By John Richardson
THE China bulls will no doubt claim that the shadow-banking system isn't a systemic risk to the country's financial system and thus, of course, the world economy and the investment strategy of many chemical companies.
They might be right. Or they might be wrong. Assuming they are right is dangerous.
"The economic slowdown does not seem to be the only cause (of the rise in non-performing loans), and, in many cases, not even the major one," said Wei Yao, China macro strategic at Societe General, in August.
"The common mistakes include involvement in speculative activities (eg property speculation or commodity trading), massive capacity expansion (eg shipbuilding and solar panel manufacturing), outsized commitments to complicated webs of mutual loan guarantees and high exposure to underground banking (eg many small and medium-sized enterprises in Zhejiang).
And as the FT Alphaville blog wrote, again in August: "While previous financial crises don't show a very consistent relationship between the scale of credit growth-to-GDP and the scale of the subsequent crisis, research compiling 42 crisis episodes shows that average annual credit growth to GDP was 8.3% preceding these events.
"China's (credit growth) growth was 27.9% in 2009 and 20% in 2010 (see the above chart)."
The latter statistics might not fully take into account the scale of China's shadow lending, given the huge difficulty in making such an assessment.
And so now let's think about what's happening in China's property sector, the target of a great amount of speculative investment.
Chinese apartment values actually fall when someone moves into a building, so instead they are being kept empty and unused.
Here is one interpretation of how the property market boosts the economy:
*Land is obtained at a low price, or even for free, from rural communities.
*Local governments sell the land to the property developers.
*The developers then sell the apartments, which never get occupied, but they do get traded and are used as collateral.
"This explains why you can get current price: earnings ratios of 14:1 in China's Tier 1 cities, compared to a maximum of 5:1 at the peak of the US subprime bubble," said a keen observer of China.
"China has lots of land, and so theoretically the game can continue for years more. But only if there is still cash to fund the system," he added.
House prices have picked up, thanks to official lending via the May-September economic stimulus package.
This has helped to keep the bubble inflated.
Plus, as the FT pointed out in the article we linked to yesterday, the official lenders are making money from wealth management products (WMPs).
The WMPs fund the shadow-banking system from which some property developers are getting their money.
What happens if economic reforms, including a reduction in speculative lending, take the air out of the bubble?
Beijing might even end up being frightened of reforms as fixing the problem could be a systemic risk.
Not fixing the problem kicks the can down the road, inviting a bigger crisis later on.