Leveraged-up and under-regulated wealth funds were behind last week's spike in the ore price – and there may be more of those to come.
![Iron ore prices accelerate with speculators in the driver's seat](/content/dam/images/g/n/i/9/s/4/image.related.afrArticleLead.620x350.gni9bz.png/1460622423776.jpg)
When iron ore prices jumped an astonishing 19 per cent on March 7, explanations ranged from the conventional – more Chinese economic stimulus – to the bizarre, including the timing of a horticultural expo in Hebei province. In context, the price spike appears as one element of a pattern of skyrocketing speculative activity within Chinese financial markets. Spillovers beyond China's borders similar to last week's moves will become more frequent in 2016.
This is not a story of Chinese stimulus, but a story of informal financing run amok. Low trading inventories and seasonal ore buying by Chinese mills still matter, of course, but the liquidity powering such sharp price moves is just one byproduct of a Chinese financial system rapidly growing in size, complexity and opacity, despite the slowdown in the real Chinese economy. This is a very recent phenomenon in China, with speculative activity dramatically increasing over the past year.
Financial sector output reflected 8.5 per cent of Chinese GDP in 2015, higher than the peak proportion in the United States during the decade before the global financial crisis, and doubling relative to the size of China's economy over the past 10 years. Remove financial services from the Chinese economy, and overall GDP growth was just over 5 per cent in 2015. Chinese bank assets grew by $5.6 trillion in 2015, rising by over three times the size of Australia's GDP, in just one year.
About 37 per cent of these newly created bank assets in 2015 ($2.1 trillion) were claims on banks or other financial institutions, of uncertain credit quality. These are essentially funded through bank issuance of so-called "wealth management products", which are commercial paper-type instruments promising investors returns higher than conventional deposit rates. Banks use these to attract and retain depositors.
Yet in a weakening economy, there are very few assets with returns high enough to repay these investors or depositors the 3 per cent to 5 per cent offered. The "search for yield" has hit China as well, and it has taken forms very similar to those that imploded during the global financial crisis.
'Shadow' banking sector
To achieve target rates of return, banks are placing funds with third-party institutions such as securities companies, trust companies, credit guarantee companies, or other asset managers, which act as de facto "special purpose vehicles" for the banks, similar to those used by Lehman Brothers. These institutions then borrow funds from large Chinese banks overnight to add leverage to their speculative bets. Borrowing by these lightly regulated entities rose by 260 per cent in 2015.
If all of this sounds unnecessarily complex, it is, and this activity is difficult for Chinese authorities to monitor and regulate as well. Despite efforts to clamp down on the "shadow" banking sector for years, outright speculation in the equity market drove much of the growth in informal margin financing and bank assets early in 2015, and speculation in the bond market and in other informal lending instruments are now taking its place.
This includes funds flowing to anything sensitive to liquidity conditions that could generate those targeted rates of return, including bonds, equities, property, and commodities such as iron ore.
In other words, China's financial system is producing far more assets than the real economy can support, and much of this asset growth is funding outright speculation by third-party institutions operating outside of regulators' purview, rolling over their funding every day from Chinese banks.
Yet rapid growth in credit has not benefited the real economy in China, as growth continued slowing in 2015 despite a record expansion in bank assets. Credit to failing institutions keeps otherwise unproductive capacity operating and contributing to output, pushing down prices and reducing incentives to invest.
The spike in iron ore prices last week may be one of the first international spillovers from speculative activity in China's financial system, but it will not be the last. There have been solvency problems within China's banking system for years, but the growth of these highly leveraged third-party entities engaging in speculative activity now raises the spectre of liquidity problems within Chinese banks as well. These may only increase the incentives, and provide the funding, for Chinese citizens to move even more of their domestic savings abroad, into global property markets.
Chinese authorities are aware of the problems within their financial system but have no easy solutions. Chinese corporates are deeply in debt and desperately need lower interest rates. Cracking down on short-term borrowing in the interbank market could quickly lead to rising interest rates, higher corporate bond yields, and an even weaker Chinese economy.
More disruptions from China's $31 trillion banking system, the largest single-country banking system in the world, can be expected within global financial markets as long as the regulatory touch on smaller banks remains light.
Yet the lessons for Chinese leaders from the global financial crisis are similarly clear: the financial sector cannot grow divorced from the rest of the economy, as it has done in recent years, without risking a bumpy deleveraging that impacts credit to industries of the past and the future alike.
This deleveraging process will clash with Chinese politicians' obsession with economic and political "stability".
Logan Wright is a Hong Kong-based director of China markets research at Rhodium Group.