China’s Shadow Currency Addiction Is Inflating ‘the Mother of All Bubbles’

China has a thing for a speculative, off-the-books, and hard-to-regulate shadow currency—and it isn’t Bitcoin. Indeed, it’s an addiction that makes China's on-again, off-again fling with the hyped up cryptocurrency look positively irrelevant. While the total worldwide market for Bitcoin and its many clones is valued in the billions, China’s domestic shadow banking market is valued in the trillions.

The shadow currency in question comes in the form of bankers’ acceptance notes, or BANs, paper issued by banks that are, in some cases, as good as cash. BANs, which are essentially IOUs in the form of bank checks, are being used as a form of "wildcat" currency to increasingly finance speculation as banks and corporations alike are running short of cash.

The issuance of BANs has more than doubled to 1.6 trillion yuan ($261 billion) in the first four months of 2013 from 636 billion yuan a year ago, helping to inflate what some observers have worryingly called “the mother of all bubbles.” BANs may end up being the mortgage-backed securities of China.

In theory, bankers’ acceptance notes are nothing more than certified checks with a bank guarantee, popularly used in every country with a developed financial system. A buyer from Shenzhen might have a hard time convincing a vendor in Shanghai that his credit is good enough to pay for goods by writing a regular check. But if that check is guaranteed by a major financial institution, say the People’s Bank of China, it’s no big deal. In this way, BANs help facilitate trade, which is also why they’re perfectly legal. And if vendors accept these notes to be as good as money, they more or less act as legal tender.

If BANs are being used to fund actual trade, such as the shipment of a new order of smartphones, as they are designed to do—customers are required to provide proof of an underlying transaction in order to receive one—there’s minimal risk for the banks. As long as BANs are used as the method by which currency is transferred, rather than currency itself, they'll largely remain stable.

But if no such underlying transaction exists, and the BANs are consequently used essentially as a secondary currency within the country, the bank then suddenly has an open liability for what amounts to high-risk speculation, a situation that has seemingly become the norm.

“The truth is, most BANs are not used to support real transactions,” a “grinning” shadow banker in Shenzhen told the Diplomat, which noted that the practice “harkens back to US banking in the era before fiat currency, when banks used their own banknotes to purchase reserves of everything from gold bullion to national bank notes, British pounds, and bushels of wheat.”

Here’s the problem with China: Because of its tightly regulated economy, everyone loves BANs.

State-owned banks love them because stringent statutory requirements force them to maintain high loan-to-deposit ratios, but since BANs are recorded off the books, they can increase their leverage without appearing to be at risk. In fact, BANs actually boost their deposit ratio, allowing them to make additional loans. A customer could show up with 100 yuan, which then gets deposited to the bank, and leave with 200 yuan worth of BANs, hidden from regulators since they don’t show up on the bank’s balance sheet.

State-owned enterprises love them because they’re a source of easy funding for cash-strapped businesses struggling with liquidity as the growth of China’s economic machine inevitably slows. Businesses can team up and sidestep transaction requirements to acquire BANs by setting up fake trades, such as selling the same supplies to each other, which banks willingly fund. When those trades cancel out, the companies are left only with the BANs, highly liquid, bank-guaranteed assets as good as cash produced out of thin air.

“The elephant in the room is that the shadow institutions are the co-dependent evil twins to the commercial banks,” writes Anne Stevenson-Yang of J Capital Research. “This is true in two ways: banks are reliant on the shadow institutions to supply their liquidity, and shadow institutions get a lot of their capital from the banks.”

The circulation of BANs has borne an underground market. Since BANs are issued by regional banks, notes from one province might not be accepted in another. In need of actual cash, a shadow banker might offload his stash of BANs for a discount. The funds then trickle down into an assortment of speculative investments such as the real-estate market, widely considered to be overheating, which often don’t produce cash flow. When you’re using BANs to build ghost towns, there’s no one around to pay the rent.

Like Bitcoin, the use of BANs is limited despite remaining liquid. You can’t use them to buy groceries or a beer at your local watering hole. They're now largely used for propping up the country’s growing shadow economy and also an indicator of systemic deficiencies. If things were working as they should, there would be little need of BANs outside of  guaranteeing business-to-business transactions.

The issue is exacerbated by the fact that local government officials are in on the operation, in the form of local government financing vehicles (LGFVs), part of China’s post-2008 stimulus and infrastructure projects. Now that these LGFVs are 19 trillion yuan in debt, the easiest way to kick the can is to partner up with local banks and start their own printing press, an issue that China’s leaders are gravely aware of.

“There is a risk of banks and LGFVs colluding to fake security deposits and print BANs with no underlying trade,” the Ministry of Finance warned as early as 2011, but a heavy-handed crackdown by officials might be out of the question. When nine trillion yuan of BANs are circulating in an economy with a monetary base of 107 trillion yuan, according to the People’s Bank of China, the economic implications could be disastrous.

In reality, the actual size of the BAN market and how far it reaches is impossible to know thanks to non-existent accounting, which makes for an apt comparison to the US subprime mortgage crisis, during which banks' loan portfolios became highly leveraged and interconnected through the use of opaque derivatives. When the banks are finally called upon to pay up on their BANs, they won’t have the funds, which could cause the whole charade to fall like dominoes, as cascading defaults ripple across the country. Just as the US government took control of Freddie and Fannie to keep them solvent—which required tens of billions of taxpayer dollars—the last man standing in this high-stakes game of musical chairs will be the state.

Growing concerns of this eventuality caused ratings agency Fitch to downgrade China’s credit rating earlier this year. “Ultimately we think China’s debt problem is going to require sovereign resources to resolve and debt will migrate onto China’s sovereign balance sheet,” said Andrew Colquhoun, head of Asia sovereign ratings at Fitch. “We don’t yet know what form this will take—central bailouts of local governments or of banks, perhaps.”

As with all unsustainable games, all it takes for the whole thing to come tumbling down is the realization that the inflection point has been reached and people head for the exits. "If people realize there is a huge bubble in the real estate sector, that could create huge problems," Oliver Rui, a finance professor at the China Europe International Business School in Shanghai, told NPR. "Even if the project is good, if everyone calls in the loans, then no one can return the money."

And when that happens, all that will be left is a bunch of worthless paper, but the implosion could have worldwide reverberations, warned Bank of England Governor Mark Carney. He noted last week that the “greatest risk” to the global financial system still suffering from the credit bubble five years after the collapse of Lehman “is the parallel banking sector in the big developing countries.”

For now, China’s shadow banking economy rumbles on, mimicking the American wild west prior to the National Banking Acts of 1863 and 1864. Maybe having a centralized, regulated system isn’t such a terrible thing after all.

@sfnuop