Chinese credit market spreads give a red alert for an imminent subprime-style banking crisis

Posted on 02 March 2014 with no comments from readers

The Chinese credit market is giving a red alert with signals similar to those that occured before the US subprime banking crisis. Banks have become cautious of lending to each other, while investors are taking shelter in only the safest government bonds and gold.

One gauge of financial stress – the spread between the two-year sovereign yield and the similar-maturity interest-rate swap – reached 121 basis points last month, the widest in Bloomberg data that started in 2007. There is a sense of deja-vu here.

Armageddon warning

Before the 2008 US financial crisis traders successfully gauged lending appetite by monitoring the difference between the London Interbank Borrowing Rate and the overnight indexed swap. Many assumed then that the Federal Reserve would be monitoring the same indicators and know what to do, just as the market assumes a similar omnipotence for the Chinese authorities at the moment.

But the story being played out is remarkably similar to the subprime crisis. The Shibor-repo rate is similar to Libor-OIS. Chinese shadow banking is the new subprime. Credit spreads are widening just as they did in 2007. Monetary growth is falling as credit tightens.

In times of financial stress it is the weakest links in the chain that break first. In 2008 that was the Lehman Brothers bankruptcy. What will it take in China? Recent bailouts tell us little. Trust funds are the weakest link in modern China. There are overwhelming trust fund redemptions coming due this year. The clock is ticking.

Another sign that Chinese investors sense that their credit system may be about to come unstuck is the national mania for buying gold. Switching to hard assets is another classic move by investors interested in preserving their wealth in a paper money crisis.

Timing impossible

It is impossible to know exactly when such a crisis will happen. The authorities know the indicators well and are adept at papering over the cracks. This is not the first time that the stock market is foreseeing a crash, the intensity of which may be unclear now. The economists expect the worst and the least and are constantly monitoring the indicators in both of the world’s biggest economies.  Whatever little bit of early information is passed on to the concerned will have a profound impact just like a good Ethereum Code review can draw real publicity and word-of-mouth publicity.They even change the newspaper headlines if necessary. But there has never been a credit expansion on the scale of recent Chinese growth in history without a blow-up in the banking system.

It is not going to be any different this time. When it happens local interest rates will shoot through the roof, property and stock market prices will plummet and the cost and restriction of credit will send the most heavily indebted into bankruptcy leading to widespread job losses and social unrest.

This is the ‘creative destruction’ phase of capitalism that we saw all over the world in 2009. Provided that central banks then allow market forces to operate you get a leaner and fitter economy emerging from the rubble, except that this was not allowed to happen the last time around and they borrowed instead.

Those chickens are now coming home to roost!

Posted on 02 March 2014