Can China experience a meltdown?

[indian_foxhound]

As China slows, the loan defaults will increase
as will unhappy customers. In an era of social
media, it will be more difficult for the
government to prevent people from removing
their money from the system Zhang Ke, the vice-chairman of China’s accounting
association, is worried. He and his firm audit the
books of Chinese local governments. According
to Mr Zhang the debts of the local governments
are is “out of control” and could spark a bigger
financial crisis than the US housing market crash. In a way this is not news. The only thing that is
news is that a senior Chinese figure is talking
about it. But if China’s debts are so big, why
doesn’t it spark a panic? Mr Zhang’s assessment of the Chinese debt
situation has a lot of company. The International
Monetary Fund (IMF) and the rating agencies
have all flagged the issue. Recently Fitch cut
China’s sovereign debt rating, the first such cut
since 1999. A rare downgrade in a world where many emerging markets are seeing more
optimistic outlooks. China’s debt problems have been around since
the recession of 1999. To avoid a recession in
2009, the Chinese government opened the
monetary floodgates by forcing the banks to
make loans and lend they did. Most of the money
went to provinces, cities, counties and villages for various projects. The problem with financing
projects with bank loans rather than taxes is that
the projects have to generate sufficient income to
service the loans. According to Mr Zhang this is
not happening. The local governments were not
paying back the loans, just rolling them over. “The only thing you can do is issue new debt to
repay the old,” he said. Like the US Federal Reserve, this type of stimulus
has been going on for the past four years. The
pile of debt is now quite high. It is estimated to
be between Rmb10 trillion and Rmb20 trillion
($1.6 trillion and $3.2 trillion), equivalent to
20%-40% of the size of the Chinese economy. It hasn’t stopped. Despite questions over solvency,
the hunt for yield has allowed the local
governments to issue Rmb283 billion of bonds in
the first quarter of 2013. This is more than double
the total for the same period last year. In theory
local governments are prohibited from issuing bonds. But thanks to investment companies, a
financial innovation designed to get around the
restrictions, they have been flooding the market. Sadly, like the Fed’s efforts, the massive stimulus
in all forms is having a limited effect. China’s
growth has slowed to 7.7%. The mercantilist
money machine has been stopped by falling
demand in China’s main export markets. The
structure of the stimulus is aimed at the wrong segment of the Chinese economy, local
governments and state-owned business rather
than private businesses. The structure of the
Chinese system makes it exceptionally difficult for
it to rebalance. Even the economist prime
minister, Li Keqiang, has admitted that the economy will have to “climb hills and cross
ridges”. So China might be rolling down a hill, but
will it fall off a cliff? Will China’s problem morph
into a panic? To determine the answer we must
look at the causes of a panic. At their very core, business cycles are about the
tension between greed and fear. Excessive
optimism about the future creates greater risk
taking. This can be exacerbated by extended
periods of accommodative monetary policy. The
expansion of credit coupled with assumed government guarantees of easy money allows
fear to recede. Growth appears to be a one-way
bet. With access to easy credit, investors increase
their bets. This drives asset prices away from
fundamentals. The combinations of imperfect
information, asymmetries and ever optimistic forecasts seem to justify the inflated asset prices.
After several years of this, the markets are in the
middle of a full-blown credit bubble that inflates
an asset bubble. Financial innovation or financial
reform can change the financial system in ways
that obscure the risk. The classic example is the US collapse. Alan
Greenspan and his successor Ben Bernanke
convinced the markets that low interest rates
would help to rejuvenate the American economy.
The housing bubble was considered an accurate
valuation by the market. The financial innovation of collateralized debt was seen as an efficient
way to spread the risk throughout the market.
Since the assumption was that collateralized debt
was perfectly safe, the financial system could use
huge amounts of leverage, but the exact amount
was unclear and could only be estimated. The demand for collateralized debt created a market
for any collateralized debt regardless of the ability
of the borrower to repay the loan. The result
was, of course, the Great Recession. How does China fit into this description? As I
noted above the Chinese government has been
flooding the economy with money for years.
Money to state-owned enterprises (SOEs) and
local governments is lent at subsidized rates
basically without restrictions. So there is a vast potential for leverage. Since both the locals and
the SOEs are branches of the Chinese government,
investors and banks have assumed that they
cannot default. The Chinese government has the
enviable reputation of being able to engineer one
of the most successful development stories in history. So the assumption is that the country will
continue to grow its way out of any temporary
pull back. Recently more money was funnelled
into the system through financial liberalization.
The so-called shadow banking system has
provided investors ways to get far better interest rates than are on offer at the state-owned banks. Still the Chinese economy is different. It is heavily
state controlled. Just because it seems to fit into
the template does not mean that there will be a
horrific meltdown. The estimable Financial Times
Beijing bureau chief, Jamil Anderlini, doesn’t think
that a panic is possible. Slow growth definitely, but no panic. His analysis divides recent panics into three
categories: interbank freeze, or foreign capital
outflows, and depositor bank runs. An example
of an interbank freeze would be the collapse of
Lehman Brothers. The Lehman collapse was
particularly horrific because the problem had to do with counterparty exposure. Large leveraged
trades were made between banks. If one side
defaulted the other would also lose money. When
Lehman went under, no one knew who was
exposed or how much. So all lending stopped. Mr
Anderlini doesn’t think this is a problem in China. China’s regular financial system is composed of
state-owned banks. In a crisis the Federal
Reserve or the European Central Bank can only
provide liquidity and hope. In China the
government can actually order the lending to
continue. Foreign capital outflows were the cause of the
Asian financial crisis. Many of the Tiger countries
like Thailand had borrowed in dollars. When the
crisis hit, foreign investors pulled out, putting the
economies into a tailspin. There is a similar issue
in the Eurozone. Countries like Greece sold euro bonds to foreigners who assumed a credit rating
equal to Germany. When the crunch came the
foreigners left. China does not have a convertible currency. Its
exposure to international investors is quite
limited. Besides it has $3.44 trillion in foreign
exchange reserves. So it has the firepower to
avoid a meltdown. So far I agree. China cannot have a liquidity or a
currency crisis, however, a depositor bank run in
my view is possible. Mr Anderlini believes that
the state-owned banks including the big three
Industrial and Commercial Bank of China, China
Construction Bank and Bank of China “are effectively backed by the full weight of the
Communist party” and the Chinese state. This is
certainly true. Chinese banks are all state-owned
and too big to fail, but there has been a major
change. What is not too big to fail are the local
government bonds, trust vehicles, Wealth
Management Products (WMPs), real estate and
other private company bonds, in short the
Chinese shadow banking system. These are
credit flows that have been transferred off bank books or securitized loans. The shadow banking
system has increased four-fold in size since 2008
to about Rmb20 trillion ($3.2 trillion), or 40% of
gross domestic product. It could be as much as
Rmb24.4 trillion, or nearly 50% of GDP. Recently it
has been metastasizing at an incredible rate. Conventional bank loans from the state banks
made up 95% of loans in 2002. This has
decreased to 58 % last year. Total financing has
increased almost eight-fold during that time. Trust
loans surged 679% in last December alone to 264
billion yuan from a year earlier. The recent growth of the Chinese economy would have
been impossible without these loans. But these loans suffer from two major problems.
Although the purchasers assume they are as safe
as bank deposits, they are not backed up by
banks or anyone else. Second, there is the classic
bank issue: an enormous asymmetry between
the assets and liabilities. The most popular WMPs have durations of one to three months. But the
funds provide financing for much longer terms,
often multi-year loans. WMPs and bonds are considered safe, because
firms, especially firms connected to the
government, do not default. Private firms go
under. Usually the owner disappears at night. But
state firms or large firms partially owned by the
state are kept afloat either by mergers or by rolling over loans, until now. Recently two solar
firms—Suntech and LKD’s bonds went into
default. Also banks are having problems with
WMPs. Customers at a China Construction Bank
branch in the north-eastern province of Jilin
complained to regulators that they lost more than 30%. One of CITIC’s, a large financial
conglomerate, products was at risk because of an
overdue loan worth more than Rmb70 million
($11 million). Losses from a product sold by
Huaxia Bank, could reach up to Rmb100 million
($16 million). These losses are small, but the surprising thing is that they are happening at all. So all the elements are in place: Financial
innovation, an extended period of easy money,
credit expansion, assumption of government
guarantees, poor risk assessment, and worst of
all, poor information. As China slows, no doubt
the defaults will increase as will unhappy customers. In an era of social media, it will be
more difficult for the government to prevent
people from removing their money from the
system. As faith in the financial system declines,
no doubt so will the faith in the Communist party,
which, according to a quickly terminated online survey, has an 80% disapproval rating. Like Mr
Anderlini, I have no doubt that China will slow,
but it could be in for something much worse as
Mr Zhang noted.

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