Forget Europe, China Could Be Lehman 2.0

David Keohane at FT Alphaville points out that

The Shanghai composite index has now fallen for the past 7 days in a row and is down some 10 per cent since a high on May 4th.

Here’s a chart from Bloomberg displaying the index over the past year:
Not only has the index declined about 10% on the last two months, but it is down more than 20% in the past year. For all the recent bullish talk over further stimulus from China, the domestic market is certainly not buying it.

Although this chart provides a disturbing outlook for China, it has been largely overlooked by the mainstream media which continues to focus on a possible Lehman 2.0 moment out of Europe. What if the next Lehman moment actually comes from China instead? Discussing the risks posed by credit guarantee companies, Patrick Chovanec suggests:

The web of interlocking, often incestuous, and sometimes circular credit arrangements is reminiscent of Wall Street in the lead-up to the subprime crisis, in which a relatively small amount of mortgage losses, which most people believed could be contained, triggered a chain reaction that brought down major banks and froze credit across the entire global economy.

According to the article from Caixin magazine, banks were effectively outsourcing their loan review processes to these credit guarantors. Similar to mortgage lenders during the US housing boom, it appears the interests of banks and credit guarantee companies aligned to produce a massive extension of credit with little consideration about the borrowers’ ability to repay. With housing prices falling and property development no longer booming, it appears these financial institutions have begun the Ponzi finance portion of a Minsky cycle, whereby in Patrick’s words:

a lot of these firms are actually insolvent and are just borrowing from Peter to pay Paul, in order to postpone the day of reckoning.

That day of reckoning will come, but the question of timing remains uncertain. The larger concern is, how big and systemic will losses be? If it was difficult to determine the extent of the issue in the US, trying to do so in China will be nearly impossible given the general uncertainty surrounding any publicly reported economic/financial data. Could the fallout from these lending schemes actually be the next black swan? Only time will tell. For now it appears that as China’s growth is slowing, risks within the financial system and chances of a hard landing are growing.