Published August 14, 2013

The Beginnings of a Chinese Banking Crisis?

The LIBOR rate is a lot like your water heater: You never think or hear about it unless something has gone terribly wrong.

LIBOR (which stands for London Interbank Offered Rate) is the price banks charge to lend each other money overnight. During the 2008 financial crisis, LIBOR spiked to 6.88%, essentially halting all lending between banks. Bankers wouldn't even lend to each other for a few hours overnight, for fear that they wouldn't get their money back in the morning. In the case of Lehman Brothers, they were right.

And you surely remember the LIBOR scandal of 2012, when a cadre of banks were accused of manipulating the all-important rate for their own profit. Given that LIBOR rates influence a staggering $360 trillion in financial products, including student loans and mortgages, it's curious that that accusation didn't balloon into the scandal of the century as some experts predicted.

Yes, you can safely assume that if people are chattering about LIBOR, trouble is brewing. Which is why it's notable that LIBOR is back in the news today.

Actually, that's not entirely accurate.

What's in the news is SHIBOR—the Chinese equivalent of LIBOR (substitute "Shanghai" for "London"). SHIBOR spiked to a mind-numbing 25% in late June—yet unless you reside in the Far East, are a financial junkie, or both, you probably didn't hear anything about it.

David Franklin, market strategist at Sprott Asset Management, is here to explain why China may be facing the worst-ever credit bubble—and what that might mean for you as an investor. Read on for his balanced analysis of China's banking system and the quiet (at least in the Western world) crisis that has absolutely pummeled Chinese financial stocks.

See you next week.

Dan Steinhart
Managing Editor of The Casey Report

Shanghai Surprise

By David Franklin, Market Strategist, Sprott Asset Management (

The Economist recently reported that the Industrial and Commercial Bank of China (ICBC) displaced Bank of America to become the world's biggest bank in 2012, marking the first time in history a Chinese bank has reached this pedestal. China now has four of the world's ten biggest banks.

Together, these Chinese banks have a combined market capitalization of close to $1 trillion Canadian dollars, or three times the market cap of the Canadian banking sector. ICBC alone has 393 million individual customers, which according to the Telegraph is the equivalent of a single bank managing the bank accounts of every man, woman, and child in Western Europe. In fact, Chinese banking-sector assets have increased by $14 trillion since 2008, which is the entire size of the US commercial banking sector. China is a global banking force to be reckoned with.

From the outside, however, observing the Chinese banking system can be "like watching two dogs fighting under a carpet." It's clear that something is happening, but it's hard to tell exactly what.

June 19, 2013 will go down in Chinese banking history as the day that overnight borrowing rates hit a record high 25%, thus effectively freezing the Chinese credit market. Under normal market conditions, the SHIBOR—which is the rate at which Chinese banks are willing to lend to each other for short periods of time—is typically less than 3%. Expert opinion is sharply divided over both the causes and implications of these skyrocketing lending rates.

In one corner we have Charlene Chu from Fitch Ratings, who evoked memories of Lehman Brothers and Northern Rock when she suggested in the Telegraph that an extreme spike in the SHIBOR is an indication that China is wrestling with "the worst ever credit bubble." At the heart of this credit bubble is the opaque shadow banking system of trusts, wealth-management funds, and offshore vehicles that allows companies to avoid regulations and hide large amounts of debt.

Echoing the same sentiment, China watcher Gordon Chang, known for his book The Coming Collapse of China, sees the country on an economic decline and views the current interbank lending stress as further support for his position. Chang describes a timeline of key events leading to the jump in interbank lending rates:

"The crisis began in the first week of May when the state administration on foreign exchange issued that rule cracking down on fake export invoicing. That triggered a $40 billion outflow from the banking system and in the month of June we saw two failed central government bail auctions, two spikes in interbank rates, and two waves of default in the interbank markets. Each crisis is getting worse than the previous one."

Both experts suggest that skyrocketing interbank rates signify the dire state of the Chinese banking system. They point to a credit bubble that has gotten out of hand and portends a collapse of the economy.

Surprisingly, other experts suggest that there is nothing to be concerned about. Earlier this month Liao Qiang, a Beijing-based director at Standard & Poor's, argued that "Given that China's credit is mostly funded by its internally generated deposits, I don't think a real financial crisis, which is normally manifested in a liquidity shortage, will happen anytime soon."

Adding support to this view, the People's Bank of China (PBOC) stated in a letter published Monday, "At present, the overall liquidity of the banking system [is] at a reasonable level," and further suggested that lenders should better manage their own balance sheets. The PBOC also soothed concerned markets this week when it assured that it would provide cash to institutions that need it.

In summary, both Standard & Poor's and the PBOC are saying to us, "Nothing to see here folks, move along."

These divergent quotes highlight the huge contrast of opinions when it comes to the SHIBOR spike. But whether investors believe in the "utter collapse" or a "business as usual" scenario, they are not waiting around for the winner to emerge from "under the carpet." Investors are selling Chinese banking shares: the Shanghai financial subindex lost as much as 22% in the month of June and has yet to recover, according to data compiled by Bloomberg.

Investors have clearly chosen their dog in this fight by voting against the banks. Regardless of which scenario ultimately plays out, the fact that expert opinions are so divergent on such a critical issue at such a sensitive time is the real surprise.

David joined Sprott Asset Management Inc. in 2008 as a research analyst and divided his time between Sprott Asset Management LP and Sprott Consulting. David's main focus was on equity research within the precious metals and materials sectors. In April 2009, David became the coauthor of the monthly "Markets at a Glance" articles with Eric Sprott and subsequently became market strategist in February 2010. David was named CEO of Sprott Private Wealth in March 2011 and oversaw the business unit of Sprott that provides wealth-management services to high-net-worth individuals, foundations, and trusts. In January 2013, David returned to Sprott Asset Management as market strategist.

A frequent guest speaker at conferences across the globe, David has also been featured in numerous newspaper articles and television shows, providing insights on the ever-changing financial landscape. David contributes to Sprott's Thoughts, Sprott's daily e-letter that offers timely, entertaining, and useful investment insights. David is also a former director of a publicly listed Australian gold company.

David previously worked at Integral Wealth Securities and Toll Cross Securities in Institutional Equity Sales. He has an honours degree in economics from Wilfrid Laurier University.