There's a parasite in China sucking up money faster than the country can print it
Reuters
China's shadow banking system will soon begin to suck money out of the country's economy at a mind-bending rate, according to analysts at HSBC.
This news couldn't be coming at a worse time. The global economy is on tenterhooks after the the UK decided to leave the European Union in mid-June. That issue prompted China to devalue its currency, the yuan, by the most since August. Generally when that happens, cash starts to flow out of the country.
The problem with China's shadow banking system right now is that there are a few things going on — like falling interest rates — that could make it a source of capital flight while also siphoning off much-needed cash flowing through the economy into a dark, black hole, like a parasite. A big, fat money tick.
WMP WMD
But first, let's clarify what we mean by shadow banking. In general, China's shadow banking system is made up of wealth management products, or WMPs, carried off balance sheet.
ReutersThese are debt or debt-like instruments that pay out higher interest rates to investors. This is important because over the last year and half, as the Chinese economy has slowed down, the People's Bank of China has lowered interest rates in order to keep cash flowing through the economy, as can be seen in this chart from HSBC.
This is what makes WMPs so attractive, even though they're riskier than normal financial instruments. China is a developing market, and investment options are limited. The stock market became something of a no-go after it crashed last summer and again in February.
As such, the growth of WMPs has exploded as Chinese investors have looked for places to park cash.
In a note to clients on Thursday, HSBC estimated that the WMP market is 24% larger than China's domestic stock market, the A-share market.
From HSBC:
"If Wealth Management Products (WMPs) continue to expand at their current rate, in two years' time as much as a third of the retail funding activities in China's banking system will take place off balance sheet. That will make it even harder for regulators to estimate risk in the banking sector and to monitor linkages between the country's shadow banking activities, capital markets and the real economy."
Even before rates started falling, WMPs were a problem for the Chinese government. They're opaque, and as Deutsche Bank pointed out in a recent note, they allow money to be siphoned off to unproductive projects — China's infamous roads to nowhere and empty cities.
The parasite
The WMP problem is now so huge that it's starting to suck up cash lying around in the Chinese economy like a horde of locusts. Economists use "M2" to describe the part of an economy's money supply that includes cash, checking deposits, and what is known as "near money" — extremely liquid assets like savings deposits, money market mutual funds, and other time deposits.
HSBC points out that M2 growth has settled in around 12% to 15% a year over the last few years. It was 20% while the economy was growing faster. WMPs, HSBC analysts estimate, are growing much faster than that.
"What that means, quite simply, is that money is flowing into WMPs faster than the pace at which it is being created, implying that liquidity is being sucked in from the real economy," the analysts wrote. "In our opinion, the sustainability of such a situation is questionable, and this is potentially one of the key factors that could trigger a systemic risk event down the road."
Reuters
Falling interest rates in China create a different set of problems that are becoming visible strains on the system. It's unclear how long WMP interest rates can stay higher than those of plain-vanilla debt instruments. They've already been falling.
That makes them less desirable to investors, and that means less money will flow into the products.
And there are two consequences to consider there.
Firstly, a lack of inflows means the WMP market itself is in danger. Without inflows, this market is unsustainable, and the risk of defaults increases, among other things.
From HSBC:
"We expect further fundamental risks to emerge as the economy continues to slow. This will show up not just in the form of higher non-performing loans or more bond defaults, but also more direct investment projects generating weaker returns than expected and ultimately falling equity valuations.
"Risk will increase for more than just traditional debt underlying but across asset classes. The higher exposure to non-conventional asset classes for trust, insurance and broker WMPs has exacerbated such downside risks. Therefore, we think that the conditions for WMPs to become non-performing (i.e. missing interest payments or principal redemption) will increase."
Secondly, it means that investors will get scared and run off to other asset classes. HSBC thinks they could flee to the US dollar, and that means even more money flowing out of the Chinese economy.
You'll recall that Chinese outflows generally mean intense turmoil in its domestic markets, as well as likely leading to volatility worldwide. We saw this in August, after the country's big currency devaluation, and again in February, when a falling yuan lead to big outflows in December and January and scared the pants off investors.
One more problem that is China's and China's alone: Chinese investors have been known to freak out over money lost in the shadow banking system. Financial collapse is not great for "social harmony," which the government has always emphasized as a key to keeping the whole project that is the People's Republic of China afloat.
For more on China's delicate situation, check out Business Insider's Linette Lopez and Josh Barro on their podcast Hard Pass interviewing investor Jim Chanos:
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