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The credibility of farmers, priests and prostitutes \’96 and bankers?

August 26, 2009 in Banks, Financial crisis, NPLs by Michael Pettis | 51 comments

Three weeks ago China Daily published a pretty funny article about a recent survey on credibility that had taken place in China. According to the article,
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At a time when shamelessness is pervasive, we are often at loss as to who can be trusted. The five most trustworthy groups, according to a survey by the Research Center of the Xiaokang Magazine, are farmers, religious workers, sex workers, soldiers and students.\’a0
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A list like this is at the same time surprising and embarrassing. The sex business is illegal and thus underground in this country. The sex workers’ unexpected prominence on this list of honor, based on an online poll of more than 3,000 people, is indeed unusual.\’a0
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It took the pollsters aback that people like scientists and teachers were ranked way below, and government functionaries, too, scored hardly better.\’a0 Yet given the constant feed of scandals involving the country’s elite, this is not bad at all. At least they have not slid into the least credible category, which consists of real estate developers, secretaries, agents, entertainers and directors.

I am not sure what secretaries have done to get themselves such poor rankings (could they mean party secretaries?), and I am not sure what kind of directors they mean (movie directors? managing directors?) but not everyone found this survey funny.\’a0 Last week a columnist in the People\’92s Daily had this to say about the same survey:

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In recent years, China has already paid a high price for the prevailing credibility crisis. The annual losses caused by bad debts have reportedly amounted to about 180 billion yuan, and the direct economic losses induced by contract fraud each year is also up to 5.5 billion yuan. Besides, shoddy and fake products contribute to another great loss involving at least 200 billion yuan. Generally, credibility crisis would cost China as much as 600 billion yuan every year.
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The shortage of credibility is not only seen in the market transactions, but in the officialdom as well. Corruption in any form is about to erode the faith of the general populace in authorities and officials at different levels.
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Perhaps, the survey result can just give a restricted description on China’s credibility status, or people can take it with a grain of salt. But it did portray a picture of the spiritual outlook of today’s Chinese society, with money as the overriding motive. It is this that especially deserves attention.

Although I fully accept that sex workers are more credible than government officials, I am outraged that teachers are so much lower on the list than prostitutes.\’a0 Since bankers have become so out-of-fashion recently, I have been vociferously denying my banker roots and assuring everyone that I am and always have been a professor, but now it seems that in order to get any respect I am going to have to buy tight jeans and a leather jacket and try to convince friends that I actually make my living turning tricks.\’a0 At my age it won\’92t be easy, but probably a lot easier than convincing people that I am a farmer (unless it\’92s on a plate I can\’92t tell a potato from a chicken) or a priest.
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Speaking of low credibility, last week the South China Morning Post reprinted a New York Times article on continued losses in the US banking system:
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Banks in the United States are now losing money and going broke the old-fashioned way: They made loans that will never be repaid. \’a0As the number of banks closed by the US Federal Deposit Insurance Corp has grown rapidly this year, it has become clear the vast majority of them had nothing to do with strange financial products that seemed to dominate the news when the big banks were nearing collapse and being rescued by the government.
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\’85Staying away from strange securities has not made things better. Jim Wigand, FDIC’s deputy director of resolutions and receiverships, says lenders that are failing now are in worse shape – in terms of the amount of losses relative to the size of the banks – than the ones that collapsed during the last big wave of failures from the savings and loan crisis.
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The severity of the current string of bank failures shows many of the proposed remedies batted about since the crisis began would have done nothing to stem the closures. \’a0These banks did not go beyond their depth with derivatives or hide their bad assets in off-balance sheet vehicles. Nor did their traders make bad bets; they generally had no traders. They did not make loans they expected to sell quickly, so they had plenty of reason to care that the loans would be repaid.
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What they did do is see loans go bad, in some cases with stunning rapidity, in volumes that they never thought possible. \’a0That so many loans are souring is a testament to how bad the recession – and the collapse in property prices – has been. But looking at some of the banks in detail shows they were also victims of their own apparent success. Year after year, these banks grew and took more risks. Losses were minimal. Cautious bankers appeared to be missing opportunities.
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Besides the fact that this suggests that it is not just in China that prostitutes may be more respected than bankers, I found this article very interesting for two reasons.\’a0 The first is because it suggests pretty clearly that green shoots notwithstanding, we are far from an end to the banking crisis in the US (and, I assume, elsewhere), and it is going to take a while longer before bank balance sheets are robust enough to expand.\’a0 All of this will adversely impact both consumer spending and business investment for the foreseeable future.
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The second reason I found this article interesting is that I think it supports an argument I have been making for a while, that the current financial crisis was not \’93caused\’94 by derivatives or complex securitizations.\’a0 It was caused, as nearly all financial crises in history have been caused, by banks being forced to accommodate excess liquidity and taking on too much risk \’96 something they must do when monetary conditions are too loose for too long.\’a0 Making opaque investments in derivatives and complex securitizations is, of course, one way to take on too much risk, but it in no way caused the excessive risk-taking.
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When observers insist that it was the deregulation and fragmentation of the \’93Anglo-Saxon\’94 financial model, and the ease with which Wall Street was able to innovate financially that caused the big losses, I can sympathize only with the observation that we paid an awful lot of money to some very smart people whose great contribution to society \’96 a newer kind of exotic swap, let\’92s say \’96 was not terribly valuable.\’a0 But it wasn\’92t the system itself that caused the crisis. \’a0After all one of the main reasons for the prestige of the \’93Anglo-Saxon\’94 model was that its greatest competitor, the very highly regulated, rigid, highly integrated and almost innovation-devoid counterpart, the Japanese banking system, collapsed so frightfully \’96 if less spectacularly \’96 after 1990, and now the article cited above suggests that a lot of banks even in the US also managed to collapse in very old-fashioned ways \’96 something Hyman Minsky would have predicted would happen even without the help of dastardly derivatives.

This is one of the reasons why I take it almost as an article of faith that the massive expansion in Chinese credit will lead inevitably to a massive expansion in bad lending, and that the \’93great\’94 economic data is actually worryingly weak given the amount of resources, especially banking resources, expended to produce those numbers.\’a0 Too many regulators here who should know better (and too many foreign observers, too) are convinced that Chinese banks are safe from losses because Chinese banks were too slow to understand complex financial instruments and so took on very limited (and often ill-advised) exposure to these instruments, and because they continue to be sharply constrained in their abilities to do so.\’a0 In fact the biggest losses are always caused by exposure to real estate or lending against insufficient future cashflows, whether these comesin the form of old-fashioned loans or in the form of total-return swaps on sub-prime mortgage tranches.
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Interestingly enough, it seems that recently there has been an increasing chorus of warnings within China about mounting risks in the banking system, and more generally about problems in the fiscal stimulus package.\’a0 For much of the year the Chinese fiscal stimulus has been described \’96 as I heard repeatedly during my testimony last February in Washington, to my surprise \’96 as the \’93gold standard\’94 of stimulus packages, but over the past two months the number of worriers seems to have expanded dramatically.\’a0 The Financial Times in an article earlier this week put it this way:
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Official readings of industrial production, fixed investment, power consumption and gross domestic product all show a strong revival, while equity and property prices have soared in recent months. There have even been signs of a recovery in exports, although these are still about one-quarter below the levels of a year ago.
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But a growing number of economists and officials say the positive growth data hide worrying structural imbalances and the government\’92s response to the crisis may only have postponed an inevitable reckoning. With the world looking to China as a beacon to lead the way out of economic gloom, a second downturn would have a big impact on global confidence, not to mention commodity prices.\’a0 \’93There is such a thing as good 5 per cent growth and bad 8 per cent growth,\’94 according to one senior adviser to the government. \’93We worry that what we\’92re seeing falls more into the latter category.\’94
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The concerns are the ones I have been discussing here for the past year \’96 the fiscal stimulus is exacerbating the domestic imbalances, non-performing loans are certain to rise dramatically, and there is little evidence that consumption is going to grow organically quickly enough to absorb Chinese capacity.\’a0 The article goes on to say:
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\’93The main concern we have now is that a tremendous volume of loans was extended very rapidly to the corporate sector at a time when corporate profitability was declining,\’94 says Charlene Chu at Fitch Ratings. \’93That would suggest there will be some significant asset quality problems down the road.\’94
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While state-owned enterprises have been inundated with loans from the state banks, economists worry too that China\’92s vibrant private sector has been largely left to fend for itself.\’a0 \’93The fiscal and monetary policy response to the crisis has mostly benefited the largest enterprises and biggest projects,\’94 says Wang Yijiang, professor of economics and human resources management at the Cheung Kong Graduate School of Business in Beijing. \’93The small and medium-sized enterprise sector provides 75 per cent of the jobs to China\’92s urban workforce but now it is shrinking for the first time in 30 years of economic reforms.\’94
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Not surprisingly, it was Chinese economists who were quicker to sense the problems than most foreign economists and observers, whose optimism has generally been more robust.\’a0 For example the highly respected Yu Yonding, an economist with the Chinese Academy of Social Sciences and a former member of the PBoC\’92s monetary policy committee (who told me three months ago at a conference at Tsinghua University, during which I presented my now-standard argument that China\’92s development model was about to fail, that the problem with my analysis was that I am much too optimistic about China), had an OpEd piece in today\’92s Financial Times that repeats the familiar litany:
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China has rebounded from the global slump with vigour. In the second quarter, its official figures showed year-on-year gross domestic product growth of 7.9 per cent. Those who doubt the quality of China\’92s macroeconomic statistics can check its physical statistics: in June, electricity production increased 5.2 per cent, reversing the falls of the previous eight months. It is almost certain that China\’92s GDP will grow more than 8 per cent this year.
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But there are problems looming. More investment thanks to China\’92s rescue package threatens to worsen the already severe overcapacity, while the cash injection is already creating asset bubbles.
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Dr. Yu warily suggests specific policy recommendations when he says that \’93China\’92s rebalancing is more the result of the global economic crisis than of policy initiative. China could do more to eliminate both internal and external price distortions to reduce its dependency on external markets.\’94\’a0 Eliminating these price distortions involves, I suspect, revaluing the currency, liberalizing interest rates, and doing the other things that I and others have suggested would address the root imbalances between consumption and production, albeit at the expense of accelerating unemployment in the short term.\’a0
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Premier Wen himself has been actively warning about trouble ahead.\’a0 Earlier this week the South China Morning Post had this to say (although I wasn\’92t able to find any reference in the local press):
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Premier Wen Jiabao warned the mainland faces new economic problems and said Beijing would stick to its stimulus plan because the recovery lacks a solid foundation, according to comments reported yesterday. Mr Wen cautioned against being “blindly optimistic” despite improvements in the economy, according to a statement on the State Council’s website.

\’93[The economy] still faces many new difficulties and problems,” Mr Wen was quoted as saying during a visit to southeastern China that ended yesterday. “There are still a lot of unstable and uncertain factors ahead and the economic situation ahead is still very grave, although both the world economy and the national economy are making positive changes now.” \’a0He cautioned that the effects of some government measures might fade while others would take time to show results, the cabinet statement said, without elaborating.
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Meanwhile there is more and more talk about attempts by the PBoC and the CBRC to limit and control the banking expansion.\’a0 The CBRC has apparently been tightening capital adequacy requirements and is reportedly going to disqualify subordinated debt from being counted as bank capital. \’a0Chinese banks have been encouraged to raise their capital ratios, and one of the ways they have done so is by selling subordinated debt \’96 there was about $30 billion issued in the first half of 2009, versus about $10 billion in 2008. \’a0But much, if not all, of this subordinated debt was purchased by other banks, so it always made a lot of sense to eliminate bank subordinated debt from any notion of a capital cushion.\’a0 In a banking crisis, just when banks need capital, this asset immediately becomes worthless.
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Yesterday\’92s Financial Times had an interesting little piece on all this:
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The banking regulator last month told lenders to raise reserves to 150 per cent of their non-performing loans by the end of this year, up from 134.8 per cent at the end of June. A communiqu\’e9 last Friday canvassed views on deducting holdings of other lenders\’92 subordinated or hybrid debt from supplementary (non-core) capital. Then there are softer measures, such as reminding banks to ensure that loans for investment in fixed assets actually end up there. The central bank also has raised money-market rates to drain liquidity. The effects of all this can be seen in the M2 measure of money supply, which was up 28 per cent at the end of July, year on year, but which fell 3 basis points from the end of June.
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This is how China tightens: imperceptibly, by degrees. As Goldman Sachs points out, China\’92s last tightening cycle began not when it raised rates in November 2004 but 18 months earlier when the central bank began to issue short-term bills to mop up excess cash. Listen to the rhetoric now, and you can almost hear the fluttering of doves. But look at the evidence, and it is obvious that hawks are gathering.

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RMB 1.5 trillion in new Chinese lending — can we turn this thing off?

July 8, 2009 in Banks, NPLs by Michael Pettis | 59 comments

I don\’92t have time to do a long entry today, but in my June 30 entry I marveled at the huge explosion in new lending, and claimed that credible rumors suggested that total new loans for June would be an astonishing RMB 1.2 trillion.\’a0 That would bring total new lending for 2009 to RMB 7.06 trillion, nearly three times last year\’92s first-half total of RMB 2.45 trillion.

Well, I was wrong.\’a0 Here is what an article that just came out on Bloomberg says:

China\’92s new lending more than doubled in June from a month earlier, increasing concerns bad loans and asset bubbles will emerge amid a credit boom.

New lending was 1.53 trillion yuan ($224 billion), the central bank said on its Web site today, bringing total lending this year to 7.4 trillion yuan. The calculation for new loans is preliminary, the central bank added.

The government is countering an export collapse by flooding the economy with money to fuel domestic demand. Rapid credit growth poses a risk to the nation\’92s lenders and a concentration of credit in some industries and businesses may damage the stability of the financial system, the banking regulator said yesterday.

\’93Excess liquidity is fueling speculation and that means asset bubbles and wasteful investment,\’94 said Isaac Meng, a senior economist at BNP Paribas SA in Beijing. \’93Expect credit to slow dramatically in the second half.\’94

I was more than 20% too conservative in my prediction. \’a0This is the third biggest month in history, and of course all three of them occurred this year.

Today bank stocks were down, on rumors that the very high and clearly unsustainable loan growth rates would soon come to an end. \’a0If you need any evidence of how topsy-turvy things have become that fact should be enough.

Under \’93normal\’94 circumstances the possibility that banks would continue to force new loan growth at anywhere near the current rates should raise terrible concerns about an explosion in future loan losses and cause bank stocks to collapse.\’a0 Instead, it is concern that this lending spree might come to an end that causes bank stocks to fall.

Of course this might not be totally irrational. \’a0If you believe, as most of us do, that there is an implicit guarantee by the government on future loan losses, then this is clearly a heads-we-win, tails-the-government-loses proposition.\’a0 Let them pile on the loans at the guaranteed spread between lending and deposit rates.

I guess it is time to introduce something that I might call the Pettis Rule of Banking (although I am way, way down on the list of people who first thought of this):\’a0 \’93It is not even theoretically possible in a banking system in which bankers are given unlimited liquidity, tremendous pressure to make loans, and an implicit guarantee against losses, that enormous amounts of bad loans will not be made.\’94

Debt is up, trade is down, and we still don\’92t know which way to list

June 15, 2009 in Balance of payments, Banks, Economic growth, Exports and imports, Fiscal debt and deficits, PBoC, Real estate by Michael Pettis | 35 comments

I am still working on my piece on the global savings adjustment and will probably post it in the next week or so. The main point is to discuss what the implications are for China if we see simultaneously over the next few years an increase in US savings and a reduction in global investment. For today I wanted to discuss some of the economic data coming out of China as well as a couple of debt-related issues.

US debt and the dollar

But first, a quick digression. Today\’92s Financial Times has an article titled \’93Fears over US sovereign debts unfounded\’94 which, as the title implies, argues that \’93Fears of a crisis of confidence in the US sovereign debt market \’96 and a subsequent dollar collapse \’96 are unfounded.\’94 On a related note Bloomberg has an article today which notes that \’93Russian Finance Minister Alexei Kudrin said the dollar is in \’91good shape,\’92 further affirming that there\’92s no substitute for the world\’92s reserve currency.\’94

It\’92s great that commentators are coming back, however temporarily, to a sense of reality and common sense. There never was likely to be a crisis in the ability of the US government to fund its deficits, and all the pleading to foreign governments to continue purchasing dollar assets was based on very fundamental misunderstandings of both the form of the global adjustment and the functioning of the global balance of payments. For the former, the problem we are facing is that as Asian savings soared over the past decade, they were accompanied by a collapse in US savings. This is not a coincidence. An increase in savings in one part of the world requires a reduction in another, and causality can work either way, so please dear readers spare me the whose-fault-is-it outrage \’96 it is not relevant here. The point is that without a marked increase in global investment, one requires the other.

The collapse in US savings was unsustainable, and it is now reversing. This creates a problem of excess global savings, which means financing deficits for creditworthy governments is not going to be a problem and will not result in soaring real interest rates. In fact Paul Krugman has a brief piece, based on numbers from Brad Setser, that shows the explosive rise in US government debt is more than matched by the contraction in household debt.

This is just another way of saying the same thing. Of course I will add my by-now-tiresome point that we do not have to worry about discretionary decisions by foreign governments as to whether or not they will continue financing the US fiscal deficit. Foreigners do not finance fiscal deficits. They finance current account deficits, and one (the current account deficit) cannot occur without the other (the financing). As long as the US runs trade deficits with China (or Russia or anyone else), those deficits will be financed, and the only thing that will stop that is a contraction in the US trade deficit, which is actually expansionary for the US economy and will reduce the need for fiscal expansion.

Remember, the US can force foreigners to invest $2 trillion a year in the US by the simple expedient of running a $2 trillion annual trade deficit. But this cannot possibly be a good thing. If we want the trade deficit to go down, we must also want foreign financing of the US to go down by exactly the same amount. This is not high-falutin\’92 economic theory, it is rather an arithmetical necessity. (By the way I tried to explain something related this Saturday when, on CCTV9\’92s Dialogue, two points were made \’96 that the contraction in the US trade deficit was causing great pain in China, and that Chinese officials were warning the US government sharply to reduce its fiscal borrowing. China cannot ask both that the US slowdown its contraction in consumption and that the US government slowdown its fiscal expansion. It is precisely the growth of the US fiscal deficit that will cause a slowdown in the contraction of US net consumption.)

The second point, that the dollar is still in \’93good shape\’94 as the world\’92s dominant reserve currency, should be obvious. I have not gotten around to writing why all these spectacular (or spectacularly reported) moves by China and others to \’93undermine\’94 the reserve status of the dollar \’96 announcements by Putin, currency swap arrangements between China and a host of countries desperate for cash, the announcement by a major Chinese banks that it will make the RMB available for international transactions, and so on \’96 are all of almost no consequence except to the paranoid. At some point I will write more about it.

Debt and risky debt structures are rising

Let me turn to debt. Last week Andrew Batson had a very interesting, and very important, I think, article in The Wall Street Journal, discussing the impact of the stimulus on the government\’92s real debt position. \’93The cost of China’s stimulus program,\’94 he writes, \’93is turning out to be much larger than official figures indicate, raising the stakes for the government’s attempt to restart high growth through massive borrowing.\’94 He points out that a lot of the spending is being funded by provincial and municipal borrowings and by corporate borrowings, \’93virtually all of which are indirectly backed by local governments.\’94

He concludes: \’93As the central government is ultimately liable for those hidden debts, China’s total state debt is closer to 35% of GDP than the 18% shown by official figures.\’94 In fact I have always argued that other not-yet-recognized liabilities, such as hidden municipal and government debt, the bankrupt AMCs, and other non-recognized debt, probably means that real government debt levels are higher than the official numbers by at least 15-25% of GDP, which suggests that, correctly counted, government debt levels may now be approaching 50-70% of GDP. If we throw in the possibility that the current bank-lending spree is also likely directly or indirectly to add to government debt burdens in the future (contingently, through a rise in NPLs), I would not be surprised if policy-makers are already starting to consider the possibility of a debt problem at the central government level. I am not saying that this must happen, but only that it is easy to construct some fairly plausible scenarios, involving the continuing global adjustment and the concomitant Chinese adjustment, that can easily suggest a debt problem.

My concerns of course were not made more palatable after I saw a very interesting article in last week\’92s Caijing (and what other magazine would have reported this?), with the unsettling subtitle \’93The property market bubble burst last year, but developers are still afloat thanks to governments, banks and a ’subprime’ solution.\’94

The article notes how unlikely it is that the massive contraction and the difficulties in last year\’92s property market were not accompanied by high-profile failures among property developers. This is because, they explain, \’93local governments and banks have intervened to prop up Chinese property developers following last year’s sharp contraction in the real estate market,\’94 and they show how this has happened.

Focusing on the case of Greentown China Holding Ltd, a large property developer that nearly went bust, they write:

Greentown faltered in the fourth quarter 2008 and stood on the brink of liquidation early this year. But it survived after a bank agreed to refinance foreign debt and a local government approved a grace period for land payments. Moreover, trust funds that use what at least one expert called a “subprime” scheme offered flexible financing for development projects.

Shou said his company has dodged the crisis. But he admitted that pulling through 2008 was extremely difficult. Indeed, Greentown saw a 10 billion yuan gap between its 2008 sales target and actual results. And debt payments loom for 2009.

The article\’92s authors, Zhang Yingguang and Gong Jing, go on to draw the unwelcome conclusions:

Industry executives think similar, short-term rescues for major property developers have occurred more frequently in recent months than generally acknowledged. For evidence, they point to the absence of high-profile failures in the industry.

This suggests that there are a lot of very dodgy debt deals out there that are based on nothing more than hopes and prayers. This doesn\’92t imply, of course, that all these deals will go bad. What I am worried about is something a little different \’96 the highly pro-cyclical nature of these deals. If China recovers, these deals will probably do fine and will be repaid, and so will never show up as contingent debt, but if economic conditions deteriorate of course that is precisely when they will go bad.

And of course that is precisely when we most desperately don\’92t want them to go bad. Throughout history credit bubbles always end up, in their later stages, with these kinds of highly pro-cyclical structures (read about investment trusts in the 1920s for example, or the Japanese real estate and lending markets in the 1980s, or, in case you\’92ve already forgotten, the sub-prime market not so long ago). As long as economic conditions and liquidity-driven asset prices continue to improve, these highly unstable structures survive and prosper, but just when you most desperately want to avoid their breakdown, when conditions turn nasty, they come crashing down on you. These kinds of structures are what I call in my book (The Volatility Machine) highly \’93inverted\’94 structures and they systematically increase volatility by reinforcing both good times and bad times.

Recent economic data

Finally, as everyone knows by now, a number of economic indicators were released last week, some good some bad. Some of the good news, according to an article in the South China Morning Post, was:

The National Bureau of Statistics said in Beijing that annual industrial output growth rebounded to 8.9 per cent in May from 7.3 per cent in April, outpacing a median forecast of 7.5 per cent. Annual growth in retail sales rose to 15.2 per cent in May from 14.8 per cent in April, slightly ahead of forecasts, partly due to a moderate pace of deflation.

For all of last year, retail sales were up 21.6 percent. Together, the two read-outs suggested a 4 trillion yuan (HK$4.5 trillion) government stimulus plan, allied with consumer spending, is starting to overcome weak global demand for the exports that powered the country\’92s breakneck growth in recent years.

Accompanied by the rise in US retail sales, this indicated to many that the Chinese stimulus package is working and that the global and Chinese economies may have bottomed out. In the author\’92s words, \’93A growing conviction that the global economy is starting to claw its way out of the deepest recession in six decades has seen stock markets rallying strongly from the depths plumbed in March, while hopes of burgeoning demand have driven prices of oil and industrial metals to multi-month highs.\’94

The next bit of good news was mainland investment levels. According to another article in the same paper:

Mainland investment surged in May on the back of government pump-priming and a recovery in the property sector, providing fresh evidence that the world\’92s third-largest economy is leading others on the path to recovery.

Investment in urban areas in fixed assets such as apartment buildings and roads rose 32.9 per cent in the first five months from a year earlier, compared with a 30.5 per cent rise in the first four months, t he National Bureau of Statistics said on Thursday.

Economists said that translated into a 40 per cent leap in May alone. Adjusted for inflation, the increase was even greater because mainland prices have been falling for several months.

Actually I think this is not good news at all. To me it indicates nothing more than that if you pump enough money into investment, investment will rise. A much more important question, and one of course not addressed by the data, is whether pumping money into investment is the best way to force the necessary adjustments in the Chinese economy, and whether this does not represent a \’91doubling up\’94 of china\’92s bet on the global recovery. That is something only time will tell, and I have written about this enough times elsewhere to leave it at that.

The bad news is that, according to a release today by the Ministry of Commerce, foreign direct investment in the mainland dropped 17.8% year-on-year in May for the eighth straight monthly fall. Honestly I don\’92t think this is such a big deal except to the extent that it gives us a \’93businessman\’92s\’94 view of economic prospects in China that is very different from the economic-recovery view so popular in the Chinese (and foreign) press, although of course it may simply reflect the desire abroad for cutting exposure and cutting capacity.

Much more interesting to me is the trade data. According to an article in Thursday\’92s People\’92s Daily:

China’s exports and imports shrank for the seventh month in row in May, the General Administration of Customs said on Thursday. Exports fell 26.4 percent in May from the same period a year ago to 88.758 billion U.S. dollars. Imports were down 25.2 percent to 75.36 billion U.S. dollars. The trade surplus was 13.39 billion U.S. dollars.

The decline in exports and imports in May were worse than the 22.6% fall in April\’92s exports and the 23.0% drop in April\’92s imports, although Goldman claims that the decline is more or less flat if measured on a seasonally-adjusted basis.

April\’92s and May\’92s trade surpluses ($13.1 and $13.4 billion) were substantially below the equivalent numbers last year ($16.7 and $20.2 billion), so from that point of view we can argue that China is finally starting to reduce the negative net demand it provides to the world. Two caveats are in order, however. First, for the first five months of the year, China\’92s trade surplus is still up more than 13% compared to last year \’96 $89.1 billion in 2009 versus $78.6 billion in 2008.

Second, imports would have fallen much faster except for the surge in commodity imports. Jamil Anderlini at the Financial Times gives one, benign, explanation for the surge:

Chinese import volumes of many commodities and natural resources surged in May, indicating a rebound in infrastructure building. That supported figures on Thursday showing fixed-asset investment was 32.9 per cent higher in the first five months of the year, compared with the same period in 2008, an implied rise of 38.7 per cent in May alone from a year earlier.

Keith Bradsher, in an article in Wednesday\’92s New York Times gives possibly a very different explanation:

Strong buying by China has helped lift commodity prices around the world this spring, but growing evidence suggests that a sizable portion of this buying has been to build stockpiles in China, and may not be sustainable.

At least 90 large freighters full of iron ore are idling off Chinese ports, where they face waits of up to two weeks to unload because port storage operations are overflowing, chief executives of shipping companies said in interviews this week. Yet actual steel production from that iron ore is recovering much more slowly in China, and Chinese steel exports remain weak.

Commodities and shipping executives describe Chinese stockpiling in recent months of a range of other commodities as well, including aluminum, copper, nickel, tin, zinc, canola and soybeans. Starting in April, China began stockpiling significant quantities of crude oil.

There have been rumors and some evidence of stockpiling for months, and if this is the case, and of course if the stockpiling is not sustainable, then the import numbers are likely to have been artificially boosted. Real demand by China for foreign goods will have actually been much lower.

Of course all of this has a trade impact. Regular readers don\’92t need me to rehash the arguments. Suffice it to say that the Chinese fiscal stimulus, rather than an adjustment to the new economic realities, in my opinion, is still based on boosting production and investment and constraining consumption, in spite of statements to the contrary (for example today\’92s People\’92s Daily has another front page article in which Premier Wen \’93stressed the importance of promoting domestic consumption\’94).

Unless the world recovers rapidly and sustainably and, more importantly, US consumers return to the heady days of financing their consumption by binge borrowing, we are going to need to see a greater trade adjustment in China. Trade tensions are not improving. Last week I had dinner with a very senior China manager at a large German company and he told me expected anti-dumping suits to surge in the first quarter of next year. As if to beat him to the punch yesterday\’92s Financial Times came up with this story (\’93China accused of predatory pricing practices\’94):

India\’92s small and medium enterprises have warned that they are suffering because of cheap imports from China. They are urging New Delhi to accelerate anti-dumping investigations and impose tougher safety and quality checks on Chinese products.

The appeal for greater government protection came amid rising tensions between New Delhi and Beijing over trade, after a high-profile dispute over an Indian ban on Chinese made toys. India\’92s Federation of Chambers of Commerce and Industry said on Sunday that a survey of 110 small and medium-sized manufacturers found that about two-thirds had suffered a serious erosion of their Indian market share over the past year, because of cheaper Chinese products.

In its statement, FICCI said the Chinese imports were between 10 and 70 per cent cheaper than comparable Indian products, a price differential that it said was \’93huge and difficult to explain\’94. Amit Mitra, the FICCI\’92s secretary-general, said Indian industries were being hurt by \’93typical Chinese predatory pricing\’94 intended to drive rivals out of business so that Chinese companies could capture the market \’96 and then raise prices to more normal levels. The bite was felt by companies in a range of sectors, including processed food, light engineering, building materials and heavy engineering, chemicals and textiles, FICCI said.

The fact that Indian wages are lower than Chinese wages is probably not enough to compensate for China\’92s much better infrastructure, but there are other reasons for the price differential. I discussed some of these reasons in an entry earlier this month.

Tags: Greendown

Stimulus \’96 at what cost?

June 8, 2009 in Banks, Fiscal stimulus by Michael Pettis | 25 comments

Today is the second day of the dreaded gaokao, the national college entrance exam that more than half of all Chinese kids in their age cohort will sit to determine whether or not they will go to university (just over 60% of the test takers will start college next September) and, much more importantly, which one they will attend. Throughout Beijing anxious parents are standing glumly in the heavy (but cleansing) June rain waiting for their kids to emerge from the exams so that they can pepper them with worried questions. It is a scary time for a lot of people.

In the previous six years the number of students taking the exam has jumped every year, from 5.3 million in 2002 to 10.5 million in 2008. This year, for the first time, the number of students sitting the exam has actually declined to 10.2 million.

The official position is that the decline reflects a drop in the number of 18-year-olds in China, but there has been widespread discussion in the press that the decline was too large to be explained just by the smaller number of high-school graduates, and that in part it reflects fears of rising unemployment among college graduates. College is becoming a less attractive option to some Chinese.

6.1 million college students will graduate this month and, according to the Ministry of Human Resources and Social Security, about 1 million have been unable to find jobs so far. Over the past three years the number of college graduates finding jobs has stagnated even as the number of graduates has surged, even during the boom years of 2006 and 2007. Part of this was caused by the surge in college enrollment, but at least part of the employment difficulties facing college graduates has been blamed on the very poor quality of university education, especially in the new or newly expanded schools, and its failure to prepare students for the kinds of jobs that the market wants.

Over recent months the government has made finding position for graduates, including in the army and as rural high school teachers, a top priority. The front page of today\’92s People\’92s Daily has an article citing a speech by Premier Wen Jiabao in Xi\’92an (in Shaanxi province) encouraging graduates to widen their job search:

Chinese Premier Wen Jiabao has urged the country’s college students to find grassroots jobs in less developed regions as the economic downturn increases pressures in employment market. Visiting Xi’an, capital of central Shaanxi Province, from Friday to Sunday, Wen said employment was one of the government’s priorities for the sake of the country’s economy and for the future of individuals.

\’93College students, laid-off workers and migrant workers waiting for jobs are my biggest concern,\’94 Wen told job hunters at an employment center. He encouraged graduates from universities and colleges to find work in grassroots regions, and called on employers to create more jobs.
\

\
Since the second half of last year, the government has implemented a series of policies to create jobs. The State Council, or Cabinet, also decided to give living allowances to graduates who went to the central and western regions for internships.
\

Besides exhorting college grads to take the kinds of jobs they usually shun, the government is also still working on boosting growth. The Ministry of Finance recently raised the rebate of export taxes by around 15%, according to another article in today\’92s People\’92s Daily. This is part of the move to increase China\’92s export competitiveness, but I am not sure these kinds of measures are likely to have much positive global impact beyond crowding out export competitors and worsening the global trade environment.

As badly as Chinese exports have been hurt, and exports were down 22.6% year on year in April, Chinese exporters have still done much better than other exporting countries in Asia and elsewhere, suggesting that they have managed to avoid much of the brunt in the contraction in global imports, led by the contraction in the US. This, as I argued in last week\’92s entry, has as much to do with credit and interest rate policies as it does with any inherent competitive advantage.

Not surprisingly, given these moves, expectations of a rise in the value of the RMB are declining. For the fifth day in a row, according to an article in today\’92s Bloomberg, the 12 month RMB forward declined, trading currently at 6.714, implying a 1.8% appreciation over the year (because these forward markets cannot easily be arbitraged, they do not price according to interest differentials, as forwards normally do, and so may contain more expectational content that a lot of other forward markets).

Meanwhile an interesting article in always-hard-hitting Caijing worries about the flood of bank credit, and whether borrowers are earning nearly enough to cover interest costs:

Chinese bank lending increased to more than 5 trillion yuan between January and April, nearly three times the credit level reported during the same period last year. Even if new loans average only 500 billion yuan during each of the remaining eight months of 2009, the year’s total would be more than 9 trillion yuan \’96 more than all loans issued over the previous two years combined.

The industrial sector’s recent performance provides solid grounds for concern over this rapid credit growth. A National Statistics Bureau survey of 22 regions found industrial profits totaled only 323 billion yuan during the first quarter, down 32 percent from a year earlier. That means annual profits for all industries will amount to only about 1.6 trillion yuan this year.

Outstanding loans currently stand at 35 trillion yuan. Assuming companies have kept a moderate debt ratio averaging less than 50 percent, their capital investments now exceed 35 trillion yuan. And profits of 1.6 trillion yuan versus 35 trillion in capital investment means an annual return rate of only 4.57 percent, below the weighted loan interest rate of 4.76 percent we saw in March. In this sense, companies seem to be in a rather weak position to finance debt with earnings.

Although the writer of the piece, economist Lu Lei, thinks that continued expansion in the banking system creates enormous risks, he doubts that the PBoC will put the brakes on bank lending for a number of reasons, the most important being that commercial bank lending is at the heart (and lungs and nearly every other organ I can think of) of the fiscal stimulus program, and without it, there is no stimulus.

Looking at tax revenues, local governments nationwide were unable to collect as much in the first quarter as in the same period 2008. In fact, tax receipts fell 1.4 percent, in sharp contrast to the 34.7 percent increase posted a year earlier. Cursed with double pressure from a directive to invest and shrinking revenue, local governments have had every incentive to use banks as financing proxies.

Now we’re faced with the possibility of undesirable negative GDP growth. Banks, concerned about defaults, may grant only 300 billion yuan in new loans every month for the rest of the year. So we’re stuck with a painful choice between two losing scenarios: a more moderate monetary policy that would cripple fiscal policy, leading to an outright “hard-landing;” or continuing a loose monetary policy backed by fiscal spending, which risks future loan losses and a weaker market. To get around the problem, the central bank may be forced to fill holes at banks by pumping in money, in effect imposing an inflation tax on all consumers

Lu lei\’92s \’93painful choice\’94 is exactly right, and what an inevitable worrier like me has been worrying about since last summer. In January I wrote about this \’93all but the kitchen sink\’94 policy, of throwing everything they can into stimulating the economy, and said that although this would certainly result in higher than expected growth this year, it would come at a real cost. I wrote:

This strategy may be politically necessary but ultimately represents a gamble on the duration of the global slowdown. If the duration is short and the slowdown light, it will have been a winning gamble, and once the world takes off again China can get serious about resolving the internal imbalances.

Of course if the global slowdown is long and deep, the gamble will have failed. That means, dear readers, that if Chinese GDP growth in 2009 is higher than I projected \’96 say 8% \’96 I will not whip out the party hats and favors. Instead I will immediately begin whining about the state of the banking system.

To make matters worse there is a story that appeared a few weeks ago in an article in Australian newspaper The Age, warning about something that has been much discussed over the past year, that the fiscal stimulus package, or more precisely, the way it is being financed, could lead to rising contingent debt at the provincial and municipal level.

Beijing will have to jam on the economic brakes to save cities from bankrupting themselves, says a top Chinese adviser. He Fan, an assistant director at the Chinese Academy of Social Sciences who frequently advises top leaders, says as much as two-thirds of Beijing’s 4 trillion yuan ($A773 billion) stimulus program will be spent by local governments, financed mainly by state-owned banks.

\’93Some local governments will virtually go bankrupt,\’94 Professor He told BusinessDay. \’93Previously, local governments got all their money from selling land. This is not sustainable. Some areas have already sold quotas from the next 30 years.\’94 A number of large cities are thought to be at risk, including Kunming and Hangzhou, with their funding problems exacerbated by a slump in real estate sales.

Professor He goes on to worry that easy money has poured into asset markets as well as questionable projects that were previously rejected by the NDRC.

\’93Banks have strong incentives to lend to NDRC-approved projects because if they end up as a fiasco, there is no political risk,\’94 he said. \’93They can say \’91it is not my fault, the NDRC told us to lend\’92.\’94

When banks are encouraged to lend huge amounts, and with an implicit guarantee against any losses, it is pretty hard to imagine their not embarking on a wild lending spree. On a related but very different subject, I have been corresponding with Steve Keen, a professor at the University of Western Sydney and someone whose blog I often read and whose unconventional insights I find very valuable and persuasive (the fact that he is an expert in and admirer of the works of Hyman Minsky doesn\’92t hurt either).

I wrote to him to ask his thoughts on the implications on monetary policy and debt structures of China\’92s rising savings rate. It seems to me that as savings rise as a share of GDP, this must have dampened the impact of the very loose monetary conditions in China over the past several year. If this is the case, and if savings rates do indeed decline in the next few years, there could be important consequences for monetary policy. I plan to think about this a little more and, if I come up with anything interesting to say, I will write about it. Maybe some of the readers of this blog might have some interesting ideas. Steve Keen\’92s initial response included the following:

Now that the American private sector has stopped borrowing, but both American and Chinese governments are pumping base money into the system, and American consumers and businesses are desperately trying to delever, the dynamics alter considerably. But I expect the overall result will be a relative fall in the Chinese “savings rate” and a rise in the American one.

Obviously I think looking at this from the point of view of savings rather than debt is why we haven’t worked this out to date. A lower consumption rate is definitely part of it, but the debt flows themselves-which generate the monetary flows that then accumulate in accounts depending on consumption rates–are the driving part of the story, not the consumption rates themselves.

Tags: Steve Keen

Distortions in the Chinese lending environment

May 3, 2009 in Asian development model, Banks, Fiscal stimulus, Money growth, NPLs by Michael Pettis | 38 comments

Things have been so busy this past week with various writing commitments and with the celebration of the third anniversary of my music club (four amazing shows with some of Beijing\’92s greatest artists and a lot of support and coverage from local music scene participants an the press) that I have been neglecting my blog. For today\’92s entry I don\’92t have any major points to make but I did want to take a look at some of the anecdotal information we are getting about the bank-part of the fiscal stimulus package.

The context is last week\’92s post in which I argued that the almost certain reversal over the next few years of American ability to grow consumption at a faster rate than GDP will put huge pressure on the Asian development model, and will require Asian consumption to grow much faster than Asian GDP. However if the current loan explosion is mismanaged, this may itself sharply constrain Chinese consumption growth, thus locking China into a long transition period of turgid growth.

In that light two weeks ago The Economic Observer, one of the better local newspapers, had an interesting article titled \’93Millions of Small Businesses Still Starved of Credit\’94. The growth of smaller businesses, many of which are in the service industry, is one important way for Chinese net consumption to grow, but it seems that their ability to obtain financing is being sharply limited by formal or informal policies that are driving capital into the investment sector. The article suggested that even with the explosive loan growth in the banking system, smaller companies are finding it extremely difficult to get loans.

New loans in China for the first quarter of this year would amount to nearly 4.6 trillion yuan, but behind the staggering figure, millions of small and medium-sized businesses nationwide were still struggling to raise funds.

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Data from the National Association of Industry and Commerce (NAIC) showed that in January of this year, private firms had 421 billion yuan in short-term loans, a 700 million yuan decrease from December 2008. That was despite 400 billion yuan in new short-term loans released that month.
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The article goes on to mention a survey of businesses in Chongqing that indicated that 82% of small and medium-sized businesses there considered the lack of funds the main hindrance to their development. Quoting Chen Yongjie, an official with the National Association of Industry and Commerce, the article goes on:

The Chinese government has recently pushed measures to solve financing problems for small and medium-sized businesses – for example, China’s Banking Regulatory Commission has required banks to open loan departments exclusively for small companies. But Chen said it was hard to tell how effective these measures would be: “What we can see clearly now from the statistics is that loans for small and medium-sized businesses are still dropping.”

It would be normally be surprising that loans are expanding so rapidly (we have already increased net new lending in the first quarter of 2009 by more than all of last year\’92s loan increase) while whole sectors of the economy are struggling to find financing, but my friend Dan Rosen sent me a Bloomberg article from Friday with a line which he found very funny and a tad startling. According to the article:

The largest borrower in the quarter was government-owned China Aviation Industry Corp., or AVIC, the nation\’92s biggest aerospace company. The Beijing-based company received 236 billion yuan from 11 Chinese banks, including ICBC, China Construction and Bank of China. It won another 100 billion yuan of credit from Export-Import Bank of China on April 16, without specifying how the money will be used.

AVIC General Manager Lin Zuoming said in an April 16 interview with Beijing-based newspaper Economic Observer that his biggest worry is how to allocate the borrowings to increase returns.

It\’92s the last line, of course, which Dan marked out. The largest single borrower, it turns out, has taken out around $35 billion in loans but doesn\’92t seem terribly certain about why he borrowed the money. I don\’92t want to read too much into a single throwaway line, but it is certainly consistent with all the stories and rumors we hear about banks lending not because borrowers need money for specific (hopefully profitable) projects but rather because they want to show loan growth, and the safest way to do that is to convince large companies and projects with explicit or implicit government guarantees to borrow massive amounts of money. Of course it helps that managers aren\’92t terribly concerned about creating value for their shareholders, but this is almost certainly a recipe for future growth in NPLs.

Obviously I (along with most of the readers of my blog) am not the only ones to realize this. Friday\’92s South China Morning Post had this to say:

Citic Bank Corp, the country\’92s seventh-largest lender, is optimistic about this year\’92s earnings outlook and is reining in loan growth to safeguard against a rise in bad loans. Chief executive Chen Xiaoxian said the bank would adopt stricter loan checks and had sent inspectors to those branches that had recorded a surge in discounted bill financing in the first quarter. \’93Banks need to take more forceful actions to increase risk controls,\’94 he told reporters.

The article goes on to say:

Total lending by mainland banks in the first quarter reached a record 4.58 trillion yuan, close to the government\’92s minimum target for the whole year of 5 trillion yuan. Asked about his top concern, Mr Chen said: \’93Of course, it is asset quality given such fast loan growth.\’94

Mr Chen called the surge unsustainable. He did not disclose how much Citic Bank had lent in the first three months, but he said the pace would slow. \’93No matter how complicated your businesses are, you must clearly know the default rate,\’94 he said of lessons learned from the global financial crisis.

Of course Mr. Chen is right. The current rate of loan growth is unsustainable and the biggest concern must be the risk of a sharp rise in NPLs. One would expect that all of this would quickly cause the PBoC to put the brakes on lending. The always intelligent Jim Walker of Asianomics thinks this will happen, but is nonetheless so worried about continued loan expansion he asks in an April 14 report:

Exactly why is this process dangerous?

First of all, China has an extremely high M2 to GDP ratio to begin with. As Figure 2 shows, M2 in 2008 already represented 158% of GDP. Compare this with money conditions in the US where M2 accounts for just 54% of GDP (the US ratio is read off the left-hand scale). If the US\’92 monetary easing efforts are such that investors are convinced that the dollar is no longer available reserve currency then the conclusion must be the same as regards the renminbi \’96 only much more so. The only reason that the renminbi is not nose-diving in world currency markets is because domestic economic actors are not allowed to sell it.

For Walker, the explosive growth in lending is exacerbating what was already a very big problem, China\’92s huge bank-funded overinvestment. He goes on:

The second word of warning is that this breakneck monetary expansion will have to cease soon. The PBoC says that it will support economic growth through easy monetary conditions. It has certainly been true to its word so far but the problem will quickly become one of having a \’91tiger by the tail\’92. In Hayek\’92s analysis of economic growth he concluded that the only way an economic system hooked on credit could maintain its growth rate was for it to add ever increasing amounts of credit to that already existing. Adding the same amount of credit would result in recession-like conditions.

This, in his view, was the road to hyperinflation. The alternative, putting the brakes on monetary expansion, would lead to economic depression. On the assumption that Beijing will not wish to risk a hyperinflationary outcome we suspect that it will slam the brakes on the banks (which are clearly out of control already) within the next few months, regardless of the comments being made by the PBoC today. The next move in monetary policymaking in China will be to tighten, a move that will be badly received by markets that are already starved off profits.

Perhaps, but most analysts are betting against Walker. Xinxin Li of the Observatory Group points out that Wednesday\’92s decision by the State Council (effectively the equivalent of the executive cabinet) to reduce the capital ratio requirement for financing capital spending for infrastructure \’93is a further effort by the central government to implement its massive fiscal stimulus plan, in order to boost investment demand and support economic growth.\’94 In his opinion the current policy environment \’93makes any hawkish statement from the PBoC politically incorrect. Just a couple of days ago, Vice Premier Li Keqiang said that the global financial crisis is having a deeper impact on the Chinese economy, showing that the top leaders are unlikely to drop their guard on the economic difficulties until Chinese economy firmly is on a recovery track..\’94 In his April 28 report he concludes:

While the PBoC is concerned about the current pace of money expansion, it is unlikely to impose tightening measures to slow lending growth in the near term, due to an unclear economic outlook and the political priority on economic growth. China\’92s loose monetary conditions will likely persist in Q2.

The problem here is that Jim Walker\’92s analysis may be right but Xinxin Li\’92s prediction may also turn out to be right (and I suspect that Li doesn\’92t necessarily disagree with Walker\’92s analysis). Just because there is an urgent need for a policy doesn\’92t mean that it will happen. I remember that in early 2007 I argued aggressively that the PBoC would have to engineer a maxi-revaluation of the RMB because a slow revaluation would create huge hot money problems for the country. Of course the maxi-revaluation didn\’92t happen, and many of my friends seem to find my very wrong prediction a never-boring topic of conversation, but I defend myself by saying the analysis was correct, the prediction of huge hot money inflows was also correct, and soon enough the warnings about how destabilizing these inflows will be will also turn out to be correct. The global crisis intervened, and we will now see that China\’92s failure to have adjusted the currency much earlier, as a way of accelerating the transition from export growth to domestic-consumption growth when conditions were so good, will have a very painful cost.

So even if Jim Walker is right in that Beijing has no choice but to slow loan growth, he can still be wrong about assuming that they will. That of course would be the worst possible outcome.

Before ending, I wanted to cite a line from my friend Justin Winkle, who was responding to the comment discussed above that Dan Rosen found funny and startling. I am sure this has absolutely nothing to do with the topic under consideration, but here it is anyway.

My quote of the year is a line from Lewis Carroll appropriated by my stockbroker to describe the global economy: \’93If you don’t know where you are going, any road will get you there.\’94

As long as I am doing literary allusions I was just rereading PG Wodehouse\’92s classic Joy in the Morning, in which Lord Worplesdon explains to Bertie Wooster, in one of their very rare moments of camaraderie, why an American businessman they know seems so easily startled:

\’93Odd, this neurotic tendency in the American businessman. Can you account for it? I can. Too much coffee.\’94

\’93Coffee?\’94

\’94That and the New Deal. Over in America, it appears, life for the businessman is one long series of large cups of coffee punctuated with shocks from the New Deal.

I guess you can find economic history in the oddest places.

Tags: Lewis Carroll, PG Wodehouse, SMEs

The death of the Asian development model

April 25, 2009 in Asian development model, Banks, Consumption and production, Fiscal stimulus, NPLs by Michael Pettis | 77 comments

One of the few areas in which the Chinese fiscal stimulus package is unquestionably having a positive effect is on growth forecasts \’96 although mainly because forecasts seem to be coincident indicators more than leading indicators. In the past couple of week Morgan Stanley raised its 2009 forecast for Chinese GDP growth from 5.5% to 7.0%, while Goldman Sachs upgraded growth forecasts from 6.0% to 8.3%. UBS has raised its forecast from 6.5% to between 7% and 7.5%. RBS has jumped from 5% to 7% and Barclays is up from 6.7% to 7.2%. On the other hand Standard Chartered, worried about the sustainability of the \’93rebound,\’94 has kept its 2009 GDP growth forecast at 6.8%, and the IMF is still at 6.5%

At any rate I\’92ve never provided my own forecast of Chinese growth partly because I am not smart enough to come up with an economic forecast and partly because it always seemed to me that in the short-term Chinese growth was going to depend very heavily not on economic conditions but rather on the hard-to-predict outcome of the fierce policy debate taking place in China. As I see it, one side of the debate \’96 which seems to include people around the PBoC and the National Bureau of Statistics, along with many of the more prominent of the think-tank policy critics \’96 is arguing that as difficult as it is, the crisis is a good occasion to force China to change its development model and financial system in a direction that will provide China with a healthier basis for stable, long-term growth. They are eager to see policies aimed at switching resources from production to consumption, even at the expense of a short-term increase in unemployment, and they tend to see the recent surge in credit and investment not as solutions to the crisis but rather as policies that will make things worse for China in the medium term.

On the other hand a different group of policymakers and power brokers \’96 who include, I think, the Ministry of Commerce, the important exporter constituencies, and above all the powerful provincial and municipal leaders \’96 are much more concerned with enacting measures that immediately address the expected rise of unemployment in the short term. These measures include pouring money into investment \’96 mainly into infrastructure and the SOEs \’96 and of course the huge increase in bank lending. They often point out that these policies saved China after the 1997-98 crisis, and so can save China again.

As an aside, and without wanting to take the 1930s analogy too far, this debate in China is a little like the split in the 1930s between the internationalists in the US who favored hard money (incorrectly, I think) and a rapid liquidation of overcapacity (painful but probably correct), and who vehemently opposed measures, including tariffs and competitive devaluations, to boost employment via boosting the export of overcapacity, versus the large and powerful constituencies, dominated by local congressmen, miners, farmers and many industrialists, who stressed immediate moves to weaken the currency, boost production, and resolve US unemployment even at the expense of the global system. In part because the 1929 stock market collapse thoroughly discredited bankers and economists, and in part because politicians are always more likely to be influenced by large domestic constituencies than by internationalists, the latter group pretty resoundingly won the debate, at least in the early part of the crisis, and clearly not to the US\’92s obvious benefit.

Although the debate is much less transparent in China today than it was in the US in the early 1930s, I think the latter group \’96 the domestic constituency and provincial leaders \’96 is once again winning the debate, at least for now. It is probably no surprise to regular readers of my blog that I largely disagree with this camp, and the main reason I didn\’92t want to forecast very low 2009 GDP growth numbers with much confidence is because I doubt the former group will win the debate. As I see it, the massive expansion in credit and investment we are experiencing is simply more of the same set of policies that, especially over the past five years, have pushed China ever deeper into the Asian development model, and to the extent that they are successful they will keep pushing China, which I think of as exemplifying the Asian development model on steroids, in the same direction. Beijing, in other words, is increasing the dosage of steroids. (I think I am mixing metaphors all over the place.)

The reason I think this is a mistaken strategy is because I would argue that the Asian development strategy is dead, and over the next three to five years it will become increasingly evident that 2008 was the year it died. I may be wrong, of course because it is doubtful but not inconceivable that the great consumption party in the US can resume for a few more years. It would not be the first time that what seemed like an unstoppable correction in the trade imbalances was interrupted. To a certain extent we already saw a dress rehearsal for this event in the 1987 crash, around which time the US trade deficit, which had risen to around 3.5% of GDP the year before (a level which seemed unimaginably high at the time), began its inexorable reversion, to the point where the US achieved a small surplus in the early 1990s.

The period during and after the 1987 crash more or less marked the end of that stage of the Japanese miracle, although by then Japan was so caught up in the monetary expansion that had begun with the automatic monetizing of its massive trade surplus with the US in the early 1980s, that an internal bubble kept the local party going for another 2-3 years before it, too, finally ended, and ended disastrously \’96 although many people, especially here in China believe, mistakenly in my opinion, that the bubble was set off by the Plaza Accord.

But the Asian development model didn\’92t really die then (although the temporary shift in US consumption may have created the serious dislocations that helped lead to the 1997 crisis). At the time the US was itself caught up in great productivity and liquidity growth cycles that kept the model alive by causing a surge in US growth and, later, an even more rapid surge in US consumption.

The rise of US savings

What does the structure of US growth have to do with the Asian development model? As I see it the Asian development model involves polices that aim directly or indirectly at boosting savings and channeling huge amounts of subsidized resources (usually subsidized by savers, and so constraining consumption) into investment and manufacturing capacity. Some people call this mercantilism, and in many ways it does correspond to certain classic mercantilist policies, but I am wary of defining it this way because \’93mercantilism\’94 is such a loaded word.

At any rate because the combination of consumer constraint and producer subsidy meant that growth in production was likely seriously to outstrip growth in consumption, the Asian development model necessarily involved generating large and consistent trade surpluses \’96 either Asian countries exported the difference between consumption and production or they would have been forced to run up ever increasing inventory. Of course for small countries, running trade surpluses didn\’92t matter too much \’96 and it made sense to have a strong external outlook because domestic markets weren\’92t big enough to create the necessary efficiencies and economies of scale to justify the huge investment, and their individual trade surpluses were easily buried within overall global trade.

In other words for small countries the need to export is not likely to be a constraint since they can always generate trade surpluses without creating significant global trade distortions. But when large countries, or a large grouping of countries, have policies aimed at generating trade surpluses they run into a very strict constraint \’96 that some country or group of countries must be capable and willing to run large corresponding trade deficits. Without this willingness to run trade deficits, the Asian development model must inevitably run into brutal 19th-Century-style cycles of rapid production growth leading to overinvestment crises.

This is the main vulnerability of the Asian development model \’96 its dependence on an importer of last resort. We don\’92t often think of this as a weakness because for so long the US was seen as the automatic importer of last resort, so much so that we didn\’92t even consider it a constraint. But we may have gotten lazy in our thinking. Many people who should know better simply write off US consuming habits as something endemic to American culture, and we just assume it as a universal constant, but in fact US consumption levels, like those of every other country, respond to changes in conditions, and these are about to change.

There are at least two reasons for the change. The first has to do with specific policy initiatives, and the second with changes in underlying economic conditions, especially household balance sheets. To address the first, I will refer to President Obama\’92s economic speech last week when he said: \’93We must lay a new foundation for growth and prosperity \’97 a foundation that will move us from an era of borrow and spend to one where we save and invest, where we consume less at home and send more exports abroad.\’94

A New York Times editorial draws from Obama\’92s speech at least one important implication for the future growth of China and Asia:

In a series of comments in recent weeks, Mr. Obama has begun to sketch a vision of where he would like to drive the economy once this crisis is past. His goals include diminishing the consumerism that has long been the main source of growth in the United States, and encouraging more savings and investment. He would redistribute wealth toward the middle class and make the rest of the world less dependent on the American market for its prosperity. And he would seek a consensus recognizing that an activist government is an acceptable and necessary partner for a stable, market-based economy.

\’85Embedded in that approach is a far-reaching implication: that the rest of the world should no longer count on the United States to snap up imported goods or run up large trade deficits. It is by no means clear that Mr. Obama has the policy tools needed to bring about that kind of change; we are, after all, fundamentally a consumer society. His advisers point to his support for innovative ways of increasing personal savings.

We should never underestimate the immense flexibility of the US and its ability to restructure itself at a pace far faster than most other countries can manage (anyone who grew up in the dismal 1970s will remember the dramatic \’96 and seemingly improbable \’96 US economic transformation of the 1980s), and if the Obama administration is serious about creating conditions for an increase in US savings, it probably wouldn\’92t be a good idea to bet heavily against success..

Negative US consumption growth?

More importantly, during the past decade while the US was growing rapidly, the US trade deficit surged from just over 1% of GDP to over 7% of GDP. When consumption growth exceeds GDP growth, which must happen when the trade deficit is growing, it necessarily implies a build-up of debt, and sure enough, debt levels in the US surged while savings collapsed to zero and the trade deficit grew rapidly.

Those days are almost certainly over. Even without Obama\’92s desire to create conditions for an increase in US saving rates, US households have to increase their savings and rebuild their balance sheet, which means that we have several years ahead of us of deleveraging and increased savings. It also means we have several years ahead of US consumption growing more slowly than US GDP. I don\’92t think anyone is expecting much net growth in US GDP for the next three or four years, and so it is not at all implausible that we will see negative growth in US consumption and, as a consequence, a collapse in the US trade deficit, which may even turn into a trade surplus. The pace of this transition will largely depend on US fiscal policies aimed at slowing, but not eliminating, the contraction in demand.

If the US is no longer the importer of last resort, and if no one else can replace the US in that role in the medium term (I stress medium term because in the long term the demographic changes in Europe and Japan \’96 and China for that matter \’96 may well result in rising trade deficits in those countries), then any development model that necessarily results in production growth exceeding consumption growth \’96 high savings development models, in other words \’96 will run into the trade deficit constraint. They must run surpluses to grow, but if no one else runs sufficiently large deficits, they simply cannot run those surpluses.

This is what I mean about the \’93death\’94 of the Asian development model. The not-so-hidden but also not-always-explicit assumption behind Chinese growth \’96 with China, as I wrote earlier, representing the Asian development model on steroids \’96 is that large and growing US trade deficits were vital to its success. But if the US is now entering a period of contracting deficits, the model is dead.

This is why I am worried about recent fiscal and credit policies. It is not just that these policies are slowing down the rate at which China will adapt to the new world of lower US trade deficits. More importantly perhaps is that the only obvious replacement for US demand \’96 domestic Chinese demand \’96 will itself be sharply constrained by current policies, especially credit policies.

Why? Among other things because if the explosion in new lending (loans are up 15% in the first quarter of this year) leads, as it almost certainly will, to a subsequent explosion in non-performing loans, in the next few years just as China is expanding its production and struggling with US reluctance to absorb its rising excess capacity, the resolution of the NPLs will itself constrain Chinese consumption. Resolving future NPLs, in other words, will reduce future domestic consumption growth in China, just as the current resolution in the US of bad loans and shattered household balance sheets must come with reduced US consumption growth.

This is because if China\’92s banks see an explosion in non-performing loans it will have to pay for that increase in the coming years in one or both of two ways. The central government can recapitalize the banks by giving them money, which they have raised by borrowing or increasing taxes, or the regulators can keep deposit rates very low as a way of subsidizing bank profitability so that they earn their way out of the NPL losses. They did both after the last banking crisis, and will probably do both again. There is a third thing they can do, appropriate the money from SOEs, but I suspect that there won\’92t be nearly enough to resolve the NPLs \’96 the World Bank estimates that the last banking crisis cost China 55% of GDP.

Both strategies will represent, ultimately, a large transfer of income from households to banks, and in either case it will also represent a continued drag on consumption growth in the medium term. If the government borrows to bail out the banks, it will divert resources from the real economy and so slow income growth. If it raises taxes, it will reduce disposable income and so reduce household consumption growth. If it keeps interest rates low it will again reduce disposable income (interest income is an important source of income) and so slow consumption growth (in China lower interest rates tend to increase the savings rate).

Since it is unlikely that the US will be in a position in the near future to return to the halcyon days of large trade deficits, and since no other economy can replace the US in the role, turgid consumption growth in China will translate directly into turgid GDP growth for many years. Rising non-performing loans are not a small threat to China\’92s long-term growth. If the Asian development model is dead, China will need domestic consumption growth more than ever, and this is cannot be the best time for China to try to revive the production-enhancing model in a way that may limit future domestic consumption growth.

By the way in their next meeting the Guanghua Students Monetary Policy Committee will debate whether or not the PBoC should cap loan growth. I will report the arguments and conclusions of these remarkably sophisticated students.

Banker? Or Grocer?

March 16, 2009 in Banks, Currency regime, NPLs by Michael Pettis | 12 comments

Replenishing bank capital

One of the students in Peking University’s Guanghua Students Monetary Policy Committee, a group for which I am an advisor, put together last week a summary of plans to raise capital adequacy ratios for Chinese banks.\’a0 I thought it would be useful to reproduce his numbers.\’a0 According to him, Shenzhen Development Bank, Everbright, China Merchant Bank and CCB have recently issued RMB 83.2 billion ($12.2 billion) in subordinated debt.\’a0 Minsheng Bank, ICBC, Industrial Bank and BoC plan to issue an additional RMB 243 billion ($35.5 billion) of subordinated debt. \’a0Minsheng is also planning to issue RMB 1 billion in shares.\’a0

At the same time in December the CBRC required that the big five banks raise their loan loss provisions from 100% to 130% of the loans in the bottom three of the five credit categories.\’a0 Off the top of my head I think the second category \’96 \’93special mention\’94 loans \’96 comprises roughly three times as many loans as the bottom three categories combined, and many analysts assume that anywhere from one-half to all should properly be classified as doubtful or impaired. \’a0Given the huge growth in lending and lax lending standards during the past few years (during what had to be a great time to be a banker), I think skepticism about the quality of bank portfolios is very much in order.

Policymakers are assuring everyone that the banking system is healthy, as policymakers everywhere always do.\’a0 I, of course, have my doubts, so I think it is very prudent that while they praise the banking system on one hand the authorities are making banks take on more capital and larger loan loss provisions. \’a0I think it is extremely unlikely that we don\’92t see a surge in NPLs over the next two years.\’a0 This is particularly likely since credit expansion for February turned out to be RMB1.1 trillion, three to four times the amount of new lending last February which, when combined with last month’s RMB1.6 trillion, means than net new loans for the first two months of this year are significantly more than half of net new lending in 2008.\’a0 Of course it might be pointed out that most of this new lending is to state-sponsored projects and was strongly “encouraged” by policymakers, so it is likely to come with explicit or implicit guarantees, but in the case of a surge inNPLs I suspect that banks will nonetheless be forced to take losses before the government itself steps in.

Aside from loan and capital-raising figures other numbers are not looking too positive.\’a0 The wholesale price index came out today, with wholesale prices falling 6.0% year on year.\’a0 Part of this was caused by falling crude and commodity prices, but there is enough left over to make me continue wondering about underlying liquidity conditions.\’a0 Logan Wright told me Saturday that he expects to see very low, or even negative, reserve accumulation over the quarter, and regular readers of my blog know that\’a0I consider reserve accumulation to be the strongest indicator of underlying monetary conditions in China.
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Manufacturing output for the first two months of the year was up 3.8% from the same period last year, which was well below already low projections (because of the moving Spring Festival holidays it doesn’t make much sense to compare individual months in the first quarter).\’a0 Much of what little growth occurred was powered by a surge in concrete production and, to a lesser extent, by a sharp increase in vehicle sales.\’a0 The optimists would say that this shows that the government stimulus is working.\’a0 Pessimists would argue that the increase in auto sales may well be short-lived because it surged largely after a cut in taxes, and there are persistent rumors of a significant increase in car purchases by government-related entities.\’a0\’a0 In both cases the\’a0 growth in sales might then be seen as anticipated purchases that take will have trouble persisting.

Likewise pessimists would also argue that the surge in concrete production is not evidence that the stimulus is having an effect but rather evidence\’a0 that people believe that it will have an effect, and so are building inventory in anticipation (the same is probably true of the recent surge in steel production and inventory levels).\’a0 This is good news if the stimulus actually does have a big impact on demand, since rising inventory prevents bottlenecks, but of course bad news if the stimulus turns out to be weaker than expected, in which case the need to work off inventory will slow future production to below actual usage.\’a0

Aside from high loan growth numbers and low growth in manufacturing output, retail sales figures also came out last week. \’a0 According to an article in Thursday’s South China Morning Post:\’a0

Growth in retail sales slowed to 15.9 per cent over January and February from December\’92s 17.4 per cent growth and 22 per cent in October, the statistics bureau said.\’a0 \’93It seems clear the domestic demand is slowing in China, and this could be happening at a faster pace than the sales data suggest,\’94 said Moody\’92s Economy.com analyst Sherman Chan in a report. \’93Having households pull back on spending is exactly what China does not need.\’94

Beijing is trying to prod consumers to spend more with measures that include subsidizing appliance purchases for rural families. But families save heavily for education, health care and other expenses, and analysts say they are unlikely to spend more on consumer goods until Beijing creates a social safety net to ease such burdens.\’a0 A market research company, DDMA, said a February survey found 45 per cent of those polled had cut back on spending, down from 7 per cent in January.\’a0

Xinhua put a different spin on the numbers in an article the next day:\’a0

China’s retail sales grew 15.2 percent in the first two months to 2 trillion yuan (293.8 billion U.S. dollars), the National Bureau of Statistics (NBS) said Thursday.\’a0 The figure, although lower than the 20-percent-plus increase a year earlier, was encouraging, analysts said.

Retail sales growth in January and February was equal to or even higher than last year adjusted for inflation, said Zhuang Jian, senior economist with Asian Development Bank.\’a0 The consumer price index (CPI), a major gauge of inflation, hit a 12-year high of 8.7 percent in February 2008 but fell 1.6 percent in the same month this year.\’a0 “Domestic consumption has remained stable so far, despite the economic slowdown,” he added.\’a0\’a0

I think Xinhua’s interpretation is probably closer to the mark but in either case it seems, not surprisingly, that household consumption is almost certainly declining.\’a0 Remember that retail sales are not a great indicator of household consumption in China because they include lots of other things, including government consumption.\’a0 In addition I should add thatCICC , one of China’s three leading investment banks, came out with a report on March 11 which I cannot excerpt but which basically advised caution about the retail sales figures and the outlook for household consumption.

A difficult transition

On a very different subject, two days ago I received a very interesting and intelligent email from one of my readers, a student who I believe is from the South\’a0of China (I am guessing this because he mentioned his plan to set up a business in Guangxi) although I am not sure if he is currently at Peking University or at another school.\’a0 He has allowed me to reprint his email, although I am not sure whether he is comfortable with my using his name, so I will reprint part of his letter while leaving out his name and any private references.\’a0 I have edited the letter slightly to make it follow the format that I use in this blog:

Being a student and a loyal reader of your blog, you have all but convinced me that China should continue to allow its currency to appreciate, for China and the world’s sake. This is in spite of the fact that my family runs an export business and appreciation of the currency will most definitely affect our business in a negative way.\’a0 In light of the global financial crisis, the big theme in China is how to increase domestic spending and gradually make the export oriented businesses more domestic-dependent. And I always tell myself that the appreciation of the RMB will help because imports will be cheaper and that will directly increase the purchasing power of Chinese consumers.\’a0

Today, I went shopping with my girlfriend at Carrefour and I was trying to find some evidences to support my theory. Today we bought about RMB100 of food, typical of the things that we would need for the next 2-3 days.\’a0 Roughly, I would say we bought RMB30 worth of meat (chicken and pork), RMB40 worth of fish, RMB20 of milk/dairy and RMB10 of shampoo.\’a0 Then I try to determine how much the Chinese consumers would save if the exchange rate was changed.\’a0 Here is what I realize:\’a0

All RMB 100 of food are made right here in China. Even the RMB10 foreign brand shampoo is made by a factory in Shanghai. So, I thought, what would happen if the dollar to RMB exchange rate becomes 1:4? Well, the cost of making these items wouldn’t decrease that much because most of the components that go into producing these items are not imported and would stay pretty much the same. (Please correct me if I am wrong in this assumption.)

However, if the exchange rate suddenly becomes 1:4, a lot of Chinese exporters, including my family’s juice business, which actually has a good margin compared to other labor intensive industries, will go out of business.\’a0\’a0

In addition, perhaps now it would make economic sense for western companies to import their products (beef, fish, milk, shampoo) into China (of course assuming that the tariffs stay the same) and domestic consumers would buy imported goods because they are better quality and may now be cheaper. \’a0

So this also adds additional pressure to the manufacturers. furthermore, perhaps now P&G would in this new exchange rate environment consider producing its shampoo in the U.S., because relatively speaking, P&G’s cost of production in the U.S. would have gone down.So China gets hurt in a multiple of ways as a result of China revaluing its currency:\’a0

1. Export companies go out of business.

2. Domestic companies get more competition from foreign companies and are forced to cut prices and maybe wages.

3. Foreign companies will have less incentive to invest and do production in China.

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The benefit is that Chinese consumers will buy more imported goods, but I am not even sure if the consumers will get more purchasing power as a whole because as in our shopping experience, almost all of the things that I buy are made locally, so the prices wouldn’t really drop. (I can see in the case of luxury goods, i.e. LV, or Gucci, where they would be come sufficiently cheaper if the exchange rate re-values.)\’a0

\’a0So in conclusion, on the one hand, based on PPP or Big Mac index, I get the impression that the RMB is greatly undervalued (i.e. 1 Big Mac in US is $4, and 1 Big Mac in China is RMB 12-15). Yet, if the RMB were to really go up in value, the economy would definitely be hurt in many ways.

What is wrong and what can we do?\’a0\’a0

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This is a great letter because (aside from the fact that it shows why I enjoy teaching here so much, given the intelligence and thoughtfulness of so many of the students I meet) it indicates in a very concrete way how complex the policy decisions are and how difficult the transition process is likely to be.
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The first thing I would bring up is the issue of the effect of revaluation on the food purchased at Carrefour.\’a0 Of course it is true that the cost to make those Chinese-made goods would not decline in RMB terms except to the extent that they included foreign components (which may be more than many realize, since much of the fertilizer used by Chinese farmers comes from abroad, as does the oil they use to transport their products to Carrefour), but that does not necessarily mean that their cost to the consumer would not decline.\’a0 All of these things can be manufactured abroad, and it may be that Malaysian chickens, Australian milk or the same shampoo manufactured in Vietnam would become so much cheaper that either Chinese consumers would begin to buy more foreign food, or Chinese producers would have to lower their costs or improve their quality to compete.\’a0 This directly benefits Chinese consumers.\’a0

Of course it might hurt Chinese farmers and producers, and this is why the transition becomes difficult.\’a0 In a very abstract way we can argue that whatever pain the farmers feel is less than the gains other Chinese enjoy.\’a0 Cheaper food for Chinese consumers means that they have more money leftover to go to restaurants, buy books, or get haircuts, and so Chinese businesses that supply these services will benefit.\’a0\’a0

In an even more abstract sense we can argue that China does some things relatively better than other countries, and some things relatively worse \’96 that is, the specific conditions in China, including its infrastructure, labor markets, educational systems, and so on mean that Chinese can do some things more productively and efficiently and other things less so.\’a0 By allowing the RMB to appreciate (or by otherwise relaxing constraints that affect the relationship between production and consumption), Chinese businesses and producers will be forced to concentrate on the things they can do more productively and efficiently than others, while leaving others to do the things they don\’92t do so well.\’a0\’a0

This increases the total economic well-being of China and the countries with which it trades, and so at least in principle every country can become a little better off.\’a0 Remember that if China buys more from abroad, that doesn\’92t mean that Chinese producers must sell less.\’a0 Whatever money China exports to pay for those imports represents a net increase in either 1)foreign buying of things that Chinese producers are good at making or 2)foreign investment in China, which increases the productivity of Chinese workers.\’a0 Both of these are good for China\’92s economic prospects and both result in rising employment.\’a0

But there is no getting around the fact that the process will be painful in the short term, as the student writing the letter has pointed out.\’a0 Although in the long run China and Chinese workers and consumers will almost certainly be better off as China makes the transition to a more balanced and domestic-driven economy, there are nonetheless short term costs.\’a0 Resources and labor will not be smoothly reallocated from exporters to domestic service producers and manufacturers who serve the local markets.\’a0 What usually happens is that, to use the very dry jargon of economists, these resources and labor will be \’93freed up\’94 as exporters go bankrupt or downsize.\’a0\’a0

As economic conditions change, and as exporting becomes less profitable, businesses aimed at local consumers will take advantage of newly available assets, resources and labor to begin operating, and gradually China will once again reach more or less full employment with a very different economic structure.\’a0 But of course remember that at first, domestic demand (and domestic employment) will actually decline as workers lose their jobs.\’a0 This is where the government can and should play an important role, for example by boosting domestic consumption as much as possible so that it quickly becomes profitable for Chinese companies to target the domestic market.\’a0

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Allowing and even encouraging this transition may therefore seem like a bad idea for China, but as the global crisis shows, it will be impossible for a large economy like China’s to continue depending so much on the export sector and on foreign investment.\’a0 It must make the transition, and the later it does so the more difficult it will be.\’a0
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\’a0When the US made a similar transition 200 years ago, after the panic of 1797 when the Bank of England suspended gold payments, and when the US Quasi-War with France and the Napoleonic Wars in Europe decimated the US export trade, it did so over at least two very difficult decades, and after sharp rise in unemployment in the early years.\’a0 Eventually the whole country shifted its economic structure and, needless to say, the shift turned out to be crucial for the subsequent success of the US economy.\’a0\’a0
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Japan was forced to confront the failure of its own export-led model in the late 1980s and early 1990s, and, as everyone knows, the process has not been easy. \’a0Of course it would have been better for the US and Japan if they had try to adjust earlier, when global trading conditions were optimal, but like China in the past decade, it is hard to make an adjustment when things seem to be going so well.\’a0 It almost always takes a crisis to force the change, even though this makes the process of change that much more difficult.

By the way although much of the above is a fairly standard exposition on how free trade benefits everyone, I am not necessarily a believer in unfettered free trade for China.\’a0 Remember that under conditions of free trade and no currency intervention Chinese businesses and producers will be forced to concentrate on the things they can do better than others, while leaving others to do the things they don\’92t do so well.\’a0 This of course benefits the whole world in the short term, but China may not be happy over the long term with its comparative advantages.\’a0 It might find that cheap labor and low technological skills are not the kinds of advantages it wants to enjoy.

In that case a very strong argument can be made that selective protection can alter the relative advantages China has by encouraging innovation and development in areas in which China now has a relative disadvantage.\’a0 I won\’92t say much more about this (which is anyway likely to be highly controversial) except to note that as far as I have been able to determine from the historical evidence, with exception of a few very small trading nations, every technologically and socially advanced country since the British in the 17th and 18th centuries did so behind trade and other barriers aimed explicitly at altering the country\’92s technological and commercial position.\’a0

Much of this theory is beautifully summarized and implemented in Alexander Hamilton\’92s writings, and it is worth noting that the US, unlike its largely free-trading counterparts in Latin America, had the highest import tariffs of any major country for most of the 19th Century.\’a0 The risk of this kind of protectionist policy of course is when trade protection is allied with attempts to foster national champions, which almost always results in the worst of both worlds.\’a0 Competition breeds innovation, and state-supported national champions are almost always global losers.\’a0

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Before closing I should switch the subject and mention that Canada’s Globe and Mail had an article Friday about my insistence that a very wide-spread claim — that China is Washington’s banker — is based on a misunderstanding of the reserve accumulation process, and that it is probably more useful to think of China as a shop that sells to the US and accumulates IOUs, rather than as its banker.\’a0 You can find the article here.\’a0 Banker’s lend discretionary money, whereas grocers only accept IOUs from important clients on purchases from the store.\’a0 It is an important distinction, I think.

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Tags: Subordinated debt

CITIC and risk management practices

October 22, 2008 in Banks, Consumption and production by Michael Pettis | No comments

After several rallies in the past month I said it was just a question of time before the Chinese stock markets tested\’a0their recent lows, and today the SSE Composite closed at 1896. \’a0It\’92s become so easy to be skeptical after every surge that I don\’92t want to fall into the trap of just assuming that each is bound to fail.\’a0 Still, I have had trouble finding a good reason for any of the recent rallies \’96 all driven primarily, it seems to me, by government attempts to bully the market up \’96 and, sure enough, they have always reversed themselves fairly quickly. \’a0

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This week in spite of a good Monday (up 2.2%), the market lost ground on Tuesday (down 0.8%) and Wednesday (down 3.2%) with the SSE Composite finishing below its October 16 close of 1910. \’a0This is flat from its September 18 close.\’a0 Remember that Thursday September 18 was the day the government announced a bunch of market-supporting measures, including that Central Huijin was going to buy bank shares. \’a0Coming on the back of a global market surge the SSE Composite rallied 9.5% that Friday and ran up another 7.8% the following Monday, adding a further 2.7% over the next three days.\’a0 Less than four weeks later it has given everything back.

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Aside from the continued insanity in the markets, a lot of things have happened during the three days I was at a conference in Shanghai, which means I have not been able to cover events on this blog in the timely way I would have liked.\’a0 As everyone knows by now CPI and PPI numbers for September were announced on Monday and came in lower than last month\’92s numbers. \’a0I don\’92t have a lot to say about this beyond what I said in my last entry. \’a0On Monday 4th quarter GDP growth was also announced, and at 9% it came in well below everyone\’92s expectations. \’a0We seem to be fully caught up in the game of constant downward revisions in everyone\’92s estimates for this year\’92s and next year\’92s GDP growth numbers.

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During the conference (a very interesting one organized by Chatham House) I was asked by one participant about what I thought next year\’92s GDP growth numbers would be.\’a0 I had to beg off by saying I am not an economist and the only thing I would want to predict about next year\’92s numbers is that they are going to be lower than expected.\’a0

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I say this because it seems to me that we have yet seen the full impact of the global crisis.\’a0 As I see it, much of the dynamics of the past few years can largely be described as the relationship between Chinese excess savings and American excess consumption, and I think these are going to alter considerably, and not in a benign way. \’a0It is the latter that absolutely must change in response to the global crisis.\’a0 The US is unlikely to continue to have such a low rate of savings as crashing house prices and stock markets reduce so much of the stock of accumulated savings \’96 American savings, in other words, will almost certainly rise as a share of GDP (as probably will, by the way, Europe\’92s).

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This has an inescapable corollary.\’a0 The rest of the world must inevitably see a rise in consumption that is as great as the US (and European) decline in consumption (the flip side of the rise in savings, made worse if US income stalls or declines), if global demand is to remain unchanged.\’a0 When you add to this the fact that in large parts of the world we are unlikely to see much of a rise in consumption, and may even see a fall (in Latin America, for example, and among commodity exporters), this in principle means that Chinese (and other Asian) consumption is going to have to grow sharply to absorb most of the US and European decline.\’a0 If it doesn\’92t, world growth will slow sharply.

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Given that the economies whose savings rate must grow account for anywhere from one-half to two-thirds of world GDP, that puts a huge amount of pressure on a sickly Japan and South Korea and an increasingly unsteady China to generate rising domestic demand.\’a0 I think it is unlikely that such an increase in domestic demand will happen without a much more massive fiscal expansion in China than most of us are counting on, so my guess is that we are going to continue to revise our growth future estimates for China (and the world) downwards. \’a0

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One of the impressions I got at the Chatham Conference (ok, not a new impression, but a reinforcement of an old one) is that there is a very sharp split in the views on the Chinese financial system between analysts who have extensive experience in a wide variety of markets and analysts who focus almost exclusively on China.\’a0 The former seem generally to share my pessimism about the Chinese financial system, whereas the latter are amazingly (to me) sanguine.\’a0

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Because their main experience of crisis is the recent US crisis, I think these scholars are confusing risky balance sheets in general with the specific risks that brought down foreign banks reently. \’a0There is real difficulty here in understanding that even though Chinese banks probably have little exposure to the sub-prime mess or to complex derivatives, it is not those instruments per se that created the crisis, but rather excess risk\’96taking encouraged by excessively loose money (although to be fair I think most foreign commentators don\’92t get it either). \’a0These instruments were only the way in which banks took on excessive risk, they were not the cause of the excessive risk.\’a0 Japanese banks in 1990 weren\’92t brought down by US sub-prime mortgages or toxic derivatives, but rather by old-fashioned loans, and it is useless to think that these former are the only risk to a banking system.

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In that light it is worth noting the recent CITIC scandal. \’a0Over the weekend some of my students began telling me about rumors of a $2 billion loss at CITIC. \’a0This was confirmed on Monday, when it was announced that a badly conceived and unauthorized hedging strategy had gone seriously wrong and, as a consequence, CITIC was facing a huge unexpected loss.\’a0

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It is still not clear exactly what happened, but from what I can tell this \’93hedge\’94 was a pretty bizarre hedge \’96 it seemed far more like a misconceived speculative bet to me.\’a0 According to an article in today\’92s South China Morning Post it was also not exactly a recent problem:

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Questions have also been raised about the timing of Citic’s profit warning, given on Monday. It knew about its currency exposure six weeks ago. Stock exchange rules require listed companies to disclose price-sensitive information promptly.

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The article goes on to say \’93More worryingly, other local companies are exposed to similar currency contracts.\’94 \’a0Almost right on cue another problem was announced:

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Shenzhen Nanshan Power warned that company officials had signed oil derivatives contracts without the firm\’92s approval, intensifying fears about internal risk management at mainland companies.\’a0 Shenzhen-listed Nanshan Power said on Wednesday its officials had signed two option-related contracts with a subsidiary of Goldman Sachs to bet on crude oil prices, although analysts said the contracts were still in the money. \’a0Trading in the stock was suspended last week.

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What does all this mean? \’a0It has been very difficult to get a firm grasp on exactly what is going on in Chinese companies and banks as far as risk management goes.\’a0 My working assumption is that they have very little risk management experience, very weak rules on disclosure, and a perverse set of incentives. \’a0That suggests to me that when faced with the same set of pressures faced by the leading Western corporations and financial institutions \’96 i.e. ferocious liquidity growth and a previous environment of high rewards for excess risk taking \’96 they are even more likely to have made some very risky bets.

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Their lack of transparency has kept us from knowing exactly what is happening, but lack of transparency protected US and European banks for only so long before that very lack of transparency became the problem itself.\’a0 The few glimpses we can get into risk management among Chinese institutions do not give me much comfort. \’a0If there is an economic slowdown, prepare to be surprised by all the garbage that comes out.

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Worrying about the banking system

September 23, 2008 in Bank run, Banks, Financial crisis by Michael Pettis | No comments

While Monday\’92s stock market, led by the banks, continued Friday\’92s big bounce back, rising 7.8% to add to Friday\’92s 9.5% surge, leaving us at a 2-week high (largely on buyback talk, I think), worries about the banking sector actually seemed to be deepening.\’a0 Today, perhaps in response, the stock market was a lot more confused, with the SSE Composite gaining or losing 50 points five times, before closing down 35 points at 2202, for a loss over the day of 1.6%.\’a0 Most other indices \’96 many of which track market value much better than the widely followed SSE Composite \’96 fell by a lot more.\’a0 The CSI 300 index was actually down 3.8%.

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What\’92s going on with the banks?\’a0 A lot of recent attention has been focused on Chinese banks\’92 exposure to Lehman and other collapsing US credits. \’a0The nominal numbers being reported are relatively small compared to the bank\’92s capital base and earnings expectations, but there are persistent rumors that the reported exposure understates the extent of the problem.\’a0 That would not be a surprise to many of us.\’a0 A Peking University professor who I was talking to yesterday said emphatically: \’93Do not trust any number the banks submit.\’94

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I am not sure if I am as negative as he is, but coincidently today I had lunch with one of my graduate students who spent the summer working in the treasury department of a large city bank whose name, for obvious reasons, I cannot mention.\’a0 He told me that one of the discoveries that surprised him during his time there was the sheer amount of fake bond trades engineered to raise trading volume numbers. \’a0A bank will sell a large volume of bonds today to another bank at some market-related price, with the agreement that the buyer will sell them right back tomorrow at the same price.

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Although there has been little economic change as far as the transaction goes \’96 the bonds were merely temporarily \’93parked\’94 \’96 both banks get to report higher trading volume, which is necessary for them to retain their dealer licenses with the PBoC. \’a0How much of the total trading volume is fake, I asked him \’96 10%, 20%….50%?\’a0 I think much more, he said. \’a0

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I don\’92t know how widespread this is \’96 he said the dealers in his bank claim it is very common \’96 but it does suggest that the government bond and money markets are a lot less liquid than we might think. \’a0This might not matter much for now, but it does suggest that, in a bad market, prices may be a lot more volatile than we would hope and liquidity tighter.

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At any rate I have absolutely no idea if the rumors of understated exposure to bad US credits are true, but today Market News International, which tends to have very accurate inside sources in Beijing, had an article titled \’93Government Concerned Banks More Exposed to Wall St. than Disclosed\’94. \’a0The article cited statements by unnamed sources who claim that the Ministry of Finance \’93has already held at least one meeting to discuss a proposal that would involve the sale of treasury bonds to raise funds for a cash injection.\’94

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Although the article claims that nothing has yet been presented to the State Council, who would probably have to approve any such proposal before it could be enacted, it is interesting that in spite of all the soothing noises about healthy banks and limited exposure the government is so worried. \’a0Perhaps they are only taking precautionary steps, with little expectation that they will ever need them. \’a0If that is the case, needless to say, it certainly is a good thing. \’a0Well-thought-out precautionary plans seem to have been in very short supply among both US and Chinese officials in recent years.

\’a0

The most interesting news today, from my point of view, was the release of a report by Fitch ratings on the Chinese banking system. \’a0The report, prepared by Fitch\’92s Charlene Chu, argues that Chinese banks are starting to show the first signs off stress and makes the point \’96 obvious to most of the smart folk who read my blog \’96 that what looks good during great credit conditions can easily look a lot less healthy in a less welcoming environment.\’a0

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The steadily declining NPL ratio of recent years, for example, has been caused largely by surging loans, but a surging loan market can hide serious credit problems that only emerge during a slowdown, and Fitch claims to see increasing evidence of borrower stress among smaller companies (although they are quick to point out that they are only seeing the beginnings of stress).\’a0 They also point out that overdue loans, after declining steadily for many years, reversed course this year to show a 31% jump, from December 2007 to June 2008.\’a0 Every single bank of the twelve they monitor except one (Huaxia) showed large increases.

\’a0

Granted, overdue loans of RMB 187 billion may not be much compared to the overall loan portfolio, and is only 2% higher than the December 2006 figure, but in China we need to be far more focused on the trends indicated by the proxies than by the proxies themselves.\’a0 The point is that in the first half of the year, when the economic stress was much lower than it is today and probably even lower than it is likely to be next year, one measure of credit deterioration rose sharply.

\’a0

Fitch also mentions one of the things I discussed in a blog entry three weeks ago \’96 the repackaging of loans into wealth management products.\’a0 Fitch says it is difficult to track these transactions, but they believe that about RMB 50-100 billion was done in 2007, mostly in the second half, whereas as much as RMB 315 billion was done in the first half of this year.\’a0 This isn\’92t large in absolute terms \’96 I am guessing equal to just over 2% of new loans extended \’96 but it confirms my suspicions that off-balance sheet lending (by which I include lending in the informal banking sector) has surged in recent quarters.\’a0 They also refer to something I had heard of but knew little about \’96 what they call \’93entrusted lending on behalf of third parties\’94 \’96 which has also grown substantially. \’a0Aside from the fact that Fitch \’96 like me \’96 worries whether these are truly off-balance sheet when things turn ugly, it shows that there is an awful lot more leverage on both sides of corporate and household balance sheets than we think.

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There is a lot more in the Fitch report, and it is certainly worth reading, partly because it is one of the first in what I expect will be a series of increasingly nervous reports by other firms on the banking system.\’a0 The report concludes with:

\’a0

After years of stable, strong economic growth and a benign credit environment, Chinese banks appear to be approaching their first real test of resilience since starting to operate more fully on commercial terms. \’a0How trying this test will prove to be, and how banks ultimately will fare, remains to be seen. While China\’92s largest banks have achieved a remarkable amount of progress in recent years, deeper, more difficult reforms of banks\’92 credit culture, risk management, and governance remain in the early stages.

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As a result, Fitch continues to be quite cautious with regard to Chinese banks\’92 ratings, knowing that history has shown that even bad entities can look good during strong economic times. These reservations are underscored by concerns that potential future credit losses may be being under-estimated due to weaknesses in the data underlying banks\’92 expected loss models.

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One piece of possibly good news for the banks as far as liquidity goes, but not good news for NPLs or the performance of the economy, was a PBoC household survey released today. \’a0Chinese households, according to the result of the survey of 20,000 households in fifty cities, have lower inflation expectations than before, but they are also more nervous about the economy and plan to save more (i.e. consume less).\’a0 They also plan to invest less in real estate and stocks \’96 only 13% of the respondents said they would like to buy a house in the next quarter, which struck me actually as a high number but is apparently the lowest quarterly number recorded since the series began in 1999. \’a0I assume this increased savings means a faster growth in bank deposits.

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Meanwhile a similar survey on corporations also by the PBoC was also released today, with evidence that corporations are increasingly worried about future growth. \’a0According to an article in today\’92s China Daily:

\’a0

Chinese entrepreneurs and bankers are concerned about a domestic economic slowdown more than before, according to a quarterly survey by the central bank in the third quarter\’85A survey of about 5,000 businesspeople show they have higher expectation of an economic slowdown, the People’s Bank of China said in a statement on its website.

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The macroeconomic expectation index, which gauges entrepreneurs’ confidence in future economic growth, dropped sharply to 1.3 percent in the third quarter from 10.3 percent in the second quarter and 16.8 percent in the third quarter of last year. It was the lowest point since last year.

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If corporations and households are both worrying about upcoming economic conditions, we may see both fixed asset investment and consumer demand slow. \’a0Coming on the back of what seems to be declining global demand for exports, there is a real risk that slowing growth exceeds even the more pessimistic expectations. \’a0

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On a final note, I had been meaning to discuss this last week, but the indefatigable Logan Wright of Stone & McCarthy had a very interesting piece out on September 19, \’93Monetary Policy Signals in the Chinese Interbank market\’94.\’a0 Early in his report he says:

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The Chinese interbank market is turning upside down. Previously, banks avoided purchases of central bank paper if they had a better alternative for the funds, including lending out the money. Now, sterilization paper is in demand, and banks appear increasingly cautious about lending out funds, particularly to smaller companies. This suggests that the central bank’s recent cut in smaller banks’ reserve requirements is not likely to boost lending growth significantly, but issuance of sterilization paper is likely to surge due to rising demand. \’a0\’a0

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I have never been convinced that the PBoC actions on credit \’96 raising minimum reserves, for example, or imposing lending caps or changing interest rates \’96 have had nearly as much impact on the overall credit market as many suppose, largely because of the tremendous leakage in the system, including some of the things that the Fitch report mentions. \’a0The main impact of these PBoC credit measures, it seems to me, has been to cause equivalent but opposite shifts elsewhere in the financial system that partly or wholly negate the economic impact of the original measure.

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So, for example, constraining loan growth at a time when corporates demanded more loans simply pushed loan formation outside the formal banking system \’96 and it is pretty clear that this has happened quite a lot.\’a0 Even raising interest rates for commercial bank deposits and loans altered the balance of loan and deposit demand outside the banking system in ways that limited the net impact \’96 higher bank deposit rates encouraged depositors in the riskier informal system to shift deposits from the higher-paying informal banks to the lower paying but safer commercial banks, so that at least part of the impact of higher rates on deposits and loans was dissipated.

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That is why I am not nearly as convinced as most other analysts are that one way the policy-makers can respond to a monetary contraction is to reduce minimum reserves or relax lending constraints.\’a0 I don\’92t think these measures have been effective on the way up, and won\’92t be on the way down.\’a0

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Slowing economy and rapid credit growth?

September 1, 2008 in Banks by Michael Pettis | No comments

On Friday the Chinese stock markets had their second up day in a row (a rare occurrence this year), with the SSE Composite trading up 2.0%.\’a0 Today, however, the markets reverted to form, and the SSE Composite dropped 2.9% to close at 2327 which is, I think, the lowest point they have reached since February of last year.

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What seemed to drive the market down today was a confluence of events suggesting that government fears of an economic slowdown may be reasonable.\’a0 Today the China Federation of Logistics and Purchasing released its calculation of August PMI (purchasing managers\’92 index).\’a0 It registered a seasonally adjusted 48.4, the same as in July, and the second month in a row that it came in at contractionary levels (anything below 50).\’a0 At the same time CLSA released its own PMI calculations, which also came in below 50 \’96 the first time this has happened since the survey began nearly three years ago.

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I think the main thing to watch now is consumer demand.\’a0 Growth in consumer demand in the past few months has been quite good, but as I discuss in my August 14 entry, it is not clear if at least part of this might not simply be anticipated consumption for the Olympics.\’a0 If that is the case, we may see a slowdown in consumer demand in the coming months.

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Remember that the three pillars of Chinese growth are domestic consumption (both private and public), net exports, and domestic investment.\’a0 Global conditions are generally weak, which suggests that exports are going to be a lot less powerful in fueling Chinese growth than they have been in the past. \’a0If domestic consumption also starts to grow more slowly, that places much of the burden of fueling growth on domestic investment, but without foreign or Chinese consumption to buy its production, it will only be a matter of time before the third pillar begins to wilt too.

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Most hopes are on an expansion in fiscal spending to solve the growth problem, and there is little question that policy-makers are seriously considering their options here. \’a0There has been a lot of discussion, both publicly and privately, about government proposals to stimulate the economy via tax cuts or infrastructure spending. \’a0I have always been a little skeptical, however, about how easy this is likely to be. \’a0

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In first place, if there really is an economic slowdown we may see a sharp rise in NPLs in the banking system, and along with it a sharp rise in contingent liabilities on the part of the government sufficiently large to constrain their ability to spend.\’a0 Given how big the loan portfolio of the banking sector is relative to GDP, a small rise in the NPL ratio will have a big impact on total government debt via contingent liabilities.

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Secondly I am less certain than others about the fiscal position of the government. \’a0In this I guess I have been a bit of a contrarian, since nearly every other analyst I have read or spoken to points to the relatively healthy fiscal position of the government and the sharp rise in fiscal revenues as an indication of how much room the government has to prime the fiscal pump.

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But for me, the fact that fiscal revenues have risen so sharply while the government has maintained its fiscal position in a small deficit or surplus, depending on which period you measure, indicates an equally sharp rise in fiscal expenditures, and I doubt that an economic slowdown will have nearly as big an impact on lowering expenditure growth as it has on revenue growth. \’a0On the contrary.

\’a0

In that light I was interested to see an article in today\’92s South China Morning Post that suggests that although not as pessimistic as I am, the Ministry of Finance might not be as optimistic as some others are:

\’a0

The mainland’s finance ministry yesterday warned of increasingly austere times ahead as funds flowing into government coffers last month slowed sharply from the revenue expansion seen earlier this year. Slowing growth in fiscal revenue reflects tougher times in the world’s fastest-growing economy as well as heavy spending on disaster relief and earthquake reconstruction.

\’a0

The July figures come at a time when economists widely expect Beijing to be more proactive in spending to boost the economy after first-half gross domestic product growth slowed to 10.4 per cent from 11.9 per cent last year

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Fiscal revenue last month grew 16.5 per cent from July last year to 607 billion yuan (HK$692.83 billion), compared with the 30.5 per cent expansion in the first seven months, the Ministry of Finance said. Beijing projects an increase of 14 per cent in fiscal revenue for the full year, according to the government’s budget at the start of the year. Fiscal revenue rose 32.4 per cent last year.

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The article goes on to say that in July, fiscal expenditures rose 40.9% year on year, or 29.7% for the first seven months of the year versus the same period last year.\’a0 That disparity in growth between revenues and expenditures strikes me as worth wondering about, even before the economy faces the consequence of a slowdown. \’a0

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I know, I know, I am going to be accused of being overly pessimistic, but perhaps many years of bond trading (and in developing countries no less) has left me looking for potential trouble spots, and it really can\’92t be controversial for me to point out that when things go bad, they tend to go bad on several fronts simultaneously. \’a0If there is an economic slowdown I am willing to bet that we will see both a sharp deterioration in the government\’92s fiscal position and in banks\’92 loan portfolios, and I also suspect that the growth impact of a major fiscal expansion will be less than we expect.

\’a0

At any rate the newspaper quotes the MoF as saying:

\’a0

“We expect fiscal income will follow this trend of expanding only moderately for the rest of the year and the pressure for spending to increase is big,” the finance ministry said. “The past growth was achieved on the basis of the steady and rapid development of the national economy. Extra money is needed to stabilise prices and cope with natural disasters. We can’t ignore the fact that the fiscal conditions are actually quite tight.”

\’a0

Perhaps the MoF really believes this or perhaps they are simply positioning themselves to ward off an expected massive call on their resources. \’a0We\’92ll know some time next year, I guess.

\’a0

Meanwhile the PMI release did bear some good news.\’a0 PMI input prices have dropped sharply in July, which suggests that PPI might not rise as quickly in the next few months as it has in the past.\’a0 I am prepared to be wrong about my alarmist inflation forecasts if PPI begins to subside quickly, but I am not ready to change my views for another two or three months since I think we can easily see temporary respite within a much longer inflationary trend. \’a0I mention this especially since yesterday\’92s newspapers reported (another) strike by Shenzhen\’92s bus drivers and conductors that have left thousands of travelers stranded.\’a0 Although China does not freely allow workers to organize or strike, the fact regular strikes over low pay in Shenzhen over the past months have disrupted service suggests that wage pressures have not gone away.

\’a0

Before concluding this already long entry I want to mention an August 28 MNI article forwarded to me by Logan Wright.\’a0 One of the things that I try to teach my students is to use simple models to try to anticipate changes that may take place in the economy, and then to look for these changes. \’a0They are not always obvious if you are not looking for them.

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For example, I have always assumed that the huge supply of money created by China\’92s currency regime and the huge demand for funding created by its inefficient growth would have to meet. \’a0Much of the intermediation has taken place via the banking system, but of course with the lending constraints that were put in place over the last year, bank loans have grown much less quickly than we would have expected.

\’a0

For many analysts, this is more or less then end of the story. \’a0Policy-makers were able to slow lending growth, as planned. \’a0But that didn\’92t make sense to me: the supply of and demand for funds was as strong as ever. \’a0In that case, I assumed, lending constraints were just likely to force intermediation into other parts of the financial system. \’a0

\’a0

Based on this simple model, I made two predictions.\’a0 First, that the informal banking sector and other parts of the banking sector not covered by the lending constraints were probably growing very quickly. \’a0Second, that banks would increasingly engage in activity that would allow loan growth to take place off the balance sheet and away from the formal constraints.\’a0 I remember telling my friend Chris Keogh, one of the heads of Goldman Sachs China activities, that I expected there to be a burst in securitization taking place as banks shifted loans off balance sheet.

\’a0

The first prediction seems to have happened.\’a0 We have no good numbers on the informal banking sector but anecdotal evidence suggests that indeed it is growing quickly.\’a0 In fact over the past few months a lot of ink has been spilled on the subject \’96 informal banks are now a hot topic. \’a0Also, as Stephen Green of Standard Chartered pointed out a few months ago (see my May 18 entry), loan growth among policy banks and in the dollar loan portfolios of commercial banks, neither of which is covered by the lending constraints, have grown very quickly.

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The second prediction turned out to be a lot less successful.\’a0 There have been loan securitizations in China in recent months, but not nearly as many as I expected. \’a0I put this down mainly to a non-transparent regulatory system that made it difficult for banks to innovate around restrictions. \’a0

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It turned out, however, that I may have just been looking in the wrong place.\’a0 Here is what MNI says:

\’a0

Chinese banks are bypassing tough controls on their lending behavior by raising money for their clients via wealth management products, a move which analysts said highlights the limits of the government’s attempts to control the banking system through quantitative measures.

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Wealth management products have exploded in popularity this year, with 53 banks selling 2,165 products equivalent to around one trillion yuan ($146.3 billion)\’a0 during the first half alone, more than the 819 billion yuan in such products sold over the whole of last year.
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\’a0\’a0\’a0\’a0
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But all is not as it seems. Industry observers note that over a third of the value raised has been for products which are structured like non-transferable debentures, with banks repackaging them as wealth management products and marketing them on behalf of clients.

Apparently the banks are packaging loans as securities, but rather than sell them in the public markets they have been selling them privately to their high net worth clients. \’a0The article goes on to say:

\’a0

Xu Hanfei, a Shanghai-based bond analyst with the Industrial Bank of China, said that around 300 billion yuan raised through the sale of these kinds of wealth management products in the first half of this year wound up with Chinese companies or local government vehicles. \’a0Sichuan-based Southwestern University of Finance and Economics estimated that Chinese companies and local governments raised around 385 billion yuan via these products during the first seven months of this year.

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That compares with the 2.8 trillion yuan that Chinese banks extended via their traditional loan books during the same period. The People’s Bank of China introduced a quarterly loan quota system this year in a bid to hold loans at last year’s 3.6 trillion yuan.
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Xu acknowledged that wealth management products are being used to bypass the loan quota and continue raising funds for clients, even if the banks themselves aren’t taking on the actual risk. \’93Wealth management products are a good substitute for bank lending \’96 banks want to maintain the pace of loan expansion but the PBOC has capped lending growth with a quota so we’ve had to improvise,” Xu said.

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This kind of activity is not necessarily a bad thing for the banking industry \’96 on the contrary, it helps banks to learn about securitization and to earn fee income while limiting their risks by passing them on to clients. \’a0We should worry however about the level of sophistication of their clients and whether, if there ever is a problem, these loans are truly gone from the banks\’92 balance sheets. \’a0The recent problems faced by UBS, Citibank and many others show that just because a loan has been shoved off the balance sheet onto investors does not mean that the bank has totally eliminated its exposure, especially if large scale defaults lead to political pressure.

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But the real point of this article, as I see it, is to highlight the difficulty of addressing the symptoms of a problem without addressing its root cause. \’a0China\’92s \’93tight\’94 monetary policy has been anything but tight.\’a0

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It is easy to claim that China\’92s rapid monetary expansion can be controlled simply by placing limits on the consequent credit expansion.\’a0 It is na\’efve to believe, however, that the reality is that simple. \’a0China continues to suffer from rapid monetary expansion. \’a0When policy-makers try to control the consequences of that expansion without controlling the fundamental problem \’96 for example by placing lending constraints on the banks, or by trying to control the rise of prices \’96 they are likely to be doing little more than shift the problem from where they can see it to where they can\’92t.

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« Older entries

Banks

The credibility of farmers, priests and prostitutes \’96 and bankers?

RMB 1.5 trillion in new Chinese lending — can we turn this thing off?

Debt is up, trade is down, and we still don\’92t know which way to list

Stimulus \’96 at what cost?

Distortions in the Chinese lending environment

The death of the Asian development model

Banker? Or Grocer?

CITIC and risk management practices

Worrying about the banking system

Slowing economy and rapid credit growth?

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