China has failed to curb excesses in its credit system and faces mounting risks of a full-blown banking crisis, according to early warning indicators released by the world’s top financial watchdog.
A key gauge of credit vulnerability is now three times over the danger threshold and has continued to deteriorate, despite pledges by Chinese premier Li Keqiang to wean the economy off debt-driven growth before it is too late.
The Bank for International Settlements warned in its quarterly report that China’s "credit to GDP gap" has reached 30.1, the highest to date and in a different league altogether from any other major country tracked by the institution. It is also significantly higher than the scores in East Asia's speculative boom on 1997 or in the US subprime bubble before the Lehman crisis.
Studies of earlier banking crises around the world over the last sixty years suggest that any score above ten requires careful monitoring. The credit to GDP gap measures deviations from normal patterns within any one country and therefore strips out cultural differences.
It is based on work the US economist Hyman Minsky and has proved to be the best single gauge of banking risk, although the final denouement can often take longer than assumed. Indicators for what would happen to debt service costs if interest rates rose 250 basis points are also well over the safety line.
China’s total credit reached 255pc of GDP at the end of last year, a jump of 107 percentage points over eight years. This is an extremely high level for a developing economy and is still rising fast .
Outstanding loans have reached $28 trillion, as much as the commercial banking systems of the US and Japan combined. The scale is enough to threaten a worldwide shock if China ever loses control. Corporate debt alone has reached 171pc of GDP, and it is this that is keeping global regulators awake at night.
The BIS said there are ample reasons to worry about the health of world’s financial system. Zero interest rates and bond purchases by central banks have left markets acutely sensitive to the slightest shift in monetary policy, or even a hint of a shift.
“There has been a distinctly mixed feel to the recent rally – more stick than carrot, more push than pull,” said Claudio Borio, the BIS’s chief economist. “This explains the nagging question of whether market prices fully reflect the risks ahead.”
Bond yields in the major economies normally track the growth rate of nominal GDP, but they are now far lower. Roughly $10 trillion is trading at negative rates, and this has spread into corporate debt. This historical anomaly is underpinning richly-valued stock markets at time when profit growth has collapsed.
The risk is a violent spike in yields if the pattern should revert to norm, setting off a flight from global bourses. We have had a foretaste of this over recent days. The other grim possibility is that ultra-low yields are instead pricing in a slump in nominal GDP for years to come - effectively a trade depression - and that would be even worse for equities.
“It is becoming increasingly evident that central banks have been overburdened for far too long,” said Mr Borio.
The BIS said one troubling development is a breakdown in the relationship between interest rates and currencies in global markets, what it describes as a violation of the iron law of “covered interest parity”.
The concern is that banks are displaying a highly defensive reflex, and could pull back abruptly as they did during the Lehman crisis once they smell fear. “The banking sector may become an amplifier of shocks rather than an absorber of shocks,” said Hyun Song Shin, the BIS's research chief.
This conflicts with what the Bank of England has been saying and suggests that recent assurances by Governor Mark Carney should be treated with caution.
Yet it is China that is emerging as the epicentre of risk. The International Monetary Fund warned in June that debt levels were alarming and “must be addressed immediately”, though it is far from clear how the authorities can extract themselves so late in the day.
The risks are well understood in Beijing. The state-owned People’s Daily published a front-page interview earlier this year from a “veryauthoritative person” warning that debt had been “growing like a tree in the air” and threatened to engulf China in a systemic financial crisis.
The mysterious figure – possibly President Xi Jinping – called for an assault on “zombie companies” and a halt to reflexive stimulus to keep the boom going every time growth slows. The article said it is time to accept that China cannot continue to "force economic growth by levering up" and that the country must take its punishment.
One bright spot is a repayment of foreign debt denominated in dollars. Cross-border bank credit to China has fallen by a third to $698bn since peaking in late 2014 as companies scramble to slash their liabilities before the US Federal Reserve raises rates. The tally for emerging markets as a whole has fallen by $137bn to $3.2 trillion.
China's problem is internal credit. The risk is that a fresh spate of capital outflows will force the central bank to sell foreign exchange reserves to defend the yuan, automatically tightening monetary policy. In extremis, this could feed a vicious circle as credit woes set off further outflows.
The Chinese banking system is an arm of the Communist Party so any denouement will probably take the form of perpetual roll-overs, sapping the vitality of economy gradually.
The country was able to weather a banking crisis in the late 1990s but the circumstances were different. China was still in the boom phase of catch-up industrialisation and enjoying a demographic dividend.
Today it is no longer hyper-competitive and its work-force is shrinking, and time the scale is vastly greater.