SocGen: China’s Massive Credit Misallocation Will End In A Painful Burst

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Despite the seasonal factors behind the recent surge in Chinese interbank rates, experts have argued that it has persisted because of the tough stance taken by Chinese policymakers.

Societe Generale’s Wei Yao expects liquidity conditions to stay tight through the second half of 2013.

Yao sees credit growth falling from 25% year-over-year (YoY) to 16-18% YoY. Meanwhile, she expects non-bank credit growth to slow from 50% YoY, to about 30%.

“The growth implication of the liquidity squeeze will be undoubtedly negative. Interest rates on bank loans,
corporate bonds and shadow banking credit have begun to rise across the board as we speak, further
discouraging credit demand. We are concerned whether this approach will really tilt credit distribution more towards the real economy in the short term. Much of the credit misallocation in China stems from the fact that lending is often not based on financial strength but on the implicit guarantee from the state.”

Small and medium enterprises (SMEs) and smaller property developers will all be hit. But local government financing vehicles (LGFVs) could need more credit to make up for rising interest rates with implications for infrastructure investment.

Yao like other experts believes that policymakers are willing to stomach short term pain for stable long-term economic growth.  Bottom-line: A credit burst is painful and inevitable:

“In our view, there is no other ending to China’s massive credit misallocation than a painful burst. The question is when will it start unwinding and at what pace. Given the control that Beijing has over the economy and financial system, the answer lies more with the political willingness and/or policy (mis-)calculation, at least at the beginning of  the process.

“Beijing’s tough stance on the ongoing episode of interbank liquidity tensions shows that the willingness is finally here, although the aim is still to engineer a gradual burst. Whether or not Chinese policymakers will be able to pull off a controlled burst, more negative events will follow, including corporate failures, nonperforming loans and bond defaults. This is the beginning of the end.”

Yao thinks the risk of systemic financial crisis will be manageable in 2013 but will increase in coming years. And we need to watch and see if it is a controlled burst or not.