One of the few areas in which the Chinese fiscal stimulus package is unquestionably having a positive effect is on growth forecasts – although mainly because forecasts seem to be coincident indicators more than leading indicators. In the past couple of week Morgan Stanley raised its 2009 forecast for Chinese GDP growth from 5.5% to 7.0%, while Goldman Sachs upgraded growth forecasts from 6.0% to 8.3%. UBS has raised its forecast from 6.5% to between 7% and 7.5%. RBS has jumped from 5% to 7% and Barclays is up from 6.7% to 7.2%. On the other hand Standard Chartered, worried about the sustainability of the “rebound,” has kept its 2009 GDP growth forecast at 6.8%, and the IMF is still at 6.5%

At any rate I’ve never provided my own forecast of Chinese growth partly because I am not smart enough to come up with an economic forecast and partly because it always seemed to me that in the short-term Chinese growth was going to depend very heavily not on economic conditions but rather on the hard-to-predict outcome of the fierce policy debate taking place in China. As I see it, one side of the debate – which seems to include people around the PBoC and the National Bureau of Statistics, along with many of the more prominent of the think-tank policy critics – is arguing that as difficult as it is, the crisis is a good occasion to force China to change its development model and financial system in a direction that will provide China with a healthier basis for stable, long-term growth. They are eager to see policies aimed at switching resources from production to consumption, even at the expense of a short-term increase in unemployment, and they tend to see the recent surge in credit and investment not as solutions to the crisis but rather as policies that will make things worse for China in the medium term.

On the other hand a different group of policymakers and power brokers – who include, I think, the Ministry of Commerce, the important exporter constituencies, and above all the powerful provincial and municipal leaders – are much more concerned with enacting measures that immediately address the expected rise of unemployment in the short term. These measures include pouring money into investment – mainly into infrastructure and the SOEs – and of course the huge increase in bank lending. They often point out that these policies saved China after the 1997-98 crisis, and so can save China again.

As an aside, and without wanting to take the 1930s analogy too far, this debate in China is a little like the split in the 1930s between the internationalists in the US who favored hard money (incorrectly, I think) and a rapid liquidation of overcapacity (painful but probably correct), and who vehemently opposed measures, including tariffs and competitive devaluations, to boost employment via boosting the export of overcapacity, versus the large and powerful constituencies, dominated by local congressmen, miners, farmers and many industrialists, who stressed immediate moves to weaken the currency, boost production, and resolve US unemployment even at the expense of the global system. In part because the 1929 stock market collapse thoroughly discredited bankers and economists, and in part because politicians are always more likely to be influenced by large domestic constituencies than by internationalists, the latter group pretty resoundingly won the debate, at least in the early part of the crisis, and clearly not to the US’s obvious benefit.

Although the debate is much less transparent in China today than it was in the US in the early 1930s, I think the latter group – the domestic constituency and provincial leaders – is once again winning the debate, at least for now. It is probably no surprise to regular readers of my blog that I largely disagree with this camp, and the main reason I didn’t want to forecast very low 2009 GDP growth numbers with much confidence is because I doubt the former group will win the debate. As I see it, the massive expansion in credit and investment we are experiencing is simply more of the same set of policies that, especially over the past five years, have pushed China ever deeper into the Asian development model, and to the extent that they are successful they will keep pushing China, which I think of as exemplifying the Asian development model on steroids, in the same direction. Beijing, in other words, is increasing the dosage of steroids. (I think I am mixing metaphors all over the place.)

The reason I think this is a mistaken strategy is because I would argue that the Asian development strategy is dead, and over the next three to five years it will become increasingly evident that 2008 was the year it died. I may be wrong, of course because it is doubtful but not inconceivable that the great consumption party in the US can resume for a few more years. It would not be the first time that what seemed like an unstoppable correction in the trade imbalances was interrupted. To a certain extent we already saw a dress rehearsal for this event in the 1987 crash, around which time the US trade deficit, which had risen to around 3.5% of GDP the year before (a level which seemed unimaginably high at the time), began its inexorable reversion, to the point where the US achieved a small surplus in the early 1990s.

The period during and after the 1987 crash more or less marked the end of that stage of the Japanese miracle, although by then Japan was so caught up in the monetary expansion that had begun with the automatic monetizing of its massive trade surplus with the US in the early 1980s, that an internal bubble kept the local party going for another 2-3 years before it, too, finally ended, and ended disastrously – although many people, especially here in China believe, mistakenly in my opinion, that the bubble was set off by the Plaza Accord.

But the Asian development model didn’t really die then (although the temporary shift in US consumption may have created the serious dislocations that helped lead to the 1997 crisis). At the time the US was itself caught up in great productivity and liquidity growth cycles that kept the model alive by causing a surge in US growth and, later, an even more rapid surge in US consumption.

The rise of US savings

What does the structure of US growth have to do with the Asian development model? As I see it the Asian development model involves polices that aim directly or indirectly at boosting savings and channeling huge amounts of subsidized resources (usually subsidized by savers, and so constraining consumption) into investment and manufacturing capacity. Some people call this mercantilism, and in many ways it does correspond to certain classic mercantilist policies, but I am wary of defining it this way because “mercantilism” is such a loaded word.

At any rate because the combination of consumer constraint and producer subsidy meant that growth in production was likely seriously to outstrip growth in consumption, the Asian development model necessarily involved generating large and consistent trade surpluses – either Asian countries exported the difference between consumption and production or they would have been forced to run up ever increasing inventory. Of course for small countries, running trade surpluses didn’t matter too much – and it made sense to have a strong external outlook because domestic markets weren’t big enough to create the necessary efficiencies and economies of scale to justify the huge investment, and their individual trade surpluses were easily buried within overall global trade.

In other words for small countries the need to export is not likely to be a constraint since they can always generate trade surpluses without creating significant global trade distortions. But when large countries, or a large grouping of countries, have policies aimed at generating trade surpluses they run into a very strict constraint – that some country or group of countries must be capable and willing to run large corresponding trade deficits. Without this willingness to run trade deficits, the Asian development model must inevitably run into brutal 19th-Century-style cycles of rapid production growth leading to overinvestment crises.

This is the main vulnerability of the Asian development model – its dependence on an importer of last resort. We don’t often think of this as a weakness because for so long the US was seen as the automatic importer of last resort, so much so that we didn’t even consider it a constraint. But we may have gotten lazy in our thinking. Many people who should know better simply write off US consuming habits as something endemic to American culture, and we just assume it as a universal constant, but in fact US consumption levels, like those of every other country, respond to changes in conditions, and these are about to change.

There are at least two reasons for the change. The first has to do with specific policy initiatives, and the second with changes in underlying economic conditions, especially household balance sheets. To address the first, I will refer to President Obama’s economic speech last week when he said: “We must lay a new foundation for growth and prosperity — a foundation that will move us from an era of borrow and spend to one where we save and invest, where we consume less at home and send more exports abroad.”

A New York Times editorial draws from Obama’s speech at least one important implication for the future growth of China and Asia:

In a series of comments in recent weeks, Mr. Obama has begun to sketch a vision of where he would like to drive the economy once this crisis is past. His goals include diminishing the consumerism that has long been the main source of growth in the United States, and encouraging more savings and investment. He would redistribute wealth toward the middle class and make the rest of the world less dependent on the American market for its prosperity. And he would seek a consensus recognizing that an activist government is an acceptable and necessary partner for a stable, market-based economy.

…Embedded in that approach is a far-reaching implication: that the rest of the world should no longer count on the United States to snap up imported goods or run up large trade deficits. It is by no means clear that Mr. Obama has the policy tools needed to bring about that kind of change; we are, after all, fundamentally a consumer society. His advisers point to his support for innovative ways of increasing personal savings.

We should never underestimate the immense flexibility of the US and its ability to restructure itself at a pace far faster than most other countries can manage (anyone who grew up in the dismal 1970s will remember the dramatic – and seemingly improbable – US economic transformation of the 1980s), and if the Obama administration is serious about creating conditions for an increase in US savings, it probably wouldn’t be a good idea to bet heavily against success..

Negative US consumption growth?

More importantly, during the past decade while the US was growing rapidly, the US trade deficit surged from just over 1% of GDP to over 7% of GDP. When consumption growth exceeds GDP growth, which must happen when the trade deficit is growing, it necessarily implies a build-up of debt, and sure enough, debt levels in the US surged while savings collapsed to zero and the trade deficit grew rapidly.

Those days are almost certainly over. Even without Obama’s desire to create conditions for an increase in US saving rates, US households have to increase their savings and rebuild their balance sheet, which means that we have several years ahead of us of deleveraging and increased savings. It also means we have several years ahead of US consumption growing more slowly than US GDP. I don’t think anyone is expecting much net growth in US GDP for the next three or four years, and so it is not at all implausible that we will see negative growth in US consumption and, as a consequence, a collapse in the US trade deficit, which may even turn into a trade surplus. The pace of this transition will largely depend on US fiscal policies aimed at slowing, but not eliminating, the contraction in demand.

If the US is no longer the importer of last resort, and if no one else can replace the US in that role in the medium term (I stress medium term because in the long term the demographic changes in Europe and Japan – and China for that matter – may well result in rising trade deficits in those countries), then any development model that necessarily results in production growth exceeding consumption growth – high savings development models, in other words – will run into the trade deficit constraint. They must run surpluses to grow, but if no one else runs sufficiently large deficits, they simply cannot run those surpluses.

This is what I mean about the “death” of the Asian development model. The not-so-hidden but also not-always-explicit assumption behind Chinese growth – with China, as I wrote earlier, representing the Asian development model on steroids – is that large and growing US trade deficits were vital to its success. But if the US is now entering a period of contracting deficits, the model is dead.

This is why I am worried about recent fiscal and credit policies. It is not just that these policies are slowing down the rate at which China will adapt to the new world of lower US trade deficits. More importantly perhaps is that the only obvious replacement for US demand – domestic Chinese demand – will itself be sharply constrained by current policies, especially credit policies.

Why? Among other things because if the explosion in new lending (loans are up 15% in the first quarter of this year) leads, as it almost certainly will, to a subsequent explosion in non-performing loans, in the next few years just as China is expanding its production and struggling with US reluctance to absorb its rising excess capacity, the resolution of the NPLs will itself constrain Chinese consumption. Resolving future NPLs, in other words, will reduce future domestic consumption growth in China, just as the current resolution in the US of bad loans and shattered household balance sheets must come with reduced US consumption growth.

This is because if China’s banks see an explosion in non-performing loans it will have to pay for that increase in the coming years in one or both of two ways. The central government can recapitalize the banks by giving them money, which they have raised by borrowing or increasing taxes, or the regulators can keep deposit rates very low as a way of subsidizing bank profitability so that they earn their way out of the NPL losses. They did both after the last banking crisis, and will probably do both again. There is a third thing they can do, appropriate the money from SOEs, but I suspect that there won’t be nearly enough to resolve the NPLs – the World Bank estimates that the last banking crisis cost China 55% of GDP.

Both strategies will represent, ultimately, a large transfer of income from households to banks, and in either case it will also represent a continued drag on consumption growth in the medium term. If the government borrows to bail out the banks, it will divert resources from the real economy and so slow income growth. If it raises taxes, it will reduce disposable income and so reduce household consumption growth. If it keeps interest rates low it will again reduce disposable income (interest income is an important source of income) and so slow consumption growth (in China lower interest rates tend to increase the savings rate).

Since it is unlikely that the US will be in a position in the near future to return to the halcyon days of large trade deficits, and since no other economy can replace the US in the role, turgid consumption growth in China will translate directly into turgid GDP growth for many years. Rising non-performing loans are not a small threat to China’s long-term growth. If the Asian development model is dead, China will need domestic consumption growth more than ever, and this is cannot be the best time for China to try to revive the production-enhancing model in a way that may limit future domestic consumption growth.

By the way in their next meeting the Guanghua Students Monetary Policy Committee will debate whether or not the PBoC should cap loan growth. I will report the arguments and conclusions of these remarkably sophisticated students.

Replenishing bank capital

One of the students in Peking University’s Guanghua Students Monetary Policy Committee, a group for which I am an advisor, put together last week a summary of plans to raise capital adequacy ratios for Chinese banks.  I thought it would be useful to reproduce his numbers.  According to him, Shenzhen Development Bank, Everbright, China Merchant Bank and CCB have recently issued RMB 83.2 billion ($12.2 billion) in subordinated debt.  Minsheng Bank, ICBC, Industrial Bank and BoC plan to issue an additional RMB 243 billion ($35.5 billion) of subordinated debt.  Minsheng is also planning to issue RMB 1 billion in shares. 

At the same time in December the CBRC required that the big five banks raise their loan loss provisions from 100% to 130% of the loans in the bottom three of the five credit categories.  Off the top of my head I think the second category – “special mention” loans – comprises roughly three times as many loans as the bottom three categories combined, and many analysts assume that anywhere from one-half to all should properly be classified as doubtful or impaired.  Given the huge growth in lending and lax lending standards during the past few years (during what had to be a great time to be a banker), I think skepticism about the quality of bank portfolios is very much in order.

Policymakers are assuring everyone that the banking system is healthy, as policymakers everywhere always do.  I, of course, have my doubts, so I think it is very prudent that while they praise the banking system on one hand the authorities are making banks take on more capital and larger loan loss provisions.  I think it is extremely unlikely that we don’t see a surge in NPLs over the next two years.  This is particularly likely since credit expansion for February turned out to be RMB1.1 trillion, three to four times the amount of new lending last February which, when combined with last month’s RMB1.6 trillion, means than net new loans for the first two months of this year are significantly more than half of net new lending in 2008.  Of course it might be pointed out that most of this new lending is to state-sponsored projects and was strongly “encouraged” by policymakers, so it is likely to come with explicit or implicit guarantees, but in the case of a surge inNPLs I suspect that banks will nonetheless be forced to take losses before the government itself steps in.

Aside from loan and capital-raising figures other numbers are not looking too positive.  The wholesale price index came out today, with wholesale prices falling 6.0% year on year.  Part of this was caused by falling crude and commodity prices, but there is enough left over to make me continue wondering about underlying liquidity conditions.  Logan Wright told me Saturday that he expects to see very low, or even negative, reserve accumulation over the quarter, and regular readers of my blog know that I consider reserve accumulation to be the strongest indicator of underlying monetary conditions in China.

Manufacturing output for the first two months of the year was up 3.8% from the same period last year, which was well below already low projections (because of the moving Spring Festival holidays it doesn’t make much sense to compare individual months in the first quarter).  Much of what little growth occurred was powered by a surge in concrete production and, to a lesser extent, by a sharp increase in vehicle sales.  The optimists would say that this shows that the government stimulus is working.  Pessimists would argue that the increase in auto sales may well be short-lived because it surged largely after a cut in taxes, and there are persistent rumors of a significant increase in car purchases by government-related entities.   In both cases the  growth in sales might then be seen as anticipated purchases that take will have trouble persisting.

Likewise pessimists would also argue that the surge in concrete production is not evidence that the stimulus is having an effect but rather evidence  that people believe that it will have an effect, and so are building inventory in anticipation (the same is probably true of the recent surge in steel production and inventory levels).  This is good news if the stimulus actually does have a big impact on demand, since rising inventory prevents bottlenecks, but of course bad news if the stimulus turns out to be weaker than expected, in which case the need to work off inventory will slow future production to below actual usage. 

Aside from high loan growth numbers and low growth in manufacturing output, retail sales figures also came out last week.   According to an article in Thursday’s South China Morning Post: 

Growth in retail sales slowed to 15.9 per cent over January and February from December’s 17.4 per cent growth and 22 per cent in October, the statistics bureau said.  “It seems clear the domestic demand is slowing in China, and this could be happening at a faster pace than the sales data suggest,” said Moody’s Economy.com analyst Sherman Chan in a report. “Having households pull back on spending is exactly what China does not need.”

Beijing is trying to prod consumers to spend more with measures that include subsidizing appliance purchases for rural families. But families save heavily for education, health care and other expenses, and analysts say they are unlikely to spend more on consumer goods until Beijing creates a social safety net to ease such burdens.  A market research company, DDMA, said a February survey found 45 per cent of those polled had cut back on spending, down from 7 per cent in January. 

Xinhua put a different spin on the numbers in an article the next day: 

China’s retail sales grew 15.2 percent in the first two months to 2 trillion yuan (293.8 billion U.S. dollars), the National Bureau of Statistics (NBS) said Thursday.  The figure, although lower than the 20-percent-plus increase a year earlier, was encouraging, analysts said.

Retail sales growth in January and February was equal to or even higher than last year adjusted for inflation, said Zhuang Jian, senior economist with Asian Development Bank.  The consumer price index (CPI), a major gauge of inflation, hit a 12-year high of 8.7 percent in February 2008 but fell 1.6 percent in the same month this year.  “Domestic consumption has remained stable so far, despite the economic slowdown,” he added.  

I think Xinhua’s interpretation is probably closer to the mark but in either case it seems, not surprisingly, that household consumption is almost certainly declining.  Remember that retail sales are not a great indicator of household consumption in China because they include lots of other things, including government consumption.  In addition I should add thatCICC , one of China’s three leading investment banks, came out with a report on March 11 which I cannot excerpt but which basically advised caution about the retail sales figures and the outlook for household consumption.

A difficult transition

On a very different subject, two days ago I received a very interesting and intelligent email from one of my readers, a student who I believe is from the South of China (I am guessing this because he mentioned his plan to set up a business in Guangxi) although I am not sure if he is currently at Peking University or at another school.  He has allowed me to reprint his email, although I am not sure whether he is comfortable with my using his name, so I will reprint part of his letter while leaving out his name and any private references.  I have edited the letter slightly to make it follow the format that I use in this blog:

Being a student and a loyal reader of your blog, you have all but convinced me that China should continue to allow its currency to appreciate, for China and the world’s sake. This is in spite of the fact that my family runs an export business and appreciation of the currency will most definitely affect our business in a negative way.  In light of the global financial crisis, the big theme in China is how to increase domestic spending and gradually make the export oriented businesses more domestic-dependent. And I always tell myself that the appreciation of the RMB will help because imports will be cheaper and that will directly increase the purchasing power of Chinese consumers. 

Today, I went shopping with my girlfriend at Carrefour and I was trying to find some evidences to support my theory. Today we bought about RMB100 of food, typical of the things that we would need for the next 2-3 days.  Roughly, I would say we bought RMB30 worth of meat (chicken and pork), RMB40 worth of fish, RMB20 of milk/dairy and RMB10 of shampoo.  Then I try to determine how much the Chinese consumers would save if the exchange rate was changed.  Here is what I realize: 

All RMB 100 of food are made right here in China. Even the RMB10 foreign brand shampoo is made by a factory in Shanghai. So, I thought, what would happen if the dollar to RMB exchange rate becomes 1:4? Well, the cost of making these items wouldn’t decrease that much because most of the components that go into producing these items are not imported and would stay pretty much the same. (Please correct me if I am wrong in this assumption.)

However, if the exchange rate suddenly becomes 1:4, a lot of Chinese exporters, including my family’s juice business, which actually has a good margin compared to other labor intensive industries, will go out of business.  

In addition, perhaps now it would make economic sense for western companies to import their products (beef, fish, milk, shampoo) into China (of course assuming that the tariffs stay the same) and domestic consumers would buy imported goods because they are better quality and may now be cheaper.  

So this also adds additional pressure to the manufacturers. furthermore, perhaps now P&G would in this new exchange rate environment consider producing its shampoo in the U.S., because relatively speaking, P&G’s cost of production in the U.S. would have gone down.So China gets hurt in a multiple of ways as a result of China revaluing its currency: 

 So in conclusion, on the one hand, based on PPP or Big Mac index, I get the impression that the RMB is greatly undervalued (i.e. 1 Big Mac in US is $4, and 1 Big Mac in China is RMB 12-15). Yet, if the RMB were to really go up in value, the economy would definitely be hurt in many ways.

This is a great letter because (aside from the fact that it shows why I enjoy teaching here so much, given the intelligence and thoughtfulness of so many of the students I meet) it indicates in a very concrete way how complex the policy decisions are and how difficult the transition process is likely to be.

The first thing I would bring up is the issue of the effect of revaluation on the food purchased at Carrefour.  Of course it is true that the cost to make those Chinese-made goods would not decline in RMB terms except to the extent that they included foreign components (which may be more than many realize, since much of the fertilizer used by Chinese farmers comes from abroad, as does the oil they use to transport their products to Carrefour), but that does not necessarily mean that their cost to the consumer would not decline.  All of these things can be manufactured abroad, and it may be that Malaysian chickens, Australian milk or the same shampoo manufactured in Vietnam would become so much cheaper that either Chinese consumers would begin to buy more foreign food, or Chinese producers would have to lower their costs or improve their quality to compete.  This directly benefits Chinese consumers. 

Of course it might hurt Chinese farmers and producers, and this is why the transition becomes difficult.  In a very abstract way we can argue that whatever pain the farmers feel is less than the gains other Chinese enjoy.  Cheaper food for Chinese consumers means that they have more money leftover to go to restaurants, buy books, or get haircuts, and so Chinese businesses that supply these services will benefit.  

In an even more abstract sense we can argue that China does some things relatively better than other countries, and some things relatively worse – that is, the specific conditions in China, including its infrastructure, labor markets, educational systems, and so on mean that Chinese can do some things more productively and efficiently and other things less so.  By allowing the RMB to appreciate (or by otherwise relaxing constraints that affect the relationship between production and consumption), Chinese businesses and producers will be forced to concentrate on the things they can do more productively and efficiently than others, while leaving others to do the things they don’t do so well.  

This increases the total economic well-being of China and the countries with which it trades, and so at least in principle every country can become a little better off.  Remember that if China buys more from abroad, that doesn’t mean that Chinese producers must sell less.  Whatever money China exports to pay for those imports represents a net increase in either 1)foreign buying of things that Chinese producers are good at making or 2)foreign investment in China, which increases the productivity of Chinese workers.  Both of these are good for China’s economic prospects and both result in rising employment. 

But there is no getting around the fact that the process will be painful in the short term, as the student writing the letter has pointed out.  Although in the long run China and Chinese workers and consumers will almost certainly be better off as China makes the transition to a more balanced and domestic-driven economy, there are nonetheless short term costs.  Resources and labor will not be smoothly reallocated from exporters to domestic service producers and manufacturers who serve the local markets.  What usually happens is that, to use the very dry jargon of economists, these resources and labor will be “freed up” as exporters go bankrupt or downsize.  

As economic conditions change, and as exporting becomes less profitable, businesses aimed at local consumers will take advantage of newly available assets, resources and labor to begin operating, and gradually China will once again reach more or less full employment with a very different economic structure.  But of course remember that at first, domestic demand (and domestic employment) will actually decline as workers lose their jobs.  This is where the government can and should play an important role, for example by boosting domestic consumption as much as possible so that it quickly becomes profitable for Chinese companies to target the domestic market. 

Allowing and even encouraging this transition may therefore seem like a bad idea for China, but as the global crisis shows, it will be impossible for a large economy like China’s to continue depending so much on the export sector and on foreign investment.  It must make the transition, and the later it does so the more difficult it will be. 

 When the US made a similar transition 200 years ago, after the panic of 1797 when the Bank of England suspended gold payments, and when the US Quasi-War with France and the Napoleonic Wars in Europe decimated the US export trade, it did so over at least two very difficult decades, and after sharp rise in unemployment in the early years.  Eventually the whole country shifted its economic structure and, needless to say, the shift turned out to be crucial for the subsequent success of the US economy.  

Tags: Subordinated debt

After several rallies in the past month I said it was just a question of time before the Chinese stock markets tested their recent lows, and today the SSE Composite closed at 1896.  It’s become so easy to be skeptical after every surge that I don’t want to fall into the trap of just assuming that each is bound to fail.  Still, I have had trouble finding a good reason for any of the recent rallies – all driven primarily, it seems to me, by government attempts to bully the market up – and, sure enough, they have always reversed themselves fairly quickly.  

This week in spite of a good Monday (up 2.2%), the market lost ground on Tuesday (down 0.8%) and Wednesday (down 3.2%) with the SSE Composite finishing below its October 16 close of 1910.  This is flat from its September 18 close.  Remember that Thursday September 18 was the day the government announced a bunch of market-supporting measures, including that Central Huijin was going to buy bank shares.  Coming on the back of a global market surge the SSE Composite rallied 9.5% that Friday and ran up another 7.8% the following Monday, adding a further 2.7% over the next three days.  Less than four weeks later it has given everything back.

Aside from the continued insanity in the markets, a lot of things have happened during the three days I was at a conference in Shanghai, which means I have not been able to cover events on this blog in the timely way I would have liked.  As everyone knows by now CPI and PPI numbers for September were announced on Monday and came in lower than last month’s numbers.  I don’t have a lot to say about this beyond what I said in my last entry.  On Monday 4th quarter GDP growth was also announced, and at 9% it came in well below everyone’s expectations.  We seem to be fully caught up in the game of constant downward revisions in everyone’s estimates for this year’s and next year’s GDP growth numbers.

During the conference (a very interesting one organized by Chatham House) I was asked by one participant about what I thought next year’s GDP growth numbers would be.  I had to beg off by saying I am not an economist and the only thing I would want to predict about next year’s numbers is that they are going to be lower than expected. 

I say this because it seems to me that we have yet seen the full impact of the global crisis.  As I see it, much of the dynamics of the past few years can largely be described as the relationship between Chinese excess savings and American excess consumption, and I think these are going to alter considerably, and not in a benign way.  It is the latter that absolutely must change in response to the global crisis.  The US is unlikely to continue to have such a low rate of savings as crashing house prices and stock markets reduce so much of the stock of accumulated savings – American savings, in other words, will almost certainly rise as a share of GDP (as probably will, by the way, Europe’s).

This has an inescapable corollary.  The rest of the world must inevitably see a rise in consumption that is as great as the US (and European) decline in consumption (the flip side of the rise in savings, made worse if US income stalls or declines), if global demand is to remain unchanged.  When you add to this the fact that in large parts of the world we are unlikely to see much of a rise in consumption, and may even see a fall (in Latin America, for example, and among commodity exporters), this in principle means that Chinese (and other Asian) consumption is going to have to grow sharply to absorb most of the US and European decline.  If it doesn’t, world growth will slow sharply.

Given that the economies whose savings rate must grow account for anywhere from one-half to two-thirds of world GDP, that puts a huge amount of pressure on a sickly Japan and South Korea and an increasingly unsteady China to generate rising domestic demand.  I think it is unlikely that such an increase in domestic demand will happen without a much more massive fiscal expansion in China than most of us are counting on, so my guess is that we are going to continue to revise our growth future estimates for China (and the world) downwards.  

One of the impressions I got at the Chatham Conference (ok, not a new impression, but a reinforcement of an old one) is that there is a very sharp split in the views on the Chinese financial system between analysts who have extensive experience in a wide variety of markets and analysts who focus almost exclusively on China.  The former seem generally to share my pessimism about the Chinese financial system, whereas the latter are amazingly (to me) sanguine. 

Because their main experience of crisis is the recent US crisis, I think these scholars are confusing risky balance sheets in general with the specific risks that brought down foreign banks reently.  There is real difficulty here in understanding that even though Chinese banks probably have little exposure to the sub-prime mess or to complex derivatives, it is not those instruments per se that created the crisis, but rather excess risk–taking encouraged by excessively loose money (although to be fair I think most foreign commentators don’t get it either).  These instruments were only the way in which banks took on excessive risk, they were not the cause of the excessive risk.  Japanese banks in 1990 weren’t brought down by US sub-prime mortgages or toxic derivatives, but rather by old-fashioned loans, and it is useless to think that these former are the only risk to a banking system.

In that light it is worth noting the recent CITIC scandal.  Over the weekend some of my students began telling me about rumors of a $2 billion loss at CITIC.  This was confirmed on Monday, when it was announced that a badly conceived and unauthorized hedging strategy had gone seriously wrong and, as a consequence, CITIC was facing a huge unexpected loss. 

It is still not clear exactly what happened, but from what I can tell this “hedge” was a pretty bizarre hedge – it seemed far more like a misconceived speculative bet to me.  According to an article in today’s South China Morning Post it was also not exactly a recent problem:

Questions have also been raised about the timing of Citic’s profit warning, given on Monday. It knew about its currency exposure six weeks ago. Stock exchange rules require listed companies to disclose price-sensitive information promptly.

The article goes on to say “More worryingly, other local companies are exposed to similar currency contracts.”  Almost right on cue another problem was announced:

Shenzhen Nanshan Power warned that company officials had signed oil derivatives contracts without the firm’s approval, intensifying fears about internal risk management at mainland companies.  Shenzhen-listed Nanshan Power said on Wednesday its officials had signed two option-related contracts with a subsidiary of Goldman Sachs to bet on crude oil prices, although analysts said the contracts were still in the money.  Trading in the stock was suspended last week.

What does all this mean?  It has been very difficult to get a firm grasp on exactly what is going on in Chinese companies and banks as far as risk management goes.  My working assumption is that they have very little risk management experience, very weak rules on disclosure, and a perverse set of incentives.  That suggests to me that when faced with the same set of pressures faced by the leading Western corporations and financial institutions – i.e. ferocious liquidity growth and a previous environment of high rewards for excess risk taking – they are even more likely to have made some very risky bets.

Their lack of transparency has kept us from knowing exactly what is happening, but lack of transparency protected US and European banks for only so long before that very lack of transparency became the problem itself.  The few glimpses we can get into risk management among Chinese institutions do not give me much comfort.  If there is an economic slowdown, prepare to be surprised by all the garbage that comes out.

While Monday’s stock market, led by the banks, continued Friday’s big bounce back, rising 7.8% to add to Friday’s 9.5% surge, leaving us at a 2-week high (largely on buyback talk, I think), worries about the banking sector actually seemed to be deepening.  Today, perhaps in response, the stock market was a lot more confused, with the SSE Composite gaining or losing 50 points five times, before closing down 35 points at 2202, for a loss over the day of 1.6%.  Most other indices – many of which track market value much better than the widely followed SSE Composite – fell by a lot more.  The CSI 300 index was actually down 3.8%.

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

I am not sure if I am as negative as he is, but coincidently today I had lunch with one of my graduate students who spent the summer working in the treasury department of a large city bank whose name, for obvious reasons, I cannot mention.  He told me that one of the discoveries that surprised him during his time there was the sheer amount of fake bond trades engineered to raise trading volume numbers.  A bank will sell a large volume of bonds today to another bank at some market-related price, with the agreement that the buyer will sell them right back tomorrow at the same price.

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

I don’t know how widespread this is – he said the dealers in his bank claim it is very common – but it does suggest that the government bond and money markets are a lot less liquid than we might think.  This might not matter much for now, but it does suggest that, in a bad market, prices may be a lot more volatile than we would hope and liquidity tighter.

At any rate I have absolutely no idea if the rumors of understated exposure to bad US credits are true, but today Market News International, which tends to have very accurate inside sources in Beijing, had an article titled “Government Concerned Banks More Exposed to Wall St. than Disclosed”.  The article cited statements by unnamed sources who claim that the Ministry of Finance “has already held at least one meeting to discuss a proposal that would involve the sale of treasury bonds to raise funds for a cash injection.”

Although the article claims that nothing has yet been presented to the State Council, who would probably have to approve any such proposal before it could be enacted, it is interesting that in spite of all the soothing noises about healthy banks and limited exposure the government is so worried.  Perhaps they are only taking precautionary steps, with little expectation that they will ever need them.  If that is the case, needless to say, it certainly is a good thing.  Well-thought-out precautionary plans seem to have been in very short supply among both US and Chinese officials in recent years.

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

The steadily declining NPL ratio of recent years, for example, has been caused largely by surging loans, but a surging loan market can hide serious credit problems that only emerge during a slowdown, and Fitch claims to see increasing evidence of borrower stress among smaller companies (although they are quick to point out that they are only seeing the beginnings of stress).  They also point out that overdue loans, after declining steadily for many years, reversed course this year to show a 31% jump, from December 2007 to June 2008.  Every single bank of the twelve they monitor except one (Huaxia) showed large increases.

Granted, overdue loans of RMB 187 billion may not be much compared to the overall loan portfolio, and is only 2% higher than the December 2006 figure, but in China we need to be far more focused on the trends indicated by the proxies than by the proxies themselves.  The point is that in the first half of the year, when the economic stress was much lower than it is today and probably even lower than it is likely to be next year, one measure of credit deterioration rose sharply.

Fitch also mentions one of the things I discussed in a blog entry three weeks ago – the repackaging of loans into wealth management products.  Fitch says it is difficult to track these transactions, but they believe that about RMB 50-100 billion was done in 2007, mostly in the second half, whereas as much as RMB 315 billion was done in the first half of this year.  This isn’t large in absolute terms – I am guessing equal to just over 2% of new loans extended – but it confirms my suspicions that off-balance sheet lending (by which I include lending in the informal banking sector) has surged in recent quarters.  They also refer to something I had heard of but knew little about – what they call “entrusted lending on behalf of third parties” – which has also grown substantially.  Aside from the fact that Fitch – like me – worries whether these are truly off-balance sheet when things turn ugly, it shows that there is an awful lot more leverage on both sides of corporate and household balance sheets than we think.

There is a lot more in the Fitch report, and it is certainly worth reading, partly because it is one of the first in what I expect will be a series of increasingly nervous reports by other firms on the banking system.  The report concludes with:

After years of stable, strong economic growth and a benign credit environment, Chinese banks appear to be approaching their first real test of resilience since starting to operate more fully on commercial terms.  How trying this test will prove to be, and how banks ultimately will fare, remains to be seen. While China’s largest banks have achieved a remarkable amount of progress in recent years, deeper, more difficult reforms of banks’ credit culture, risk management, and governance remain in the early stages.

As a result, Fitch continues to be quite cautious with regard to Chinese banks’ ratings, knowing that history has shown that even bad entities can look good during strong economic times. These reservations are underscored by concerns that potential future credit losses may be being under-estimated due to weaknesses in the data underlying banks’ expected loss models.

One piece of possibly good news for the banks as far as liquidity goes, but not good news for NPLs or the performance of the economy, was a PBoC household survey released today.  Chinese households, according to the result of the survey of 20,000 households in fifty cities, have lower inflation expectations than before, but they are also more nervous about the economy and plan to save more (i.e. consume less).  They also plan to invest less in real estate and stocks – only 13% of the respondents said they would like to buy a house in the next quarter, which struck me actually as a high number but is apparently the lowest quarterly number recorded since the series began in 1999.  I assume this increased savings means a faster growth in bank deposits.

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

Chinese entrepreneurs and bankers are concerned about a domestic economic slowdown more than before, according to a quarterly survey by the central bank in the third quarter…A survey of about 5,000 businesspeople show they have higher expectation of an economic slowdown, the People’s Bank of China said in a statement on its website.

The macroeconomic expectation index, which gauges entrepreneurs’ confidence in future economic growth, dropped sharply to 1.3 percent in the third quarter from 10.3 percent in the second quarter and 16.8 percent in the third quarter of last year. It was the lowest point since last year.

If corporations and households are both worrying about upcoming economic conditions, we may see both fixed asset investment and consumer demand slow.  Coming on the back of what seems to be declining global demand for exports, there is a real risk that slowing growth exceeds even the more pessimistic expectations.  

On a final note, I had been meaning to discuss this last week, but the indefatigable Logan Wright of Stone & McCarthy had a very interesting piece out on September 19, “Monetary Policy Signals in the Chinese Interbank market”.  Early in his report he says:

The Chinese interbank market is turning upside down. Previously, banks avoided purchases of central bank paper if they had a better alternative for the funds, including lending out the money. Now, sterilization paper is in demand, and banks appear increasingly cautious about lending out funds, particularly to smaller companies. This suggests that the central bank’s recent cut in smaller banks’ reserve requirements is not likely to boost lending growth significantly, but issuance of sterilization paper is likely to surge due to rising demand.   

I have never been convinced that the PBoC actions on credit – raising minimum reserves, for example, or imposing lending caps or changing interest rates – have had nearly as much impact on the overall credit market as many suppose, largely because of the tremendous leakage in the system, including some of the things that the Fitch report mentions.  The main impact of these PBoC credit measures, it seems to me, has been to cause equivalent but opposite shifts elsewhere in the financial system that partly or wholly negate the economic impact of the original measure.

So, for example, constraining loan growth at a time when corporates demanded more loans simply pushed loan formation outside the formal banking system – and it is pretty clear that this has happened quite a lot.  Even raising interest rates for commercial bank deposits and loans altered the balance of loan and deposit demand outside the banking system in ways that limited the net impact – higher bank deposit rates encouraged depositors in the riskier informal system to shift deposits from the higher-paying informal banks to the lower paying but safer commercial banks, so that at least part of the impact of higher rates on deposits and loans was dissipated.

That is why I am not nearly as convinced as most other analysts are that one way the policy-makers can respond to a monetary contraction is to reduce minimum reserves or relax lending constraints.  I don’t think these measures have been effective on the way up, and won’t be on the way down. 

On Friday the Chinese stock markets had their second up day in a row (a rare occurrence this year), with the SSE Composite trading up 2.0%.  Today, however, the markets reverted to form, and the SSE Composite dropped 2.9% to close at 2327 which is, I think, the lowest point they have reached since February of last year.

What seemed to drive the market down today was a confluence of events suggesting that government fears of an economic slowdown may be reasonable.  Today the China Federation of Logistics and Purchasing released its calculation of August PMI (purchasing managers’ index).  It registered a seasonally adjusted 48.4, the same as in July, and the second month in a row that it came in at contractionary levels (anything below 50).  At the same time CLSA released its own PMI calculations, which also came in below 50 – the first time this has happened since the survey began nearly three years ago.

I think the main thing to watch now is consumer demand.  Growth in consumer demand in the past few months has been quite good, but as I discuss in my August 14 entry, it is not clear if at least part of this might not simply be anticipated consumption for the Olympics.  If that is the case, we may see a slowdown in consumer demand in the coming months.

Remember that the three pillars of Chinese growth are domestic consumption (both private and public), net exports, and domestic investment.  Global conditions are generally weak, which suggests that exports are going to be a lot less powerful in fueling Chinese growth than they have been in the past.  If domestic consumption also starts to grow more slowly, that places much of the burden of fueling growth on domestic investment, but without foreign or Chinese consumption to buy its production, it will only be a matter of time before the third pillar begins to wilt too.

Most hopes are on an expansion in fiscal spending to solve the growth problem, and there is little question that policy-makers are seriously considering their options here.  There has been a lot of discussion, both publicly and privately, about government proposals to stimulate the economy via tax cuts or infrastructure spending.  I have always been a little skeptical, however, about how easy this is likely to be.  

In first place, if there really is an economic slowdown we may see a sharp rise in NPLs in the banking system, and along with it a sharp rise in contingent liabilities on the part of the government sufficiently large to constrain their ability to spend.  Given how big the loan portfolio of the banking sector is relative to GDP, a small rise in the NPL ratio will have a big impact on total government debt via contingent liabilities.

Secondly I am less certain than others about the fiscal position of the government.  In this I guess I have been a bit of a contrarian, since nearly every other analyst I have read or spoken to points to the relatively healthy fiscal position of the government and the sharp rise in fiscal revenues as an indication of how much room the government has to prime the fiscal pump.

But for me, the fact that fiscal revenues have risen so sharply while the government has maintained its fiscal position in a small deficit or surplus, depending on which period you measure, indicates an equally sharp rise in fiscal expenditures, and I doubt that an economic slowdown will have nearly as big an impact on lowering expenditure growth as it has on revenue growth.  On the contrary.

In that light I was interested to see an article in today’s South China Morning Post that suggests that although not as pessimistic as I am, the Ministry of Finance might not be as optimistic as some others are:

The mainland’s finance ministry yesterday warned of increasingly austere times ahead as funds flowing into government coffers last month slowed sharply from the revenue expansion seen earlier this year. Slowing growth in fiscal revenue reflects tougher times in the world’s fastest-growing economy as well as heavy spending on disaster relief and earthquake reconstruction.

The July figures come at a time when economists widely expect Beijing to be more proactive in spending to boost the economy after first-half gross domestic product growth slowed to 10.4 per cent from 11.9 per cent last year

Fiscal revenue last month grew 16.5 per cent from July last year to 607 billion yuan (HK$692.83 billion), compared with the 30.5 per cent expansion in the first seven months, the Ministry of Finance said. Beijing projects an increase of 14 per cent in fiscal revenue for the full year, according to the government’s budget at the start of the year. Fiscal revenue rose 32.4 per cent last year.

The article goes on to say that in July, fiscal expenditures rose 40.9% year on year, or 29.7% for the first seven months of the year versus the same period last year.  That disparity in growth between revenues and expenditures strikes me as worth wondering about, even before the economy faces the consequence of a slowdown.  

I know, I know, I am going to be accused of being overly pessimistic, but perhaps many years of bond trading (and in developing countries no less) has left me looking for potential trouble spots, and it really can’t be controversial for me to point out that when things go bad, they tend to go bad on several fronts simultaneously.  If there is an economic slowdown I am willing to bet that we will see both a sharp deterioration in the government’s fiscal position and in banks’ loan portfolios, and I also suspect that the growth impact of a major fiscal expansion will be less than we expect.

At any rate the newspaper quotes the MoF as saying:

“We expect fiscal income will follow this trend of expanding only moderately for the rest of the year and the pressure for spending to increase is big,” the finance ministry said. “The past growth was achieved on the basis of the steady and rapid development of the national economy. Extra money is needed to stabilise prices and cope with natural disasters. We can’t ignore the fact that the fiscal conditions are actually quite tight.”

Perhaps the MoF really believes this or perhaps they are simply positioning themselves to ward off an expected massive call on their resources.  We’ll know some time next year, I guess.

Meanwhile the PMI release did bear some good news.  PMI input prices have dropped sharply in July, which suggests that PPI might not rise as quickly in the next few months as it has in the past.  I am prepared to be wrong about my alarmist inflation forecasts if PPI begins to subside quickly, but I am not ready to change my views for another two or three months since I think we can easily see temporary respite within a much longer inflationary trend.  I mention this especially since yesterday’s newspapers reported (another) strike by Shenzhen’s bus drivers and conductors that have left thousands of travelers stranded.  Although China does not freely allow workers to organize or strike, the fact regular strikes over low pay in Shenzhen over the past months have disrupted service suggests that wage pressures have not gone away.

Before concluding this already long entry I want to mention an August 28 MNI article forwarded to me by Logan Wright.  One of the things that I try to teach my students is to use simple models to try to anticipate changes that may take place in the economy, and then to look for these changes.  They are not always obvious if you are not looking for them.

For example, I have always assumed that the huge supply of money created by China’s currency regime and the huge demand for funding created by its inefficient growth would have to meet.  Much of the intermediation has taken place via the banking system, but of course with the lending constraints that were put in place over the last year, bank loans have grown much less quickly than we would have expected.

For many analysts, this is more or less then end of the story.  Policy-makers were able to slow lending growth, as planned.  But that didn’t make sense to me: the supply of and demand for funds was as strong as ever.  In that case, I assumed, lending constraints were just likely to force intermediation into other parts of the financial system.  

Based on this simple model, I made two predictions.  First, that the informal banking sector and other parts of the banking sector not covered by the lending constraints were probably growing very quickly.  Second, that banks would increasingly engage in activity that would allow loan growth to take place off the balance sheet and away from the formal constraints.  I remember telling my friend Chris Keogh, one of the heads of Goldman Sachs China activities, that I expected there to be a burst in securitization taking place as banks shifted loans off balance sheet.

The first prediction seems to have happened.  We have no good numbers on the informal banking sector but anecdotal evidence suggests that indeed it is growing quickly.  In fact over the past few months a lot of ink has been spilled on the subject – informal banks are now a hot topic.  Also, as Stephen Green of Standard Chartered pointed out a few months ago (see my May 18 entry), loan growth among policy banks and in the dollar loan portfolios of commercial banks, neither of which is covered by the lending constraints, have grown very quickly.

The second prediction turned out to be a lot less successful.  There have been loan securitizations in China in recent months, but not nearly as many as I expected.  I put this down mainly to a non-transparent regulatory system that made it difficult for banks to innovate around restrictions.  

It turned out, however, that I may have just been looking in the wrong place.  Here is what MNI says:

Chinese banks are bypassing tough controls on their lending behavior by raising money for their clients via wealth management products, a move which analysts said highlights the limits of the government’s attempts to control the banking system through quantitative measures.

Wealth management products have exploded in popularity this year, with 53 banks selling 2,165 products equivalent to around one trillion yuan ($146.3 billion)  during the first half alone, more than the 819 billion yuan in such products sold over the whole of last year.
    

But all is not as it seems. Industry observers note that over a third of the value raised has been for products which are structured like non-transferable debentures, with banks repackaging them as wealth management products and marketing them on behalf of clients.

Apparently the banks are packaging loans as securities, but rather than sell them in the public markets they have been selling them privately to their high net worth clients.  The article goes on to say:

Xu Hanfei, a Shanghai-based bond analyst with the Industrial Bank of China, said that around 300 billion yuan raised through the sale of these kinds of wealth management products in the first half of this year wound up with Chinese companies or local government vehicles.  Sichuan-based Southwestern University of Finance and Economics estimated that Chinese companies and local governments raised around 385 billion yuan via these products during the first seven months of this year.

That compares with the 2.8 trillion yuan that Chinese banks extended via their traditional loan books during the same period. The People’s Bank of China introduced a quarterly loan quota system this year in a bid to hold loans at last year’s 3.6 trillion yuan.

Xu acknowledged that wealth management products are being used to bypass the loan quota and continue raising funds for clients, even if the banks themselves aren’t taking on the actual risk. “Wealth management products are a good substitute for bank lending – banks want to maintain the pace of loan expansion but the PBOC has capped lending growth with a quota so we’ve had to improvise,” Xu said.

This kind of activity is not necessarily a bad thing for the banking industry – on the contrary, it helps banks to learn about securitization and to earn fee income while limiting their risks by passing them on to clients.  We should worry however about the level of sophistication of their clients and whether, if there ever is a problem, these loans are truly gone from the banks’ balance sheets.  The recent problems faced by UBS, Citibank and many others show that just because a loan has been shoved off the balance sheet onto investors does not mean that the bank has totally eliminated its exposure, especially if large scale defaults lead to political pressure.

But the real point of this article, as I see it, is to highlight the difficulty of addressing the symptoms of a problem without addressing its root cause.  China’s “tight” monetary policy has been anything but tight. 

It is easy to claim that China’s rapid monetary expansion can be controlled simply by placing limits on the consequent credit expansion.  It is naïve to believe, however, that the reality is that simple.  China continues to suffer from rapid monetary expansion.  When policy-makers try to control the consequences of that expansion without controlling the fundamental problem – for example by placing lending constraints on the banks, or by trying to control the rise of prices – they are likely to be doing little more than shift the problem from where they can see it to where they can’t.

Today’s unexpected withdrawal by hurdler Liu Xiang from participation in the Olympics – because of a leg injury – has been a real emotional blow to many of my friends and students in China.  Condolences to all.  It is a disappointment to see such a great athlete unable to defend his title in his own country.   Sad as his withdrawal has been for many of us here, there is still a lot to be excited about as the Olympics wind down.  Tomorrow I will see Brazil play Argentina in the soccer quarterfinals, thanks to the generosity of my former Tsinghua student Richard Zhang, now a rising star at McKinsey, and on Wednesday one of my favorite Beijing musicians, Shouwang, is taking me to see track and field events at the Bird’s Nest (finally I get to see the magnificent stadium from the inside!).

But not all the news is Olympic-related.  Xinhua reports today that the first half of 2008 saw a slowdown in the growth rate of loans to real estate developers and buyers.  According to the article:

Chinese bankers held loans totaling 5.2 trillion yuan (about 580 billion U.S. dollars) to real estate developers and housing buyers by the end of June, up 22.5 percent year-on-year, the People’s Bank of China (PBOC) said Friday.

The central bank said the growth rate was two percentage points lower than the same period last year, representing a decline for seven consecutive months since last December.  Loans to real estate development stood at 1.9 trillion yuan by June, up 17.7 percent year on year. The growth rate was eight percentage points lower than the same period last year.

The country’s lenders granted 3.3 trillion yuan to housing buyers buy June, representing an increase of 25.6 percent year on year. The growth rate was 1.8 percentage points higher than the same period last year.  Real estate developers and housing buyers received 398.84 billion yuan in loans between January and June, which was 170.66 billion yuan less than the same period last year, said the PBOC.

China’s real estate investment grew fast in the first half, but the housing price decline in some cities has strengthened a wait-and-see attitude among housing buyers, which retarded housing sales.  The country’s real estate developers sold out about 260 millions quare meters houses in the first six months, and the sales value totaled one trillion yuan, representing an decrease of 7.2 percent and 3.0 percent over the same period last year, respectively.

The PBoC had been warning banks to control their exposure to real estate.  Obviously the banks are responding, although 22.5% growth year on year is nothing to sneer at, and it should be pointed out that the growth rate in real estate loans still exceeds total loan growth, so as a proportion of total loans real-estate-related loans have not declined at all.  Still, with real estate exposure in the banks (formally recognized as such or, in many cases, not) creating probably the biggest worry for the PBoC in case of a slowdown in economic growth, this is relatively good news.

It is clearly a good thing that the PBoC is worried about and monitoring real estate exposure.  Among the many problems faced by the banking system, a sharp decline in real estate prices is probably the biggest single risk.  The still unanswered and vitally important question for me, I think, is about real-estate-related loans in the informal banking sector.  There is a lot if anecdotal evidence of developers turning to the informal banking sector – in spite of short maturities and high interest rates – as a replacement for the restricted funding provided in the past by the formal banking sector. 

I don’t know whether or not there is a similar moderation in the rate of new lending among informal banks, but the worrier in me thinks probably not.  At first glance this might seem not to matter.  If informal banks go bust because of excess exposure to bad real estate loans, it might not seem to matter to the formal banking and payments system, and so might have limited impact on the loan portfolios of the large banks and, via the banks, on the underlying economy.  Without knowing the links between the informal and formal banking systems, however, this optimism might be unwarranted.  I can think of at least three ways in which problems in the informal banks can spread:

1.        A decline in real estate prices can be exacerbated by forced liquidation of real estate loans extended by the informal banks.

2.        Formal banks may find themselves unexpectedly in a junior credit position if assets owned by a company turn out to have been used to collateralize loans from informal banks.

3.        Informal banks may have directly or indirectly obtained funding from the formal banking sector.

On a related note I got an interesting email today from one of my former Peking University students.  He says (with some editing on my part):

I just talked to a friend in a city in the south.  Interestingly, he tried to pay back his mortgage loan last week, and get another 3 year loan again (many entrepreneur there rely heavily on this kind of financing as working capital, sometimes, from informal banks of course).  However, he was told that the term of next loan had to be just 1 year instead of the usual 3 yrs, and he has to go through the application process again every year.

Collapsing property and other assets prices in some cities like Shenzhen seem to have made banks cautious of a probable rise in default risk, and the tightening will hurt these small enterprises further.

I don’t know how widespread this shortening of maturities is, but a common problem in banking is that when risks are perceived to have risen, lenders often respond (rationally, in the case of each individual bank or investor) by readjusting their portfolios in ways that increase overall riskiness in the system.  

For example as lenders became increasingly worried about the risks in Mexico in 1994, one of the consequences was a surge in short-term borrowing by the Mexican government as creditors became increasingly reluctant to extend long-term loans.  This of course increased the risks of a liquidity contraction to the Mexican government, and when that contraction happened, the Mexican government came close to defaulting.

This happens all the time as the perception of risk rises.  I wouldn’t be surprised – if there were an effective way to measure loan maturities for all loans in the system, including those extended by the informal banking sector – to see that average loan maturities in China have declined substantially in the past several quarters.  This, of course, increases the overall liquidity risk in the system.

Meanwhile the stock market continues to plunge.  On Friday the market experienced its first and only up date since the Olympics started, rising 0.9% to close at 2451.  Today it changed direction dramatically and dropped 5.3% to close at 2321 (this in spite of a 58% first-day jump – which is pretty mild by Chinese standards – in share price for the $1.5 billion IPO for South Locomotive and Rolling Stock). 

The Thursday before the Olympics started, the market closed at 2728, so we have seen a total decline of 14.9% during the past eleven Olympic days (seven trading days).  I wrote in an August 11 entry that before the Olympics end we might see the market test 2300, the level below which their have been rumors that the government will intervene.  We are now less than 1% away from that level and we still have the rest of this week to go.

It is not completely clear why the markets have behaved so poorly in the last week, although the answer is probably multiple.  A lot of analysts are worried about a slowdown in economic growth, the possibility of an increase in inflation still scares many (as it should), and there is a lot of concern about dilution effect of a possible upcoming sale of non-tradable shares as these become tradable.  There is also worry that hot money inflows may have already begun to reverse themselves (for example see this ChinaStakes.com article).  This perception comes from the widespread belief that the increase in foreign exchange reserves in June was substantially less than the combination of FDI, trade surplus, and other identified inflows.

Actually this perception is incorrect, and represents mistakes in the way most analysts count the rise in PBoC reserves.  I discuss why true growth in June’s foreign exchange reserves actually exceeded the identifiable inflows in a July 14 entry.  I don’t think hot money outflows are likely to be the main culprit behind the declining stock market, but I don’t discount the possibility that, as the perception of China’s riskiness increases, and as concern grows about the imposition of further restrictions on short-term inflows and outflows, we may begin to see at least some hot money reverse direction and leave the country.

On a related topic, today to a large fund manager asked me whether or not it made sense to buy Chinese stocks at these levels.  From a short-term trading point of view I am not sure I would be in a hurry to buy because I still think we are going to face a post-Olympic hangover that may affect the markets.  I think at least part of the surge in consumer spending last month and this month will have been Olympic related (new TV sets and entertainment units, Olympic souvenirs, sports equipment and clothing, flags, traveling to Beijing, and the kind of spending that comes from exuberance at China’s sporting triumphs), and this is likely to be reversed in the September and October numbers.  That should keep downward pressure on the market.

On the other hand over the medium term a number of Chinese stocks probably represent good value.  I haven’t looked at the discount between A-shares (which only Chinese nationals can buy) and B-shares (which foreigners are permitted to buy) in several months because I closed out all my positions much earlier this year (thank the gods!), but because of lower liquidity B-shares have typically traded at a 30-40% discount to A-shares.  If this continues to be the case, I think a very strong case can be made for the selective and gradual acquisition of a diversified portfolio of B-shares, especially in the more defensive industries and less leveraged companies.

The stock market started out badly today, dropping 1.8% during the first two hours of the trading day, before a press conference by Hu Jintao, stressing the need for growth, brought back optimism over government-engineered policies to boost growth.   From its low the market surged 2.8%, to close at 2802, up 0.9% for the day.  According to an article in today’s Financial Times:

Answering questions solicited beforehand, Hu used carefully worded answers to flag hopes to tame inflation while keeping the engines of growth primed, and he held out the prospect of some political reforms in the wake of the Olympics.  ”We must see that currently there are uncertain and unstable factors in the international environment, and China’s domestic economy faces increasing challenges and hardships,” he said.

Hu singled out inflation as a big concern but balanced that with a call for continued growth.  “We must maintain steady, relatively fast development and control excessive price rises as the priority tasks of macro adjustment,” he said.

None of this should have been a surprise.  There have been rumors for weeks of a shift in orientation and last week’s Politburo meeting and PBoC announcement have pretty much confirmed that the authorities are far more nervous about slowing growth than about rising inflation.  Of course lip service continues to be paid to fighting inflation largely, I suspect, because many seem to believe that inflation is more likely to be a consequence of rising inflationary expectations than of rising money supply.

As part of this effort to boost growth – and clearly as a sop to angry Southern exporters – export rebates were reduced effective August 1, according to an article in China Daily.  My student Cui Enze, who is currently in an internship in New York, reports in an email today:

On July 30, State Administration of Taxation published a new policy that reduced textile industry export rebates ratio from 13% to 11%.  Obviously this policy is in response to ease the strong complaint from exporters and aimed to stop the slowdown of textile exports.  A government official in NDRC attributed the difficulty of textile exporters to four reasons, RMB appreciation, external demand slowdown, labor and material cost rise and domestic macroeconomic policy including export rebates, among which RMB appreciation is the most important.

There are also strong rumors – and of course not at all unexpected – that the strict new lending caps announced late last year are going to be further softened.  According to an article in the South China Morning Post, “China’s central bank has raised banks’ lending quotas by 5 per cent, banking sources said on Friday, the most substantial move yet by Beijing to prop up the economy in the face of slowing demand for the country’s exports.”  Because this move hasn’t been put in writing – it was apprently announced during meetings on Thursday, according to unnamed sources – it is not totally clear what this actually means in terms of loan volume, but it is clear that loan caps are being relaxed.  

It is worth pointing out that the recent surge in bank deposits means that loan caps have been a far more serious constraint on lending than have the several increases in minimum reserve ratios.  This relaxation comes just in time.  An article in the current National Business Daily warns that, given current rates of loan growth, the existing lending caps mean that by November Chinese banks will have to stop all new lending.

More interesting to me was the announcement yesterday in the China Securities Times of the creation of a new department within the PBoC whose mandate, it seems, is to coordinate and manage foreign exchange policies.  Cui Enze also compiled information about this in his email to me.  He continues:

A new department launched within the PBoC – the Exchange Rate Department – has just been approved by the State Council.  This new department will combine part of the PBoC’s monetary policy department, financial market department and also parts of the functions of SAFE, and it will be an individual department dealing with exchange rate policy research and formulation.

This suggests that the government wants to pay more attention and place a more important status on the exchange rate.  It will help also help smooth the process of exchange rate reform.  Moreover, it is very interesting to note that under the current difficult conditions that this Exchange Rate Department has been set up.  I think it is a preparation for more aggressive RMB reform. So far, no time schedule has been set.   

A very interesting report on ChinaStakes.com gives us additional color:

The PBoC has twelve departments and six bureaus. The exchange rate office currently operates under the Monetary Policy Department. Now the PBoC seeks to strip the exchange rate office from the Monetary Policy Department and make it an independent department.

A researcher?under anonymity, at the Chinese Academy of Social Sciences told Chinastakes.com that by making the exchange rate office an independent department, the PBoC may reinforce the influence of exchange rate policy in macroeconomic control in future. The Monetary Policy Department is the most important department at the PBoC. The director of this department will usually be promoted to a higher position in the PBoC.

It has been three years since the launch of exchange rate reforms in July 2005. The establishment of the Exchange Rate Bureau indicates the increasingly important or even key role of exchange rate policy in China’s current monetary policy system.

It may also mean that the Monetary Policy Department is unable to formulate internal and external monetary policies at the same time, and it may be better to transfer the responsibility of making exchange rate policy to the Exchange Rate Bureau, so the Monetary Policy Department can focus on domestic policies such as interest rates, and credit.

Victor Shih has an early and thorough analysis on his RGE blog entry of what this may mean, and some of the potential problems that may arise.  To me it is interesting that they are trying to coordinate exchange rate policy within the larger context of capital flows in China and abroad and local financial markets.   China’s monetary policy is, for the most part, simply an extension of its currency regime and it does make sense to place the exchange rate at the center of a whole set of policies.  

I am not sure, however, about separating monetary policy from the exchange rate policy, but perhaps this is in preparation for a future in which the PBoC will actually be able to determine domestic monetary policy (after the currency floats?).  Whether Enze is right – that this is preparation for more aggressive RMB reform – will take time to decide, but my guess is that whether or not that is the intention, when the exchange rate moves back squarely back into the center of the policy debate, as I expect it to do by the end of this year, this department may play an increasingly important role in Chinese policy formulation.

Standard & Poor’s have just raised China’s long-tem sovereign credit rating to A+, based on its strengthening external position.  In part this reflects China’s strong fiscal position – in June according to a release today by Credit Suisse, China’s consolidated fiscal surplus for the previous twelve months reached RMB 443.5 billion, equal to about 1.5% of GDP (although needless to say I am worried about hidden expenditures that may one day show up as contingent liabilities).  But the upgrade mainly means, I think, that China has accumulated so much in the way of foreign currency reserves that it will have little difficulty in repaying its very limited foreign-currency external obligations. 

Even though I am pessimistic on the domestic side, I agree with the S&P upgrade, and would even argue that China deserves a better rating.  The authorities are so determined to avoid a 1997-style crisis that they have made it all but impossible for the country to face pressure on refinancing (or simply paying off) its external debt.

However, rising oil prices and increasing talk of coal shortages at home put a damper on the stock market today, with the SSE Composite down 1.2%, led by refiners and airlines, to close at 2802.  Fan Gang, a member of the central bank’s monetary policy committee, is nonetheless pretty upbeat for the post-Olympics market.  According to an article today in the South China Morning Post, he recently told a local magazine, the Xinmin Weekly, that since we have already seen an adjustment in stock market and real estate prices, there is no need to expect one after the Olympics.  “We needn’t worry about the post-Olympic economy at all. How could [stock] prices drop any further?”

Perhaps he really believes that, or perhaps he is just keeping in step with the request by regulators to stay upbeat before the Olympics.  About a week after foreign newspapers reported that regulators had instructed domestic fund managers and market participants not to say or do anything in the next few weeks that might hurt the market, the China Daily reports:

Top securities regulators have vowed to maintain stability in and strengthen supervision of the capital market to ensure orderly trading in the run-up to and during the Olympic Games.  “Preparations should be made to deal with any emergency and prevent trading from being harmed by rumors or hackers’ attack,” Shang Fulin, chairman of China Securities Regulatory Commission (CSRC), said.

Meanwhile I think a new entrant has joined in on the battle of the RMB.  According to an article in today’s Bloomberg:

The appreciation of China’s currency has hurt employment in the country’s east, where most exporters are based, Yin Chengji, a spokesman for the Ministry of Human Resources and Social Security said.  “There has been some regional and structural impact,” he said in Beijing today after a news briefing.  “But employment demand remains strong in central and western parts of the country. The overall employment situation is basically stable.”

The argument that a rising RMB is contributing to unemployment is now very widely proposed and accepted.  This is going to make it very difficult once again to shift concerns back to China’s monetary regime, and I would guess that we are going to need quite a setback, probably in the form of inflation or a banking setback, before China’s monetary problems are addressed.  This means, to me, that the adjustment, when it comes, is likely to be much more painful than necessary.

At any rate as these stories indicate, on the policy front there isn’t a whole lot new happening beyond the knocking of heads together to achieve (a very fragile and probably temporary) consensus in favor of growth over tightening and, of course, the endless hunt for security threats in the run-up to the Olympics.

On a different topic altogether, in my June 29 entry I mentioned that one of my former students had called me up to tell me about growing worries in the derivative markets.  In my attempt to explain the problem on my blog I wrote the following:

According to him, a very popular recent lending structure involved lowering borrowing costs for corporate borrowers by having the borrower implicitly sell a complex derivative (this is a common, and often dangerous, way of lowering borrowing costs).  Let me explain this as schematically as I can.

A corporation borrows some notional amount from a bank, for five years, and agrees to pay 8% on the loan.  The corporation and the bank simultaneously enter into a swap, for the same notional amount, in which the bank agrees to pay the corporation 1% annually, as long as the euro interest rate curve is “normal”.  Should the curve invert, however, the corporation must pay the bank some amount, typically 4 bps per day according to my source.

The net result is that the corporation is able to borrow money at 7% instead of 8%, and in exchange it agrees to pay a significant penalty if the euro curve inverts – something that is extremely unlikely to occur, the CFO is probably told.  From the bank’s point of view, they are still getting 8% funding, because they simply strip the option and sell it on to the foreign banks, who have the capability and expertise to monetize the option.

It sounds great on the face of it.  As long as the euro curve does not invert, and I am sure the corporate borrower is given reams of data showing how rare that occurrence is, everybody is happy.  The corporation borrows at 7%.  The local bank lends at 8%, and makes additional fee income by implicitly buying the option from the corporation at a lower price than it sells to the foreign bank.  And the foreign bank gets to sell a fairly complex derivative whose pricing formula is opaque (in investment banking jargon, “opaque” means “I can get away with charging a lot”).

Unfortunately, from what I have been told, the euro curve has inverted, and has been inverted for over a month.  Furthermore, it is deeply enough inverted that there is little expectation that it will normalize soon.  Corporations have suddenly seen their borrowing cost mushroom.  The transaction that had previously reduced borrowing costs by 1% a year was now increasing borrowing costs by 10% a year on an annualized basis.

About a week after I posted this a couple of newspapers, including the South China Morning Post, wrote stories about these transactions – the losses had become big enough to generate some attention.  Last week another of my students called me up to tell me that the story hadn’t ended.  He sent me this (slightly edited) email today:

Basically all the major foreign banks (i.e their credit portfolio managers) are buying protection against the Big Four Chinese banks to hedge their counterparty risk.  Although there is a standard CSA signed between foreign banks and Chinese banks, as a matter of fact all the Chinese banks nonetheless have refused to settle margin calls on their mark-to-market losses in the Euro CMS trades they put on as a hedge against similar transactions with their corporate clients.  5yr CDS of ABC and ICBC is bid at around 170 bps, but nobody is willing to show an offer at all.

According to my student, and to explain the above, the cost of default protection against the Big Four has soared because all the foreign counterparts, unable to get margin posted as required by the derivative agreements and unwilling to take the Big Four to court, are now facing the possibility of credit losses uncovered by margin.  They are running around looking to buy credit default protection, but there are few sellers.  He goes on:

One of the things being discussed around here is that each of the Big Four probably has $1-3 billion in paper losses already.  

I heard some of the contracts expire in September or December this year, and there is no sign of any normality of the inverted euro curves, especially when you have such a hawkish ECB.  Given the liquidity and cash position of the big four Chinese banks, there is no worry of any credit event to be triggered so far. But going forward all foreign banks will definitely act in a more prudent way when dealing with Chinese banks whose credibility and professionalism will be given a big question mark after the recent unpleasant experience.

I remember in the late 1980s there were similar difficulties dealing with Japanese banks, who didn’t seem to understand many of the risks they were taking and refused to play by the rules, even after having agreed to them.  After an initial rush to deal with them (Japanese banks, it seemed, were going to rule the world one day), most bankers and traders I know decided that they weren’t worth the trouble – I myself came to that decision in 1988 after a particularly annoying and difficult transaction – and stopped dealing with them.

My student tells me that the Chinese banks are refusing to settle with the foreign banks largely because their corporate clients won’t settle with them and pay up on the bet-gone-wrong.  This, of course, should be irrelevant – a bank takes on only his counterpart risk, not the risk of his counterpart’s counterpart, unless it is explicitly agreed to in the contract.  Chinese banks must keep to the terms of the deal entered into whether or not their domestic clients have done so.  One explanation of why the Chinese banks may refuse to put up margin could be that these transactions are not well-known within the bank, and no loan manager wants to draw his superior’s attention to them.  Requesting liquidity to post margin would probably elicit questions.

The scale of these losses isn’t huge, relative to the bank balance sheets, but the types of transactions entered into, and the responses to market losses, should set some alarm belles ringing.  This isn’t the sort of information that should strengthen our confidence in the ability of local banks easily to withstand a slowdown

The stock market raced up today, with the SSE Composite closing at 2778, 3.49% higher than yesterday’s close.  Since investors are still digesting yesterday’s mix of good news and bad news – GDP slowing, fixed asset investment soaring, CPI down, PPI up – I suspect the main cause of the decline may have been the decline in oil prices to $130 a barrel.

Cui Enze, one of my Peking University students currently completing a summer internship at Van Eck in New York, was nice enough to sleuth out the CPI numbers for me on the National Bureau of Statistics of China website.  According to him, this is the breakdown of the food and non-food components of CPI:

Without the actual index numbers, it is hard to extract much information from this series except to note the obvious – that non-food inflation is low but rising.  If I make a simplifying assumption that non-food inflation last year ranged from zero to 1%, it implies that non-food inflation year to date is probably running at an annualized pace of 2-3/4% to 3-3/4%.  This is not particularly high in itself, but remember that these numbers are being held down by price controls and, more importantly, that if Chinese monetary policy were consistent with low inflation, the surge in food prices should have caused at least some deflation in non-food prices.

Enze also sent me a separate note in which he alerted me to an article in this week’s Caijing

Just read news on the Caijing website that the CEO of a big private company (GoldenSun) in Yi Wu of Zhejiang province disappeared the other day.  The reason is that this company has 1.4 billion RMB outstanding debt which was borrowed through informal banks. Of the 1.4 billion, 800 million is principal and 600 million is interest not paid. The asset of this company has been audited or sold to repay part of debt.

This company had been borrowing through informal banks at an interest rate of only 2%-3% in 2005, but ever since late 2007, the interest rate has climbed as high as 12%, which brings a huge cash flow pressure to the private companies in Zhejiang. This year, several other owners of private companies in Yi Wu have fled because they can’t repay the high interest.  As most of the small companies in Zhejiang are export companies, the RMB appreciation and rising price of raw materials have significantly reduced their profit margin.

I checked the English version of Caijing and saw the story, although it didn’t have as much information as the Chinese version which Enze cites.  It did say the following:

A source told Caijing that Zhang raised money through a local version of China’s informal “gao li dai” credit system, which lets private individuals lend cash at high interest rates to persons or companies through go-betweens known as “hui tou.”  The system flourishes thanks to legal loopholes.  In Zhang’s case, the hui tou allegedly included local officials and lawyers. Many lenders mortgaged homes to raise the money that Zhang borrowed over the past two years, the source said.

The article closes by quoting a Yiwu-area banker as saying: “More bosses will flee later this year.”  I suspect that these sorts of stories are going to become more common.

For now I don’t know how common these sorts of defaults are likely to be, but at least this article does address one question that comes up a lot.  I have often heard people assert that the informal banking system is not a significant source of banking risk because loans are too small to matter, even in the case of serial default.  But this story involves loans from the informal sector of significantly more than $100 million to one client.  This sounds like regular banking to me.

Another student, who wants to remain anonymous for obvious reasons, also sent me an interesting note today (it’s great to have such great students).  He is spending the summer as an intern at one of the larger and better city commercial banks in the southeast.  He tells me (with some editing on my part, largely to hide names):

We saw some weird stuff yesterday in the money market.  If you only looked at the money rate, it was a normal day, but in the real market, a Big Four bank unexpectedly ran out of liquidity, and they were asking for money eagerly from other banks.  Because this bank is a major money-provider in the market, small or city banks like us cannot lend them money at a very high rate (because of their power and “mianzi”).  We worry that they may punish us later when we lack money ourselves, so most of us choose to say: “Sorry, but we also lack money.”

It wasn’t until 3:30 in the afternoon, that the bank finally got the money it needed, but because of their lack of money, small banks also could not borrow.  Our bank was also caught in this trap and not able to borrow one cent before 3:30.

My student goes on to tell me that his money market traders told him that these sorts of liquidity squeezes have become increasingly common during this quarter.  I haven’t been able fully to figure out what this means.  It may simply be the expected consequence of the several hikes in minimum reserve requirements.  If so, this puts a little hair on the statement I cited yesterday by a banking regulator who warned that further reserve hikes were hurting the system. 

I wonder if anyone else among my readers saw something similar and can explain what happened or how common it is.  One of the few things I learned from my banking classes at Columbia Business School (and amply confirmed in my many years as a bond trader) is that problems in the banking system usually first turn up in the plumbing – the otherwise very unglamorous  money markets.  I always tell my finance students to keep an eye on the money markets, and I am glad to see that at least one of them has taken me seriously.

As if keeping time with Victor Shih’s article (see previous entry) Standard & Poor’s warned yesterday that non-performing loan ratios in China have risen, and added that corporate defaults in 2008 may increase because of tighter credit controls and weakening demand from a slowing U.S. economy.  NPLs for the major commercial banks (the big five plus the 12 joint-stock banks) stood at 6.63% of total loans at the end of September 2007, and rose to 6.74% by the end of December.  This may seem like a small increase in the ratio, but remember that this increase occurred during what can only be described as optimal times – the economy grew at well over 11% in the 4th quarter, the country was flooded with new money, inflation increased faster than interest rates (which causes debt payments to decline relative to revenues and asset values), loans expanded rapidly (which should push the NPL ratio down), and equity issuance surged.

We can only guess what will happen if Chinese borrowers are hit by a combination of rising interest payments, slowing external demand and credit constraints.  There are already good reasons to suspect that the NPL ratios seriously underestimate the true extent of NPLs, and of course it is well know that most of the improvement in the NPL ratio during the last five years (the NPL ratio was around 20% in 2003) occurred because of the huge increase in loans outstanding – total loans outstanding grew by over 16% in 2007.  The question is whether that increase in loans, made during what can only be described as a party atmosphere, doesn’t include a large amount of future bad loans.  Bad loans, as old bankers always point out, are usually made during good times.

In that context I should bring up an interesting (and alarming) article from yesterday’s Spiegel titled “German State-owned Banks on the Verge of Collapse”.  The opening paragraph says:

The German government has had to bail out state-owned banks with taxpayers’ money after their managements recklessly gambled away billions on subprime investments. But if a state-owned bank were to go under, the consequences could be disastrous for the whole economy.

The article describes how the state-owned banks, “one of the key pillars of the country’s banking system”, had engaged in such reckless lending behavior during the boom years of the recent past that they were almost wholly unable to withstand last year’s credit contraction.  A number of the largest banks have been forced to their knees, and there is an increasing risk that a few major defaults could bring the whole system down.

It is a nightmare scenario that the government financial supervisory authority now believes is increasingly likely. Germany’s public-sector banks speculated far more heavily than private banks in American subprime mortgage securities. Now these banks’ beleaguered executives are calling on the government to bail them out from a disaster of their own making.

For Wolfgang Reuter, the author of the piece, a major cause of the crisis was the skewed incentives created by state ownership and effective state guarantees.

Ortseifen and Matthäus-Maier are perfect examples of the fatal mix of amateurism, greed and political protection that is symptomatic for many of Germany’s state-owned, partially state-owned and public sector banks. It is an environment that can only thrive in the shadow of the state — and that has drained more than €20 billion from the public treasury within the last decade.

Until now, the government has always been there to pick up the tab in the end. Fully aware of this safety net, the executives at state-owned banks gambled with their employers’ assets as if there was no tomorrow. Munich-based BayernLB did it with stocks in Singapore, Bankgesellschaft Berlin with real estate investments, and WestLB with holdings in British companies.

Anyone who is not responsible for bearing the consequences of the risks he or she takes can easily turn into a gambler. And the bets kept increasing in recent years, getting more and more public-sector banks into financial hot water. Now the banks find themselves lacking the assets they need to weather the turmoil of an international financial crisis.

I bring up the German experience to make two points.  First, the speed in which a banking system can unravel after many years of what seemed like robust growth is often astonishing, and the way in which the unraveling takes place is almost always unexpected.  Second, state ownership is no guarantee of safety.  In fact in the German case it seems that state ownership may have exacerbated the poor lending decisions.

I shouldn’t need to make the last point, but I cannot remember how many times I have been assured that the difference between Chinese banks and non-Chinese banks is that unlike the latter, Chinese banks are state-owned, and that fact makes a banking crisis in China nearly impossible.  Wrong on both counts.