George Soros has caused a bit of a frisson by calling China the greatest risk to the global economy. In a Project Syndicate article, the famed hedge fund manager stressed that China has been able to use its control over credit to heat up and cool off its economy. The government tried cutting lending back in 2012, but when the credit squeeze become painful, the officialdom eased in mid-2013 and the expansion resumed.

Soros’ concern is that debt levels have hit the point where an end-game is nigh; he believes the Chinese have only a couple of years of current levels of debt expansion at their disposal before the side effects become too damaging.

But why the dour view? Many argue that the government controls the banks, and the Chinese command economy model has outdone the West, so critics are barking up the wrong tree. But the picture has changed radically in the last few years. Even as of 2008, the productivity of more debt was falling. It was taking $4-$5 of new borrowing to generate $1 in GDP growth. That was comparable to the level of debt productivity on the eve of the crisis in the US.

The big source of worry isn’t just the level of debt but its structure, meaning the explosion of the shadow banking system. Bloomberg gives a good overview, in Shadow Banking Risks Exposed by Local Debt Audit. It’s important to keep in mind that bulk of government spending takes place at the local level, which accounts for 80% of expenditures even though it collects only 40% of total tax revenues. Borrowing, which finances local development projects, makes up the difference. But it’s not straightforward borrowing: “Local governments have set up more than 10,000 financing vehicles to fund projects such as subways and airports because regulations limit their ability to borrow money directly.” And the rise has been explosive:

China’s audit of local governments exposed an increased reliance on shadow banking, swelling the risk of default on 17.9 trillion yuan ($3 trillion) of debt. Bank lending dropped to 57% of direct and contingent liabilities as of June 30 from 79% at the end of 2010, while bonds rose to 10% from 7%, National Audit Office data show. Trust financing surged to 8% from zero, while other channels that sidestep loan curbs accounted for the remaining 25%. The yield on five-year AA notes, the most common rating for local government financing vehicles, jumped by a record 158 basis points last year to 7.6%. That exceeds the 5% on emerging-market corporate notes, Bank of America Merrill Lynch indexes show. “As banks tightened their purse strings, local governments had no choice but to resort to shadow banking and incur more expensive borrowing costs,” said Tang Jianwei, a Shanghai-based economist at Bank of Communications Co., the nation’s fifth-largest lender. “That will further constrain their repayment ability and eventually overwhelm some lower-level entities which have borrowed way beyond their means. I won’t rule out some defaults in 2014.” Premier Li Keqiang is cracking down on less-regulated shadow banking activities, estimated by JPMorgan Chase & Co. at $6 trillion in May last year, while the central bank engineered a cash crunch in June 2013 to push deleveraging in the world’s second-largest economy. …. [G]rowth in bank loans to local governments slowed to 19% to 10.1 trillion yuan from the end of 2010 to June 30, 2013, compared with a 67% jump in total debt, audit data showed. Trust financing to LGFVs surged to 1.4 trillion yuan from zero and bond issuance more than doubled to 1.8 trillion yuan.

Local government debt rose by nearly 2/3 in under three years, with the growth concentrated in the shadow banking sector.

Another Bloomberg report (hat tip Ilargi) shows how overall private debt levels are rising to troubling levels (particularly given that emerging economies typically have less mature financial systems and hence less reliance on borrowing):

China’s second-biggest brokerage said record debt threatens to trigger a financial crisis as borrowing costs jump to unprecedented highs despite a cooling economy. Liabilities at non-financial companies may rise to more than 150% of gross domestic product in 2014, raising default risks, according to Haitong Securities Co. The ratio of 139% at the end of 2012 was already the highest among the world’s 10 biggest economies, according to the most recent data. That compares with 108% in France, 103% in Japan and 78% in the U.S., figures from the Bank for International Settlements and the World Bank show. “We are concerned that the debt snowball may get bigger and bigger and turn into a crisis,” Li Ning, a Shanghai-based bond analyst at Haitong Securities, said in an interview on Jan. 3. “Default probabilities from next year may rise because more and more Chinese companies depend on new borrowings to repay old debt.”

Now by nature, no one, including the Chinese government, has great data on the shadow banking system. But what we can infer does not look pretty. One of its mainstays is “wealth management products”. The wee problem is that these wealth management products (as you can see from the data above, they show up in the trust category) have helped suck funds out of banks. One of the reasons China has long had such rampant speculation (stocks, real estate, businesses speculating in commodities via stockpiling) is that interest rates on deposits have long been below the rate of inflation.

WMPs have short-term funding (in the past one to two weeks, but a funding market squeezes by the central bank have now pushed more WMPs to borrow for two to three month tenors), and invest in these real estate development projects. They have the exact same problem as structured investment vehicles, which blew up in 2007 and 2008: investors may decide not to roll their investment. And if they withdraw funds and their monies can’t be replaced on comparable terms, the vehicle needs to be liquidated. Lots of liquidations on the same time frame leads to distressed prices and big losses for the funders.

Investors have reason to be concerned. Some WMPs have lost money. Bloomberg tells us arrearages are rising:

Local government debt overdue at the end of June was 1.15 trillion yuan, or 10.56% of borrowings, the audit report showed. That compares with the 1.3% overdue ratio in the banking system, reflecting the practice of rolling over regional debt instead of classing it as delinquent, according to Barclays Plc.

10% late and potentially in default is not a good number.

Even though these products are regulated, they aren’t regulated all that much. So the central government tried tightening up and issued a new release. FT Alpahville quotes a caustic reading by Anne Stevenson-Yang at J-Capital of the draft rules:

The hilarious new Document 107 on shadow banking betrays how toothless the government is in the face of the mounting debt, because the only solution presented is more debt. The regulations, as reported by the Financial Times, presents shadow banking as a healthy innovation in the economy, but some shadow banks, like online Ponzi schemes, need to be “closely monitored.” The shadow of Document 9, issued last spring by a new and naïve regulator, is being politely forgotten.

Many commentators are taking comfort in the authorities having succeeded in getting more of the WMPs to fund with two to three month funding rather than one to two week money. But remember, the first acute phase of the credit crisis was when the asset backed commercial paper market, which funded structured investment vehicles (which invested heavily in subprime-related debt) froze. ABCP was mainly 30 day tenor. If you can’t renew your funding because investors get freaked out about losses, you can’t renew your funding. Two to three months just gives you more time to deal with the problem. But remember the failed efforts by the US Treasury to orchestrate a solution (the so-called MLEC).

And why was Treasury panicked? For reasons that apply even more in the China case. The SIVs were supposedly off balance sheet vehicles that had been created by banks. But investors demanded that the bank stand behind them and the banks knuckled under. FT Alphaville cites another China analyst, Stephen Green and his team at Standard Chartered, who write that Chinese investors similarly expect the banks to support these vehicles:

A banker involved in managing his bank’s WMP business told us that if there were more than 10 client complaints about a product, a senior bank manager would have to travel to Beijing to explain to the regulator what had happened – an unpleasant experience, and one likely designed to ensure that the bank solves the problem before complaints become too loud. The implication is that despite all the attempts to persuade WMP investors that the risk is theirs, practice so far suggests that the risk is actually the banks’.

And the Standard Chartered report shows how as the spread between the rate paid on WMPs and deposits rises, they are attracting not just wealthy individual investors’ funds, but increasingly corporate cash.

Now consider how that relates to the Bloomberg story cited earlier, that the Chinese companies are increasingly borrowing to but defaults are expected to rise because more are unable to repay the debt and are expected to have trouble rolling it. If some of these companies are also the ones that are investing in WMP, you can see the potential for implosion: the corporate borrower can’t roll his own borrowings, and therefore can’t renew his investment in the WMP when it matures. This, by the way, is how a Minsky Ponzi process ends.

FT Alphaville raises all the proper alarms but hedges its bets:

The risks of WMPs are manifold and we’ve covered them before– potentially risky duration mismatch (borrowing very short-term against illiquid assets such as property developments); underlying assets which are almost always well-hidden from investors; vulnerable trusts, securitisation companies and asset management companies creatively channeling the funds; and no explicit backstops — but some comfort can be drawn form the reality that bankers seem to understand that they are expected to make sure their WMPs don’t go belly up. Fact is more funds flowing to them seems unavoidable if higher borrowing costs are needed to restrain credit growth.

Funny, I remember people who should have known better saying in Japan in the later 1980s that its stock market would never go down, its capital flows were too large. And readers of this blog may recall the “wall of liquidity” of early 2007, the insane amount of money flooding the credit markets thanks to the phenomenal leverage provided by CDOs. As Soros indicated, China probably has more runway before the borrowing starts to collapse under its own weight. It’s hard to see how this movie has a happy ending.