Bright Light on a Shadow Economy

As rumors go, this one was not exactly a barn-burner. A customer of a small lender in Yancheng, a prefecture-level city in northeastern China, had asked to withdraw his money, which totaled a little over $30,000. He was denied. Not exactly a big deal, and by accounts it wasn’t even true.

But what happened next is definitely newsworthy. The rumor spread rapidly—from one person to dozens, then to hundreds. Social media inevitably played a part, with at least one user passing on the story via Weibo, the nation’s microblogging service. Soon enough, hordes gathered outside the bank asking if it was out of funds. Staffers from the institution and even government regulators stepped in to control the situation, reiterating that the story was completely unfounded. To show that the bank wasn’t out of money, stacks of bills were propped in the window for all to see.

It didn’t work. The crowds kept growing, and they wanted their money back.

In a triumph of capitalism, all of the bank’s branches were kept open. Armored vehicles brimming with cash were brought in to appease the depositors, some of whom, witnesses reported, were carrying bags and baskets with which to take home their savings.

Of course, the problems didn’t end there. If this bank was in trouble, how safe were others?

As the crisis entered a second day, and then a third, another institution became the victim of the same rumors. Rural Commercial Bank of Huanghai, which is close by, tried hard to combat the stories, with a brightly flashing electronic sign outside the main branch and a video message from its president. A statement issued jointly by representatives of the China Banking Regulatory Commission and the Zhejiang Sheyang Rural Commercial Bank assured depositors that the banks’ capital position was strong.

This being China, it’s hard to establish just how many customers actually took their money out. It seems likely that at least some of the panicked depositors were elderly folk with memories of the collapse of rural credit cooperatives, which wiped out many people’s savings. The concerns were perhaps justified: The cooperatives were part of the shadow banking sector, which promised unreasonably high returns to unwitting consumers, and many inevitably failed.

The consensus seems to be that it’s a different world now. But is it?

Hands with String

To be sure, China’s banking sector is tightly regulated. Bankruptcies are almost unheard of, which is why this most recent run on the bank caught everyone by surprise. But it did happen, so can it happen again, and perhaps on a much larger scale. To put it bluntly, as some have, is there a potential bomb of Lehman-like proportions ticking away?

China is now so integral to the global economy that it’s certainly a fair question. Some signs are troublingly familiar:  For the last five years—by no coincidence at all, not long after the banking crisis in the United States—the government has actively promoted a credit boom. The market responded with gusto, and the numbers are astonishing.

However, this is all in the Chinese economy, and the most unnerving element in the equation is that a significant majority of this credit is not exactly transparent or otherwise above board. In fact, it’s estimated that at least two-thirds of the financing came from financial institutions that are not banks. At least some of those vast funds supporting the infrastructure building bubbled up from the shadow sector. Could the boom be followed by a bust?

The banking crisis of 2008 was arguably halted by a cash infusion, the infamous bank bailouts. Thanks to its considerable lending over the past decade and more, the central Chinese administration appears to have the resources to conduct a similar rescue, if one is needed. For all the posturing in foreign policy, not to mention the stark philosophical difference, China and the U.S. both have nothing to gain and everything to lose by letting important institutions go under.  The run on the bank in Yancheng was no more than a ripple, and there’s no danger of a flood.

However, the Chinese banking economy still represents a queasy mix of free-market capitalism and heavy-handed socialism, with the latter having more power. This kind of structure is historically unprecedented, and it would be naïve to think that we have all the answers.

 

From Motown to Europe

Think Detroit, and then think Germany, or Belgium. It’s a stretch to be sure, but moving forward, this is exactly the kind of leap many financial services professionals will have to make.

Here’s why. Late last week, the city of Detroit—the largest city in the largest county in the state of Michigan, boasting a rich history in fields as diverse as automobiles and music—filed for bankruptcy, by far the largest of its kind in U.S. history. At the core of the massive filing is the simple fact that the city, after more than half a century of decline, can’t keep up payments on some $18 billion in debt. Even in a best-case scenario, it will only be able to pay out a small portion of that in the near future. (The reality might be more in the direction of a worst-case scenario.)

So who is it that’s holding all this debt? Well, that’s where those European markets come in.

The Detroit debacle, which has been so long in the making, has tentacles that reach all the way across the Atlantic to financial conglomerates in Europe, and the institutions and individuals who in turn hold all those bonds. Back in the middle of the last decade, a group of international financial services institutions (led at first by UBS) sold more than $1.4 billion of bonds. There were more rounds of financing later, and it’s (almost) easy to understand why: In those heady days, the lure of low-risk high-return bonds were too tempting to resist.

Fast forward to mid-2013, and it’s not just multinational conglomerates holding vastly devalued paper. (For the record, UBS has been in the news for facing a $50 billion loss, getting a bailout from the Swiss government, and being forced to overhaul its investment practices.) This time nationalized banks in places like Germany and Belgium are suffering too. The debt they collectively hold was once worth hundreds of millions; now, not so much. To compound the tragedy is the simple reality is that many of these institutions and individuals have already sustained significant losses in recent times. The Detroit filing promises to greatly add to that long list of woes.

On a related front, the bankruptcy is in an area that’s still somewhat grey—the size and complexity of this filing aside, it’s a fairly recent phenomenon with not much case law. Municipal restructuring, especially on this scale, is a new frontier, and there are even valid questions as to whether the filing is completely legal. A veritable army of bankruptcy lawyers and accountants is poised to enter the fray, incurring high bills in the process. Every party is acutely aware that every decision and every court ruling will set precedents for other cities in similar straits.

The same goes for the banks involved too. Apart from the scale of the problems, Detroit is far from alone in being in having troubling financial obligations; other cities and states took money from European lenders when the going was good, and those bills are coming due soon.

Who will be the next to go the Chapter 9 route, and which banks will be on the hook for it? We’ll find out soon.

This is just one reason why it’s why it’s so interesting to see the financial services industry’s reaction to potential markets like Iraq and Egypt. Companies such as Citibank and Standard are said to be exploring the idea of expanding into Iraq, which has virtually no banking industry left but will clearly need one to move forward. Meanwhile in Egypt—the site of so much recent turmoil—banking industry representatives are touting improvements in the nation’s economic indicators, including stock market spikes. That could be the first step toward drawing foreign investments.

It’s surely a strange world when torment in one country can be a welcome opportunity in another. But what these events also indicate is that good news in one year can spell disaster in the next.