Streetwise Professor

June 26, 2014

There’s Gold in Them Thar Vaults, Boys! Um, Maybe Not

Filed under: China,Commodities,Economics,Politics,Regulation — The Professor @ 7:48 pm

If the vaults are in China, that is. Over the weekend I posted on the fraudulent commodity-based lending (collateralized by aluminum) in Qingdao. Now a Chinese government auditor claims that the gold used as collateral in $15 billion of loans does not exist.

To put this into context, Goldman (ha!) estimates that there are about $80 billion in loans in China collateralized by gold. Thus, the auditor’s report means that at least 20 percent of those loans are fraudulent. Given that it is likely easier to verify the existence of gold pledged as collateral than is the case for copper or soybeans, this suggests that even higher percentages of these other commodity-based loans (totaling another $80 billion) are backed by warehouse receipts that aren’t worth the paper they are printed on.

This situation creates the conditions for a horrific information contagion, which is the worst sort of systemic risk. Many analyses of systemic risk focus on counterparty credit risk, where the failure of one institution topples a set of interconnected dominoes. But historically, the domino problem has been less of a source of financial crises than information contagion. For instance, information contagion was arguably a far more important cause of the 2008 crisis than counterparty contagion.

Information contagion is a panic that results when the quality of assets in one part of the financial system leads people to question the value of other assets, usually similar but not always. For instance, in 2008,  the problems at Bear and Lehman were the result of bad mortgage investments by these firms. This raised questions about the solvency of other financial institutions that held, or were believed to hold, similar assets. Suddenly all banks became suspect, and had problems funding their assets. They started dumping assets to raise cash, which cratered prices and thereby created problems in institutions that had to mark their assets to a (now depressed) market. Banks that had extended liquidity support to SIVs had to bring them back on their balance sheets, threatening to make them undercapitalized.

Information contagion is most likely to occur, and is most severe when it does, when (a) asset values and balance sheets are opaque, and (b) financial institutions engage in a lot of maturity transformation (i.e., borrowing short to lend long). When asset values and balance sheets are opaque, market participants are more likely to draw inferences from revelations about the values of other firms/assets, because they can’t evaluate the firms/assets directly. In these circumstances, bad news about one firm or one type of asset can lead to a massive loss in confidence in other firms and assets. When these assets are funded with short term borrowings, firms can’t roll over their loans under these conditions, and are more likely to go bankrupt. Moreover, they are more likely to dump assets in fire sales that impose externalities on other firms holding similar assets.

China’s financial system is nothing if opaque. This is particularly true of the shadow banking system, but the banking system is also incredibly murky. For instance, the actual quality of loans on bank books is very difficult to assess. A lot of loans reported as performing are actually quite dodgy.

Information contagion is especially likely because the nature of the revelations about commodity loans raises serious questions about the monitoring of loans and the evaluation of the creditworthiness of borrowers and the quality (and existence!) of their collateral by financial institutions. If banks do a bad job at evaluating commodity loans and borrowers, and commodity collateral, it is reasonable to infer that they do a bad job at monitoring other loans and evaluating other borrowers. It is these sorts of inferences that lead to information contagion.

Moreover, maturity transformation is ubiquitous in China. This is especially true in the shadow banking system.

What this means is that although a few tens of billions of loans backed by non-existent collateral may not seem like a big deal in a financial system with about $17 trillion in credit outstanding (about 35 percent of which is in the shadow sector), the ramifications are far more serious than the value of these commodity loans suggest. There is a serious risk that doubts about the quality of the commodity loans will lead to growing doubts about the quality of other assets, especially in the shadow banking sector.  This creates the potential for panics and runs in that sector, and given the connections between shadow financial institutions and mainstream banks (connections which are themselves opaque) this could spillover into the conventional sector.

In other words, the potential for information contagion in a highly leveraged (with credit at about 250 percent of GDP), highly maturity transformed, and exceedingly opaque financial system is what makes the fraudulent commodity loans a big deal. Potentially a very big deal.

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  1. To your pile of risk factors I would add a very high investment/GDP ratio over the last several years, suggesting a higher probability of malinvestments that tend to be revealed as soon as the panic starts, reinforcing it.

    Comment by srp — June 27, 2014 @ 5:26 pm

  2. @srp. Agreed. The level of investment is clearly insane, and cannot generate returns sufficient to repay the debt used to fund it. But they keep doubling down and using credit driven investment to keep the GDP growth number equal to plan. (Another illustration of the limits of GDP as a metric of anything meaningful.)

    The ProfessorComment by The Professor — June 27, 2014 @ 6:58 pm

  3. Excellent, thankyou.

    In all my reading on systemic risk, this is the first time I have heard of ‘information contagion’. More proof of the value of your blogging (and of my need to continue my informal learning!)

    Is China enough of a market economy for this to severely affect the economy? My suspicion is that, should a panic arise, the government will ringfence the SOEs and large banks, throw the market sector and entrepreneurs to the wolves, and pump another bucketload of credit into the economy and financial system, to maintain its ‘pulse’. Plus round up a bunch of ‘dissidents’, for demonstration purposes, and rattle sabers in the near abroad, for the purpose of distraction.

    The Chinese financial system is on course for trouble, yes, but they may have enough ‘juice’ to keep the game going for another round or two.

    This is all speculation, mind – nothing more than a thought experiment, for consideration. I really don’t know.

    Best wishes,

    Comment by Ex-Regulator on Lunch Break — June 28, 2014 @ 1:24 am

  4. Apologies – I see that, in your response to srp you’ve discussed their ability to ‘double down’ on credit-driven investment.

    Economic and financial policy in much of the world at the moment appears to be variations on this theme: keep extending credit, by any means, to the financial sector, in order to avoid credit writedowns and capital losses and to keep activity ticking over until ‘something comes along’. It may work for the US and the UK, but I think demographic trends and corrupted market mechanisms in Europe, China and Japan mean that severe trouble is a matter of ‘when’, not ‘if’.

    I feel tremendously sorry for the poor people trapped in these systems. I have numerous Japanese friends and I worry about how they will deal with what’s coming down the road.

    Off topic: any thoughts on the Obama administration’s misuse of the IRS to target political opponents? And the blatant, transparent lies about missing emails, and the destruction of evidence on computer hard-drives? Please, no need to write anything, if you think it might put you in the cross-hairs of an ‘audit’. (I’m safe, I’m on another continent).

    Comment by Ex-Regulator on Lunch Break — June 28, 2014 @ 1:38 am

  5. @Ex-Regulator. No apology necessary: I appreciate your earlier comment, and agree with the prediction of what the Chinese will do. On several occasions in the past, in response to the accumulation of non-performing loans (mainly to SOEs) they stripped bad assets out of banks and put them in opaque structures that essentially hid the problem and spread out the pain over time. They will likely do that again. But for how long? Especially since the problem gets bigger in each round. I don’t know the answer, except that the answer isn’t “forever”, as some seem to believe. As you note (in your remark about throwing the market sector and entrepreneurs to the wolves) these bailouts are redistributive, and as they get bigger entrepreneur Peter won’t have enough to pay SOE Paul. They will have to find a way to steal from the savings of the population, which will (as you again note) require a crackdown on dissent.

    Yes. Japan is tragic.

    Re the IRS. Fear of an audit hasn’t kept me silence. My mother is convinced that what I’ve written about the administration in the past will come back to haunt me :-P, so what’s to lose?

    I think the situation is appalling. The initial targeting. The egregious cover-up. But what is most appalling is the fact that the US media is complicit in the cover-up. But I guess that’s just one more thing to throw on top of the already huge, stinking pile.

    The ProfessorComment by The Professor — June 28, 2014 @ 7:45 am

  6. They will likely do that again. But for how long? Especially since the problem gets bigger in each round.

    For as long as America is its No. 1 trading partner, that’s for how long. It seems to me China is learning well from the American strategy. Just Dark Pool everything, whether it be stocks, bonds and/or loans. Before long, the only one who knows what’s really going on is The Shadow.

    I’ll have another post up in the next week entitled Coming To America. Renu will be one of the main characters.

    Comment by Cold N. Holefield — June 28, 2014 @ 8:27 am

  7. I think I’ll include the following article in that blog post as an exhibit. If so, I’m torn between naming the post Coming To America, Hog Wild or Trading Places. If the latter title, I’ll be sure to include some of the technical jargon bandied about in this space for dramatic irony when you consider the chocolate egg of free markets is really hollow in the middle.

    Is the US About to Become One Big Factory Farm for China?

    The small number of companies that dominate global meat production is about to get smaller. The Chinese corporation Shuanghui International, already the majority shareholder of China’s largest meat producer, has just bought US giant Smithfield, the globe’s largest hog producer and pork packer, in a $4.7 billion cash deal. (It still has to get past Smithfield’s shareholders and the US Treasury Department’s Committee on Foreign Investment, which reviews takeovers of US companies.)

    In an ironic twist, China appears to be taking advantage of lax environmental and labor standards in the US to supply its citizens with something it can’t get enough of. Industrial pork: the iPhone’s culinary mirror image.

    Traders don’t give a shit about any of the above. Not one wit. The only thing they care about is maximizing their return on financial instruments that have nothing to do with productive value. Meanwhile, the pigshit keeps piling up while the traders pretend it’s jasmine and rose as they roll around in it like children on a playground at recess — for schools that still have recess.

    Comment by Cold N. Holefield — June 28, 2014 @ 9:19 am

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