I would argue that a more compelling reason to raise capital is the almost-certain surge in NPLs over the next three or four years.  In fact I am pretty surprised that these rumors caught the market by surprise.  Every time that banks have engineered a policy-induced surge in lending, they have followed up with a surge in NPLs, and it would be pretty extraordinary if this time were any different.  A refusal to raise capital levels would have been very imprudent, and it is pretty clear that the PBoC and the CBRC are already worried about the impacts of the credit expansion on the banking system.

Raising capital by selling equity is one way for banks to protect themselves from the consequences of bad lending, but I have been arguing for a long time that the main way banks have been recapitalized in the past has been the very wide spread between the PBoC-mandated lending and deposit rates.  This was more or less confirmed in an interesting but perhaps little noticed speech last week by Governor Zhou.  According to an article in Reuters,

China needs to maintain a certain spread between deposit and lending rates in order for banks to be able to support the economy, Zhou Xiaochuan, the governor of the People’s Bank of China, said on Friday. The central bank sets a ceiling on the rates banks may pay depositors and a floor on their lending rates. The built-in margin is a rich source of profit for Chinese banks that strengthens their balance sheets.

Speaking at a forum, the central bank chief also said China must ensure that its pro-investment policies do not lead to overcapacity, which he said was already plaguing some sectors.

The low deposit rates mean that Chinese savers are effectively being taxed to replenish bank capital.  Although this may be necessary in order directly to maintain the health of the banking system, it indirectly undermines the banking system in another way.  By forcing Chinese households not only to subsidize China’s very low cost of capital for producers and SOEs, but also to protect the banks from the effect of economically non-viable policy loans, Chinese households are bearing a pretty hefty share of the cost of China’s investment-led boom, and it is these same households whose surging consumption will be necessary to absorb the increased production resulting from the investment boom.

Given the increased financial burden being placed on them, I doubt that they will be able to do so.  After all, it is because of lesser versions of these same policies in the past that the enormous gap between production and investment exists in the first place.  And if they cannot raise their consumption sharply to absorb all this additional excess production, the banks will be stuck financing rising inventory and unprofitable companies.  It’s a vicious circle.

There is no easy way to resolve this problem, and it is pretty clear that Governor Zhou understands this, at least this is how I interpret his warning about pro-investment policies leading to overcapacity.  Interestingly enough around the same time as his speech the Financial News , a government newspaper, published a PBoC opinion piece that argued, according to an article in the South China Morning Post this week, that the “mainland should immediately halt some of its real estate stimulus policies, or risk inflating a bubble that in its bursting would wreak financial and even social trouble.”

On the same day the CBRC also struck.  According to an article in People’s Daily,

China’s banking regulator on Monday asked the country’s commercial banks to better manage risks and avoid year-end volatility in lending. Commercial banks should ensure that lending increase was kept in a stable and sustainable pace, the China Banking Regulatory Commission (CBRC) said.

Financial institutions with low capital adequacy ratio and no practical remedy plans would face restrictions in various sectors such as overseas investment, branch increase and business expansion, it said.  The CBRC called for enhanced inspections in financial system to detect problems after surging loan extends between the fourth quarter last year and the second quarter this year.

There seems to be a real tug of war.  On the one hand much of China’s industrial and exporting sectors along with provincial and local leaders, are eager to see a continuation of the financial policies that have goosed employment and GDP growth at the expense of domestic consumption.  On the other hand the macro and financial specialists are worried about the growing imbalances and their impacts on the financial sector.  Professor Yu Yonding of the CASS Post-Graduate school, a former member of the Monetary Policy Committee and one of the smartest analysts on China, gave a speech in Melbourne yesterday in which he warned about China’s over-reliance on exports and investment and suggested that the imbalances are worsening, not improving.  I strongly recommend that interest readers check out the speech for themselves.

In part the debate resolves around the issue of financial sector reform, especially of the banking system.  This is an extremely important topic because most economists and analysts, including me, believe strongly that financial sector reform will be one of the most important steps forward for the healthy development of the Chinese economy.  The Chinese financial system misallocates capital on an heroic scale.

A few days ago I was in a debate with a friend of mine about whether or not there has in fact been financial sector reform and liberalization in China, even after the US financial crisis gave anti-reformers what seemed like an unanswerable argument against financial liberalization.  My friend argued that instead of taking the easy way out and backtracking, China has in fact deepened financial sector reforms.  In support he referred to numerous statements by regulators to this effect, and other moves to liberalize finance in China.  For example there is no question that the Chinese bond market is growing.  According to an article in Tuesday’s Financial Times,

Emerging east Asia’s local currency bond markets have tripled as a proportion of the global market since the Asian financial crisis, but remain plagued by poor liquidity, according to a report published on Tuesday by the Asian Development Bank.  It says the region’s local currency bonds outstanding accounted for 6.2 per cent of the global total in the first quarter of this year, compared with 2.1 per cent in the fourth quarter of 1996, on the eve of the 1997-98 Asian crisis.

The $3,658bn of bonds outstanding amounted to nearly seven times the value in 1996, reflecting efforts by governments in the region to strengthen and deepen local bond markets to avoid the pitfalls of extensive borrowing in foreign currencies.

The bulk of the increase reflects a surge of local currency bond issuance in China, which accounted for 3.7 per cent of the global market in the first quarter of 2009, from just 0.2 per cent in 1996.  China remains the fastest-developing market for local currency corporate bonds, growing 87.7 per cent year on year, but the Philippines was second, with 65.8 per cent growth year on year, according to the ADB’s Asia Bond Monitor.

Perhaps more excitingly, foreign firms are likely to be welcomed into China’s domestic bond markets.  Rumors about this started on Monday with a CICC report and then seem to have been confirmed in an article in today’s People’s Daily:

Foreign companies may be able to sell bonds in China within a year as the government expands its domestic capital markets, according to China International Capital Corp (CICC), the No 2 underwriter of yuan debt this year.  ”The first group of future international issuers is likely to be blue-chip companies,” John Cheng, CICC’s investment banking managing director, said in an interview on Tuesday.

Overseas “firms will increase their presence in China and they’ll need to match their growing yuan assets with instruments in yuan, be it debt or equity,” he said.  China is urging domestic companies to tap bond and equity markets for funding and reduce reliance on banks after regulators said record loan growth poses risks. Authorities will consider allowing sales of high-yield corporate bonds to provide new sources of funding, People’s Bank of China Deputy Governor Hu Xiaolian said on Nov 18.

But in spite of the good noises, I am very skeptical about whether there has been real reform or liberalization in the financial sector, especially during the past year.  Why?  Because for me this would involve two main types of reform, on neither of which has there been any advance.  First, interest rates would have to be decontrolled and liberalized in order to remove the financial repression implied by extremely low interest rates.  I see no evidence that this has happened.  Interest rates are as controlled, and as much a policy tool, as ever.

Second, there needs to be substantial improvement in bank governance, so that the lending and investment decision is a function of economic rather than non-economic factors.  This is another way of saying that there must be a reduction in the process that leads to such massive capital misallocation.

Although there have been a series of baby steps in that direction, I would argue that these were completely undermined – reversed, in fact – by the surge in lending this year.  Any chance that the financial system is getting better at making the capital allocation decision was blown away by the events especially of the first half of this year.  The Chinese financial system, I would argue, is less liberalized, and certainly less efficient, today than it was one year ago and even five years ago.  This may sound like an outrageous statement, but reform has to be more than tinkering on the side.  To matter it must address the fundamental problems in the financial sytem – which I believe to be distorted interest rates and weak governance – and I don’t believe either has been addressed.

Finally, I want to mention two additional recent papers that have come out on the Chinese economy.  First is my misnamed “Brief” for the Carnegie Endowment, which discusses the tug-of-war between rising US savings and persistently high Chinese savings and what the consequence are for the global balance and international trade.  Second is a paper called “Overcapacity in China: Causes, Impacts and Recommendations,” released today by the European Union Chamber of Commerce in China.  Full disclosure: I was involved partially in the preparation of the paper.

And for those who celebrate my favorite holiday: Happy Thanksgiving.

But on to grayer topics.  When the US economic data for the third quarter of 2009 came out last Thursday judging by the market reaction it seemed much more mixed to me than it apparently did to others, especially as far as it relates to China.  It is true that after four quarters of negative growth, with GDP contracting 3.8% in the year to July, we finally got positive GDP growth of an annualized 3.5%.  This was above expectations, and given China’s reliance on US overconsumption, the increase certainly seemed to be good news.

Even better, much of that growth was powered by a 3.4% increase in personal consumption, which was itself powered by the rather astonishing 22% increase in durable goods consumption – or perhaps not so astonishing if we chalk it up, as most experts do, to the “cash for clunkers” program.  Americans, it seems, bought a lot of cars in the third quarter of 2009.

As I (and many others) see it, however, this surge in auto sales in the US isn’t likely to represent new and sustainable purchases, and so undermines any optimism generated by the growth in consumption.  The surge in car sales may simply be Americans taking advantage of temporary government subsidies, and to that extent represent not new purchases but rather an anticipation of future purchases.  If that is the case, whatever we get this year in new car sales will result in a reduction next year.

Why am I so negative about the good consumption numbers coming out of the US?  Because the rise in personal consumption was accompanied by a 3.4% decline in household disposable income.  If US household income declines, and this is likely to continue as unemployment rises even further, it is hard to imagine that US households are really going to splurge on new consumption.  Consumption and household income must move in the same direction over any reasonable time period to be sustainable.

As if on cue, this was at least partly confirmed by the subsequent release of September numbers.  As Friday’s Financial Times put it:

US consumer spending stalled in September after climbing in each of the prior four months, dampening spirits, as the effects of government stimulus programmes started to wane.  Personal consumption expenditures fell by 0.5 per cent, or $47.2bn, last month, commerce department figures showed on Friday. The data were in line with the predictions of Wall Street economists, who expected that the expiration of the popular “cash for clunkers” car rebate scheme would hit spending.

In September, spending on durable goods, which includes cars, fell by 7.2 per cent after jumping by 6.7 per cent the previous month.  Incomes were flat in September, slipping by just 0.1 per cent, after ticking up by 0.1 per cent in August. Companies are continuing to freeze pay or cut salaries as they wait to see the shape of the economic recovery.

So in spite of temporarily good consumption numbers, there probably has been no sustainable increase in US consumption, just in government financed spending.  Both China and the US are dealing with their imbalances either by slowing down the rebalancing or by exacerbating the very things that caused the imbalances in the first place.  Slowing down the adjustment makes good political and social sense, of course, but it shouldn’t blind us to the fact that US households cannot continue leveraging up to absorb the excess production that Chinese companies are leveraging up to produce.  We will rebalance, one way or the other.

By the way, and speaking of not rebalancing, net new lending in October might be up.  According to an article in Bloomberg:

China’s four biggest banks granted 136 billion yuan in new loans in October, higher than the previous month, Caijing magazine reported, citing industry data. Bank of China Ltd.’s new loans in October were 44 billion yuan, the most among all the banks, Caijing said. China Construction Bank Corp. lent 36 billion yuan, Industrial & Commercial Bank of China Ltd. granted loans of 33 billion yuan and Agricultural Bank of China lent 23 billion yuan, the magazine said on its Web site.

Resolving the imbalances

The same day the economic numbers were released Tom Holland had an interesting piece in the South China Morning Post on two “new” proposals for solving the Asian side of the destabilizing imbalances at the heart of the global economy – one from the International Monetary Fund and one from Barclays Capital.  The first:

As the IMF points out in its regional economic outlook published yesterday, household savings have actually declined across much of Asia over the past 10 years. Even in China, the personal savings rate has remained more or less constant, which means it cannot be ordinary individuals who are responsible for the explosion in the region’s excess savings.

What’s actually happened…is that saving by Asian companies has ballooned since the crisis of the 1990s. Thanks to energy and land subsidies, cheap credit, low wage costs and lax environmental standards, Asian companies have made bumper profits in recent years.  And because of weak corporate governance, they have been able to retain a large portion of those earnings rather than paying them out to shareholders as dividends, feeding the savings glut.

The answer, according to the IMF, is to strengthen corporate financing options, so companies no longer need to hang on to earnings, while beefing up corporate governance standards to ensure a better dividend payout.  The IMF estimates that raising emerging Asia’s financial market development and corporate governance standards to rich-world levels would lower the region’s corporate savings by 7 per cent of gross domestic product, wiping out the savings glut and going a long way towards rebalancing the world economy.

I think it is widely agreed that there should be a more robust mechanism for forcing SOEs and other large corporations to disgorge their profits and return them to shareholders, including the government, but I wonder if it isn’t a little more complicated than that.  As I see it, SOE profits are not the result of their value creation but are rather more than 100% explained by various subsidies delivered from the household sector.  Without subsidized and controlled interest rates, even ignoring the other subsidies, the most important of which may be the currency undervaluation, SOE profits in the aggregate would be negative.

In that sense SOE profits are simply part of the transfer from household income to the state sector, and the most efficient way to return the money to households is likely to be to raise deposit and lending rates rather than dividend them back to shareholders.  If the shareholders gain access to those profits via increased dividend payments, as I see it we are still seeing a transfer of income from Chinese households to the state sector.

The state may spend it more wisely than the SOEs (something that I would have to see to believe), but unless that money directly or indirectly was sent back to the household sector, perhaps by paying for health care or lower taxes, it doesn’t really address the fundamental problem.  If it goes into state-favored investment projects, there will have been no rebalancing.  I am convinced that Chinese households need to receive a larger share of national income, or their consumption growth will always lag growth in production and high savings rates will persist.

The second new proposal described by Holland:

The emerging-Asia economics team at Barclays Capital have come up with a different solution to the problem. In a report also published yesterday, they argue that the way to get rid of the region’s excess savings is not for Asian countries to save less but for them to invest more. Barclays’ analysts argue that Asia’s problem is not low consumption. Across much of the region, with the exception of China, household consumption ratios are similar to those in the European Union. Instead, the source of the glut is the low level of investment, which has declined since the Asian crisis.

Given Asia’s heavy need for infrastructure, Barclays recommends that governments should use the region’s excess savings to ramp up investment in order to promote future economic development. That certainly appears to be China’s preferred solution. The problem, however, is ensuring that investment is channelled into productive projects rather than misallocated to building excess capacity.  Barclays’ answer is to finance more projects with private, rather than government, capital. That, however, would need financial reform and stronger governance in order to work.

I can’t speak for the rest of Asia, but I doubt that what China needs is a lot more investment.  We seem to have forgotten all the lessons of the overinvestment crises of the 19th and early 20th centuries (and perhaps Japan in the 1980s) in favor of the mantra that increasing investment is always a good solution to whatever the current problem is.  Although there is no question that much of the world probably invests too little (e.g. the US), the idea that there is infinite scope for additional investment is simply not true, and I worry that so much of China’s investment is already non-viable that increasing it significantly can only make matters worse.  Building yet more stuff, if it does not repay the cost of the investment, means reducing future consumption, and it is consumption growth that powers economies over the long term.

Perhaps I am sounding like a skipping CD, but for rebalancing to occur in China we need households to grab a larger share of income.  Any other solution, I think, misses the point.  China entered the crisis with the highest investment rate in history, and probably also one of the highest rates of misallocation of investment in recent times, and then grew it sharply and quickly.  This probably isn’t the solution to low Chinese consumption.

What the 1930s tell us about the coming protection

Finally, Barry Eichengreen and Douglas Irwin have a July 2009 NBER paper out with the title “The Roots of Protectionism in the Great Depression” which examines the relationship between protectionism and monetary conditions.  According to the very helpful abstract:

Previous research has shown that countries that remained on the gold standard tended to endure sharper and longer downturns than those that allowed their currencies to depreciate. Eichengreen and Irwin offer an important trade-policy corollary: without the flexibility to depreciate their currencies, many gold-standard nations turned to trade restrictions in hopes that these would boost their domestic industries and curb unemployment. Thus, the 1930s’ rush to protectionism was not so much a triumph of special-interest politics as it was a result of second-best macroeconomic policies, the authors write. Their study “suggests that had more countries been willing to abandon the gold standard and use monetary policy to counter the slump, fewer would have been driven to impose trade restrictions.”

This was a fascinating paper that covers a lot of the ground in Eichengreen’s magisterial Golden Fetters.  I think the paper (like the book, incidentally) has a lot to say about the current crisis, and the political implications are, I think, a little worrying.  When they argue that countries that were tied to, or late to abandon, the gold standard were the ones most likely to employ protectionist measures, they could also be arguing that countries whose exchange rates are forced untenably high are also more likely to use protectionist measures to achieve adjustment by other means.

In that sense the refusal of Asian central banks to permit the needed appreciation of their currencies against the dollar may end up having the same impact on the adjustment process of the overvalued currencies.  The 1930s seemed to show, according to the authors, that when their currencies could not adjust, countries became protectionist.  So if the overvalued dollar cannot adjust except against the euro, and if the already overvalued euro has to bear the brunt of any further adjustment, will American and European politicians be forced into the “second-best” option of trade protection?  No prizes for guessing what I think.  By the way the chorus of complaints over the currency regime seems to be getting louder.  After Paul Krugman’s piece in the New York Times last week I saw the Financial Times had a pretty strong piecetoday by Alan Beattie called “Renminbi at heart of trade imbalances.”

By the way, Douglas Paal, Taiya Smith, Michael Swaine and I will be speaking at a Carnegie Endowment event, on President Obama’s trip, to China on Thursday, November 5 from 12:15 to 2 p.m.  I have been told that it will be live-streamed and there will be opportunities for questions.  If anyone is interested he can find it here.

China’s banking regulator said it plans to tighten rules on personal loans, seeking to prevent the misuse of funds and curb “irregularities,” especially in lending for auto and real-estate purchases.  The regulations, now being circulated in draft form, are aimed at ensuring loans enter the real economy rather than for speculative purposes, according to a China Banking Regulatory Commission statement posted on its Web site today.

This story has already drawn so much cynical comment from Chinese and foreign observers that I won’t say much more about it.  The second article has Liu Mingkang, head of the China Banking Regulatory Commission, worrying about “blind” expansion among the smaller city banks.  In my last entry I discussed the fact that the bulk of new lending seems to be occurring at the level of city banks and cooperatives, perhaps because they are more easily controlled by cash-strapped local governments, and this may have the result of increasing distress among these banks in the event of an economic downturn.

Perhaps policymakers agree.  According to Xinhua:

Chinese city commercial banks should avoid aiming to expand in terms of size and speed, and ranking among peers, Liu Mingkang, chairman of the China Banking Regulatory Commission, said in a statement posted on the commission’s website Wednesday.   The foundation of the country’s economic recovery was not yet solid, and city banks should pursue prudent growth and pay more attention to and prepare for economic changes, he said.

China’s 136 city commercial banks achieved an average capital adequacy ratio of 13 percent by the end of 2008. Non-performing loans ratios stood at 2.3 percent and the provision coverage ratio was 114 percent.  By the end of June, total assets of city commercial lenders hit5 trillion yuan (732 billion U.S. dollars), up 37.9 percent from a year ago.

Neither of these concerns is especially new, but I have to add that it is becoming harder to go more than a day or two without seeing yet another announcement by the authorities warning about the consequences of the mad dash in credit expansion.  I am not an insider, of course, but it seems to me that we have been getting a rising crescendo of rumors about conflicts and disagreements within policy-making circles about the ultimate consequences of the fiscal and credit stimulus, and it is pretty clear that a lot of people in senior positions are very worried.

Part of the worry, of course, is about rising protectionism.  Today Vice Premier Wang Qishan, who by the way has not turned out to be nearly as visibly active in economic affairs over the past two years as I expected, met in Hangzhou with U.S. Trade Representative Ron Kirk, Commerce Secretary Gary Locke, and Secretary of Agriculture Tom Vilsack.  According to an article in Bloomberg:

The governments of China and the U.S. must “stand firmly together against trade protectionism,” Chinese Vice Premier Wang Qishan said today at a meeting with U.S. officials in eastern China’s Hangzhou city.  His comment underscores an effort to resolve disputes between the two economies, which have $409 billion of trade between them.

Ron Kirk’s more neutral response was that trade frictions are a “normal part of a growing, mature relationship” that should not derail broader bilateral ties.  I don’t want to read too much meaning into these comments, but they do seem to symbolize the growing distance between the perceived interests of the two countries.

Matters weren’t helped by reports of a largely symbolic upcoming launch, by China, of an investigation into whether US carmakers are being unfairly subsidized by the government.  I say this is largely symbolic because I think most US cars sold in China are made here in China.  The Financial Times article on the subject referred to the investigation as Beijing’s “turning the tables” on Washington.  It may well be, but I would imagine that if each country started investigating export subsidies in the other country China would have a hard time winning the argument, and as the trade surplus country most reliant on export markets to absorb its exess capacity, it would be the more vulnerable to trade disputes.  This is not a good argument in which to engage.

Diversifying investment

Meanwhile, and perhaps as a reaction to the sense that too much of the burden of growth is being borne by the government, directly or though the banks, it seems that policymakers want to diversify the funding source.  Wednesday’s People’s Daily has this to say:

China will take more measures to encourage private investment in the next stage of its 4-trillion-yuan ($585 billion) stimulus package, an official with the National Development and Reform Commission (NDRC) said Tuesday.  The NDRC, the country’s top economic planner, will allocate 3 billion yuan of government investment for small and medium-sized enterprises (SMEs) to promote their innovation capability, energy saving and emission reduction, and production condition improvement, said the official.

The government will roll out policies to shore up private investment in expanding market threshold and improving administrative service, according to the official.  The official added that the stimulus investment will support more livelihood projects, and promote innovation and environment protection though he did not elaborate on any specific investment plans.  The NDRC will also strengthen supervision over investment programs to avoid fund abuse and overcapacity, according to the official.

If they are able to decentralize investment decision-making I think that will mostly be positive, since the more we push decision-making down into the hands of people closer to the ground the more informed and intelligent the decisions are likely to be.  I am not convinced however that this is going to happen very quickly.  Previous attempts to diversify decision-making – for example the much-vaunted governance reform of the banks – ended up creating more heat than light.  It is not easy to give up control.

There was another interesting bit in Xinhua Wednesday, this time about industrial profits.

Industrial enterprises in China’s 22 regions reported a combined profit of 1.55 trillion yuan (227.5 billion U.S. dollars) in first nine months, down 9.1 percent year on year, the National Bureau of Statistics (NBS) said Wednesday.  NBS statistics showed the decline was 4 percentage points less than that of January-August period.

Altogether 35 of the 39 major industrial sectors realized profit growth or smaller profit declines compared with the first eight months, said the NBS.  Core business revenues of those companies reached 28.8 trillion yuan in the first nine months, up 3.4 percent from a year earlier. The growth rate was 1.5 percentage points higher than that of the first eight months.  The accounts receivable of enterprises in the 22 regions stood at about 3.56 trillion yuan at the end of September, up 10.6 percent year on year.

A number of my economist friends are very puzzled that furious economic growth seems to come hand-in-hand with declining profitability.  I am not sure I fully understand why this might be happening, but I will add that to me profitability is not a very useful measure of economic value-added in China since, as I see it, there are huge subsidies provided to manufacturers in China in the form especially of low interest rates – as well, of course, as other things such has controlled prices for land, energy and other commodities.  In that case changes in profitability are at least as likely to reflect changes in the nature of the subsidies as they are to reflect changes in underlying economic conditions.

To return to a subject carried in my last two posts, the People’s Daily also had an interesting comment (titled “Metal stockpile sell-off unlikely”) on commodity stockpiling, probably in response to the increasing discussions on that topic.

Chinese investors holding metal inventories are unlikely to sell them quickly because of adequate levels of cash on hand, a senior executive at Sucden Financial Ltd said yesterday. The downside risk to metals prices is limited due to high liquidity, Jeremy Goldwyn, who oversees business development in Asia for London-based Sucden, said in an interview at a Hong Kong conference. Copper prices may rise to record levels sometime next year, said Goldwyn.

Inventories of copper at warehouses monitored by the Shanghai Futures Exchange are more than five times the level at the beginning of the year after 4 trillion yuan in stimulus spending and State stockpiling boosted imports to a record. Prices in London have more than doubled this year on record Chinese imports.  “The view is that China has seen high imports and that these inventory levels were maybe getting excessive and maybe forming a downward pressure on imports and demand,” Martin Squires, executive director at JPMorgan Securities Ltd in London, said.

Consumer stockpiles of copper, excluding government inventories, could be as much as 600,000 to 700,000 metric tons, said Squires.  Inventories of copper at Shanghai warehouses stood at 95,976 tons last week, up from 17,822 tons at the start of the year. China’s copper imports more than doubled in the first nine months to 2.6 million metric tons, according to customs data.

Private Chinese investors may have stockpiled more than 50,000 tons of copper and as much as 20,000 tons of nickel, Goldwyn said on Sept 17. Chinese smelters may have between 200,000 and 300,000 tons of lead stockpiled, he said then.  Gauging metals demand in China is notoriously difficult amid increased speculation by retail investors. A possible overhang in supply amid high imports and production threatens to damp demand, Chen Hongzhou, vice-manager of the marketing department at Chinalco Luoyang Copper Co, said.

University rankings

Finally, and this is on a completely different subject, although one that interests me a great deal and might interest readers looking for some color on China, People’s Daily Tuesday hailed the creation of “China’s Ivy League”.

China’s Ministry of Education voiced on Monday its support for the formation of C9, an academic conference comprising nine domestic prestigious universities and referred to as China’s Ivy League by some experts.

Xu Mei, the ministry’s spokeswoman, said the establishment of the conference is a “helpful attempt that is conducive to the country’s construction of high-quality colleges, cultivation of top-notch innovative talents and enhanced cooperation and exchanges between Chinese universities and their foreign counterparts.”

On October 12, nine institutions of higher learning including the elite Peking University and Tsinghua Univerisity signed cooperative agreements that featured flexible student exchange programs, deepened cooperation on the training of postgraduates, and establishment of a credit system that allows students to win credits through attending classes in member universities of C9.

Other universities are Zhejiang University, Harbin Institute of Technology, Fudan University, Shanghai Jiao Tong University, Nanjing University, University of Science and Technology of China, and Xi’an Jiaotong University.

For those not familiar with the hierarchy within Chinese university system, there are two schools that are considered without reservation to be at the pinnacle of China’s universities, Peking University (known popularly as Beida) and Tsinghua University.  Both are in Beijing’s northwestern Haidian district (also known as the university district since most of Beijing’s most famous schools are located here) and in fact across the street from each other.  I was lucky enough to teach at both, my first four years at Tsinghua and now, for four years and counting, at Beida, and I have to say that they probably have on average the smartest student bodies in the world.

To get an idea of their dominance, every year the national exams produce two “provincial champions” for each of mainland China’s 31 provinces, municipalities (the four that have provincial status), and autonomous regions – one for each of the two high-school study tracks, hard sciences and humanities.  Of these, on occasion you might get one of the “provincial champions” choosing to go to a school other than Beida or Tsinghua, but most years every single one will choose to attend either of the two premier universities.  Beida tends to get more overall, and Tsinghua tends to get more of the hard science champions, although in recent years the discreet competition between the two has suddenly burst out into the open and the gloves taken off.  They have been much more aggressive about offering scholarship money to the top candidates in an effort to affect their choice (by the way, you cannot apply to more than one school).

Below these two there are a number of highly selective universities that compete for the rest of the students.  I was pretty aware that all the named schools except the last two were part of China’s “Ivy league”, but of course there are other highly selective schools that might have had Ivy pretensions.  In particular I was under the assumption that Sun Yat Sen University, the Foreign Service University in Beijing (although perhaps too specialized), and Nankai University in Tianjing might have qualified as being among the most selective, along with one or two others, like Wuhan and Jilin and maybe even People’s University in Beijing (popularly known as Renda).  For those interested, CASS ranks the top schools, although I am not sure about the criteria.

Beida versus Tsinghua

Because I spent so many years in both I am often asked about the differences between the top two schools, and I have to say that to me the differences are not nearly as great as are popularly supposed.  They both draw from nearly the same pool of students but there have been and still are some small cultural differences that seem to be wearing away over time.  Tsinghua has historically been heavily male while Beida historically had a slightly larger percentage of females, probably reflecting the fact that Tsinghua was for a long time primarily an engineering school (MIT is often invoked as a model) whereas Beida specialized in arts and pure sciences.  Both are moving towards a more balanced student body and academic orientation although Beida is where you still are more likely to find a philosopher or a physicist and Tsinghua an engineer.

I am very involved in helping my students get jobs in the financial services industry and so I know that Beida is by far the favorite school among global investment banks – probably placing more students in these highly-desired jobs than the next two schools combined (Tsinghua and Fudan).  Finance is the top major at each school, or one of the top two, meaning that it has the highest minimum required admission score for students who have taken the all-important gaokou, the university entrance exam that most high-school seniors take.  To give an example of how popular it is, last year 24 “provincial champions” chose to enter the Guanghua School of Management at Beida, the most prestigious of the three faculties in Beida that offer economics/finance majors.  I suspect that the School of Economics and Management at Tsinghua has a similar number, implying that around two-thirds of China’s stop students want to be bankers.

I like to think that Beida’s success in placing students in these jobs is because of my influence, but I suspect that it is more because Beida is in the front line in China in liberalizing and reforming education.  Beida students are far more likely, for example, to be required and able to take courses outside their major than students from other schools, including Tsinghua, and tend to have much more varied resumes.  You are more likely to meet a Beida finance major chattering excitedly about his philosophy or literature class than one from Tsinghua.  They also tend to be more encouraged to have outside activities and internships.  Given the extremely narrow specialization and heavy course burden of Chinese universities I think this is unquestionably a good thing, and creates more well-rounded students with greater leadership potential.

Beida is famous in modern Chinese history as being the cradle of Chinese cultural and political change.  In my first year there I asked one of my students, a sophomore from Shandong province, why he had decided to come to Beida rather than Tsinghua.  He smiled shyly but also a little proudly and said: “Because Beida is the edge of history.”  What a great answer!

But even there I suspect that the differences between the two schools are more apparent than real.  In my experience Tsinghua students are as likely to be politically active (and even fairly radical) as Beida students, and I have political discussions at equally high levels of sophistication at both schools, although perhaps my sample is heavily distorted because at both schools I dealt mostly with economy and finance majors.  Tsinghua’s engineers on average may be less politically sophisticated than Beida’s philosophy or government majors.

There is by the way, and perfectly in line with conventional views about philosophers and engineers, a wide-spread perception that Beida-educated leaders are more imaginative and Tsinghua-educated leaders more effective.  A Tsingua professor even told me two years ago that given the risky changes China is undergoing, the Standing Committee needs more Beida graduates and fewer Tsinghua graduates.

Most of these kids at these two schools, however, are amazingly bright and hard-working, a description I would extend to the students of any of China’s top universities.  With such a huge population all so eager to get into the top schools (and China is so hierarchical that everyone pretty much ranks the schools in exactly the same way – although recently there has been a rankings scandal), you can be sure that students at any of the listed schools are pretty impressive.

This is part of the reason I have stayed so long in China – for me there are few things as much fun as teaching very bright kids.  Unfortunately I think the quality of education is pretty low, and especially inappropriate for the brightest students.  Such bright kids need less rote work and memorization and more opportunities to think outside the box – a practice frowned upon within the educational system.  In that sense I think Beida is a real leader, moving Chinese elite education in a much better direction overall.

So much ink has been spilled in discussing these numbers that I won’t try to summarize, but it is worth noting that for many analysts the numbers were a very positive surprise.  Typical was this Reuters report reprinted in the New York Times:

China reported surprisingly strong trade figures on Wednesday, providing fresh evidence that the world’s third-largest economy is firmly on the path to recovery and that global demand is improving too.

…Brian Jackson, an economist at Royal Bank of Canada in Hong Kong, said the slower pace of decline was good news for China’s recovery because growth this year has depended too much on the government’s 4 trillion yuan ($585 billion) stimulus package.

But even in this article there were hints that the numbers, especially the import numbers, might not be as positive as expected.

Commodities were a driving force behind the sharp improvement in imports. China bought a record 64.55 million tons of iron ore in September, up 30 percent from August; imports of copper rose 23 percent.

Merrill Lynch’s October 14 research report puts it this way:  “Commodity import growth was stunning.”  Andrew Batson in an article in today’s Wall Street Journal explains why the high commodity share of imports might not be as positive an indicator of surging demand as the headline numbers suggest:

A pickup in China’s metal imports in September is stoking debate about how much of the nation’s commodity intake this year is driven by demand and how much is stockpiling that will soon end.

…The trade figures issued Wednesday showed China’s imports of copper rebounding from July and August slowdowns to post a 87% rise from a year earlier. Iron-ore imports also hit a monthly record, at 64.55 million tons in September, up 65% from a year earlier. The gains in imports defied many forecasts that purchases would slow after China took advantage of low prices early this year to build up stocks of many commodities. The data could be a signal that underlying demand for raw materials is stronger than first thought.

I read the data differently – not so much as evidence that demand is stronger then we thought but rather that real imports are weaker than we thought.  According to the October 14 research report by Mark Williams, of Capital Economics, “We do not expect the trend to last. China’s recovery is being driven by investment, but the recent pace of commodity import growth has been much faster than justified by the rise in current demand.  Inventories of many metals have more than doubled since the start of the year (copper inventories are up 500%).”

I think I agree with Mark.  I already discussed in last week’s entry the recent conversations I have had with chemical and steel analysts and investors who were puzzled by their inability to match China’s imports with any reasonable estimate of the end use of these products.  One place where we might see the discrepancy is in a rise in inventories, but although these have been rising, they haven’t been rising fast enough to account for the differences.

Are investors stockpiling?

It seems that there may be another explanation, and that is stockpiling by private investors.  From what I am being told, it seems that a number of wealthy Chinese investors have been speculating directly in commodities, and so some of this inventory buildup is occurring not at the company level but at the investor level.  The Wall Street Journal article mentions this possibility:

Copper stockpiles also have increased. Royal Bank of Scotland analysts estimate that as much as 900,000 metric tons of unreported copper stocks have built up in China this year. There has been some official purchasing by the State Reserves Bureau, but also a lot of private traders buying imported copper because it could be resold for a higher price domestically.

I have no information about how these positions might be financed, if this is true, but I would worry if they were debt financed, and I would worry even more if corporations were financing them indirectly by lending to principles.  Shang Ning, the very smart secretary of the PBoC Shadow Committee seminar I run at Peking University, has been trying to figure out ways of indirectly measuring this kind of stockpiling, but frankly we don’t as of yet have any very good ideas.

Clearly a lot of policymakers are worried about excess commodity stockpiles.  Earlier this week Bloomberg reported on plans to curb steel production.

China, the world’s largest steel producer, is working on plans to curb excess capacity as the nation faces “severe oversupply,” according to the nation’s third-largest mill.  The government may have detailed plans on how to close obsolete mills, advance mergers and reduce the number of iron ore importers by the end of the year, Deng Qilin, the general manager of Wuhan Iron & Steel Group, said in an interview.

…“The government will impose strict measures to effectively close outdated mills and boost consolidation,” Deng, also the chairman of the China Iron and Steel Association, said while attending the World Steel Association annual meeting in Beijing yesterday. “We bigger players will surely benefit from such a move.”

There is more than just steel.  An article in yesterday’s Xinhua reports the following:

The National Development and Reform Commission (NDRC) will mainly redress production overcapacity in six sectors, said Chen Bin, director of the Department of Industry of the NDRC, Thursday.  The six sectors include steel, cement, plate glass, coal-chemical industry, polycrystalline silicon and windpower equipment.

The NDRC also warns of obvious production overcapacity in sectors like electrolytic aluminum, ship manufacturing and soybean oil extraction, said Chen during an on-line interview on www.gov.cn., the website of China’s central government.  He said China would fight serious overcapacity in sectors like steel industry and offer guidance for new-born industries like windpower equipment to avoid low level repetitive construction.

China has achieved preliminary progresses in fighting the global economic downturn, but the foundation for economic recovery is not stable yet and overcapacity might lead to bankruptcy, unemployment and bad bank loans if it was not checked in time, he said.

Industrial policies create overcapacity

I agree with the last paragraph, but otherwise I am pretty skeptical about the fight against overcapacity.  According to my model of China’s overcapacity problem, the source of the imbalance is a set of industrial policies that systematically shift income from households to producers, and as long as these policies continue there is little chance of resolving the problem of excess production.  I have a longish piece coming out next month as a Carnegie Brief on the Carnegie Endowment website, in which I discuss this as part of a discussion about why I expect a rising US savings rate to lead almost inexorably to trade tensions.  Here is the relevant section from the first draft:

Although China is still a very poor country, there is no question that Chinese household income has grown substantially over the past few decades, but it has not grown nearly as quickly as GDP.  While China’s GDP grew at 11-12% over the 2002-2007 period, for example, MIT economist Yasheng Huang estimates that household income grew at a much lower 9%.  If we were able to adjust Huang’s measure to take into account changes in other forms of household wealth – which are described below – growth in household income would have been even lower.  This is why consumption has declined as a share of national income, and why China’s total production has exceeded its total consumption by a large and growing amount.  This is at the root of China’s high savings rate.

Why haven’t Chinese households maintained their share of national income?  Largely because the rise in household income was constrained, especially in the last decade, by industrial polices which were aimed at turbo-charging economic growth.  These policies systematically forced households implicitly and explicitly to subsidize otherwise-unprofitable investment in infrastructure and manufacturing.  Although these policies powered employment and manufacturing growth, they also led to wide and divergent growth rates between production and consumption.  These policies included:

• • An undervalued currency, which reduces real household wages by raising the cost of imports while subsidizing producers in the tradable goods sector.
  • Excessively low interest rates, which force households, who are mostly depositors, to subsidize the borrowing costs of borrowers, who are mostly manufacturers and include very few households, service industry companies or other net consumers.
  • A large spread between the deposit rate and the lending rate, which forces households to pay for the recapitalization of banks suffering from non-performing loans made to large manufacturers and state-owned enterprises.
  • Sluggish wage growth, perhaps caused in part by restrictions on the ability of workers to organize, which directly subsidizes employers at the cost of households.
  • Unraveling social safety nets and weak environmental restrictions, which effectively allow corporations to pass on the social cost to workers and households.
  • Other direct manufacturing subsidies, including controlled land and energy prices, which are also indirectly paid for by households

By transferring wealth from households to boost the profitability of producers, China’s ability to grow consumption in line with growth in the nation’s GDP was severely hampered.  Of course the gap between production and consumption is the savings rate, and as production surged relative to consumption, a necessary corollary was a rising Chinese savings rate.

The basic problem, then, is that there are very powerful policies that force a discrepancy in production and consumption growth, and the only way to eliminate overcapacity is by reversing these policies.  I am not sure that attempting to address overcapacity by administrative means can succeed, and certainly the track record of other efforts over the past year to address the imbalance doesn’t suggest otherwise.

The trade impact

In the steel sector here is one consequence of the continued surge in production, according to an article in this week’s Financial Times:

The unexpectedly swift recovery in China’s steel production has sparked fears that a glut of exports could puncture steel prices as the global industry struggles to emerge from the economic downturn, rival steelmakers have warned.  SK Roongta, chairman of the Steel Authority of India Ltd (Sail), said Chinese over-production was “a point of concern” for the world’s steel producers.

During the past year, producer margins have come under severe strain from falls in prices and high input costs. Global output fell more than 20 per cent in the first half of 2009.  The head of India’s largest state-owned steel group said that Chinese production accelerated 15 per cent in the past quarter, beating forecasts of just reaching double-digit growth.

“We believed that China would grow, but the growth in the past three to four months has certainly been a surprise. I’m not sure this level can be sustained,” he said.  “The magnitude of the growth is a surprise; not the growth per se.”

Meanwhile on Tuesday in the New York Times the always-perceptive David Barboza spells out very explicitly the implications in a much-discussed article titled “In Recession, China Solidifies its Lead in Global Trade”:

With the global recession making consumers and businesses more price-conscious, China is grabbing market share from its export competitors, solidifying a dominance in world trade that many economists say could last long after any economic recovery.

…China is winning a larger piece of a shrinking pie. Although world trade declined this year because of the recession, consumers are demanding lower-priced goods and Beijing, determined to keep its export machine humming, is finding a way to deliver.  The country’s factories are aggressively reducing prices — allowing China to gain ground in old markets and make inroads in new ones.

There are lots of reasons given for why China is able to increase its market share so dramatically, but there is little doubt in my mind that this process will cause rancor and increasing hostility, especially among trade competitors, and the focus will be on policies that continue to subsidize manufacturers.  Barboza goes on to say:

One reason is the ability of Chinese manufacturers to quickly slash prices by reducing wages and other costs in production zones that often rely on migrant workers.  Factory managers here say American buyers are demanding they do just that.

…Because China produces a diversified portfolio of low-priced and essential items, analysts say the country’s exports can hold up relatively well in a recession.  Few other countries can match what has come to be called the “China Price.”

“China has a huge advantage,” says Nicholas R. Lardy, an economist at the Peterson Institute for International Economics in Washington. “They can adjust to market changes very rapidly. They have flexibility in their labor markets. And as consumers trade down the quality ladder, China can benefit.”

The expiration of textile quotas in large parts of the world this year has also allowed China to increase its market penetration.  But equally important are government policies that support this country’s export sector — from Beijing keeping its currency weak against the dollar to its determination to subsidize exporters through tax credits and billions of dollars in low-interest loans from state-run banks.

Although the “wage flexibility” enjoyed by Chinese corporations may seem like a huge advantage, remember my earlier comments about how sluggish household income growth relative to GDP growth is the source of the overcapacity problem (consumption is likely to grow as fast as household income grows).  If I am right, it means that measures that can improve China’s export competitiveness are not good for the rebalancing effort if they exacerbate, rather than reverse, the process of transferring income from households to corporations.  Lower wages, of course, do just that, and so they cannot be a solution to China’s underlying overcapacity problem except to the extent that they allow China to expel trade competitors.  This is not a permanent solution by any means, especially in a world of rising trade tensions.

New loans still soaring

There are two pieces of related recent news.  The first, released on the same date as the trade data, was the PBoC announcement of new loans for the month of September.  According to an article Wednesday in Xinhua:

China’s new yuan-denominated loans in September rose to 516.7 billion yuan (75.68 billion U.S. dollars) from August’s 410.4 billion yuan, the People’s Bank of China, the central bank, said Wednesday.   New yuan-denominated loans in the first nine months stood at 8.67 trillion yuan, 5.19 trillion yuan more than the same period last year.

China’s foreign exchange reserve hit a new high of 2.2726 trillion U.S. dollars at the end of September, according to the central bank.  China’s monthly new loans had slowed from June’s high of 1.53 trillion yuan to 355.9 billion yuan in July as a result of bank contracting credit and the central bank’s open market operations. The figure rose to 410.4 billion yuan in August and then to September’s 516.7 billion yuan.

The broad measure of money supply, M2, which covers cash in circulation and all deposits, was up 29.31 percent from a year earlier to 58.54 trillion yuan at the end of September.   The narrow measure of money supply, M1 (cash in circulation plus current corporate deposits), was up 29.51 percent to 20.17 trillion yuan.

I think most people were surprised by the September net new loan number, expecting something in the RMB 450 billion range (last September total new lending was RMB 378 billion).  Although the current new lending of RMB 517 billion  is much lower than the astonishing RMB 963 billion monthly average this year, when you include the net paydown of bill financing in September of RMB 353 billion, the total new medium and long-term financing in September was actually RMB 870 billion.  This suggests that in fact September lending was equal to this year’s monthly average (especially if you think of the explosion in bill financing early this year as a form of “anticipated” lending).

Regular readers of my blog will know that I have no doubt that this kind of loan expansion can only make the overcapacity problem worse, since either it directly boosts current or future production, or, by leading to a rise in NPLs that will ultimately be paid for by Chinese households, it constrains future consumption growth. Interestingly enough, according to an analysis in Caijing, the share of new loans from the Big 4 was only 21%.  This is down substantially from 40% in August, 47% in July, and a whopping 70% in the first six months of 2009.

What gives?  For one thing, it means that most of the decline in lending from the insane levels of the first half of the year is explained by the decline in lending among the Big 4.   It is not so much that new lending is being pushed downward, since the smaller banks are increasing their lending at roughly the same rate as they have all year.

Chen Shanshan, an analyst at Bocom International Holdings, said large commercial banks scaled their lending after regulators tightened credit controls at the start of the third quarter.  Also, medium-sized banks saw their lending capabilities restrained by the tighter regulatory controls on capital requirements, he said.

“Banks are now actively selling loans,” and mostly selling them packaged as syndicated loans, an executive with a large commercial bank told Caijing.

I am not sure from this whether they are selling down to other banks or to investor groups.  Any color from any of my readers would be much appreciated.  As an aside on the reserve numbers, I haven’t done the numbers yet, and I have not had a chance to discuss this with Medley’s Logan Wright, but my initial back-of-the-envelope calculation suggests that hot money inflows may have moderated but are still positive.

The second piece of related news was the release yesterday by the US Treasury Department of its semi-annual report on exchange rate policies.  “Both the rigidity of the renminbi and the reacceleration of reserve accumulation are serious concerns which should be corrected to help ensure a stronger, more balanced global economy consistent with the G-20 framework,” the report said. “The Treasury remains of the view that the renminbi is undervalued.”

While the People’s Daily headline today was “U.S. says China not currency manipulator”, and most of the focus of the article was positive (although it did acknowledge that “it also alleged that the Chinese currency renminbi’s exchange rate showed a ‘lack of flexibility’ in recent period”), the Financial Times article was a little more nuanced:

The Obama administration said on Thursday that it had “serious concerns” about the value of the renminbi, but stopped short of accusing China of manipulating its currency in a closely watched report to Congress.

The Treasury toughened its language on China in its semi-annual report on exchange rate policies. While acknowledging that Beijing had been important in steadying the global economy, it said recent moves to accumulate more foreign exchange reserves “risk unwinding some of the progress made in reducing imbalances”.

But the Treasury did not say China was manipulating its currency, in spite of pressure from US labour groups and scores of legislators who argue that the undervalued renminbi makes China’s exports unfairly cheap . Pressure has built this year as manufacturers suffer huge job losses and the US unemployment rate creeps towards 10 per cent .

I am willing to bet that over the next year or two the language gets tougher, not easier.

Finally, I saw the following very interesting article on today’s Bloomberg:

China’s Ministry of Finance is, for the first time, allowing local governments to use the proceeds of land sales to fund stimulus projects, the China Daily reported, citing a ministry circular.  Local governments are required by the end of this month to have provided 1.18 trillion yuan ($173 billion) out of the 4 trillion yuan stimulus plan announced by Premier Wen Jiabao in November, the English-language paper said. Many local governments are finding it difficult to secure funds for projects because of the economic slowdown, the newspaper said.

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

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

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

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

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

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

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

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

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

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

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.

US debt and the dollar

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

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

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

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

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

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

Debt and risky debt structures are rising

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

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

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

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

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

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

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

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

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

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

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

Recent economic data

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Data from the National Association of Industry and Commerce (NAIC) showed that in January of this year, private firms had 421 billion yuan in short-term loans, a 700 million yuan decrease from December 2008. That was despite 400 billion yuan in new short-term loans released that month.

The article goes on to mention a survey of businesses in Chongqing that indicated that 82% of small and medium-sized businesses there considered the lack of funds the main hindrance to their development. Quoting Chen Yongjie, an official with the National Association of Industry and Commerce, the article goes on:

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

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

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

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

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

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

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

The article goes on to say:

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

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

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

Exactly why is this process dangerous?

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

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

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

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

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

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

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

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

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

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

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

“Odd, this neurotic tendency in the American businessman. Can you account for it? I can. Too much coffee.”

“Coffee?”

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

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