“China’s overall surge in credit in the first half of 2009,” an article in yesterday’s People’s Daily assures us, “is normal and healthy; however problems still exist in the structure, quality and flow of credit. China should continue to optimize credit structure and guard against potential risks.”
Credible rumors suggest that new loans in June will hit RMB 1.2 trillion or more, as banks rush to inflate their quarterly loan numbers, just as they did in March, on the assumption that any cap in quarterly loan growth will be based on the previous quarter’s numbers. I would argue that new lending in 2009, running at 2 to 3 times the new lending over the same period in 2008, is not at all normal and is very unlikely to be healthy. Here, by the way, is the breakdown for this year and last year (the June number is a rumored projection, so it may change):
|
New loans |
2008 |
2009 |
|
January |
804 |
1,600 |
|
February |
243 |
1,100 |
|
March |
286 |
1,900 |
|
April |
464 |
591 |
|
May |
319 |
665 |
|
June |
332 |
1,200 |
|
Half year |
2,448 |
7,056 |
|
July |
382 |
|
|
August |
272 |
|
|
September |
378 |
|
|
October |
182 |
|
|
November |
478 |
|
|
December |
772 |
|
|
Total |
4,912 |
|
These are amazing numbers. The People’s Daily article indicates, I think, the schizophrenic attitudes prevalent in China today, with growing nervousness in some circles about the consequences of this explosion in lending riding side by side with a determination to keep it up.
We are going to get 8% growth this year come what may. Since late last year I have been writing about how this everything-but-the-kitchen-sink strategy of throwing everything possible into countering the effect of the global contraction on the Chinese economy might result in higher growth this year and next but will make China’s necessary transition even more difficult and will almost certainly result in much slower growth over the longer term.
I am more certain than ever that this is the correct analysis. The biggest damage is likely to be in the banking sector, which will then create problems in the fiscal accounts. Here is how I see the two greatest risks associated with a sharp rise in NPLs:
1. NPLs are implicitly obligations of the government, whose debt is probably much higher than most of us think and whose commitment to maintaining high levels of growth will result in rising fiscal deficits. In my opinion there is almost no chance that we will not find ourselves worrying about the fiscal position of the government in the next few years. I know this may sound alarming, and it is certainly a little premature, but historical precedents are neither comforting nor forgiving.
2. If NPLs rise sharply, the banks must be protected and recapitalized. Unfortunately this will mean keeping lending rates low, to slow down NPL accumulation, and deposit rates much lower, to maintain banking profitability. As I have discussed many times before, most explicitly in my June 3 entry, low lending rates are one of the most powerful of China’s production subsidies, and low deposit rates, by acting effectively as a significant tax on household income, will significantly constrain consumption growth – basically households will be heavily taxed to protect borrowers and to recapitalize banks, and this cannot help but affect consumer spending. The consequence is that banking policies will be set directly in opposition to the necessary transition that China must make as the US trade deficit continues its long term decline.
Worries about rising NPLs in the banking sector are often brushed off with the claim that the explosion in new lending is implicitly guaranteed by the government so there is nothing to worry about as far as the banks are concerned. Would that were so. Fitch, the ratings agency which seems to be distinguishing itself as the most prudent in its analysis of the banks, has already pointed out that the self-reinforcing relationship between bank credit quality and government credibility, and if government debt is really in the range of 50-70% of GDP, which I suspect it is, I am not sure how much room there is for an explosion in bad debt.
The People’s Daily article also addresses this issue of government guarantee:
Loans secured for government projects mostly rely on “government credibility” – an invisible guarantee offered by local governments. According to data from the Jiangsu Banking Regulatory Bureau, of the loans issued by Jiangsu’s large banks to finance government platforms at all levels, 57.27 percent rely on public finances to repay debts and 49.13 percent are backed by financial commitment letters issued by local governments.
It is often difficult for banks to obtain prompt, comprehensive and correct information about the future disposable financial resources and implicit liability of local governments. If a local government faces financial difficulty, it will undoubtedly affect the quality of banks’ credit assets.
“It is often difficult,” to repeat that scary last sentence, “for banks to obtain prompt, comprehensive and correct information about the future disposable financial resources and implicit liability of local governments.” There is a distinction between loans implicitly guaranteed by local government and those of the central government, and already there has been a lot of talk in various finance circles about the fiscal position of local governments, whose revenue sources have been badly hit – and the more desperate they are the more likely they are to guarantee loans – but I don’t know how real the distinction is. Provinces and municipalities are implicitly or explicitly guaranteed by the central government, and in the case of wide-spread payment difficulties I suspect the central government will have to step in anyway.
On this subject let me make a quick detour into history. Edward Chancellor, in his book Devil Take the Hindmost, makes an interesting comment about the famous English Bank Act of 1844:
Under the terms of the Bank Act (also known as Peel’s act after the Prime Minister) the Bank of England’s discretionary ability to issue notes was restricted to a statutory £14 million above its holdings of bullion. A currency tied firmly to gold, argued the bullionists, would prevent over-speculation by defining the limit of credit and offering no escape for the reckless during a crisis. The belief that the government had legislated away financial crises provided many with a false security in the year ahead.
Aside from (I hope) undermining the inexplicably widely-held belief that financial crises occur only in periods of fiat currency, and were unknown during the gold standard days, the real punch line for me is that within just a couple of years of the Bank Act, England experienced an out-of-control railway bubble whose collapse led to the great financial crisis of 1847. I am also currently reading Lords of Finance, and I believe that it was irving Fischer – a terribly smart man who nonetheless got 1929 very, very wrong - who pointed out that one reason we were very unlikely to see a crash and depression was that the new Federal Reserve Bank was in a position to guarantee the absence of systematically foolish behavior. It seems that few things are more dangerous than the belief that governments can eliminate or sharply reduce the risk of financial crisis. The idea that a country’s financial system can act as crazily as it likes as long as the government is willing to protect it from its folly runs not only into the problem of undermining government credibility as bad debts surge, but the very belief almost guarantees that the financial system will act in a crazy way.
Can I prove that the Chinese banks are systematically behaving the way banks always seem to under such liquidity conditions? I can’t, and won’t be able to for a few years, but the anecdotal evidence bears terrible resemblance to the same kinds of anecdotal evidence in previous banking crises. For example, last week the People’s Daily had this article:
Three major Chinese lenders said Tuesday that auditors had discovered irregularities in their lending last year, but added that these findings would not affect their financial results. The Industrial and Commercial Bank of China (ICBC), China Construction Bank (CCB) and China CITIC Bank said in separate statements that the National Audit Office (NAO) found some violations of rules in last year’s routine audits. None of the lenders revealed the amount of loans involved in these violations.
…ICBC, China’s largest lender, said in Tuesday’s statement that some of its branches were found to have violated rules in business operations, and some weaknesses in management were also pinpointed.
The bank added it had corrected the violations and had moved to improve risk management and internal controls. The other two lenders said some of their branches had been found to have extended loans against rules or been negligent in supervision over borrowers after the loans were made.
And of course there’s a lot more evidence of credit gaps. Along with a study by a local economist suggesting that an awful lot of new lending was ending up on the gaming tables of Macau (which after all may perhaps be economically more justifiable than further commodity stockpiling), Wei Jianing, a deputy director at the macro-economics department of the Development and Research Center under China’s State Council, worries about money leaking into illegal stock speculation. According to an article in yesterday’s Bloomberg:
Chinese new bank loans worth about an estimated 1.16 trillion yuan ($170 billion) were invested in the stock market in the first five months of this year, China Business News reported, citing a government economist.
That’s 20 percent of the 5.8 trillion yuan loans banks extended in the period, the Shanghai-based newspaper said.
…A further 30 percent of the loans in the first five months may have been used for discounted bill financing, or short-term credits used to fund working capital needs, China Business News said today. These funds may help form a financial bubble, the newspaper cited Wei as saying, adding this is the economist’s personal view.
Stock market speculation is likely to be the least of the worries. At least there is a chance that some of those loans will get repaid. I am not sure this is true of all the other loans being made. In fact I guess I just take it as an iron-clad rule of finance that when bankers are under huge pressure to lend, and especially when there is a perception that someone is willing and able to backstop the risk, every banking system in history has or will behave in exactly the same way.
In that light today’s New York Times had an interesting article on an Argentine private banker who ended up committing fraud at UBS, even after he left to join Chase, with almost laughable ease.
The curious case of Mr. Arbizu, whose career exploded when a Chase customer discovered and reported his crime in May 2007, offers a rare window into this well-shielded world, and raises questions about how carefully some of its largest institutions monitor their bankers.
In telephone and e-mail interviews held in the last eight months, Mr. Arbizu put himself in what he said was the “3 percent of bankers who at some point get confused because of the pressure. We feel like we can take risks that other people don’t even dream to do, and that we can manage that risk — I don’t know why.”
What does this sorry story of fraud have to do with my topic? Perhaps not much, but at the very least it indicates how easy it is even for well-managed banks (ok, stop snickering, UBS is indeed relatively well-managed, but even the best managed banks have never been able to avoid stupid behavior during credit bubbles) to permit, under conditions of rising liquidity and surging financial markets, some very shaky behavior, and I would be utterly shocked if a lot of the same things weren’t occurring in Chinese banks. A lot of analysts like to claim that the credit risk management systems among Chinese banks have improved dramatically. This may very well be true, but it is easily possible for a risk management system to improve from “terrible” to “a little less terrible,” and in the past three weeks I have had conversations with an auditor for one of the Big Four banks and with a foreign advisor who has advised the Chinese government on the setting up of credit risk management systems, and both have totally and without reservation dismissed out of hand the quality of the risk-management systems of Chinese banks.
Under these conditions, and with the amount of what perhaps we can politely call non-credit-related aspects of the lending decision, is it really such an heroic assumption to assume that we are going to see problems in the quality of loan assets? I know it is now very fashionable to dismiss risk management at UBS, Chase and other Western banks, but risk management is still really a lot more experienced and independent at UBS and Chase than at their counterparts here in China.
What makes me worry even more was, paradoxically, the OpEd piece suggesting the opposite by CBRC chairman Liu Minkang, appearing the weekend edition of the Financial Times, in which he suggests that US and European banks would have been better served had the regulatory framework been as prudent as that in China.
Sometimes the most effective way to address a complex issue is by using basic, simple but useful measures. Practice shows us that traditional tools work, especially considering that financial engineering can malfunction. In recent months we have noticed that many regulators in the rest of the world have also started to embrace this “back to basics” approach.
Much has been written about what triggered the global financial crisis, but in my view it can be attributed to five factors. First of all, the firewall between capital and banking markets was eroded by unsound financial innovations. Second, macro-prudential regulation was neglected. Third, financial institutions had too much leverage and were too opaque. Fourth, incentives for staff at financial institutions were driven by short-term gains, rather than long-term benefits. Fifth, the bail-out put the cart before the horse by pumping in capital and liquidity before cleaning up balance sheets.
There is a long tradition of bankers and regulators waggling their fingers at their fallen brethren in other countries and suggesting that their own practices are much better and should have been more widely copied – just before they find themselves stuck in an even worse quagmire. Although Chinese bankers are probably right to feel annoyed, and just a little pleased, after all the self-important drivel they have had pressed on them by foreign bankers and regulators, still, I would really resist the temptation to hold up China’s system as a model. Like with Japanese bankers in the late 1980s sloughing off Americans and Europeans for their terrible banking practices that were so unlike banking practices in Japan, this is just tempting fate, and Dr. Liu’s five risk factors, and especially the second and the last two, are not exactly foreign to the Chinese banking system.
Before closing, I know I have made a number of references to the 33 A.D. banking crisis in Rome as one of the first recorded cases of a banking panic. I often get questions on it, so just for the fun of it, and because I have wanted to do this for a long time, let me post here a portion of Chapter 15 from Will Durant’s History of Roman Civilization and of Christianity from their beginnings to AD 325
The famous “panic” of A.D. 33 illustrates the development and complex interdependence of banks and commerce in the Empire. Augustus had coined and spent money lavishly, on the theory that its increased circulation, low interest rates, and rising prices would stimulate business. They did; but as the process could not go on forever, a reaction set in as early as 10 B.C., when this flush minting ceased. Tiberius rebounded to the opposite theory that the most economical economy is the best. He severely limited the governmental expenditures, sharply restricted new issues of currency, and hoarded 2,700,000,000 sesterces in the Treasury.
The resulting dearth of circulating medium was made worse by the drain of money eastward in exchange for luxuries. Prices fell, interest rates rose, creditors foreclosed on debtors, debtors sued usurers, and money-lending almost ceased. The Senate tried to check the export of capital by requiring a high percentage of every senator’s fortune to be invested in Italian land; senators thereupon called in loans and foreclosed mortgages to raise cash, and the crisis rose. When the senator Publius Spinther notified the bank of Balbus and Ollius that he must withdraw 30,000,000 sesterces to comply with the new law, the firm announced its bankruptcy.
At the same time the failure of an Alexandrian firm, Seuthes and Son due to their loss of three ships laden with costly spices and the collapse of the great dyeing concern of Malchus at Tyre, led to rumors that the Roman banking house of Maximus and Vibo would be broken by their extensive loans to these firms. When its depositors began a “run” on this bank it shut its doors, and later on that day a larger bank, of the Brothers Pettius, also suspended payment. Almost simultaneously came news that great banking establishments had failed in Lyons, Carthage, Corinth, and Byzantium. One after another the banks of Rome closed. Money could be borrowed only at rates far above the legal limit. Tiberius finally met the crisis by suspending the land-investment act and distributing 100,000,000 sesterces to the banks, to be lent without interest for three years on the security of realty. Private lenders were thereby constrained to lower their interest rates, money came out of hiding, and confidence slowly re-turned.
Except for the exotic names (I was delighted to see that there was a banking firm by the name of Brothers Pettius – maybe an ancestor of mine?) and the spice-bearing ships, this story has a remarkably contemporary ring to it, as do nearly all historical accounts of financial crisis, by the way. This story is not totally relevant to China today except to the extent that it indicates how difficult it is for banking systems flush with cash to avoid speculative lending, and how the very fact of their speculative lending then creates the conditions that can bring the whole thing crashing down. Hyman Minsky told us all about this kind of thing. There has never been a political or economic system in history that has been able to avoid the consequences of excessive liquidity within the banking system. Even the Romans learned this, and they learned it the hard way, as we always do.
[...] Read the rest of this great post here [...]
And then there’s this view from Zhou Xiaochuan posted on the PBofC website:
The high savings ratio and large foreign reserves in the East Asian countries are a result of defensive reactions against predatory speculation. During the Asian Financial Crisis, the rampant speculations of hedge funds caused large capital inflows and subsequent reversal in these countries, which exacerbated their economic woes. People in these countries were shocked, and disgusted by these speculative attacks. Afterwards, many suggested that unregulated predatory speculation caused the crisis, and appropriate international regulation was needed. However, for various considerations, some countries were against such regulations, and failed to see the need to adjust the regulatory frameworks. International organizations also failed to perform their regulatory responsibilities over abnormal capital flows, forcing the East Asian countries to amass foreign reserves to fend for themselves
Michael,
The unprecedented financing bubble will burst and create a sea of NPL’s. That much we know.
But is that the right question?
I think its more interesting to think about HOW LONG this financing can go on for. The Chinese control velocity by fiat, which makes it easier for them to manufacture inflation. Assuming rising inflation and consumer spending, is it possible that, for awhile, the NPL’s will be hidden by the very same loan growth (this is known as the “denominator effect”)?
In what year will rising Chinese NPL’s force the Chinese government to restrain loan growth? Will the Chinese use their foreign reserves to either: 1) meet/inflate domestic demand with imports; or 2) recapitalize the banking system? And if it does either, will the banks be able to keep lending for longer?
A three-year lending bubble has implications for China’s trade surplus (call it a deficit if it goes on for that long), U.S. interest rates, the dollar, global inflation, and lots of other things.
So, like with the housing bubble in the U.S., its not how to inflate demand, but for how long, how it ends, and what happens then…
I’m willing to bet your answers to those questions are more interesting than just about anyone else’s.
I can’t help wondering if the political interpretation of the Chinese government’s policies is quite different from the financial affects.
If the main policy goal is to keep the yuan undervalued to maintain large export flows, the government doesn’t really care if there are asset bubbles or collapses. The government is always going to rescue the banks and the financial system, and the yuan can stay undervalued. It also allows wealth to be transferred from underpaid workers to investors and insiders.
This policy will work as long as the mass of the Chinese people accept it. And, so far, they do. The people seem to think they are better off with the export-oriented economy, even if a hugely disproportionate amount of the fruits go to a small number of the elite. Since China’s main economic advantage is being the low-cost producer, this view may be correct.
Prof Pettis!
Thanks again for a great article.
A question relates to the implicit obligations of the government in respect to NPLs. I am thinking that perhaps some failure / consolidation amongst the smaller banks may be possible / acceptable / desirable. I realise that local government protection is strong, but could this crisis eventually set in motion some degree of movement in the smaller bank market?
Really a great contribution. Certainly on the same line on the subject. Reinforcing personal opinions on the subject. Along with Andy Xie and a couple of others.
My reading of Caijin – now nearly as regular as the FT – has let me with limited doubt about the obvious scare that has taken over some of the central authorities. Which ones? I do know. But the argumentation leaves little doubt about it.
On an aside, and more of a joke than a serious issue :
“The idea that a country’s financial system can act as crazily as it likes as long as the government is willing to protect it from its folly runs not only into the problem of undermining government credibility as bad debts surge, but the very belief almost guarantees that the financial system will act in a crazy way.”
Well you’re on your way to a gold standard. Anyway, I do mind. As most goldbugs, we have been our own central banks for a while. And leave it to economists to discover their own truth. May I recommend that Chinese economist read, and their policy-makers quote as much Rueff as they did Trifin …
Should the Bank of China move on the current pegging path a bridge too far, we are certainly not that far, I have little doubt that Asian private money will re-discover the basic virtues of precious metals.
Doing what their authorities refuse to do. On their behalf should I say.
May I dare add, by the way, that the run to commodities by Chinese firms is certainly, in some way, para-monétaire. They are making the arbitrages that their authorities refuse to do. And rightly so IMHO.
And with this knowledge of the Minski framework, it is amusing that government policy invariably trends toward preserving the ponzi unit, attempting to force financial systems flush with cash, even when there is no economic place for it.
I supposed it is the politically tenable solution and it takes years of strain before someone comes to their senses and realizes what ineluctably follows a ponzi unit.
Michael, do you think this explosion of credit is a bit like Brazil in the late 60s or more like Japan in the 80s?
Professor, what do you mean by “…Already there has been a lot of talk in various finance circles about the fiscal position of local governments, whose revenue sources have been badly hit – and the more desperate they are the more likely they are to guarantee loans”? Do you actually want to point out that the worse local government financial position is, the more likely they are to guarantee low-quality loans for projects which they thought could bring revenue (kinds of tax and fees…) to alleviate their financial distress?
By the way, talking about Chinese local government fiscal conditions, I want to further point out that too many policies, mainly the tax revenue distribution mechanism and the implicit guarantee from central government, leave no incentives for local government to improve their fiscal conditions at all. I don’t know how this is going to last, but I’m a little bit scared to imagine how the global financial market will panic when the huge debt of Chinese government is uncovered after China announces its inability to refer to any “fiscal policy” to heal its economy.
I have read many times that the moral hazard of being backed by the U.S. public via the FDIC “put” will often make U.S. banks that are the most marginal participate in the riskiest behavior — They’ll offer the highest CD and deposit rates to attract capital, make the riskiest loans to generate the largest spread, etc. In effect, doubling down and confidently hoping to grab the brass ring in an all or nothing win. I’ve heard many people say that this was part of the flaw in the management of Fannie and Freddy Mac in the recent boom times, the incentive to take on more risk beyond their charter by using their implicit government backing, and thereby goose profits, was too much to resist.
Prof. Pettis, if it is as you say that the local governments and banks are operating with the implicit Chinese Central government backing and a potential banking crisis is in the works, would it then seem logical to start looking for these “doubling down” type of extravagances and abuses? In particular, in these most financially stressed or marginal of local governments and banks? They will probably feel they have the least to lose and most to gain by going for the glory, and if they do fail, it will all be quietly guaranteed and cleaned up by the Central Government and their large checkbook.
Another question I have is what will be the effect of a banking crisis in 2010 or later on Chinese development and/or recovery, besides a massive clean up headache? Will this be an U.S. S&L level of crisis or will it be much more and the Central Government be forced into a position where they will have to start spending some of their accumulated reserves (much as the Russians were recently) to fend off crisis and cover fiscal budget gaps (as opposed to imposing an economically stifling tax load to pay for it)?
In addition, thank you for the Durant reference. I have often found their works, in particular the short book “The Lessons of History”, most educational.
Thanks for another insightful post!
Two thoughts come to my mind:
1. If China with rising NPLs is somewhat on the same path as the US but from a different starting point, i.e. as a massive surplus country, then this might ultimately lead to just that rebalancing that you have argued for for a long time. It is, as D Pearson comments, really a question of timing. And maybe China has a much greater elasticity than we currently believe just as many people wondered how the US could stay on its path of reckless spending for so long.
2. Chinese policy is much less economy-centric as western policy. So it is an interesting question who will take what share of the burden of NPLs. If it is mostly local governments, then this would mean a very much welcomed shift of power towards the central government if it has to bail out state governors. Thus this insane surge in lending could have quite a different goal than we think.
[...] There is a long tradition of bankers and regulators waggling their fingers at their fallen brethren in other countries and suggesting that their own practices are much better and should have been more widely copied — just before they find themselves stuck in an even worse quagmire. – Michael Pettis, China’s loan growth isn’t boosting my confidence in China’s “green shoots” [...]
Qingdao, I think there is no question that massive reserve accumulation was a policy response on the part of China and several other Asian countries to the shock of the 1997 Asian crisis, although once again it seems that Governor Zhou, just like with his SDR comment, is saying whether he realizes it or not something that the government has been at great pains to deny – that the Asian savings glut was one of the sources of the global imbalances. For years the official position of the Chinese government was that massively rising reserves were the unplanned outcome of US overconsumption financed by out-of-control lending, and were not caused by Chinese policies, and now he is arguing that rising reserves was a Chinese policy response to weaknesses in the international financial system. He can’t really have it both ways. By the way I never trust governments when they blame speculators – the vulnerability of Asia to the 1997 crisis was created by shockingly bad balance sheet management, and most of the capital outflows that destroyed the currencies were not speculative but the inevitable consequence of corporations with massive currency mismatches being forced to hedge. Speculators have been a convenient scapegoat for idiotic policies for hundreds of years. It is impossible to read financial history without seeing case after case of the collapse of terrible policies bringing diatribes against speculators.
David, unfortunately, as the US in the past decade and Japan after 1987 show us, it can go on for quite a long time, but that is a bad thing, not a good one. I am not sure I agree with you that “the Chinese control velocity by fiat, which makes it easier for them to manufacture inflation.” China has had a great deal of trouble with inflation, and I am pretty sure the idea that they might want to create inflation to fix the banking system is pretty far from anyone’s mind. In China inflation brings terrible political problems, and Chinese authorities seem to have even more of a fear of inflation than do the Germans.
Efertik, if the Chinese government had infinite credit, and if fixing bubbles and cleaning up NPLs were costless, political goals could easily trump economic considerations, but the Chinese government, like every economic entity, does not have infinite resources. Even the much richer and much healthier Japanese government (healthier in terms of its balance sheet) could not prevent a banking crisis from becoming an economic crisis.
Houhui, I think your idea makes a lot sense, but I think consolidation of the banking system is a political decision before it is an economic one, and I have nothing intelligent to say about the political prospects.
Daniel from Paris, according to my reading of Barry Eichengreen’s arguments as to why a reversion to the gold standard is politically impossible, it may be perfectly possible in China, but there we run into capacity constraints. I do not think there is enough gold in the world to permit China to move a significant portion of its reserves into gold without causing huge disruptions in the market. At any rate I doubt that precisely the kind of monetary discipline which you associate with gold would be attractive to a government which is not eager to impose external constraints on its abilities.
Nemo, both Brazil in the 1960 and 1970s and Japan in the 1980s provide very useful and cautionary lessons, but of course we need to be flexible in out application of history. As Mark Twain said, history might rhyme but it doesn’t repeat (I am substantially paraphrasing him). We can and should learn a lot from both episodes, but whereas I think some Chinese officials are looking at Japan’s experience, almost none bother to look at Brazilian experience. Worse for them.
Ricky and Andrew, yes, there seems to be a consensus developing that the poorer local governments with greater cashflow problems may be the most aggressive users of credit facilities and are able to do so relatively easily because of moral hazard. Unfortunately, given the poor data, we will only know for sure when it is too late. I agree that the incentive system doesn’t leave us with much confidence. There is a now much greater penalty for lack of fiscal effort than for lack of prudence. Not surprisingly I think, prudence will lack.
Pigeon, yes, it is very hard to forecast how this plays out politically, at least for me. As for the rebalancing, I have no doubt it will occur. It must. China cannot avoid adjusting iof the US does, and the US is adjusting. The question for me is whether or not it will be relatively quick and with what level of pain.
What is the likely end game if the NPLs someday explode as many readers expect and the government is forced to step in and clean up NPLs created by the banks and/or local governments? I would expect negative or no GDP growth, foreign investors run for the exits, sell assets and all try to convert RMB to USD or Euro as quickly as possible at the same time the government is printing RMB to clean up the NPLs. Despite evidence that you pointed out in your last post regarding a “natural” RMB-USD exchange rate of 4 or 5 RMB to 1 USD, and the possibility that the RMB is even more undervalued today than it was a year ago, is it not possible that the exchange rate would first go sharply toward devaluation of RMB before strengthening?
Michael,
I agree, a lengthy Chinese lending bubble would be a very bad thing, but it also would be a very important thing. In particular, I could envision the following effects:
-a reversal of the trade surplus to deficit
-higher U.S. Treasury yields
-global commodity price inflation
-the need to keep inflation going in China in order to prevent an NPL-driven deflationary crash
-the need for the Fed to keep buying Treasuries in the U.S. in order to prevent an interest rate-driven deflationary crash.
Does this all seem far-fetched? And yet, its just the logical consequence of China’s desire to inflate domestic demand…
Wonderful post. I could tell that you were going to get historical and I was formulating a question in my mind, and then you went off the charts with the reference to Ancient Rome. Here is what I am thinking though, and I mean this with absolutely no ill intent.
You have demonstrated here that you have a lot invested intellectually in the idea that the laws of finance are in fact universal. However, your historical examples are all distinctly European/Western in terms of the focus of their content.
Now, given that this is a website concerning Chinese financial markets, wouldn’t it be terribly more interesting and relevant to scour books of Chinese history and literature to construct models on Chinese banking and financial crises over the ages? Then see how it fits with models constructed explicitly around European/Western examples and what THEY have in common with the systemic problems you are analyzing today. It seems that some truly significant work could be done in looking closely and in new, creative ways at the Chinese historical record.
Still, this was a great post.
And I mean that especially with respect to the questions you raise about central vs. provincial governments. That’s obviously a significant historical motif throughout Chinese history.
No argument that financial crises can (and almost certainly will) occur under any conceivable financial system. Still, according to Mises at least, Peel’s Act was doomed to failure because while it restrained note issue, it didn’t do the same for deposits.
Michael, I was wondering if anyone had put together a good book on how China’s fiscal policy is run and what the major revenue streams are for both provincial, town, and national governments and also details on who provides what services where. Getting one’s head around this is some detail seems very important to me.
[...] Professor Pettis latest piece rather interesting. Look at the size of the loan growth posted in his latest posting, China’s loan growth isn’t boosting my confidence in China’s “green shoots” [...]
Hi David Pearson,
I share many of your questions and I drew similar conclusions as you.
I believe these questions are very hard to answer because the policies depend not on the economy, but on the politics.
The most likely turning point which I am looking at would be a collapse in investments. I think this is overdue as exports and profits are falling.
Such an event would leave no other response from the authorities than increasing consumption, via the exchange rate or via redistribution.
I guess they would choose redistribution, because they dont dare to give up the export industries. I think they would raise taxes, raise the minimal wage or directly use the deposits of the SOEs. Corporate deposits are exploding in China (actually faster than lending), it is obvious that these should be used as means of demand generation somehow.
This would result in inflation, so real effective appreciation would be forced anyway and all the conseques to the rest of the world you wrote about would be unavoidable.
Matt
I would imagine that NPL growth would be handled much as it has been done before (using the same tools):
1 – Write offs and write downs. There is some cover in the recently increased provision coverage ratios up to 130%+.
2 – Restructuring of debt (perhaps with govt involvement – for example in interest payments etc)
3 – “Toxic banks”, such as the AMCs – new or old ones – can swap the NPLs for bonds / bills (which can be rolled over again and again, or backed up by the government in the future – as happened 10 years ago – the first set of MoF backed bonds are maturing this year and next)
4 – Chinese banks can seek foreign capital again, to help them out of the trouble (as the FT hints at the end of today’s “Exiting the Dragon” article).
5 – Debt / Equity exchanges. where possible.
The nature of the implicit guarantee is a bit of mystery to me. As Prof Pettis mentions above, this becomes a political decision. A lot depends on the levels of NPLs which develop, how much the banks are prepared when this occurs (through their high interest margin profits or otherwise), and how willing the government (local or central) are to allow a bank failure / bailouts etc.
The stock market positions of any affected banks can be expected to suffer. A “chinese credit crunch” may also develop (if the government allow it to happen). Funny how a US subprime based crisis led to a credit crunch, the end effect of which may be a Chinese subprime lending crisis, followed by a credit crunch!
It is interesting that the last post returned to the theme of sub-prime. China is trying to reflate the real economy and plug the domestic component of what is a global demand gap. This takes the form of lending on a sub-prime basis to achieve this goal. Or was China really underwriting the demand that fueled its corporte sector for all these years? Yes, I think so. The colorful phrase that I like the most to describe the current US-China financial relationship is “wearing the same pair of pants.” So what is the exit strategy? Can the US pare back the alps and alfs? Can China turn off financial support for China Inc.? Probably not, otherwise we would have to face the underlying imbalances that still persist, and no one wants to do that.
Michael,
It is very interesting what you write and certainly the Roman examples have been repeated throughout history.
Is there a realistic alternative to FIAT money? It’s been shown several times that printing money to encourage growth will only get you so far and that sharp corrections will occur with some degree of regularity. I believe that printing money as a tool for growth only works if the amount of ‘good-egg’ loans outstrips the ‘bad-egg’ loans by a large proportion.
Is the thought of a commodity based currency that bad? I’m not referring to a gold standard but perhaps a more broadly based basket of currencies? Iron, copper, aluminium? some kind of ratio of these and more?
Matt, actually I do refer a lot to Latin American as well as other Asian, including Chinese, financial history, with the acknowledgement that there has been little work done on modern Chinese financial history and the first “modern” Chinese bank was only created in 1898. Also I wouldn’t consider 33 a.d. Rome as just another part of modern European financial history. The financial and social systems in Ancient Rome were more different from those of Europe today than China’s are.
Ingolf, I would have argued that Peel’s Act failed at least in part because it did not restrain note issue except at the BoE. But the main point is that whatever it did, it would not have eliminated the risk of crisis, and the fact that many people thought it might eliminate risk actually had the effect of increasing risk.
Ken C., I am not sure what you mean by a “realistic alternative.” There have been a lot of alternatives to fiat money, and like fiat money they all have deep-rooted problems, but I suspect that the “problem” is not created by the form of money but rather by the existence of uncertainty, changes in time preferences, informational asymmetries, and a host of other conditions. No type of money can remove these problems, so if by a “realistic alternative” you mean a form of money that eliminates financial or monetary risk, I, as a good Minskyite, do not believe this is even possible in theory, let alone in practice. Even if we knew how to create it and manage supply to fit with economic needs, a commodity-based money would still run into insurmountable problems
«lending rates are one of the most powerful of China’s production subsidies, and low deposit rates, by acting effectively as a significant tax on household income, will significantly constrain consumption growth – basically households will be heavily taxed to protect borrowers and to recapitalize banks,»
Isn’t that very very similar to the situation in the USA?
Blissex,
Unless things have changed dramatically in the US in the past few days I am pretty sure lending and deposit rates are set by the market. The government doesn’t determine the rates at which banks pay deposits or at which they lend to corporate customers. At any rate households who believe deposit rates are too low can easily invest their money elsewhere, including abroad. That is not the case in China.
Michael
Thanks for the interesting table on “New Loans”. But why not call it “Budget Deficit” instead?
…ok, let us call 50% of it “Budget Deficit”, and still the number would be staggering.
Ultimately, I suspect the way Beijing will react to insolvency will be to retreat from international trade and close itself off. Bad loans only matter if there is some economic contact with the outside world. Economic instability will be portended by a political crackdown, so that is what to watch for in China.
Periods of globalization rarely end well, Ancient Persia and Greece’s well developed trade relationship ended with the looting of ancient Athens.
Could it be that a lot of these loans went to real estate developers in large cities on the East Coast?
This could explain why last year and this year’s housing prices in China have maintained a stabil price level in spite of a more or less global decline in housing prices.
And it really just means that they borrow 6 months more with unrealistically high prices.
If I guessed right then in 1 to 2 years the homeowners will wake up to something they never tried before a decrease in the value of their home, something that will really slow the domestic consumption
Michael, thanks for your response (indeed, thanks for all you do here – the clarity of both your thought and your writing are a constant pleasure).
If I’ve understood you correctly, you see systemic risk as ultimately unavoidable, with no combination of currency type, financial system structure and regulation able to fully counteract the swings and uncertainties inherent in human behaviour. Somewhat reluctantly, I’ve come to similar conclusions, although it still seems to me we have some degree of choice (at least in theory) about the extent of catastrophe we periodically visit upon ourselves.
It’s odd in a way. Money and credit are such an elusive, inherently unstable phenomenon and yet they’re arguably the most critical aspect of any modern economy. Certainly, when handled badly they can do more damage than anything other than a very serious war.
The philosophical and social conditions within which a specie based financial system was allowed to work it’s brutal (but generally effective) auto-stabilising effects are gone, I think, and unlikely to return any time soon. We’ve become far too expectant that governments will cushion reality’s blows. If that’s so, only some combination of sound system architecture, effective regulation and commonsense have any chance of saving us from these periodic manic-depressive cycles. Or at least (more realistically perhaps) reducing their amplitude.
Anyway, all this is really by way of leading up to a request.
Have you somewhere laid out your thoughts on how this might best be done or, failing that, has someone else done so in a fashion you’d be reasonably comfortable to endorse?
If so, I’d be fascinated to read it.
Professor Pettis:
This fascinating debate seems to centre on: is money (whatever that is?)really neutral ?
Barro’s resurrection of Ricardian equivalence: is national debt wealth?
Your post and many comments (including Anatole Kaletsky in the Times) appear to suggest strong Ricardian Equivalence, as the distinction between bank and private debt versus public debt is becoming increasingly blurred owing to moral hasard.
If Ricardian equivalence holds in the longer-run, the USA, China and the EU are in the same boat — so what is the exit strategy other than a “commodity-based” key currency? regards James
What will the current system collapse?
I mean,we was able to foresee the collapse of the shadow banking system from the begining of the 2008.
China escaped this collapse by the monetary easing.
But when will this system collapse,and what will be the consequence of it?
I mean,as I can see it is an exponential process (the credit growth),so after a while,within a solid time period it have to collapse.
What could be the minimum and the maximum time frame?
And what could be the effect?
In the case of the global crysis,we underestimated the effect.How will it look like in the case of China?
Sorry,I mean when will it reach the limit (like the shadow bankin system),and how will the correstion look like?
The recent public warnings from high officials in Beijing on loan quality and bad debt, not to mention the public call to stamp out the corrupt use of public stimulus funds at the regional level, sound eerily similar to those coming from Zhu Rongji and other senior bureacrats just before they came up with the first of China’s bank bail-outs since 2001. In reality, new loans that are bad loans in the making will not be recognized as such for quite a while, so if there is a move on bad debts, one would have to presume that it would be a convenient time to sweep bad debts accumulated during good times under the proverbial rug. We will have to wait and see, but if the experience of the past decade can be taken as a guide, the politics that accompany turning points in monetary cycles are not so pretty in China. I would not be surprised, however, if the government decided to showcase whatever it does in the end as a testament to its financial strength (it is partly real, and partly illusory), before the magnitude of all of the bad debts being created at the local level (a big number even by China standards) come to light.
CNMa Zhige, i think the round of bailouts you mention began in 1999, not 2001.
New bubbles rising in China property market: state media
http://www.terradaily.com/reports/New_bubbles_rising_in_China_property_market_state_media_999.html
Quote:
“In the southern city of Guangzhou, the downtown housing price reached 1,600 dollars per square metre in May, close to the record high of 1,700 dollars in October 2007, the report said.”
Is the loan data available on the PBOC website? I went through a few pages of stats but I couldn’t find data that matches your chart. I want to look at data going back a few years.
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