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What Traders Should Know about China Bailing Out Peer-to-Peer Lenders

09/13/2018 4:25 pm EST

Focus: MARKETS

Monty Guild

Founder, Guild Investment Management

For several years we have been alerting our readers to the dangers posed by the over-leverage of the Chinese financial system. Eventually this over-leverage could result in a financial crisis within China, says Monty Guild. He's presenting at MoneyShow Dallas. 

Direct contagion would be limited because China’s financial system is largely separate from the rest of the world’s, but there would still be negative consequences for many banks outside China, and for the global economy if a crisis resulted in a Chinese economic slowdown or recession.

When the next global recession begins, as we have said repeatedly, it could be precipitated by a crisis in China, or in Europe -- which faces very different troubles but also has a financial system challenged by bad debts. (Indeed, Europe may be in worse shape because of its fractious politics and lack of a strong central financial authority.)

A crisis in China does not appear imminent. Just as we have been watching the risk of a Chinese financial crisis for years, we’ve also been watching those who believed it was imminent and who invested on that basis; this is one of those areas where being early is the same as being wrong.

For some medical patients, the best course of action is alert inaction -- “watchful waiting.” This is what we do with China, and with the global financial system as a whole -- we monitor stresses as we try to discern when action will be warranted.

Chinese boom builds debt

China has experienced several decades of very strong economic growth since its turn towards domestic free-market economics and its entry into the World Trade Organization.

As is often the case, that boom time resulted in the build-up of a lot of debt, as economic optimism and loosened legal strictures encouraged lenders and borrowers.

Much of that debt accrued outside of formal banking, in the so-called “shadow banking system.” The authorities permitted the emergence of this financial sector to encourage and facilitate more rapid growth. There was also a good deal of theft involved, as the sector afforded avenues for corrupt officials to use to steal money and ultimately to get it out of China, where it has helped bid up asset prices around the world (particularly real estate in many desirable markets in Canada, Australia, and the United States).

Over the past few years, particularly under the anti-corruption campaign begun by President Xi Jinping, China has begun addressing the over-leverage of its shadow banking system.

It is a delicate process, because too-harsh measures could result in an economic slowdown. Maintaining economic growth is the basis of the unwritten social “contract” that China’s authoritarian rulers have with the Chinese people.

Their social and political liberties are curtailed, and in exchange, the government continues to successfully engineer more of the growth that has lifted so many Chinese people out of poverty over the past three decades. The leaders of China’s Communist Party believe that if they fail to make good on that promise, they’ll face significant social unrest -- or even the loss of the power. They must simultaneously stabilize their financial system, reduce bad debts, fight corruption, and maintain economic growth.

It’s a tall order, but so far, they’ve been successful. Typically, they will have a period of several months of “tightening” in which they make financial conditions more stringent and enforce rules more strictly, even permitting some unofficial financial enterprises to fail without bailing out their creditors.

Then they follow with a period of “loosening” before the effects of tighter policy cause growth to decline.

The latest round of loosening ended late last year, and government policy this year has focused again on the reduction of risk in the unofficial banking sector, particularly on controlling local government debt. Other priorities have included items drawn from the blueprint created at the end of last year when President Xi Jinping launched his “New Era Economics” -- environmental policy, especially improving Beijing air quality, and housing policy, to try to curb the risk of property bubbles.

China bails out peer-to-peer lenders

Recently we noted one revealing item. Part of China’s debt problem has been “moral hazard” -- which means that people put money into schemes in the unofficial banking sector in an attempt to earn higher yields, expecting that the government will bail them out in the event of a default. The government has gradually been letting entities in the unofficial banking sector go bust, and not stepped in to make lenders and investors whole.

Recently, though, there has been a big spike of failures in two areas.

One area is “wealth management companies,” or WMCs. These are unofficial-sector lenders who promise savers a rate of return much greater than that provided by official banks.

The other is “P2P,” or peer-to-peer, fintech lending platforms. So much household saving is in WMCs and P2P products that analysts believe that defaults could ultimately have a significant impact on consumer spending.

As the defaults spiked this year, popular anger rose, and the government quickly shut down and dispersed protests in major cities.

So rather than let this surge of defaults continue and let the chips fall where they may (and let public anger keep rising), the government has asked its four big “distressed asset managers” to step in and shore up the WMC and P2P sectors.

In short, a big step backwards in the reduction of moral hazard… as products that the government was on track to permit to fail, are getting bailed out after all.

It just goes to underline how tough the problems are that the managers of China’s finances and economy are dealing with, and how delicate the balancing act among the different goals they are pursuing. For now, it is not the sign of an imminent crisis… but it is worth watching.

Investment implications: While trade tensions and currency conflicts persist, the Chinese stock market, which is driven largely by sentiment among Chinese retail investors, is unlikely to perform well.

At some future juncture, a resolution of trade issues, a rise in investor sentiment, and a cycle of looser financial policy will occur; only then will we reconsider China as an investment destination.

At some point, China will be vulnerable to a genuine financial crisis. That time is not imminent, but if it occurs, it will have global consequences, so monitor Chinese financial conditions.

At MoneyShow Dallas, Monty Guild presents: Cryptos on the cusp. The new crypto environment. Oct. 5.

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