China's Credit Bubble: Where Did All the Money Go?

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After China's first quarter growth numbers disappointed markets, two analysts said the country is failing to benefit from its brisk credit growth, as the money has not reached the "real economy".

"Economic growth in China has weakened surprisingly despite rapid credit growth in the second half of 2012 and the first quarter of 2013. Many investors ask us the same question: where has all the money gone? We believe a large part of the new credit supply in the first quarter did not go into the real economy," Nomura economists Wendy Chen and Zhiwei Zhang wrote in a fixed income research note on Thursday.

Total Chinese social financing rose to a record high and jumped by 160.6 percent year-on-year in January and by 58.2 percent year-on-year in the first quarter. Despite the boost, China reported first quarter GDP growth of 7.7 percent last week, missing forecasts of 8 percent, and down on fourth quarter growth of 7.9 percent.

(Read More: China's Colossal Credit Bubble Next Big Risk: Faber)

In addition, the flash HSBC purchasing managers' index (PMI) out this week confirmed fears of a slowdown, with the index falling to a two-month low of 50.5 for April.

"Why didn't money flow into the real economy? We think it is partly because the underlying demand for investment is weak," Chen and Zhang said.

"Fixed asset investment growth for the manufacturing industry has been on a downward trend since 2011, and dropped sharply in the first quarter of 2013, despite strong infrastructure fixed asset investment growth, which should have generated some positive spillover effects for manufacturers. The over-capacity problem in the manufacturing industry has been exacerbated by aggressive policy easing in 2009 and 2012."

Chen and Zhang explained that a high proportion of China's infrastructure fixed income issues are used to repay outstanding debt, rather than to fund the projects themselves. The economists found that of the 370 biggest issues of urban construction debt in 2012, at least 20 percent of the money raised was used to pay down old debt.

"It is not surprising to us, as many infrastructure investments projects are not yet profitable. Therefore, local government financing vehicles need to continue borrowing new funds for debt financing," Chen and Zhang said.

(Read More: Fitch Downgrades China's Currency Credit Rating)

Nomura's view is supported by recent policy actions by China's new central government, which is trying to crack down on local authorities using public assets, such as schools and hospitals, as loan guarantees for financing vehicles. The government is investigating several high profile cases of corruption in the bond markets and is pressuring commercial banks to clean up irregular activities.

"We have made some progress in regulating local financial vehicles and the trend of amassing such debt has been effectively curbed. But recently the illegal fund-raising activities by local authorities have tended to rise," the Finance Ministry reported on its website in December.

More recently, the Chinese government issued a public notice insisting that debt raised for public housing construction projects should not be used for other purposes, said Chen and Zhang, citing China's First Financial Daily newspaper.

"We believe this policy may be triggered by cases where some funds were misused. Indeed, risks of such events have been mentioned repeatedly in government documents," said Chen and Zhang.

(Read More: Chinese Officials Even More Pessimistic on Local Debt Than Fitch)

China's credit market has grown 10 percent over the last two decades, according to Goldman Sachs, which states that it is now the fourth-largest globally at about $3.41 trillion.

Concerns about the country's local government debt reached international markets early this month when a senior Chinese auditor said the level of debt was "out of control" and could spark another global financial crisis. In addition, both Fitch Ratings and Moody's Investor Services cut China's sovereign debt rating this month, citing risks that excessive local government borrowing could pose to the wider economy.

Chen and Zhang forecast China's economic growth will slow to 7.5 percent in the second quarter, as the government's crackdown weakens credit growth. "This initiative will likely lead to a slowdown in bond issuance and growth in total social financing in the coming months," they said.

By's Matt Clinch; Follow him on Twitter @ mattclinch81