Arms of the State

Last weekend, Barron’s ran a story titled China’s Banks: Worse Than you Think.  The article highlights the concerns expressed in Red Capitalism, written by Carl E. Walter and Fraser Howie.  If you haven’t already read it, we urge you to do so.  If you are pressed for time, and would prefer to spend your day watching the movie rather than untangling the web of the Chinese banking system, you are in luck.  The series of videos below offer a spectacular insight into the Chinese banking system and the politically driven economy’s history of reform, or lack thereof. In addition to Carl E. Walter, the interviews also include insights from Victor Shih, author of Factions and Finance in China: Elite Conflict and Inflation, another “must read” for those closely linked to the Chinese economy. For those that cannot spare a few hours to read the books, or even imagine listening to an hour long discussion between academics and economists, we have provided the cliff notes below.  We believe that this chain of events, described by Carl Walter, sums up the risk to the Chinese growth model quite succinctly:

If the economy continues to misallocate capital, high earning loans will increasingly be replaced by low yielding paper from the MOF. The banks will no loner have the ability to lend. If they can’t lend, growth slows. If growth slows, unemployment increases. If unemployment increases, the people are not happy and we have a larger problem in China.

And before finally moving on to the notes, Michael Pettis recently provided us with some arithmetic on investment growth:

Command economies tend to have much more rapid investment-driven growth during the good times and much more difficult and longer-lasting adjustments. No matter what your expectations were for future Chinese GDP growth, the arithmetic of rebalancing meant that you had to assume a sharp slowdown in investment. In the past, China has had rapid GDP growth driven largely by even more rapid increases in investment. The result is that investment has become a gradually larger share of GDP and household consumption a gradually smaller share.  This has gone on to the point where China is seriously unbalanced and urgently needs to adjust. In fact, given weak global conditions and rising Chinese debt, adjustment is only a “choice” for a few more years at best. After that, economic adjustment will be forced onto China. Weak foreign demand and anger on trade will prevent China’s trade surplus from driving growth, and excessive domestic debt will prevent investment from driving growth. In that case, GDP growth will drop sharply to some level well below the household consumption growth rate. This is what rebalancing means – that household consumption growth outpaces GDP growth.

No matter how optimistic you are about Chinese growth over the next five to ten years, you have to believe that investment growth rates will decline sharply, maybe extremely sharply. It is hard to put together a plausible scenario in which China rebalances and investment rates don’t come sharply down. Even the most optimistic outlook for China requires that investment growth rates drop by at least a quarter. Slightly more realistic scenarios require that investment growth rates drop by more than half. And of course, if my prediction is correct – that Chinese growth will slow to 3% – a rebalancing China will see investment growth drop by at least two thirds and probably a lot more.

Part I

  • Every decade for the past sixty years, the banks have gone bankrupt.
  • These banks were recently listed in Hong Kong, and now have international institutions as shareholders.
  • The banking sector has always been the pillar to China’s investment driven economy.  The money supply is greater now than anytime before.
  • China’s banking system didn’t exist in 1949.  The new government put in place a centrally planned economy with a passive banking system working with Russian advisors until everything “blew up.”
  • After a series of crises, the Asian Financial Crisis catalyzed the awareness in the government to strengthen the weakest link in their economy, the banks.
  • “These things aren’t banks.”  There were no audits.  They had no general ledgers.  And they didn’t have any capital.  Nor did they need any capital in the context of a centrally planned economy.
  • In the late 90s, there was this transformation where the government tried something different.  There was major hesitation towards privatizing the banks.
  • Most emerging markets don’t have complete control of the banking sector.  What you have in China is a closed system, very different than other emerging markets.
  • One of the reason the stock exchanges were created in 1991, was to concentrate the trading of government bonds. Gradually, banks became the primary investors in government bonds.
  • It is inconceivable that the Chinese government would permit any banks to encounter a liquidity problem.  If they did have one, we’d never know about it.
  • Things began to change prior to the crisis, but it all went out the window after Lehman crashed, as the party ordered banks to lend to drive growth.
  • Things are now frozen in time. The banks have stopped in their tracks. Interest rate reform is gone.  The bond market is a joke.  And foreign exchange is not going to appreciate much do to export concerns.
  • Right now, nobody sees the problems.  These banks have “super” market capitalizations so they are the clear global “winners.”
  • The Olympics marked the peak of Chinese development.

Part II

  • Once you engage in an entire year (or two) of carefree lending, you rack up a huge amount of potential non-performing loans.
  • In 2009, all the banks received an order to lend.  In the space of four weeks in February 2009, they approved $2 trillion in investment projects!!
  • Local governments did not borrow directly.  They created private enterprises, Local Government Financing Vehicles (LGFVs), to hide the debt off the central government balance sheet.
  • The central government is the key for confidence.  They must show that they are a conservative, responsible fiscally strong entity, by moving debt off balance sheet.
  • It is impossible to ignore the debt of the local governments and bank balance sheets which ultimately belong to the sovereign.
  • Bulls believe that future growth will be driven by consumption, but consumers are being taxed in every direction by government policy.
  • Household depositors, the foundation of the system, are being paid 3% on their money, as dictated by the government.  With inflation over 6%, this is financial repression.

Part III

  • The last ten years have seen two rounds of inflation. This one has been the worst.
  • It is clear that they are throwing insane amounts of money – $10 trillion per year for two years or 30% of GDP growth – to cover the problem and drive investment growth which is over 50% of GDP.
  • The government is less concerned with inflation and much more worried about the effects of a credit crunch, because this would uncover the structural issues.  Inflation helps to cover this up.
  • PBOC has implied that total LGFV loans outstanding was $14.4 trillion at year-end 2010.
  • The real estate bubble in China has been driven by over-borrowing by SOEs which have too much money, which ultimately flows into real estate.
  • Last time they “cleaned up the banks” we saw 20% recovery rates on $440 billion!!
  • The most likely vulnerability is capital flight.  The risk is not on the asset side.  This can be covered up for a long time.
  • On the liability, side depositors have the ability to withdraw capital and we are beginning to see that.
  • It is no longer difficult to move money off shore, but right now they can make more money in real estate onshore. What happens when this changes?

Part IV

  • Before they move the bad assets to asset management companies, the banks have to admit there are non-performing loans.  They are not even willing to do this now.
  • New loans to cover up bad loans are being made on a massive scale in China now to avoid recognizing NPLs.
  • You can continue taking these loans off bank balance sheets, but it ultimately ends on MOF balance sheet instead.
  • Everyone has known this model has been in place forever.  It will go on for a long time becuase there is no alternative.  Investment growth is driven by bank loans.
  • The system is extremely prone to event risks.  The longer this financial profligacy continues, the more these problems are hidden, the bigger the problem will become over time.
  • The status quo will continue unless there is some kind of crisis and new leadership.
  • If you believe that exports will no longer be the big driver of growth, then you are dependent on the banks to fuel investment growth, which by definition, must also slow.

Pop Quiz: What does a Chinese Shipbuilder, Telecom Company, Oil Producer, Railway and Food Group have in common?  See today’s FT article, China Groups Fuel Growth of Shadow Banking, to find out!  We couldn’t make this stuff up if we tried.