Water Cheung: China’s Liquidity Crunch Is Nothing Systemic – Just a Wake-Up Call for the Financial Sector

In this episode of the China’s Liquidity Crunch series, we spoke with Water Cheung, CFA, CEO of Asia Pacific at StormHarbour Securities. An industry veteran working in the Greater China region for decades, Cheung was formerly head of capital markets for China at RBS Global Banking & Markets, head of Greater China banking and markets at DBS Bank, and a managing director at CIBC World Markets. He is a CFA charterholder and is on the advisory board of the Hong Kong Society of Financial Analysts.

CFA Institute: Is the PBOC’s recent actions aimed at curtailing the so-called “shadow banking” activities in China? Have they been effective?

Water Cheung: The PBOC’s recent actions, including the hard-line statement just prior to the sharp spike up in Shibor in late June, appear to be a “wake-up call” for the commercial banks, as well as the shadow finance entities, to tighten up lending practices and manage liquidity in a more conservative manner.

Market participants are hoping that this would also mean more interest rate liberalization is coming and that lending will be more market-based and economic-based going forward. The PBOC has been talking about this for years, but little was done by way of implementation. The shadow finance activities appear to be still relatively small in absolute terms as compared to China’s GNP and in relative terms as compared to counterparts in the advanced OECD countries – based on figures from rating agencies and other analysts. However, some might argue that there are some shadow finance activities that is difficult to monitor and there is a lack of reliable statistical tracking.

CFA Institute: How serious are the bad debts problems in China’s financial sector, and is the liquidity crunch in part a reflection of the bad debt problems there?

Water Cheung: Given that there has been a fair amount of policy-driven lending in the past, the amount of bad debt is substantial but in our view still quite manageable given the financial resources of the central government. Talk of some sort of a “Lehman moment” is probably quite irrelevant at this time. The central government has substantial financial resources, and there is little chance of a systemic contagion or meltdown.

The bad debt reserve policy in China’s banks, at least on paper, tends to be quite conservative. The liquidity crunch is a situation that was “allowed to happen” by the PBOC to instill discipline on the commercial banks and to perform a “live stress test” on the financial ecosystem. I do not believe it is induced by concerns about bad debts becoming unmanageable.

The recent credit crunch probably signals a substantial decline in investment spending going forward — a greater focus on “quality” over quantity. This means that investment spending will be going to projects based on their economic viability and consistency with policy objectives, and is certainly in line with the overall goal of rebalancing the economy to one that is less investment-driven and more consumption-driven.

Someone will need to pay for the existing bad debts in the system. If interest rate liberalization were to go ahead in a major way such that consumers will not suffer as much from “financial repression” and have more disposable income to spend on consumer goods and services, then we suspect it would be the financial institutions’ shareholders who will be paying for the nonperforming loans. The relatively low valuation multiples of bank stocks are probably a reflection of the market already discounting this scenario.

CFA Institute: What do you see as the key problems and risks in China’s economy and its financial system?

Water Cheung: Maintaining social stability is a key concern of the central government and the communist party of China. Some of the key elements for maintaining social stability include keeping most people employed, narrowing the income gap and dealing with injustices in society, and changing the culture of petty bribery and tackling large-scale corruption practices (which, if successful, would also significantly reduce friction in business transactions yielding economic benefits for all concerned).

In rebalancing from investment to consumption, the central government walks a tight rope in balancing the job losses from a drop in investment spending against job gains from greater consumption spending, which needs to come from sources such as: (1) higher household disposal income arising from positive real returns on bank deposits and other fixed income investments (which in the past has been producing returns below the inflation rate); (2) continuing momentum in urbanization as supported by government policy; and (3) a drop in the household savings rate brought about by the provision of greater social security and pension benefits.

Expectations were high when President Xi Jinping and team first got on board around the 18th Party Congress last year, as he instilled a sense of crisis in government officials and party members at all levels, calling for a state of high alert. The message was that solid reforms must be thoroughly planned and forcefully executed on a timely basis in various areas. This certainly is a challenging undertaking, and the risk is that if they are overly aggressive or are not able to handle the established interest groups properly, there may be political ramifications that would destabilize economic activities and the financial system.

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