Soros likens China trusts to subprime

China has a narrow window to prevent its shadow banking system from imploding in a manner similar to US subprime mortgages, says George Soros.
George Soros, speaking at Davos earlier this year

George Soros says the immediate threat to financial markets remains the eurozone, but the mid-term challenge is for China to come to grips with its shadow banking system.

The statesmanlike investor, speaking at the Boao Forum for Asia, says a hard landing in the Chinese economy would force the People’s Bank of China to raise interest rates, triggering a wave of defaults in wealth-management products. That in turn could lead these products to “break the buck”, if their issuers fail to make up shortfalls to investors. That would lead to a market panic similar to when Reserve Fund Management, the largest money-market fund in the US, saw its value trade below par in the wake of the Lehman Brothers collapse.

Soros praises China for being the mainstay of global growth throughout the crisis and its aftermath. However, its economic model of investment into fixed assets to support its export machine has run its course, while consumption remains stuck at 34% of GDP and household savings remain in bank deposits, helping those banks funnel cheap financing to fixed investments and real estate.

He asserts that this model has at best one or two years left to operate, and that China will have to move quickly to boost household spending, including the expansion of the social safety net. He acknowledges this is going to be difficult, because it requires an overall slowdown in GDP growth. That in turn will make consumers cautious, rather than get them to open their wallets, and risks a hard landing for the economy. The world got a taste of this when the government told banks to cut back on lending, leading to a decline in Chinese economic activity.

A growing number of companies now rely on the shadow banking system for financing. They pay high levels of interest on assets in trust products that are sold to domestic investors of all types. If there is a hard landing, or even a gentle one, corporate profits — already razor thin — will not be able to support those interest payments, leading to defaults.

Chinese trusts are not legally guaranteed, but so far their sponsors have always paid up in the event of a shortfall. “If one fund breaks the buck, that could create a panic similar to that of the US subprime market in 2007 to 2008,” says Soros.

His reassuring note is that authorities in Beijing are well aware of this, and have the tools and levers to gradually transition the economy so that fewer companies come to rely on expensive trust products for capital.

But Soros worries that the central government cannot orchestrate such a grandiose transition without bucking many vested interests, such as state-owned enterprises, banks and ministries that benefit from the status quo. The emergence of the shadow banking system is evidence that financial interests have already been entrenched against the national interest.

“The government has a few years to bring this under control,” he said. He compares the situation to US subprime in the early 2000s, when it was rapidly growing but not yet overwhelming. But without forceful action by the government, China could be facing its own crisis point.

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