Remember China’s ghost cities, the sprawling, mostly-empty cities built across China on credit?
Well say hello to ghost collateral:
Back in 2014, a scandal erupted when media reports confirmed what many had previously speculated about China’s banking system: namely that much of China’s staggering loan issuance had been built (literally) upon air and that billions (or trillions) in loan collateral had been “rehypothecated” between two, three or many more debtors – or never even existed – forcing banks to accept that they would never recover much if any of the pledged collateral – in most cases various commodities – if the economy were to suffer a hard-landing resulting in mass defaults. The most famous example involved collateral fraud at China’s 3rd largest port, Qingdao, where numerous borrowers were found to have “pledged” the same collateral of steel and copper to obtain funding from various banks.
So how extensive is the problem?
At risk of spoiling the surprise, what has been going on in China, either in conventional asset-backed lending, as well as among the more esoteric, complex commodity-funded deals, which we discussed extensively in the early part of 2013 is nothing less than pure fraud: in some cases, collateral that has been pledged simply doesn’t exist. In others, it disappears as borrowers in financial distress sell the assets. There are also instances in which the same collateral has been pledged to multiple lenders, i.e. rehypothecated. “One lawyer said he discovered that the same pile of steel was used to secure loans from 10 different lenders” Reuters reports.
And while China was able to brush off its “ghost collateral” problems three years ago when it still had substantial debt incurrence capacity, and debt/GDP was about 100% lower, now that it is becoming increasingly difficult to keep the Ponzi scheme – by definition – running, especially with the recent crackdown on shadow banking, the pervasive collateral problems are about to become a huge headache for Beijing again: with the mainland facing its slowest growth in over a quarter of a century, defaults are mounting as borrowers struggle to repay their loans.
It’s long been known that China’s economy is built, to some extent, on smoke and mirrors (even more so than our own economy). But it looks like it might be smoke and mirrors all the way down…