Is China facing a “Lehman Moment” due to high shadow banking debt?
China’s shadow banking differs substantially from that of the U.S. before the financial crisis. There, the shadow lending funding the property boom consisted of collateralized and leveraged mortgage products that were highly liquid, traded instruments. Many official banks participated in this business, along with “shadow” non-banks such as insurance companies.
In contrast, China’s current shadow banking is funded mainly by the banks with few liquid instruments. Thus, the pace of decline is is more controllable compared with the U.S. crisis. Three-quarters of LGFV debt is bank debt, for example, with bonds and private investments accounting for the remainder. The recapitalization, or default process, is under the jurisdiction of the banks (with political input from the local governments and the PBOC).
Bank loans?
Where could China see a run on a bank or shadow bank? The one recent example in January 2023 of a near default by an LGFV, Zunyi Road and Bridge, was averted by a 20-year bank extension of 60 billion yuan in outstanding debt, and no repayment of principal for 10 years. It’s unclear if Zunyi will set a pattern. Regulators have hinted that it would not because they don’t want the banks to encourage the growth of bad debt or see bank margins hurt.
However, no LGFV wants to be the first to default as it could cause a chain reaction among all LGFVs, and possibly some local SOEs, and hurt the career advancement of the provincial or city party leaders.
There are many channels of debt in China’s property market. However, they all directly or indirectly go through the banks. That means that the PBOC and the Central Financial Work Commission in the Central Committee of the Politburo, along with lesser political actors in the provincial governments, have some ability to pull the strings—when the puppets threaten to dance their own tune. Significant losses will be absorbed by the weaker institutions, including poorer provinces, weaker rural banks (which may be absorbed by stronger SOE banks), and home-owners with few legal tools for compensation for lost property. The deleveraging process in the property market will be a series of lengthy, local battles, not a single war.