We haven't heard JPM CEO Jamie Dimon go this dark on China in a long time

NEW YORK – Something dark is happening in China’s banking system. It hasn’t been able to penetrate our noisy news cycle here on the other side of the world. But Jamie Dimon, the CEO of JP Morgan, knows about it.

“They have kicked out all foreigners twice in their history,” Dimon said to a crowd at the Milken Global Initiative on Monday addressing concerns with China’s financial system. “They might do it again. If you’re a shareholder of JPMorgan Chase, I just want to tell you, we’ll be fine. It will hurt. It won’t be a good year. But we’ll make money, OK?”

This from a guy who, at the end of March said Chinese banks could “buy us one day.”

The last time Dimon was close to this negative was in early 2016, when China’s markets were roiling on concerns about debt piling up in its banking system. But China’s markets have been quiet this year so far.

Here’s what’s different now. Over the past few weeks there have been signs that the Chinese government is completely serious about reducing leverage and debt in its banking system.

China Banking Regulatory Commission chief Guo Shuqing said last month that he must resign if the banking industry is a mess, and the President Xi Jinping has been sitting in Politburo meetings where “financial risk” is the topic of discussion, according to the South China Morning Post.

This means a couple of things, and most of them have to do with lending. For one, it means the government is going to try to get banks to be more real about what they have on their books, and that means cracking down on the entire shadow banking system.

That sounds good, but since the government started making noise about regulation, Chinese markets have slumped. That’s because it also means that there will be less lending to market participants and to brokerages who then lend to clients who want to lever up and get into the market.

In other words, this is upending the system as everyone knows it.

Things get messy

China’s shadow banking system is mostly made up of wealth management products (WMPs) — debt or debt-like instruments that pay out higher interest rates to investors. Banks used to keep WMPs off balance-sheet, but no more. The People’s Bank of China just put off-balance sheet WMPs on its
macroprudential assessment of banks’ risks.

This is a warning to banks that they can’t hide anymore. Plus, the China Banking Regulatory Commission (CBRC) is demanding that banks keep more liquidity on hand to deal with WMP risk.

The CBRC is also cracking down on money that banks lend out to external managers, known as “entrusted investments.” One American investor in China said who wished to remain anonymous told Business Insider that banks are lending to some investment firms and finding there’s little recourse to get their money back.

That’s because the banks are lending to brokerage firms with high interest. The brokerages then lend to customers and often allow them to extend leverage if they have a problem. The brokerages make their money from trade execution and sharing in returns. They get paid first.

Banks get paid … whenever. All of that’s been building on bank balance sheets for so long the government has to act.

The question is how. What scares Dimon — and likely the stock market — is that if this is done too quickly, regulators may also sap liquidity from the system, killing smaller players and grinding things to a halt.

And then, of course, there’s the fact that China is 1/3 of the world’s economic growth and anything that devastates its banking system, devastates everyone now.

Timing, timing, timing

Economically, China has had an easy go of 2017. Up to just about now, the economy has been stable. For example, for the first time since 2012 factories have stopped shedding jobs — a stark reversal from last year. That’s why the government is taking this opportunity to reform the financial system.

But that moment of opportunity could be ending as you read. Manufacturing numbers for April came in below expectations.

“A slide in the Caixin manufacturing purchasing managers’ index, a key gauge of factory activity, adds to the impression that China’s 2017 growth is already past its peak,” wrote Bloomberg economist Tom Orlik in a recent note.

“The index came in at 50.3 in April, down from 51.2 in March and missing expectations of a 51.3 reading. That points to a manufacturing sector continuing to expand, but at a glacial pace. Taken together with a decline in the official PMI and slumping metals prices, it suggests China’s growth may already have returned to a slowing path.”

In other words, it may be a little late to move on the banking system. But all Xi Jinping has is now. And the game is already in motion. Dimon will just have to hold on like everyone else.

Get the latest JPM stock price here.

NOW WATCH: How our universe will end: ‘The black holes will eat up everything’

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.