China Shadow Banking Crisis Could Dwarf Subprime Meltdown or Greek Debt Debacle

by Jeff Reeves | October 25, 2011 3:05 pm

China is taking some knocks lately over fears that a “hard landing” is in the cards for this booming emerging market. Admittedly, it all sounds a little overblown as China’s industrial output surged 13.8% in September over 2010 numbers — hardly indicative of an economic crisis. And although auto sales in China are lagging[1], they still are growing in what now is the largest vehicle market in the world after American car buying slowed to a crawl during the recession. And, of course, Macau casino stocks are booming[2] as disposable income among wealthy Chinese continues to be in ample supply.

But those who watch manufacturing and consumer trends in China are buying into the head-fake. The fact is almost all production and consumption trends in this nation are subject to massive risks of Chinese banking and lending — a so-called “shadow banking” system that is unregulated, corrupt and wide-reaching in this communist nation.

Consider this: According to a study issued by the People’s Bank of China in 2010, non-banking-sector lending has expanded to anywhere between $1 trillion and $10 trillion — as much as 40% of the total lending activities of China’s economy. These loans come with exorbitant interest rates, ranging from 14% to as much as 70%.

The practice has become so widespread, in part, because it isn’t loan-sharking to gamblers and drug addicts. In China, it’s mostly rich individuals and legitimate businesses lending money to other individuals and even companies as an “investment.” The red-hot growth and inflationary pressures typically have meant repayment is within reach, so both the lender and the borrower alike wind up happy with the results of the arrangement.

But what happens when loans can’t be repaid? There is little to no government oversight for these loans, so there is little to no recourse when a debtor defaults. And unlike banks, which have a large portfolio of loans and assets to fall back on, individuals making these shadow loans sometimes can’t afford a 100% loss that bites into their savings or family budget. It becomes a domino effect, where one person’s loss becomes another’s, cascading around China one lender and business at a time.

China Addicted to Shadow Banking

China recently has pledged more oversight and regulation of the shadow banking industry, but it’s not that simple. The bottom line is that China has a vested interest in this kind of lending.

The surge in lending in China is closely tied to a sharp rise in property prices. As in the U.S. before the financial crisis, it appears the Chinese have embraced the idea of loose credit to buy property as an investment.

But we learned the hard way that those investments aren’t guaranteed.

A national regulator cracking down on non-bank lending companies in China’s shadow banking sector could have a serious impact on the housing market there. Without an alternative to conventional banks, lending naturally would be out of reach for many prospective buyers. That would dampen demand — and could dampen prices as a result.

It goes beyond housing, too. As much as 90% of China car sales are conducted with cash[3] — meaning many of those buyers have obtained a loan under the table to make the purchase instead of financing through conventional lenders. If the shadow lending system in China doesn’t provide financing, how will those sales happen? Auto sales in China already are lagging, and a shock to lending could really shake up what largely is seen as the best market in the world for vehicle sales. That’s bad not just for China, but also for companies like General Motors (NYSE:GM[4]) who have all but bet the farm on Chinese auto sales.

Additionally, many cash-strapped private businesses often simply can’t get loans from commercial banks. Tighter monetary policy in Beijing has made it harder to access the formal banking sector, and state enterprises have a higher priority for the available funds. If Chinese regulators decide to crack down on this kind of lending, many small businesses will face bigger barriers, and that could impact the growth of China’s vaunted middle class.

And those are just some of the obvious and most easily explained issues at play with this banking Gordian knot.

The Real ‘Hard Landing’ for China Businesses

Perhaps the most disturbing fact of all is that shadow banking is not just a systemic risk to individual bank accounts. Yes, the lender will take a huge hit and see its savings disappear after a default. But the real risk comes after that — as the personal impacts of bad shadow lending deals trickle up into businesses.

Consider the boom in Chinese discretionary spending, and the impact that Chinese consumers have within the People’s Republic. Macau casino stocks are booming and represent the most tangible example of Chinese “play money” at work. By most estimates, China will account for about 20% of global luxury sales in 2015. Earlier this year, Prada opted for an IPO in Hong Kong to ensure it was connected to the booming Asian market. The list goes on.

As consumers suffer, these businesses will suffer.

It doesn’t end there. Consider that, according to Financial Times[5], “more than a quarter of pretax profits at China’s Yangzijiang Shipbuilding Holdings in the second quarter came from an unexpected source — not its core shipyard business, but from lending money to other companies.” This shows that it’s not just individuals cashing in on shadow banking, but corporations, too.

Remember how investors thought General Electric (NYSE:GE[6]) was bulletproof due to its massive operations, and how the subprime crisis eviscerated the stock and resulted in a 68% dividend cut due to bad loans at GE Capital? Yeah, that’s what’s going on in China right now.

How This Affects You

There are those who think this is all hyperbole, that the shadow banking system in China isn’t this bad — or that Beijing’s acknowledgement of the risks presented by this informal lending earlier this year is a sign that China is ahead of the curve and will right the ship.

Maybe. But it’s going to be a very difficult task to extricate shadow banking from China’s red-hot economy amid tight banking policy and high inflation. It won’t be done overnight, and it will involve far-reaching changes across many aspects of the Chinese economy.

To make matters worse, this isn’t just a China problem. The fate of the west — and all of our investment portfolios — is closely linked to the fate of China’s growth. American corporations from McDonald’s (NYSE:MCD[7]) to General Motors to Apple (NASDAQ:AAPL[8]) have made big investments in China on the premise that impressive growth there will continue for many years to come.

Let’s all hope there isn’t a shadow banking meltdown in China. Because if there is, the ripples will be felt all over the world as the biggest engine of economic growth breaks down.

Investors leery of a shadow banking meltdown would be wise to reduce their direct exposure to China — particularly Chinese consumers. In short, if you want to buy GM because of its operations and sales beyond China, go ahead. But don’t depend on Cadillac sales in Beijing to make you rich. Similarly, don’t buy Apple because of iPhone sales in China — buy it because you believe growth in enterprise sales will surge in the coming years.

Or if you’re willing to roll the dice on China, make sure you have an exit strategy and that you use stop-losses to protect yourself. As we saw in the fall of 2008, when the crisis hits, it can hit fast and erase your wealth in a hurry.

Jeff Reeves[9] is the editor of Write him at[10], follow him on Twitter via @JeffReevesIP and become a fan of InvestorPlace on Facebook. As of this writing, he did not own a position in any of the aforementioned stocks.

  1. auto sales in China are lagging:
  2. Macau casino stocks are booming:
  3. 90% of China car sales are conducted with cash:
  4. GM:
  5. Financial Times:
  6. GE:
  7. MCD:
  8. AAPL:
  9. Jeff Reeves:

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