After the globally coordinated rescue package was announced Monday the Chinese stock markets boomed in sympathy with the rest of the world, with the SSE Composite closing up 3.6% for the day.  Tuesday the SSE Composite shot up 3.5% within minutes of opening, but the party was already over in China.  Over the rest of the day the SSE Composite drifted down nearly 6% from its peak to close the day down 2.7%.  Wednesday was another bad day with the marking closing once again below 2000, at 1995, down 1.1% for the day.  Nothing, it seems, is able to keep this market up.

 

The announcement that the US government would use about $250 billion of the $700 billion rescue package to re-capitalize the largest US banks is in line with actions by other European governments, and will reduce some of the credit pressure on the banks.  That’s a good thing, even if it turns out not to be enough.  A lot of people are calling this move unprecedented, and representing a major change in the institution of financial capitalism in the US, but to me it only confirms that in time of crisis the government has been willing to change its ownership position.  I don’t have the numbers in front of me, but I believe that the current move to purchase equity stakes in the large US banks is not much bigger in real terms, and probably smaller in relative terms, than the purchase of bank stocks by the Reconstruction Finance Corporation in the 1930s.

 

As an aside, rumors are once again swirling around about leadership changes in the large Chinese banks and among regulators, but these rumors have been around for several months, and with everyone expecting announcements around the time of the October holidays, this seems to be happening more slowly than expected – a possible indication that leadership discussions are paralyzed by the uncertainty surrounding the crisis.  I have also heard several of my friends in the written and broadcasting media say that there are increasing constraints on what may and may not be said in the press and on TV about the international financial crisis and its possible impacts on China.

 

All this suggests that authorities are very nervous.  While the PBoC periodically announces that conditions are solid, the banking sector sound, and the economy slowing but still strong, the South China Morning Post reported yesterday the creation of a new very high level crisis committee:

 

Vice-Premier Wang Qishan will head a committee being set up to deal with fiscal uncertainties caused by the deteriorating global financial crisis, according to an official source. The decision to set up the committee is the latest step by mainland authorities to try to prevent the domestic economy following western countries into recession.

 

At the end of the Communist Party Central Committee plenary session on Sunday, the leadership said that despite the international turmoil, the mainland’s basic economic situation had not changed. However, precautions to guard against the side effects of the international slowdown were needed. The source said the central government believed “losses from the international financial crisis are limited and the country’s risk and exposure to the crisis is still controllable”.

The new committee will be at the core of efforts to deal with the international problems. It will monitor financial changes overseas and respond by adjusting mainland economic policies when necessary.

 

It is definitely a good idea to create a high level crisis committee to monitor risks and to formulate policies for a rapid response, but if the thinking really is that the main risk to China is of contagion from international exposure, I am a little puzzled. 

 

To me the real risk has always been that the same excess monetary expansion that led to overextended and vulnerable financial systems abroad will have done the same thing in China.  In other words the risk was not so much (in my opinion) that there was a huge amount of hidden exposure to sub-prime mortgages or some other foreign toxic waste that will bring the Chinese banking system down, but rather that we have our very own time bombs hidden in the various formal and informal parts of the domestic banking system and that any sufficiently large adverse shock – financial or economic or even political – can cause a sharp contraction in the banking system. 

 

The fact that the authorities seem much more obsessed with the direct contagion impact – and that the media may have been instructed not to discuss these issues too openly – makes me wonder if there is not a lot more here than I at first imagined.  I am surprised that there has been so little debate within China about whether or not the crisis presents a huge buying opportunity for China (the foreign media has been much more excited about discussing this).  Could it be that SAFE and the CIC already have such a mess on their hands that no one has any intention of buying more assets abroad for a long time?

This is all just speculation, of course.  The real news yesterday was the release of PBoC reserve numbers, but as an indication of how furiously busy things have been, it was only by late today that I have been able to look at the numbers.  After going through the numbers and talking to my friend Logan Wright, who keeps sharp tabs on the PBoC, I have to say that there are two easy conclusions from the latest release.  First, hot money inflows have almost certainly slowed and maybe even reversed.  Second, the data is getting fiendishly hard to interpret, just as we are most eager to get a little clarity.

 

Headline reserve growth was $96.8 billion in the third quarter.  This is an extraordinarily high number by any standards, but it is a measure of how out-of-control reserve growth has been in China that it is being seen by researchers and the press as a serious moderation in reserve growth.  Once again (as in the good old days before hot money hijacked the process), most of the reserve growth is fully explained by the trade surplus (which soared in the third quarter of 2008) and FDI, which was higher than average for the last few years but lower than the first two quarters (much of it puffed up by anticipated investment – a nicer name for a form of speculative inflows).

 

However there is a lot of confusion in the numbers.  Currency valuation changes during the quarter, especially in August, added a lot of volatility to our analysis.  We can only guess at the currency composition of PBoC portfolio, so unfortunately even small errors in our estimate are going to have a magnified impact on our final numbers.

 

There were also some strange goings-on in the dollar account at the PBoC account which, following my previous usage (although the name is no longer fully appropriate) I have put in the “Reserve hike” account.  I won’t go into too much detail here because the numbers aren’t big enough to change the conclusions.

 

?	Q1	Q2	July	August	September	Q3
Headline reserve growth	153.9	126.7	36.3	39.0	21.4	96.8
Trade surplus	41.7	58.2	25.3	28.7	29.3	83.3
FDI	27.4	25.0	8.3	7.0	6.6	22.0
Currency gains	38.0	-7.1	-6.5	-24.0	-12.0	-42.5
Interest	16.5	18.0	6.0	6.5	7.0	19.5
Unexplained amount	30.3	32.6	3.2	20.8	-9.5	14.5
?	?	?	?	?	?	?
Reserve hike	30.0	72.4	-1.5	-5.6	-11.0	-18.1
Adjusted reserve growth	183.9	199.1	34.8	33.4	10.4	78.7
Unexplained amount	60.3	105.0	1.7	15.2	-20.5	-3.6
?	?	?	?	?	?	?
Transfer to CIC	75.0	0.0	0.0	0.0	0.0	0.0
Adjusted reserve growth	258.9	199.1	34.8	33.4	10.4	78.7
Unexplained amount	135.3	105.0	1.7	15.2	-20.5	-3.6

 

The results of my calculations, with input from Logan Wright, I have listed in the table above.  Don’t focus on the absolute numbers because there is a lot of possible error in the numbers.  What seems pretty certain is that the huge unexplained inflows of previous months (a proxy for hot money and its various close relatives) have all but vanished by July and August and in fact have probably turned into outflows by September.

 

Should we worry?  Yes and no.  Obviously since China was, and still is, suffering from explosive monetary growth, and it is precisely this monetary growth that is creating so much risk in the domestic financial system, the fact that hot money inflows have slowed and may have even reversed is unquestionably a good thing, especially as the trade surplus has surged.  Make no mistake, however – having reserves rise by roughly $100 billion in a single quarter would in any other time or country be seen as outlandish.  If we eliminate non-monetized components of this increase in reserves (interest income and currency valuations), there were net inflows into the country of $120 billion that had to be purchased by the PBoC with a combination of currency and PBoC bills. 

 

This is more than twice the $60 billion quarterly average of 2006 – a number which once seemed astonishing.  This is a lot of domestic money growth.  Fortunately for the monetarists out there (but not for those who fear that the economy is slowing too quickly) it seems that the banks are not eager to expand loan volume too quickly.

 

But there is something about the latest PBoC numbers which should indeed cause worry.  For me one of the bad-case scenarios that we have most to worry about is a sudden reversal of hot money inflows, large enough that it puts liquidity pressure on the formal and informal banking systems.  This is clearly not a problem yet, but the shift in a matter of months from massive inflows to moderate outflows is not confidence building.

 

As a related aside, and I am now straying into areas about which I need a lot more information, by coincidence I had two meetings yesterday – one with a world famous Harvard economist and a group of PKU professors, and the other with a group of traders and bankers – in both of which South Korea suddenly became the topic of conversation.  I am no expert on Korea but the kinds of things I was hearing raised all my Latin-American-bond-trading hackles.  One of the academics said he thought that Korea would come under tremendous liquidity pressure in the next three months.  If there are problems once again in Korea I would lay pretty serious odds that capital flight will become a serious problem all through East Asia.

 

We’re starting the holiday week – October 1 is the anniversary of the 1949 revolution – so markets were closed today and will be closed for the rest of the week, and there’s a pretty good chance not a whole lot will happen on the policy front until the end of the holiday schedule.  Much of official public attention has been focused on the successful return of Shenzhou VII, whose flight included China’s first space walk.  Unofficial public attention is still on the milk scandal, whose social repercussions are likely to be fairly deep.

 

On that note I thought it might be useful to recount an interesting discussion I had last night with a group of six young Chinese friends.  The foreign media has made a lot of noise in recent months about the ugliness of China’s ultranationalist youth, and I get the impression that a lot of people abroad are worried by the spectacle of China’s being overwhelmed by mobs of goose-stepping youth proclaiming hostility to the rest of the world.  There is no question, of course, that this country has its fair share of flag-addled nationalists, but in China, like in most other countries, it is too easy to mistake the views of a very loud few for the views of the general population.  The reality here, it seems to me, is not a youth population teeming with aggressive nationalists but rather a great deal of very worried questioning about China and her future.

 

Last night my club presented a show by a well-known folk singer in his mid-30s from Shandong province.  After the show I sat down with him to chat, and was joined by five young people in their early to mid-20s who represented a pretty decent cross-section of young Chinese.  One was a software engineer from Hubei, another a college student from Fujian, a third was a bar manager from Dongbei, a fourth was a kid from Xinjiang who had just moved to Beijing a few months earlier to get a job, and the fifth was a Beijing college student majoring in design.  Although half of them were college educated none of them were graduates of elite colleges, and a few of them came from fairly poor circumstances – and so in that sense are perhaps more representative of ordinary youth than some of the nastier types we often see charging through the Beijing streets in their flag-bedecked SUVs.

 

With the help of plenty of beer we had a wide-ranging discussion, and at one point the young Hubei engineer asked me what I thought of the Beijing Olympics.  I gave him the standard response – a great success for China, wonderful show, etc. etc.  He interrupted me and said that in his opinion it was good for Beijing and terrible for China.

 

That started off a very long and impassioned discussion in which the people at the table – with the folk singer being the most demure, interestingly enough – launched into a very brutal attack on China and especially on the government.  The milk scandal was presented by everyone as proof of why China was, and was destined to be forever, a failure as a nation.  They gave many other examples and would not hear of anything good I might say.  When I tried to argue that China would inevitably experience difficult problems in the process of its growth, and that the milk scandal was one of them, they very politely but very firmly explained to me that I could only say this because I was a foreigner and knew nothing about the real China (although I had been to more parts of China than any of them except the folk singer).  They especially pointed out that as a Peking University professor the only students I meet were the ones who would run and benefit from the system, and so my views about Chinese were distorted (they said this very politely, as young Chinese are likely to be with professors, but quite firmly – they had little use for the elite).  They were utterly demoralized about prospects for ordinary Chinese and scathing about their leaders, even Grandpa Wen.  I found myself in the position (and not for the first time) of defending China and its government from very critical young Chinese.

 

I can’t discuss the whole conversation and of course I don’t want to suggest that these young people represented the totality of young Chinese opinion – after all the fact that they were at a bar to see the performance of a folk singer famous for his social concerns suggests some form of non-random selection – but it was a very striking version of a conversation I have had many times before in the past few years, both with elite college students and with less exalted types.  Often under the outpourings of pride there can still be a real despair among many young people about the prospects for their country, and many are far more skeptical about the official story than one might suppose from reading the press.  In fact I suspect the nationalistic rage of the feng qing, the so-called angry youth, may be as much a reaction to that skepticism as it is to perceived foreign slights.

 

What does all of this have to do with China’s financial markets?  I would argue that one thing it suggests, and I have made this comment before, is the brittleness of government credibility.  The idea that Chinese youth mostly follow the dictates of the official media is simply not true, even though you would have to be very naïve not to acknowledge the media influences the debate. 

 

But the fact that the government regularly directs the media and tries to limit the debate is not lost on most people, and there is a lot more skepticism, distrust, and even hostility than we might think to the China that many of us see in the press.  The government, in other words, can mobilize opinion relatively easily up to a point, but underneath it all this is a population a lot more sophisticated and a lot less malleable than we think, and when anger or frustration breaks, it can break pretty quickly (I remember this happening during the SARS crisis).  That is probably good for China in the long run (I tried to explain to my very doubtful young friends that the very fact of their skepticism undermined their pessimism, and that China was much worse off when people uncritically accepted of the official line) but suggests more instability in the short run than we might otherwise expect.

 

Again, I want to stress that these ruminations are not the result of one conversation, but that last night’s conversation was simply a very strong version of many conversations I have often had before, and although my participation in it may have colored it to some extent, it was pretty clear that these were things that these kids had thought about and argued about among themselves often.  It was the beer and feelings of bonhomie that allowed them to be so openly critical of themselves in front of the foreign professor.  

 

I suppose I shouldn’t take on topics about which I have little expertise, so to move away from my attempts at trenchant social analysis I will return to something about which I can pretend more knowledge.  I was asked today to write an Op Ed piece about the state of the Chinese financial system, and although I have committed to writing two other pieces this week (so much for the holidays), I agreed to do it.

 

I think the point of this Op Ed piece will be to argue that much of the analysis of the banking system in China is a little like the old joke about the drunk who one night loses his car keys in the middle of the road, but spends the night searching for them on the sidewalk because the light there is so much better.  Most discussions of credit and monetary policy focus on the impact of PBoC policies on the banks and the formal sector, mainly because that is where we have data, even though the real action may be going on elsewhere.

 

So for example when the PBoC raises minimum reserve requirements or imposes lending caps so as to slow loan growth, we duly note that RMB lending by commercial banks slows.  But does that mean that total credit in the economy is slowing, or does that simply mean that more rapid loan growth is now occurring in the informal banking sector and off balance sheet?  When the PBoC raises deposit and lending rates, does that mean that the cost of credit has gone up, or is that increase mitigated by a shift in lending from the more expensive informal sector to the cheaper formal sector, as deposits shift to the now-higher-paying commercial banks?  We don’t know the answer to either of these questions, but we still make assumptions about the efficacy of monetary policy based on what happens in the data we can see – and sure enough there the PBoC regulations do seem to have the desired impact.

 

However if you start from the assumption, as I do, that China’s capital controls are too leaky to be effective, then China must face the so-called impossible trinity, which argues that by managing the currency the PBoC cannot have any real control over domestic monetary policy.  In that case rather than assume that specific monetary policies will have the same impact in China as they might in the US, and seeing confirmation of that assumption in the official data, it might be more helpful to look for the types of leakages that automatically undermine the impact of that policy. 

 

I have been congratulated a lot of times recently for getting a number of forecasts right – about hot money, about the growth in off-balance sheet lending, about the stress in the banking system and growing NPLs, about the growth of the informal banking sector – but to tell the truth none of those predictions arose from any deeper understanding of China’s financial markets than other analysts have.  In fact I usually turn to much better informed friends to get a sense of what is actually going on.  

 

All that happened was that when new monetary policy was implemented, and seemed to have the intended effect, I assumed that it could not have had that effect and looked for counterbalancing changes in other parts of the financial system.  In other words I almost begin with the assumption that what drives monetary policy in a system determined by the currency regime is primarily net capital inflows, not domestic central bank policies, and then look for evidence that supports that thesis.  That means taking every bit of data with a lot of skepticism – not because the data are incorrect, but rather because what information is missing is likely systematically to counter the data we have.  

 

On a completely separate topic, Tuesday the 3-day Modern Sky Festival begins in Haidian Park, just west of Peking University.  Many of Beijing’s best indie, underground, folk and experimental musicians will be taking the two stages, including some of who I think are the freshest young bands in the world today (especially on the third day, Thursday).  Those living in the Beijing area should check it out for a very different and pleasant view of China.

Tags: Milk

What was supposed to be largely a US financial crisis seems to be spreading even further.  This might come as both a surprise and an annoyance to those who believe that the cause of the crisis was specific mistakes made by US bankers and regulators, but much less of a surprise to those who assume that runaway monetary expansion always leads to very risky and vulnerable financial systems, and the list of countries that have tolerated or even exacerbated runaway monetary expansion is a very long list.

 

Here in China, in sympathy with the weirdness abroad, the stock market is still racing around erratically.  On Wednesday the market bounced up and down violently several times before ending the day with the SSE composite up 15 points, or 0.7%.  Today, prices surged 5.3% within two hours of opening, and then gave some of it back to close at 2297, up 3.6%. 

 

The market surged, according to Bloomberg, “after the country’s two exchanges eased restrictions on equity buying by controlling shareholders and on speculation government-run investors increased purchases,” although I think the bank share purchases have been, fortunately, quite small (an article in today’s Xinhua stated that the net purchases of shares by Central Huijin in the three big banks amounted to increases in ownership of well under 0.001%).  The Bloomberg article goes on to say:

 

Under new rules taking effect today, the period in which controlling shareholders are barred from raising their stakes in publicly traded companies has been cut to 10 days before earnings are released, from 30, according to statements from the exchanges.  China’s state-owned companies should be “a role model” in promoting “stable” development of the nation’s capital markets by buying back shares in publicly traded units, the State-owned Assets Supervision and Administration Commission said Sept. 18.

 

Aside from the fact that to be a “role model” these days is pretty narrowly defined (you must simply buy shares), my former students in the market tell me that there is also serious speculation that securities rules will be changed to allow shorting and margin investing.  Although I am not sure either of these measures is likely to add stability in what is a highly speculative market (on the contrary), to some extent these rumors are more of the same old stuff.  Basically what is driving the market is government intervention and government signaling. 

 

Given how chaotic and dangerous markets have been recently, this is probably as good a time as any for market intervention, and certainly Chinese policy-makers are not the only ones around the world who think so, but investors here have been so conditioned to think of the market’s performance as almost exclusively a function of government behavior that I am afraid that the impact of the latest round of activity in China will be far more ephemeral than it might be in other markets.  Once investors perceive that the government has run out of ammunition or new tricks to spur the market, prices will plunge.  Once the market stops surging, it will very quickly lose its legs as investors pile out waiting for the next bag of tricks, and we’ll soon be testing the lows again.

 

More interesting to me than the stock market were events in Hong Kong concerning the Bank of East Asia.  After several days of rumors and speculation, long lines of depositors are now lining up at the bank desperate to take their money out – and have been so since late last night.  Deposit withdrawals actually began on Tuesday, but only really picked up steam last night.  Bloomberg says this is Hong Kong’s first bank run since the Asian Crisis of 1997, but the South China Morning Post lists the last bank run as BCCI in 1991.

 

The chairman of the bank, David Li Kwok-po, is apparently furious at what he calls “groundless” rumors about solvency problems at his bank and he and Hong Kong regulators are loudly proclaiming that the bank is perfectly safe, but, whether they are telling the truth or not, this is the way bank runs work.  There is no strong incentive for depositors to trust the safety of the bank, beyond their giving up a few days of (low) interest, and every incentive for them to flee to safety.  Even if every one knows that the bank is safe, simple game theory suggests that once the process starts, until something happens to signal that the game is over it makes sense to withdraw deposits.  More ominously, two other local banks, DBS and Dah Sing, are also now subject to rumors.  By the way there is an interesting article on the subject in today’s South China Morning Post, which also has a brief history of Hong Kong bank runs.

 

Interestingly enough, according to today’s South China Morning Post, one of the factors in the bank run was the wide diffusion of mobile phone SMS and BBS postings warning that there was trouble in the bank.  There was also a seemingly unrelated news story in the same newspaper about the closing down for three months of China Business Post, “one of the oldest financial newspapers on the mainland,” for a “scathing” report in July on Agricultural Bank of China.  Apparently the newspaper received an unexpectedly harsh punishment for reporting a story about fraud at ABC, which was later denied by the bank.  Why such a harsh punishment?  Could it be that authorities are worried by negative articles about mainland bank practices?

 

Regular readers of my blog know that I am always interested in the phenomena of bank runs.  They almost always come as a shock to places and institutions where only a short while earlier most people would have considered them inconceivable.  But the more overextended a bank’s balance sheet is, the smaller the shock needed to cause a sudden contraction, and as Nassim Nicholas Taleb has pointed out several times – often a little grumpily – these are not events whose probability can be statistically modeled in a meaningful way.  Under current conditions, we can only say that unexpected events like bank runs should not be considered unlikely.  This obviously has implications for the Chinese banking system – which actually experienced bank runs not so long ago, earlier in this decade. 

 

And implications also for the country’s currency regime.  A lot of people have been asking me recently about China’s strategy for the RMB.  Should China continue forcing the RMB up, or is it time to change strategy?  Given the possibility of slower export sales, might we even see depreciation?

 

I have never believed that the purpose or RMB appreciation was directly to rebalance trade.  For several years China needed to revalue the yuan not to reduce the trade surplus but rather to regain control of its monetary policy.  If it was able to regain control, the trade surplus would automatically decline anyway because what was pumping exports was the surge in industrial production caused by the channeling of China’s money growth into the banking system – fueled at first, in a self-reinforcing feedback loop, largely by the impact of the trade surplus on reserve accumulation.

 

At first the main source of money inflow was the trade surplus.  While this continues to be large, in the last year it has been speculative inflows that have driven reserves up.  China’s currency regime needs sharply to reduce the latter and to bring the former to a more reasonable level. Until the now it seemed to me that the only way to do so was to engineer a maxi-revaluation.  But there are four things that can, in principle, reduce the need to revalue, although all of them, one way or another, create problems for the economy. 

 

1.       If global growth slows sharply, China’s trade surplus is likely to decline.  This will reduce the impact of the trade surplus on reserve accumulation and so slow money growth.  A reduction in the trade surplus might not be enough by itself to allow the PBoC to regain control of monetary policy, but if slowing export growth leads to slowing economic growth, which then also reduces capital inflows, it might be more than enough.

 

2.       If the prospects for asset appreciation (including currency appreciation) decline, speculative inflows will slow or even reverse, thus removing the biggest recent source of unstable growth in reserve accumulation.  This means that when investors expect lower returns from their Chinese investment, the incentive to bring money into the country to invest will, of course, decline.

 

3.       If the currency is forced to appreciate surreptitiously via a surge in inflation, China can eventually reduce net inflows once the currency is perceived to be overvalued and expectations of a Vietnam-style depreciation set in – but of course in that case China will have anyway achieved everything it was hoping to avoid.

 

4.       Most dangerously, if the perception of risk in the financial system (or anywhere else in the economy, for that matter) rises, investors will begin to exit, and the worse the perception of risk that faster the exit.  At some point it even becomes self-reinforcing, as fleeing investors force an uneven contraction of the money supply, this exacerbating risk.  Unfortunately it is exactly the uncontrolled growth of money in previous years that would create the conditions for a surge in the perception of risk, by causing serious overextension in the country’s formal and informal financial systems.  This was always, in my opinion, the strongest reason for a maxi-revaluation: get monetary policy under control before the banking system became too risky

 

5.       Of course the fifth option, which is the one I had always supported, is that China revalue the RMB substantially (and in one maxi-revaluation) to reduce or even reverse capital inflows and, by reducing the consequent monetary growth, eventually slow industrial production.  This was never going to be a painless option, but I expected that if China waited too long it was likely to see either #3, a surge in inflation, or #4, a breakdown in the financial system.  It may be too late to take that option – certainly under current conditions it would be very difficult.

 

It seems to me that we may be seeing all of these things happen at once.  It is too early to say, of course, but it is pretty easy to construct a plausible scenario where the US and Europe reduce their imports substantially (so reducing or even reversing China’s export growth), investors both expect lower returns in China (the pressure for currency appreciation declines) and see higher risk in the banking system.  Whether this is accompanied by inflation or not will depend on the actions of the PBoC and on how robust and stable the financial system is, but either outcome is pretty negative.

 

The outlook is worrying.  I guess I generally try to achieve a balance between expressing my deepest worries about the banking system and being excessively alarmist in public, and this has been a particularly difficult balancing act in recent weeks, but every week it seems the banking crisis steps into yet another market.  Where will it go next?

Tags: Bank run

While Monday’s stock market, led by the banks, continued Friday’s big bounce back, rising 7.8% to add to Friday’s 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.  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%.  Most other indices – many of which track market value much better than the widely followed SSE Composite – fell by a lot more.  The CSI 300 index was actually down 3.8%.

 

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

 

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.  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.  A 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.

 

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

 

I don’t know how widespread this is – he said the dealers in his bank claim it is very common – but it does suggest that the government bond and money markets are a lot less liquid than we might think.  This 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.

 

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 “Government Concerned Banks More Exposed to Wall St. than Disclosed”.  The article cited statements by unnamed sources who claim that the Ministry of Finance “has 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.”

 

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.  Perhaps they are only taking precautionary steps, with little expectation that they will ever need them.  If that is the case, needless to say, it certainly is a good thing.  Well-thought-out precautionary plans seem to have been in very short supply among both US and Chinese officials in recent years.

 

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

 

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).  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.  Every single bank of the twelve they monitor except one (Huaxia) showed large increases.

 

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.  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.

 

Fitch also mentions one of the things I discussed in a blog entry three weeks ago – the repackaging of loans into wealth management products.  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.  This isn’t large in absolute terms – I am guessing equal to just over 2% of new loans extended – 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.  They also refer to something I had heard of but knew little about – what they call “entrusted lending on behalf of third parties” – which has also grown substantially.  Aside from the fact that Fitch – like me – 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.

 

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.  The report concludes with:

 

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.  How trying this test will prove to be, and how banks ultimately will fare, remains to be seen. While China’s largest banks have achieved a remarkable amount of progress in recent years, deeper, more difficult reforms of banks’ credit culture, risk management, and governance remain in the early stages.

 

As a result, Fitch continues to be quite cautious with regard to Chinese banks’ 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’ expected loss models.

 

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.  Chinese 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).  They also plan to invest less in real estate and stocks – 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.  I assume this increased savings means a faster growth in bank deposits.

 

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

 

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…A 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.

 

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.

 

If corporations and households are both worrying about upcoming economic conditions, we may see both fixed asset investment and consumer demand slow.  Coming 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.  

 

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, “Monetary Policy Signals in the Chinese Interbank market”.  Early in his report he says:

 

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.   

 

I have never been convinced that the PBoC actions on credit – raising minimum reserves, for example, or imposing lending caps or changing interest rates – 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.  The 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.

 

So, for example, constraining loan growth at a time when corporates demanded more loans simply pushed loan formation outside the formal banking system – and it is pretty clear that this has happened quite a lot.  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 – 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.

 

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.  I don’t think these measures have been effective on the way up, and won’t be on the way down. 

 

Finally we have a piece of somewhat good news.  Industrial production was up only 17.9% year on year in October, down substantially from September’s 18.9% year-on-year rise.  Not only is this well below last month’s number, it is also well below expectations, which were for an 18.3-18.5% rise.

 

But we shouldn’t get too excited by the decline.  September’s growth in industrial production was extremely high, and the October growth rate may be a partial rebalancing of that number.  The October figure is more or less in line with August’s 17.5% and July’s 18.0%.  

 

Also it seems to me that in past year we saw these numbers moderate around this time of year before bouncing back up again early in the next year.  This may have something to do with the reduction in credit expansion we normally see in October, including this October.  For the first ten months of the year total factory output was 18.5% higher than for the same period in 2006.

In Shenzhen, a city in Guangdong near the Hong Kong border, the local branch of the PBoC has issued instructions to local banks to limit cash withdrawals. Individuals are allowed to withdraw no more than RMB 30,000 (about $4,000) a day, RMB 50,000 a week, or RMB 200,000 a month from their bank accounts.  The limit for companies is RMB 100,000, RMB 200,000 and RMB 500,000 respectively.

 

The reason for this restriction is to slow down the flood of money leaving the mainland attempting to take advantage of the relatively lower share prices at which Chinese companies sell in Hong Kong.  I think H-shares (Hong-Kong-traded shares) trade at roughly half the price of A-shares (Shanghai- or Shenzhen-traded shares).  Of the RMB 195.6 reduction in deposits withdrawn across the mainland in the year to date, about half comes from Shenzhen, giving pretty good circumstantial evidence that this money is being withdrawn to be invested in Hong Kong.

 

I am not sure how effective these measures will be.  It is pretty commonplace here that bank records are so weak that little information travels from branch to branch, and even less so from bank to bank.  If you open two accounts at two different banks you can probably transfer half your money to one of those accounts legally and then legally withdraw the full amount permitted from each account.  The only ones who won’t be able to do this are depositors who have too little money to afford the hassle and cost of opening two accounts, but I doubt they are the big source of speculation anyway.

 

One thing though, this is good practice for dealing more generally with bank runs.

I get a lot of emails and phone calls asking me what I think is the likelihood of a sharp financial “adjustment” in China, and what the impacts are likely to be.

 

The first point to make is that it is a safe bet that China will experience financial instability, and not necessarily because of anything endearingly Chinese.  Given the experiences of other countries, and given the state of the Chinese financial system, the argument that it will suffer from a crisis is very, very plausible, and not worth, in my opinion, betting against. 

 

The obvious “generic” arguments are the easiest to set out.  No large country that I know of (and probably no small one, either) has ever been able to combine rapid growth and social transformation without periodic financial crises.  In fact offhand I cannot think of any country that has a functioning financial system and that hasn’t suffered periodic financial crises.  In the 19^th Century, for example, the US seemed to be hit by a serious panic every ten to fifteen years, on average, and it suffered at least two or three financial crises during this period that were devastating.  During its own history China has suffered financial crises or panics, most recently in 1993-94 and 1997-98, but also throughout the 20^th century and of course earlier (there is a fascinating story to be told about the relationship between China’s great remonetization in the late Ming and early Qing periods and the plundering of silver from the Americas)..

 

Against this, many China scholars argue that China today is sui generis – so different from everyone else that it can’t be judged by laws or experiences that have worked elsewhere.  The only reasonable response I can give to such an argument is that I have never worked in a country (the US, France, Brazil, Mexico, Peru, Spain, Haiti, Pakistan, Argentina, to name a few) that wasn’t at least as sui generis, nor have I ever worked in a country whose own specialists hadn’t also assured me at least a few times that because of their unique histories and circumstances these countries were too different to bear easy comparison with the rest of the world.. As silly as this sort of provincialism may seem to many, it has been a powerful undercurrent in the thinking of many China specialists – foreign as well as Chinese.

 

If China is indeed “different”, it is different in ways that don’t give me much confidence in the safety of its financial system.  Its banking system is filled with current and future bad loans; its bank managers are among the least experienced in the world in risk management and credit allocation; it has almost no financing alternatives to the banks; government credibility tends to be very brittle in China; and the national balance sheet is much weaker than that of many other countries that subsequently experienced crises.

 

The second obvious argument for arguing that China is at risk is also a “generic” argument and does not rely anything that is specifically Chinese.  This is the observation that in every case of an economy that experienced excess liquidity conditions for long periods of time, financial sector imbalances have always built up that were only discovered later when some event caused liquidity to dry up.   

One of my favorite economists, Hyman Minsky, makes the point that during periods of financial stability, institutions systematically increase their underlying risk.  There are at least two mechanisms by which they do so.  The first is that economic actors always adjust their behavior so as to obtain a risk-return tradeoff that they consider reasonable or appropriate.  It is not necessary for these actors to be risk lovers – it is only necessary for them to be willing to trade some risk for some return. 

 

During long periods of low risk, they naturally shift towards increasingly risky behavior until they have eventually achieved what for them is an appropriate trade-off.  Of course what is rational for each individual actor increases the riskiness of the whole system, and creates balance sheets that are more susceptible to unexpected shocks.  When the shock finally comes, volatility usually shoots up and the adverse impact on all the now-riskier balance sheets catches everyone by surprise.

 

The second reason has to do with everyday sorting mechanisms.  In periods of low volatility, individuals and institutions that take on higher levels of risk tend to outperform the rest.  During sustained periods of low volatility and high levels of liquidity, any financial institution will find that the bigger risk-takers — including, most importantly, the ones that ignore the risk of of illiquidity —  have moved up the hierarchy at the expense of the more risk averse, so driving the whole institution towards greater risk-taking and greater susceptibility to a liquidity event (and this entry is being written during the sub-prime crisis, in case any reminders are needed of how that happens).  Similarly, during periods of low volatility more aggressive institutions will grow at the expense of less aggressive institutions, so driving the industry towards greater risk taking.

 

China is currently going through a financial sweet spot in which high growth, floods of liquidity, and low or negative real rates are rewarding the wildest risk takers handsomely, and it would be surprising if one result wasn’t a systematic increase in balance sheet risks.  Plenty of liquidity has meant that loans can easily be renegotiated, and loan maturites can easily be extended, even if only to hide problem loans (a manager at the PBoC told me that he believes that this is why loan maturities began extending in 2004 onwards after the introduction of new monitoring systems to judge loan officers). 

 

Plenty of liquidity has also meant that corporations can easily borrow and speculate on real esate and financial markets as a way (a horribly pro-cyclical way) of jacking up profits.  There is little doubt that an awful lot of money, which doesn’t really need to be repaid just yet, has been put into non-productive investment.  As Yale’s Robert Shiller put it, “My view of booms is that they generate laxity in standards for loans.”

 

When you add to the mix the observation that combating rising unemployment is probably the government’s leading concern, and that one way to increase employment in the short term is to loosen investment criteria, and it would be very surprising if serious imbalances weren’t being built.

 

The two “generic” arguments do not require any specific knowledge about China.  The first argument is that every rapidly growing country runs into periods of financial instability, and China will be no different.  The second argument is that any financial system that enjoys a long period of financial stability and excess liquidity is highly likely to build up imbalances that will require some adjustment. 

 

China’s reserves increased by $117 billion in 2003, $207 billion in 2004, $209 billion in 2005, $247 billion in 2006, and $266 billion just in the first half of 2007.  Each dollar of reserve growth is matched by an increase in currency and central bank bills in circulation.  China’s money base has been growing at a rapid and accelerating pace.  China has had too much liqudity for too long, and and with its rigid and opaque financial system, the adjustment is probably inevitable and likely to be painful.

 

These “generic” reasons as to why we should be concerned are, to me, pretty compelling.  China is undergoing conditions – rapid economic growth under conditions of explosive growth in liquidity and credit, low or negative real interest rates, and significant policy intervention – that have almost always led, in other cases, to financial imbalances, and it would be strange to assume that they would not in this case. 

 

It is not necessarily the case, however, that an adjustment need be violent.  This depends on the structure of the financial system and the national balance sheet. If balance sheets are strong, the adjustment can be localized; if the financial system is healthy and flexible, the transmission into the real economy can be minimized; and if government debt levels are low, financial authorities can counteract the impact of the adjustment.

 

But there are very China-specific reasons that give cause for worry.  Financial crises occur when a country, whose balance sheet includes a lot of unstable, or badly structured, debt, is affected by an adverse shock that sets into motion a collapse in the balance sheet.  An economic crisis follows only if and when the financial crisis is transmitted into the real economy – almost always by shutting off the ability of producers and/or consumers to finance their activity.

 

What are the conditions for balance sheet instability?  In my book (The Volatility Machine) I list three.  There must be high levels of debt.  The relationship between assets/operations and debt/debt financing must be “inverted”.  And there must be self-reinforcing, sometimes referred to as pro-cyclical, mechanisms imbedded in the balance sheet.

 

What is a high level of debt?  There is actually an easy way to answer what seems like an impossibly difficult question: a high level of debt is whatever the market considers at any given time to be too much debt.

 

This answer is not a cop-out.  When the market believes that debt levels are too high it responds by forcing the yield to rise, and it is precisely high yields that are the problem.  They are a problem not because (or not mainly because) the government must now pay a lot more for new borrowings, so jacking up the fiscal deficit.  They are a problem because exisiting debt changes the incentive structure for old and new investors.

 

The higher the real yield on exisiting debt (the lower its price) the greater the share of the benefits of new investment that accrues to old lenders, and the smaller the share that accrues to new investors.  This is because improvements in the country’s repayment prospects are shared between the exisiting creditors and new investors. 

 

This doesn’t matter when repayment prospects are very high, since the share of the improvement that goes to existing creditors is very small (they are already highly likely to get repaid).  But it matters a lot when the market thinks repayment risks are very high (i.e. the real yield is very high).  For option geeks the relative share of any change in asset values that debtors and equity investors receive is referred to as delta.

 

The higher the delta for debt, the lower for equity, since delta must always add to one (i.e. 100% of the change in asset value must go to debt and equity investors), and by definition the smaller the share equity investors get of any change in asset value.  This creates a disincentive to invest and an incentive to disinvest (as any banker who deals with debt restructuring knows).  When investors believe a country has too much debt they force changes in the value of debt (increase yields) that automatically causes reduced investment or even disinvestment, and this has an obvious adverse impact on the ability to pay.  This is one reason debt crises often seem to spiral out of control.

 

Is China at risk of having too much debt?  We don’t really know, but a very plausible case can be made that it is.  I have written elsewhere about my estimates for the government’s total debt levels – officially around 30% of GDP but probably over 60% of GDP when you include contingent liabilities arising from unrecorded provincial and municipal debt and non-performing loans in the banking system. It is not hard to make a case that in case of an unexpected economic or liquidity contraction, non-performing loans will shoot up and force attention onto the country’s real debt levels, and the market might judge these levels to be too high.

What about the second condition of balance sheet instability – is China’s debt structure “inverted”?  An inverted debt structure is the opposite of a hedged structure.  When conditions on the asset side improve the debt burden declines, and vice versa.  Think of South Korea’s dollar debt in 1997 – when things went well, money poured into the country, assets increased in value, and profits rose.  At the same time the real appreciation of the Korean won was reducing the real cost of dollar debt. 

 

This is all fine and good and can induce feelings of euphoria when underlying conditions are doing well, but when things go badly on the asset side, for whatever reason, the whole system suddenly goes into reverse.  The debt burden balloons just when the borrower is least able to pay.  Again, think of South Korea after the sudden depreciation, when the value of dollar debt shot up just as the value of won assets was declining.

 

Much of China’s explicit debt is “hedged” – it is denominated in long-term fixed-rate RMB, so anything that causes interest rates unexpectedly to rise will automatically reduce the value of its obligations.  So far, so good. 

 

But a very large chunk of China’s debt – perhaps more than half of it – consists of contingent liabilities through the banking system.  This stuff is heavily “inverted” — the debt burden is lightest when the economy is growing, and heaviest when it is contracting.  Right now conditions are as good as they can get – China is growing quickly, interest rates are low, and the economy is flooded with liquidity – and so the growth in NPLs is probably low (in relative terms, of course — my guess is that they are still growing quickly if correctly accounted).  However should conditions change and China suffer from an economic or liquidity contraction, it is probably safe to assume that NPL’s will grow at a much faster rate than they are growing now, and we will see if the enormous increase in loans made during the last three years were always made to good borrowers. 

 

This is a classic case of an inverted balance sheet.  The liability side performs (relatively) well when the sun is shining and the economy is growing, but just when things get bleak on the asset side the debt burden begins to rise, catching the economy in a squeeze.

 

To address, finanlly, the third condition for balance sheet instability, does China have self-reinforcing mechanisms imbedded in its balance sheet?  I think there are two obvious ones.  The first of course is the normal reaction of banks to a sharp contraction.  The need to protect their own balance sheets will have them hoarding liquidity and cutting loans.  This merely reinforces the crisis and causes corporations and banks to scramble for liquidity, while also causing NPLs to rise.  Rising NPLs are self-reinforcing at some point because if they rise quickly enough, they force the banks to hoard even more, thereby throwing more borrowers into trouble and causing even more NPLs.

 

The second mechanism is the possibility of bank runs.  Most people don’t know that China has had bank runs in recent years, and my guess, from living through SARS and other credibility shocks, is that in Chinese cities government credibility is strong but brittle.  It may not take much for individual Chinese to lose faith in the ability of the government to protect their savings, and if they worry about their savings, their efforts to protect them (withdraw deposits) will just make the problem worse. 

 

The problem with bank runs is how easily they can spiral out of control.  We don’t need everyone in China to give up all trust in the government’s ability to protect them.  We only need a few (perhaps the more sophisticated) to be a little worried about a temporary problem.  If that worry causes them to withdraw deposits, and low interest rates make the opportunity cost negligible, they can quickly spark further deposit withdrawals as the problem “gradually” spreads (and with the ubiquity of mobile SMS, information can spread in a Chinese city today far more quickly then in Depression-era Smalltown USA).

 

It is not easy to predict how and when an instable balance sheet leads to financial crisis.  The point I would want to make here is that crises are inevitable, and China has many of the conditions that give reason to worry.  Unfortunately a lot of regulators, government officials, and bankers seem altogether too skeptical (and sometimes offended) about the claim that China could be at risk, when they should be worrying about contingencies (and to their credit, many people I speak to at the PBoC are concerned). 

 

There are a whole number of interesting and important questions that need to be addressed in order to understand the risks and move to mitigate them.  We need to guess what kind of shocks the national balance sheet is most susceptible to.  We need to figure out what changes need to be made to minimize that susceptibility.  We also need to understand the transmission mechanism from financial shock to economic shock, so that the government can plan what it would need to do to minimize its impact.

 

On this last point I am frankly a little worried.  My model of the world assumes that the greater the flexibility in the financial system, the more moving parts it has, and the clearer the rules of the game, the weaker the transmission from financial shock to economic contraction (the US is the prime example of a well-functioning financial system). 

 

If you agree, then you would have to be very worried about China.  The financial system is completely dominated by the banks, in a way that even Japan wasn’t in the 1980s, and the risk management and credit allocation mechanisms in the banks are rigid, opaque, and inexperienced.  This suggests that a financial shock could strongly affect economic growth.