Chu and her colleagues at Autonomous Research in Hong Kong take a top-down approach. They estimate how much money is being wasted after the nation began getting smaller and smaller economic returns on its credit from 2008. Their assessment is informed by data from economies such as Japan that have gone though similar debt explosions.

While traditional bank loans are not Chu’s prime focus -- she looks at the wider picture, including shadow banking -- she says her work suggests that nonperforming loans may be at 20 percent to 21 percent, or even higher.

The chart below shows just how much of an outlier Chu"s stark forecast was in comparison to her peers, and especially the grotesquely low and completely fabricated official number released by the banks and the government.

To be sure, it has always been in Beijing"s best interest to keep true NPL data well-hidden by everyone from the lowliest bank teller to the Politburo, who all know that merely the recognition of the problem would be sufficient to spark if not a full-blown panic then certainly accelerate capital outflows form the nation to an unstoppable degree.

Another problem with making estimates of adequate collateral protection in China, one which makes such a venture more complicated than solving the proverbial riddle, wrapped in a mystery, inside an enigma, is that the very premise of collateralization in the world"s most populous nation is nebulous. Recall that one of the biggest scandals in China in 2014 was the realization (as many had warned previously) that millions of tons of commodities were rehypothecated countless times, and thus "pledged" as collateral to numerous counterparties, and that as a result these same counterparties were unable to make sense of who owns what at one of China"s largest ports, Qingdao. In this context, it is safe to assume that loss given default rates in China are if not 100% (or more, which is impossible in theoretical terms but in practice is quite possible, as another curious side effect of unlimited collateral rehypothecation), then as close to it as possible. In early June, Reuters published an expose on China"s "Ghost Collateral" reminding China watchers that this most insidious phenomenon is anything but gone.

Since then, fears about both China total debt load and the size of its NPLs have only grown, and most recently came under the spotlight of the IMF itself, which two days ago issued a warning about Beijing’s reluctance to rein in “dangerous” levels of debt, blaming Beijing’s tolerance of high debt levels on its goal of doubling the size of the economy between 2010 and 2020.

“International experience suggests that China’s credit growth is on a dangerous trajectory, with increasing risks of a disruptive adjustment and/or a marked growth slowdown,” the IMF said. This statement is spot on, because as the IIF recently showed, total Chinese debt/GDP has now crossed above 300%, a level that in every historical instance, led to a financial crisis.

What was left unsaid is that it is only because China doubled its total debt load following the financial crisis that the world managed to avoid succumbing to an unprecedented depression in the years following the financial crisis. However, by engaging on this unprecedented debt rampage, China only delayed the inevitable.

The IMF tried to sound mutedly optimistic, adding that “the [Chinese] authorities will do what it takes to attain the 2020 GDP target,” however one look at the exponential rise in China"s various credit product prompts substantial doubt how much longer Beijing can delay the inevitable.

And then there is, of course, the biggest wildcard: how much of China"s debt is already impaired, i.e., bad.

* * *

Fast forward to today, when Charlene Chu, described by the FT as "one of the most influential analysts of China’s financial system" is back with a revised estimate that the bad debt in China has now reached a stunning $6.8 trillion above official figures and warns that the government’s ability to enforce stability has allowed underlying problems to go unchecked.

Charlene Chu built her reputation as China banking analyst at credit rating agency Fitch, where she was among the earliest to warn of risks from rising debt, especially in the country’s shadow banking system. Today many of her original views — such as concern about Chinese banks concealing risky credit in off balance sheet vehicles — have become consensus among analysts.

The story repeated with grim determination by Charlene Chu, who left Fitch in 2014 to launch the Asia operation for Autonomous Research, is a familiar one: "everyone knows there’s a credit problem in China, but I find that people often forget about the scale. It’s important in global terms,” Chu told the FT in an interview.

So if Chu held the wildly outlier view nearly two years ago that China"s NPLs amount to 21% of total, what is her latest estimate? The number is a doozy: in her latest report, Chu estimates that bad debt in China’s financial system will reach as much as Rmb51 trillion , or $7.6 trillion, by the end of this year, more than five times the value of bank loans officially classified as either non-performing or one notch above." That estimate implies a bad-debt ratio of 34%, orders of magnitude above the official 5.3% ratio for those two categories at the end of June.

Needless to say, there is a solid pushback against Chu"s conclusion, and especially those who are currently invested in Chinese financial assets are doing everything in their power to prevent her opinion from becoming gospel.

Chu is among the most bearish observers of China, and some analysts question her methodology. In particular, her estimate of Rmb51tn in bad debt is based on average credit losses across other 11 other economies that previously experienced rapid debt increases comparable to China, including Japan in 1985-97 and the US in 2000-07.

But Chen Long, China economist at Gavekal Dragonomics in Beijing, said this methodology implicitly assumes that an economic crash will eventually occur in China.

Mr Chen argues that credit losses are highly correlated with economic performance: bad loans rise when growth slows. If China can prevent a sharp downturn, credit losses will be much smaller, despite the extraordinary increase in leverage.

Chen"s conclusion is delightfully and perversely reflexive: as long as China can avoid a crash, it will avoid a crash: “If there’s an economic collapse, of course there will be massive credit losses. No one disagrees about that. But the issue is whether the collapse will actually happen. She takes that as a given,” he said, adding that Chu failed to consider examples such as Korea in the 2000s or Japan after 1997, when debt rose strongly without harming growth. Which is true, but what Chen forgot to note is that globalsince both of those examples has risen to never before seen levels, in the process making the recurrence of such one-time "success stories" impossible.

Clearly Chen sees a far happier, non "crash landing" ending for the country with the 300% debt/GDP.

As for Chu, she acknowledges that an acute crisis does not appear imminent as the government suffocating influence over both borrowers and lenders has allowed Beijing to delay problems much longer than would be possible in a more market-driven system. One factor that has foiled countless shorts over the years is that Beijing can simply order state-owned banks to keep lending to a lossmaking zombie company or to a smaller lender that relies on short-term interbank funding to stay liquid, and that"s precisely what has been happening, when looking at the various non-conventional credit pathways in China in recent years, which include Wealth Management Products, Bank Loans to Non-Bank Institutions, Shadow Banking, Repos and Certificates of Deposit.

But Chu said the ability to avoid recognizing losses only delays the inevitable day of reckoning as problems fester for longer, and grow larger than in an economy where actors respond purely to market incentives. That said, the recent spike in corporate bankruptcies indicates that even Beijing is slowly shifting to a more "market" driven stance.

“What I’ve gotten a greater appreciation for is how everything is so orchestrated by the authorities,” she said. “The upside is that it creates stability. The downside is that it can create a problem of proportions that people would think is never possible. We’re moving into that territory.”

Finally, putting it all in context is the following chart showing the total size of China"s financial sector, which as of the latest quarter has grown to $35 trillion, double the size of the US.

If Chu is right, and local savers and investors certainly know best, it would explain why when looking at SAFE data showing "onshore FX settlement" and "cross-border RMB flows”, and which reveals that net flow of RMB from onshore to offshore was another $13.8billion in July , contrary to PBOC reports Chinese outflows have not ceasued since the summer of 2015...

... as a third of Chinese bank assets being "bad" would be nothing short of a "doomsday" scenario for China"s financial system and also explains the relentless attempts by local to park their money offshore before the system one day "unexpectedly" crashes.

As Mystery Of China's Multi-Billionaire Default Deepens, A New "Bond Scare" Emerges

Last week, in a largely "under the radar" event, one of China"s wealthiest billionaires (if only on paper), Wu Ruilin, chairman of the Guangdong based telecom company Cosun Group, and whose personal fortune of 98.2 billion yuan ($14 billion) makes him wealthier than Baidu founder Robin Li who is ranked 8th on the Hurun Rich List 2016, shocked Chinese bond market watchers when he defaulted on a paltry 100 million yuan ($14 million) in bonds sold to retail investors through an Alibaba-backed online wealth management platform, citing "tight cash flow."

Needless to say, many were stunned that a billionaire for whom $14 million is pocket change, blamed "tight cash flow" for defaulting on mom and pop investors. In any case, as South China Morning Post reported, despite the founder"s personal fortune, according to a notice put up by the Guangdong Equity Exchange on Tuesday, two subsidiaries of Cosun Group are each defaulting on seven batches of privately raised bonds they issued in 2014. According to the notice, “the issuer had sent over a notice on December 15, claiming not to be able to make the payments on the bonds on time, due to short-term capital crunch."

To be sure, yet another default in a Chinese landscape suddenly littered with bankrupting debt dominoes would have been the end of it, however this morning Reuters added to the mystery when it said that the fate of the defaulted $45 million Chinese corporate bond sold through an Alibaba-backed online wealth management platform was thrown into doubt on Monday, after a bank said letters of guarantee for the bonds were counterfeit.

Quoted by Reuters, China Guangfa Bank Co Ltd (CGB) said guarantee documents, official seals and personal seals presented by the insurer of the bonds "are all fake" and that it has reported the matter to the police.

The dispute highlights challenges in China"s loosely regulated online finance industry, where retail investors often buy high-yielding bonds and other assets, expecting them to be "risk-free" due to guarantees provided by various parties.

As first reported last Wednesday, at the center of the latest dispute are up to 312 million yuan ($45 million) worth of high-yielding bonds issued by southern Chinese phone maker Cosun Group that defaulted this month. The bonds were sold through Zhao Cai Bao, an online platform run by Ant Financial Services Group, the payment affiliate of e-commerce firm Alibaba Group Holding Ltd.

Ant Financial has asked Zheshang Property and Casualty Insurance Co Ltd, which wrote insurance on the bonds, to repay investors. On Sunday, Zheshang Insurance published two documents on its website that it said were from CGB carrying the bank"s official seals, and that guaranteed Zheshang Insurance policies for the Consun bonds. The letters were issued at CGB"s Huizhou branch in December 2014, when the Cosun bonds were sold, Zheshang Insurance said.

And yet, suggesting there is a massive landmine hiding just below the surface of China"s bond market, far worse than merely the consequences rising interest rates, on Monday, CGB said the documents were fake and that it had reported the incident to police as "suspected financial fraud."

While material misrepresentation of facts in Chinese finance is hardly new, the recent alleged violations usher in a whole new breed of fraud, one which is far less nuanced and far more simpllistic and includes outright forgeries of documents that backstop tens if not hundreds of billions in debt. The Cosun dispute follows similar instances of financial fraud this year including forged bond agreements that led to brokerage Sealand Securities sharing potential losses of up to $2.4 billion. In May, the government advised banks to be vigilant after several cases of bill fraud.

Ant Financial on Tuesday said Zheshang Insurance "hasn"t any reason to refuse repayment" which it was obliged to do "within three days" of default.

Making matters worse, the fraud has taken place in the context of a bond default that, according to an Ant Financial spokeswoman cited by Reuters, was a "a one in billions incident" on the platform.

Incidentally, Cosun"s bond issuance totals 1 billion yuan, according to Zheshang Insurance. The insurer"s total registered capital is 1.5 billion yuan.

Should more such "one in billions incidents" emerge, Chinese bond investors - already freaked out by the recent record plunge in Chinese govt bond futures, soaring overnight funding rates, and fears over Fed rate hikes - will rush for the exits just as China"s housing bubble is also popping as reported yesterday, leading to a rerun of the US 2006/2007 dual bursting of the housing/credit bubbles, only this time instead of an $8 trillion financial system, the world will have to backstop China... whose banking system at last check had over $30 trillion in liabilities.

Incidentally, we wonder if now that China"s bond insurers are also under the spotlight, if that means China"s very own MBIA/Ambac moments is imminent, as billions in bond insurance contracts are deemed "fake" by the insurers who would rather not pay up on what is set to be an avalanche of defaults.

* * *

Finally, for those interested in what Bloomberg last week dubbed the "latest China Finance Scare", namely outright forgeries in various debt products, mostly focusing on Entrusted Bonds, here is a useful primer courtesy of BBG:

There’s another Chinese financial practice that’s prompting high-decibel warnings. So-called entrusted bond holdings are a way for financial institutions to skirt rules on using borrowed money to invest in bonds. How? By getting a third party to buy the bonds and agreeing to purchase them at a later date. What could possibly go wrong? How about the worst rout in China’s bond market in a decade. That’s left regulators concerned about the prospect of investors failing to make good on such arrangements, estimated to involve at least $144 billion of bonds.

1. Why entrust us with this news only now?

Concerns about entrusted bond holdings have worsened the tumble in the debt market. Last week, Caixin cited market rumors when it reported a brokerage called Sealand Securities Co. had refused to take over bonds held by a counterparty. That got investors worried. Oversea-Chinese Banking Corp. then said in a note, citing media reports it didn’t identify, that the entrusted holding agreement may have been tied to alleged fraud by ex-staff. Sealand cleared the air when it said it would in fact fulfill the bond contracts that had been stamped with a forged seal. The whole incident was enough to frighten an already jittery market.

2. So why do investors use entrusted holding agreements?

Brokerages and other institutional investors ask counterparties to buy bonds from them when they need to circumvent internal rules on note holdings and leverage, according to Xu Hanfei, a bond analyst at Guotai Junan Securities Co. Or they can simply have third parties buy the notes directly from the market. The practice boosts leverage by effectively giving the financial institutions loans: As brokerages and institutional investors don’t carry the bonds on their books, they can use the funds freed up on paper to purchase more bonds, which can then be rolled into more such agreements. “Non-bank financial institutions, which emphasize returns, have more motivation to amplify leverage through entrusted holdings,” said Li Liuyang, a market analyst at Bank of Tokyo-Mitsubishi UFJ in Shanghai.

3. How widespread is the practice?

Outstanding entrusted holdings are "in the trillions of yuan," according to Guotai Junan’s Xu. That estimate is based on the bond holdings of the brokerages and smaller banks that are major participants in such transactions. That means the amount of money tied up in such deals is at least 5 percent of the 21 trillion yuan ($3 trillion) of outstanding corporate notes in China, according to data compiled by Bloomberg.

4. What broader risks does it pose to China’s financial markets?

A default in an entrusted holding could turn what otherwise might have been a problem with one company’s liquidity into a broader credit event, given that multiple parties may be involved, according to Li at Bank of Tokyo-Mitsubishi UFJ. Li says “everyone is worried about similar situations in their transactions with non-bank financial institutions.” OCBC said that things had got so bad that banks were reluctant to lend to non-bank institutions amid a breakdown in trust between investors.

5. What are regulators doing about it?

Authorities including the central bank and the China Securities Regulatory Commission are investigating some financial institutions’ entrusted bond holdings after the Sealand incident, people familiar with the matter said Tuesday. The holdings run contrary to the central bank’s push to trim investments made on borrowed money, according to China Merchants Bank Co. “It’s just a question of when Chinese regulators will clean up entrusted bond holdings,” said Liu Dongliang, a senior analyst at the bank. Tommy Xie, an economist in Singapore at OCBC, says China’s market rout may prompt regulators to strengthen rules on entrusted holdings. He describes them as "a common practice in the grey area of the bond market.”