IS A FINANCIAL CRISIS A BIG RISK IN CHINA?

CHINA'S FINANCIAL SYSTEM: NO GUARANTEES

Patrick Chovanec

SeekingAlpha, May 20, 2012

In my debate with Andrew Batson in The Guardian in March, I noted that:

There really are two related but distinct things people have in mind when they talk about a "hard landing" for China. The first is a rapid deceleration of GDP growth – below, say, 7%. The second is some kind of financial crisis. I think we're already seeing some signs of the first, and the second is a bigger risk than most people appreciate.

In my last several posts, I've focused on the former — the slowdown in China's GDP growth. I want to switch gears here for a moment and call attention to a rather alarming story involving the latter — the risk of financial instability — which somehow slipped under most people's radar screens.

In early April, Caixin magazine ran an article titled "Fool's Gold Behind Beijing Loan Guarantees", which documented the silent implosion of Zhongdan Investment Credit Guarantee Co. Ltd., based in China's capital. "What's a credit guarantee company?" you might ask — and ask you should, because these companies and the risks they potentially pose are one of the least understood aspects of China's "shadow banking" system. If the risky trust products and wealth funds that Caixin documented last July are China's equivalent to CDOs, then credit guarantee companies are China's version of AIG.

As I understand it, credit guarantee companies were originally created to help Small and Medium Enterprises (SMEs) get access to bank loans. State-run banks are often reluctant to lend to private companies that do not have the hard assets (such as land) or implicit government backing that State-Owned Enterprises (SOEs) enjoy. Local governments encouraged the formation of a new kind of financial entity, which would charge prospective borrowers a fee and, in exchange, serve as a guarantor to the bank, pledging to pay for any losses in the event of a default. Having transferred the risk onto someone else's shoulders, the bank could rest easy and issue the loan (which it otherwise would have been reluctant to make). In effect, the "credit guarantee" company had sold insurance — otherwise known as a credit default swap (CDS) — to the bank for a risky loan, with the borrower forking over the premium.

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