Chinese storm clouds still loom, and things could get worse

Rome

THERE are no signs that the storm clouds over Beijing and Shanghai are abating. Chinese stock markets have fallen about 20 per cent this year, with few signals of stabilisation. The so-called circuit breakers have failed. Risks have grown through massive stock-market support from government funds (the "China plunge protection team") and Chinese banks' loans of over US$200 billion to institutional investors, all under the benign eye of the People's Bank of China (PBOC).

The PBOC faces serious difficulties in managing the renminbi, under pressure from the US interest-rate hike. The central bank has run down its foreign-exchange reserves from US$4 trillion in mid-2014 to US$3.3 trillion in December in a bid to stem the currency's decline.

In offshore markets, the Chinese currency is trading much lower than on the official one, stoking speculation that the PBOC is managing the official exchange rate down towards the offshore value. This detachment could be dangerous because it encourages a "dollar black market" by operators defending themselves against devaluation risks.

Offshore renminbi markets are still in their infancy (only 3 per cent of the official market), but have gained weight rapidly since the November 2015 decision to bring the currency into the International Monetary Fund's Special Drawing Rights. In a foretaste of possible Argentina-like troubles, Shanghai's foreign-exchange booths have lately attracted sizeable queues of dollar-seeking Chinese citizens.

To mitigate renminbi short-selling, the PBOC has raised the overnight bank lending rate by up to 80 per cent. In the short term, the PBOC can win these battles. But falling foreign-exchange reserves cast doubt on its ability to surmount a full-scale currency war.

The biggest risks lie within the Chinese banking system. In the last decade, credit to China's real economy has grown 10 per cent a year, with corporate debt now surpassing 147 per cent of GDP. Last year's economic growth decline to a "meagre" 6.9 per cent has raised registered bad debts to US$700 billion. This is 2.3 per cent of total banking assets, tiny compared with 40 per cent in Greece and 16 per cent in Italy, causing some independent analysts to doubt whether this adequately reflects Chinese banks' hidden risks - especially since the dollar's rise is exacerbating the problem of hard-currency loan repayments.

A dangerous accounting malpractice - transforming standard loans into "investments" supporting non-financial intermediaries (the shadow banks) - appears to be spreading. This reclassification allows banks to boost profits by circumventing regulatory standards imposing reserves against bad loans. Lack of adequate reserves could trigger uncontrolled defaults of some of these shadow loans, precipitating chaos faster than anyone can imagine. The New Year has started badly in China. We may not yet have seen the worst. OMFIF