The LA Times came out Saturday with a widely-noticed article on Beijing real estate, which features my friend Jack Rodman. Jack, who runs a firm called Global Distressed Solutions, is a bad-loan and distressed real-estate expert who has spent the last several years in China, and somehow has the energy to poke around among all the spectacular buildings in Beijing and other cities, worm his way in, and see if behind the beautiful façades there is actually some semblance of economic viability.

Apparently not. According to the article:

By Rodman’s calculations, 500 million square feet of commercial real estate has been developed in Beijing since 2006, more than all the office space in Manhattan. And that doesn’t include huge projects developed by the government. He says 100 million square feet of office space is vacant — a 14-year supply if it filled up at the same rate as in the best years, 2004 through ‘06, when about 7 million square feet a year was leased.

…To its credit, the government recognized in 2007 that the real estate market was headed toward a bubble, economists say. In an attempt to make real estate more affordable, restrictions were introduced on ownership of second homes and on foreign home buyers. But the measures came too late, accelerating the crash of an already weakening market.

The Beijing Municipal Bureau of Statistics reported this month that housing sales in the city dropped 40% last year. Chinese economists have predicted that housing prices will drop 15% to 20% in Beijing this year. Shanghai has experienced a similar decline.

Any conversation about Chinese real estate with Jack is likely to be depressing because his terrible stories aren’t much relieved by vagueness. Unfortunately he probably knows as much about the real estate market as anyone, and his conversation tends to be pretty specific and avoid the kinds of generalizations that we often make here, given the difficulty of getting hard data about some of the problems. When Jack talks about empty buildings he gives actual addresses.

And it’s not just foreign newspapers that are warning about real estate trouble. China’s leading independent business weekly, Caijing, also has an article this week that discusses the real estate mess:

Battered by global financial turmoil, foreign investors are moving quickly to liquidate stakes in Chinese property developers. The market is sinking, and investors are eager for a way out. Real estate developers, including some of the nation’s largest, are fighting to stay afloat. And so far, none have declared bankruptcy.

But key developers who snapped up land and, sometimes in a desperate scurry for cash, signed deals with equity funds and investment banks during China’s property market boom are now slipping toward loan defaults and failure.

Worries about the real estate sector are nothing new, of course. The important issue, for me, is the impact of problems in the real estate sector on the banking system. The LA Times article goes on to explain why:

The situation could get worse. Most of the real estate has been financed by Chinese banks, which have avoided writing down the loans. Eventually, they will be forced to, and that probably will have a ripple effect throughout the economy.

The problem is actually a little messier than that. There have been rumors for over a year that with the forced credit contraction of last year a lot of the riskier real estate developers had to turn to the informal banking sector for loans, and it is not at all clear to me how these get resolved in case of payment difficulties. I am assuming – like, I think, most others – that the government will want to avoid a rapid liquidation of bad loans by the banks. They will not want banks to seize collateral and sell it off for fear that this would cause the market to collapse and would result in the kind of debilitating debt deflation that Irving Fischer described in the 1930s, in which assets are liquidated to meet loan payments, causing asset prices to fall, which puts additional downward pressure on loans, and so on in a self-reinforcing cycle.

Now it is not clear to me that this kind of liquidation is always harmful. A strong argument can be made, and has often been made, that the liquidation process makes a crisis feel worse in the short term, but results in a much faster recovery because at some point very low prices create economic value to businesses of owning the assets, and their use of these assets can fuel a rapid recovery.

The classic case is the massive railroad building program in the US in the 1860s and early 1870s, which left the railroad owners saddled with expensive assets which required passenger and cargo rates that were too high to be useful to most potential passengers. Many of the railroads were never able to stop losing money. When these railroads went bankrupt after the 1873 collapse, and were subsequently liquidated, new owners were able to buy them for pennies on the dollar, and so were able to make them profitable while charging much, much lower freight and passenger rates. These lower rates sparked an economic boom by sharply reducing transportation costs, and the final value to the economy was much greater than the initial losses on the railroad assets.

The worst case, by this thinking, is if assets that are not viable at current prices are effectively taken off the market because the owners are not forced to liquidate, in which case they become a pure deadweight for the economy. The counterargument, of course, is the Fischer argument – that forced liquidation is inherently less stable because it causes a self-reinforcing cycle of price collapses.

I am not able to say which argument is correct, and anyway this sounds as much like a political argument as an economic one, but it is worth considering what might happen in China. The consensus, and I agree with it, is that the government is far more concerned about avoiding short term instability than about promoting long term viability, and so will make every effort to force banks to stretch out the restructuring process, avoid panic liquidations, and take assets off the market.

This policy can work with the formal commercial banks, but what is less clear to me is how the liquidation process will work in the informal banking sector. I am not sure whether pressure can be placed on the informal banks to prevent liquidation without seriously interfering with a wide range of market and governance mechanisms. Certainly rumors about some of the fairly brutal collection mechanisms in parts of the informal banking sector suggest that creditors might not be too eager to confront lenders. Unfortunately I do not have much of a sense of whether this process is already taking place. If any of my China-based readers knows more about this, I would really appreciate some help.

For those who find this topic of great interest, there was a fascinating article in Friday’s South China Morning Post.

With the mainland economy tanking to its slowest growth rate in seven years and banks wary of lending as defaults rise, small business operators are hocking belongings and company assets for loans from pawnshops. “Banks are reluctant to lend,” says Huang Jing, deputy business manager at Shanghai Oriental, the city’s second-biggest pawnshop. “But we have a lower threshold and can provide loans much more quickly and with shorter terms.”

Banned at the start of the Cultural Revolution, pawnshops were considered a form of capitalist exploitation that preyed on poor and desperate people. They were outlawed for two decades, until 1987, but now they do a brisk trade. From gold bullion to houses and factory equipment, customers offer a variety of assets to get loans from pawnbrokers.

Quoting Wang Fuming, chairman of a pawnshop with about $1 billion in loans, two-thirds of which are to small and medium businesses (Chinese pawnshops are huge compared to their Western counterparts and can include hundreds of branches and are actually, funnily enough, among the most efficient parts of the country’s banking system), the article goes on to say:

“About 90 per cent of small businesses in Shanghai fail to get bank loans,” Wang says. “The problem is more severe with a weak economy.” The central government has eased its monetary policy and urged banks to lend, with January lending showing a record rate of growth. Yet most new loans are directed at the country’s 4 trillion yuan economic stimulus plan and state-owned companies.

This quote about the difficulty of small businesses in Shanghai to get loans reminds me of the point, very forcefully made, by MIT’s Yasheng Huang in his excellent new book, Capitalism with Chinese Characteristics, about the difficulty small entrepreneurs have had after the reforms in the 1980s. For Huang Shanghai is Exhibit A in his claim that there has been a reversal away from a market economy to a state-led economy in the past fifteen years. He especially mentions that as the commercial banks turned mainly to funding SOEs, it was the informal banking sector that took on the bulk of the financing for SMEs.

Meanwhile, speaking of funding SOEs, there is a lot of talk in the markets about second big stimulus package aimed at delivering more consumer spending (“A second big stimulus package?” some unkind folk may wonder, “Did I miss the first?”). The front page of today’s People’s Daily has an article with the large headline “Communist Party leadership warns of ‘austere’ year for China.” It goes on to say:

The ruling Communist Party of China (CPC) said Monday the country will launch a comprehensive economic package to tackle an “austere and complicated” year ahead.

“We will increase large-scale government investment, implement and readjust a plan to revive industries, make great efforts to boost innovations, and greatly enhance the level of social security,” said a press release issued after a meeting of the Political Bureau of the CPC Central Committee. The meeting was presided over Hu Jintao, general secretary of the CPC Central Committee.

Meanwhile Xinhua yesterday reported PBoC concerns about deflation:

China’s central bank on Monday warned of deflation in the near term caused by continuing downward pressure on prices. Commodities prices were low and weak external demand could exacerbate domestic over-capacity, the People’s Bank of China (PBOC) said in an assessment of fourth-quarter monetary policy. “Against the backdrop of shrinking general demand, the power to push up prices is weak and that to drive down prices is strong,” the PBOC said. “There exists a big risk of deflation.”

While assuring us that it would ensure ample liquidity in the banking system and promote the reasonable and stable growth of credit, the PBoC, along with the CBRC, also stated three days ago that it was planning to investigate the lending spike. According to an article in the current Caijing:

A dramatic increase in bank lending in January has attracted attention from investigators with China’s central bank and regulatory agencies, Caijing has learned.

The China Banking Regulatory Commission plans to investigate the huge cash flow after banks issued 1.62 trillion yuan in loans during the month. Notes trading represented 38 percent of the total credit. Some analysts have claimed companies may be using government-encouraged bank loans to invest in the Chinese stock market, which has rallied since the start of the year.

Until today the stock market had continued its upward surge – although the SSE Composite suffered a dizzying 7.5% drop last Tuesday and Wednesday on concerns that the PBoC investigation, if it determines that a primary cause of the recent market surge was bank lending to stock speculators, may pull the rug out from under the market. The overall surge, largely on speculation about which sectors are going to receive bailout packages from the government, has made China the top performer among global stock markets this year, with the SSE Composite rising about 20% year to date.

A lot of my Chinese financial market friends are very worried that small investors are rushing in too quickly and are likely eventually to get hurt, since what is driving the markets – as always – is not changes in fundamentals but rather rumors of government intervention. The game seems to be to guess which sector will receive the next set of rumors about government bailouts and to buy accordingly.

Even if the rumors are true, I think the market is ignoring how difficult it will be for profitability to revive and how even more difficult it will be for asset prices to stabilize. Even real estate companies have seen stock prices benefit from rumors, although the sector is in serious trouble and it is only because they are in such trouble that the government would consider supporting them. Still, this is always how the stock markets work here – it ain’t about fundamentals, its all about government rumors.

At any rate today, the market may have suddenly refocused on how bad the news outside is, falling straight down after its opening, led by commodity producers and insurance companies, with the SSE Composite losing 4.6% to close at 2200.1. If the next couple of days the market remains bad, the government will almost certainly make supportive noises, so I don’t know if this drop is a temporary fall before prices move up again, or if it is the beginning of a longer decline, but either way I think the market rebound has far exceeded any real basis for optimism. It will be much lower in a few weeks or months.

Tags: Jack Rodman, Pawnshops

I think if I were an economic policymaker in China I would be spending most of my time thinking about the money supply and how it works. There is a small but growing possibility that Chinese monetary conditions are going to go wrong at exactly the wrong time, and policymakers will need to have a well-thought out and vigorous plan to address it if it happens.

It has become pretty clear that the huge amount of hot money that poured into China last year and earlier this year is beginning to reverse itself pretty sharply. According to a PBoC release yesterday, China’s foreign exchange reserves increased to $1.946 trillion at the end of 2008, up from $1.906 trillion at the end of September. Here is what Logan Wright, of Stone & McCarthy, said in a release earlier today:

The Q4 2008 foreign exchange reserve data, released yesterday, indicate that China’s six-year liquidity cycle may be coming to an end, triggered by limited expectations of further yuan appreciation alongside a rapid downturn in both the domestic property market and global consumption of Chinese exports. Despite a record-high quarterly trade surplus of $114.3 billion and additional sources of capital inflow, China’s foreign exchange reserves rose by only $40.4 billion in the fourth quarter. This suggests that China saw significant levels of capital outflows during the fourth quarter, which we estimate totaled around $120-140 billion. Valuation adjustments may explain the decline in headline reserve levels in October (by $25.9 billion), but they cannot explain the entirety of the slowdown in reserve growth during the fourth quarter.

It has become harder than ever to figure out exactly what is going on with central bank reserves – and of course just when we need clarity most – so there is a lot of variation in all of our estimates about the different components of the adjustments in reserves, but Logan is one of the most careful of the PBoC watchers and his estimates on hot money outflow fall into line with my own and most of the other credible estimates I have seen. For example Mark Williams of Capital Economics said in a release yesterday that “hot outflows may have amounted to well over $100bn last quarter, equivalent to around 8% of Q4 GDP,” and Stephen Green at Standard Chartered said in another release yesterday that he calculated the “unexplained” amount of reserve changes to be about $110 billion, although at least part of that may be accounted for by a lag in trade payments.

Remember that there are two reasons for hot money to leave China – one on which most of us have focused, and another, which may be more important but which hasn’t received the attention it deserves. The first is the expected excess return for bringing money into China or taking it out – basically the RMB deposit rate plus the expected appreciation of the RMB less the equivalent US dollar deposit rate. When there were tremendous expectations for RMB appreciation, money poured into China, and now that those expectations are evaporating, or even going negative (i.e. there is some concern that the RMB may depreciate), it is likely to leave.

The second reason for hot money flows, not as widely discussed but at least as important, is the perception of risk, especially of the financial system. Remember that whether any given level of expected appreciation results in outflows or inflows depends also on the expected risk. As risk rises, it will take a lager expected return to encourage inflows. As China’s economy contracts, and as local businesses become increasingly worried about the potential for the current crisis to lead to deeper problems, including problems with the banking system, there is an increasing incentive for wealthy Chinese businessmen to take money put of the country.

For much of 2007 and early 2008 I argued that Chinese monetary policy had locked the country into a dangerously pro-cyclical trap, and unless the PBoC engineered a one-off revaluation that would stop hot money inflows, there was a real risk of incurring destabilizing capital inflows and outflows. When things were going well and the country’s economy was booming, hot money would pour into the country, unleashing a credit bubble and exacerbating the problem of overheating and overcapacity.

Once conditions turned around, however, I worried that hot money outflows would have exactly the opposite impact, causing a contraction in the money supply that would lead to credit contraction and an even sharper economic slowdown. This is always the great danger of hot money – when things are going well it pushes the economy into overheating, while squeezing the economy just as things start to get bad.

Needless to say, the PBoC did not revalue the RMB or otherwise move quickly enough to control the torrent of hot money inflow, and now they may be forced to deal with the accompanying but opposite problem. As conditions deteriorate, hot money outflows will become a real monetary drag.

This is not to say that these outflows are creating a problem for China right now. On the contrary, with outflows more or less matching current account and FDI inflows, the net impact is that for the first time in several years the PBoC finally has some apparent control over domestic monetary policy.

What worries me and some of my other PBoC-watching friends is the implication of this reversal on future monetary conditions in China. The outflows are almost certainly likely to cause contraction in credit – especially in the informal banking sector, where much of the hot money inflow may have hidden – and one can make a very plausible argument that outflows, and the attendant credit contraction, may exacerbate the slowdown in the economy.

If it does, and in so doing increases the perception of riskiness in China, it may create further strong incentives for local business owners to take money out of the country. China, in other words, has locked itself into a highly pro-cyclical monetary policy, and one of the key points to remember about highly pro-cyclical systems is that it is very hard to predict exactly where they are going, but it is a pretty safe to predict that whatever they do they will go to extremes (as if to confirm my worry about exacerbating tendencies, I see that China’s National Bureau of Statistics has just revised upward China’s sizzling 2007 growth rate of 11.9% to 13.0%).

To extend this a little further, it is worth remembering that there were at least three important factors that caused the severity of the Great Depression in the US. First, the US had to deal with a substantial industrial overcapacity problem just as the European countries that absorbed US overcapacity by running trade deficits with the US saw the financing of these deficits interrupted. I have written about this several times in the past few weeks so I won’t discuss it further.

Second, the US did not expand fiscally nearly enough to counteract the decline in domestic and foreign demand for US production. I know that this is a controversial point and I don’t want to get into a debate about the efficacy of fiscal expansion, but as I see it the US would have been better off if the government had followed Keynes’ advice and expanded more quickly. Third, the US experienced a severe monetary contraction as some banks either collapsed, others sharply contracted their lending, and depositors and businesses hoarded cash. The Fed should have accommodated this contraction by relaxing monetary conditions but failed to do so. According to Milton Friedman this may have been the single biggest cause of the severity of the contraction.

So where does that leave China? The overcapacity adjustment in China may be much larger than the one faced by the US – with 40% of global GDP the US had to absorb a trade surplus of roughly the same magnitude as China, which accounts for only 7% of global GDP. On the fiscal side I think China will definitely expand much more aggressively than the US did in the 1930s (how could it not?) but of course there are real questions about how much real expansion there is, how it is going to be financed, and how much of it will simply be wasted or turn into NPLs. Most importantly, can China expand enough to make up for the contraction in US and European demand (the two economies are more than six times the size of China)?

The US experience in the Great Depression suggests that among the things we should be most worried about in China is underlying monetary conditions. If hot money outflows accelerate and, as is likely to happen, the trade and FDI surpluses drop sharply, we could start to see some large monthly net outflows, and it shouldn’t come as a surprise if large outflows increase the perception of risk and so encourage further large outflows. Remember that outflows mean dollars sold by the PBoC in exchange for RMB, which represents a contraction in the base money supply. If China is forced to experience a sharp monetary contraction on top of its economic adjustment, things could easily get out of hand.

A sharp monetary contraction, as I see it, basically means a sharp contraction in credit. Could we see this, and can the PBoC take steps to counteract it? Here is what the South China Morning Post had to say in an article two days ago

Yuan-denominated loans granted by mainland banks grew a robust 19 per cent last month from a year earlier, suggesting lenders are heeding Beijing’s calls to stimulate the economy. Mainland banks extended 740 billion yuan (HK$839.31 billion) in loans in December, the biggest monthly rise since January last year, the Shanghai Securities News reported yesterday.

The new loans started to rise from about 300 billion yuan monthly in most of last year to 476.9 billion yuan in November when the central government unveiled a 4 trillion yuan fiscal stimulus package and encouraged banks to help funding the toll road, railway, port and other projects under the scheme. “Bank lending has been a key indicator. It’s crucial to China’s economy-boosting efforts. The December figure shows the needed credit expansion is on the way,” said Peng Wensheng, an economist with Barclays Capital Research.

I am not sure I agree with Peng Wensheng. We are not seeing credit expansion so much as a growth in RMB-denominated loans in the formal banking system. Perhaps this is a good proxy for credit in China, but I suspect it isn’t. First, much of the growth has come in the form of a sharp increase in bill discounting, and I am not sure whether this might not include a lot of double counting. I have also heard whispers that companies are turning to short-term credit not for investment purposes but rather because of serious cashflow problems. If so, this might be the worst sort of credit expansion.

And second, it is not clear what is happening to off-balance sheet transactions – which may be in the process of being shifted back on balance sheets to meet credit targets with no real expansion in credit – or, more importantly, to the informal banking sector. The anecdotal evidence is that the latter is contracting sharply, which is consistent with the idea of hot money outflows.

Whether credit is indeed expanding or in fact contracting is, to me, still an open question, and I would argue that circumstantial evidence – the collapse in inflation, the open disgruntlement among banks about pressure to meet credit expansion targets, hot money outflows – suggest that it is contracting.

Frankly I am not sure where all of these musings lead, and I need to do a lot more thinking about the subject, but I worry that for reasons beyond the PBoC’s control we may see a much sharper monetary contraction in China than expected, especially if hot money outflows increase, and this could seriously exacerbate the downturn just as it did in the US in the 1930s. Can the PBoC accommodate this by relaxing? I don’t think so. Remember that I have argued for years that the PBoC has little to no real control over domestic monetary conditions as long as it retains the straitjacket of the currency regime. It should have gotten out years ago, or at least reduced the strength of its pro-cyclical impact by revaluing sharply before hot money flooded into the economy, but I am not sure it can easily adjust in the midst of a crisis. Perhaps they should anyway consider what the impact would be of either loosening the band considerably, or even floating.

I suspect most of my readers outside China are more interested in enjoying the holiday season than in spending much time following my blog, while most of my readers inside China are focusing on upcoming exams, but anyway my recent writing commitments are so intense that I haven’t been able to post much recently. For what it is worth I have a short piece appearing soon on YaleGlobal Online about why the US-China trade relationship was the “cause” of the recent financial crisis.

I have a much longer piece that will appear in the January issue of the Far Eastern Economic Review that sets out the balance-of-payments framework necessary, in my opinion, for understanding not just how the current crisis came to pass but also how bad it can become if policymakers do not react correctly. The Financial Time’s Martin Wolf has kindly asked me to prepare a shorter version of the piece to appear on the FT blog next month.

Still, for all the writing commitments, there are a few things I wanted to note in my blog entry today. Today’s New York Times has an interesting article on South Korea that I suspect is going to set the tone for a lot of what will happen in the upcoming months:

South Korea posted a current-account surplus for a second consecutive month in November, which may help ease pressure on the won, the region’s worst-performing currency this year. The surplus was $2.06 billion, compared with $1.67 billion in November 2007, the Bank of Korea said…The nation posted a record $4.75 billion excess in October…South Korea has posted current-account shortfalls every month but three this year as higher oil prices and the weaker won drove up the cost of imported goods.

A few days ago the Financial Times had another interesting, related piece.

Vietnam devalued the dong by 3 per cent on Thursday in its latest attempt to keep its export-dependent economy afloat. The government said that 2008 economic growth had shrunk to 6.23 per cent from 8.5 per cent last year and there were signs it was likely to slow further in 2009. Several analysts have warned of the threats of competitive devaluations among Asia’s exporting economies but Hanoi’s move comes after spending most of the year trying to maintain the currency’s strength to slow spiralling inflation.

…Several analysts noted that while governments have resisted pressure for protectionist policies, there are fears they might take the short cut of devaluation. Thailand and Taiwan have recently become net purchasers of dollars, provoking the Asian Development Bank to warn against “unnecessary and excessive interventions in the currency markets, especially to depreciate domestic currencies”.

Vietnam has also cut interest rates several times which, as I have argued before, in an economy whose banking system funnels credit primarily to investment, and not consumption, is as much as an export-enhancing measure as currency depreciation.

One consequence of the financial crisis will inevitably be capital outflows from developing countries. The necessary corollary of capital outflows is trade surpluses. Without running a trade surplus no country can consistently support capital outflows, and as obvious as this is, it also seems to be a source of tremendous mystery to many experts and policymakers. Keynes for example pointed this out in his fury at the way Germany was required to post war reparations in the 1920s while its ability to generate export surpluses was all but eliminated by the victorious powers. Capital exports by definition require trade surpluses.

This is just another way of saying that a lot of developing countries that had been running trade deficits will soon be, if they aren’t already, running trade surpluses. Instead of contributing their net demand to the world economy, as they had via their trade deficits, they will now be contributing their net supply.

This will not help the world imbalances. The biggest contributors of net demand are the US and non-Germany Europe, and both of these regions are seeing a rapid decline in their net demand contribution (i.e. their trade deficits are expected to shrink). To adjust to this decline the world needs new sources of net demand or else global production must contract sharply via factory closings and rising unemployment. But the largest net supply country, China, is increasing its export of net supply (its trade surplus has been rising) while several trade deficit countries in Asian and elsewhere are switching to trade surplus or otherwise trying to reduce their deficits.

This cannot be sustainable. We cannot expect production to rise while consumption declines except if it comes with a dangerous rise in forced investment (also known as inventory). The crisis cannot even begin to be considered in its final stages until this issue is resolved.

Meanwhile domestically the debate about how to respond to the global crisis is still raging, although it is far from clear that we have anything close to a consensus among policymakers. Today’s South China Morning Post has the following article:

A former mainland central banker has called for a halt to the country’s recent flurry of actions to loosen monetary policy, a view partially echoed by analysts. Wu Xiaoling, who was a deputy governor of the People’s Bank of China before she left a year ago, said deep cuts in interest rates and reserve requirement ratios intended to boost lending could backfire, damaging confidence and adding pressure to bank balance sheets.

“I don’t think we should do more on the monetary policy side,” Ms Wu, now a vice-head of the financial committee of the National People’s Congress, told the Economic Observer newspaper yesterday. “Intensive policy moves will not help stabilise market expectations. Instead, they will cause panic among companies and the public, making the situation worse.”

I am glad to see that there is increasing concern about further interest rate cuts, although not for the reasons cited by most. For me, interest rate cuts in China will have very different effects than they might in the US. In the US, where a great deal of credit goes to consumption, lowering interest rates can be seen as boosting consumption as much as boosting production. At any rate the US, which contributes the largest amount of excess net consumption to the world and must bring it down, has every reason to focus on production-boosting measures as well as consumption-boosting measures.

But China is different. First of all there is little to no consumer credit in China, so cutting interest rates won’t do much to boost consumption. It might do so indirectly by reducing mortgage payments (Chinese mortgages are all floating-rate mortgages) and perhaps by slowing the decline in real estate prices, but it is not clear how big an effect that might have on increasing consumption, especially since even lower interest rates aren’t likely to create much buying interest for real estate. In fact there is some evidence in China that households may actually contract spending when deposit rates are cut since they need to save more to achieve their precautionary savings targets.

On the other hand with most credit going to investment, lowering interest rates definitely reduces further the cost of production. I know that the idea of lowering interest rates in an economic contraction is firmly entrenched in economic wisdom, and I am taking what may seem like an extremely opposite viewpoint, but I doubt that cutting interest rates is what China needs to do if it is expecting to adjust to the global payments adjustment. Every domestic policy must be aimed at boosting demand, and anything that increases China’s “competitiveness” is a dangerous detour since it can only exacerbate global imbalances and increase the likelihood of trade friction.

While still on the subject of banking, there is another very interesting article from the South China Morning Post on pyramid schemes and underground banking. As the financial system in China contracts, in spite of regulatory attempts to force credit expansion, I think the informal banking sector is going to get increasing scrutiny. In addition, and the Bernie Madoff scandal should remind anyone who needs reminding, financial crises always result in the uncovering of financial scandals and fraud on a massive scale, which already seems to be happening here. Rather than comment I will quote extensively from the article:

Beijing will impose severe penalties on people involved in pyramid sales schemes, underground banking or manipulation of government statistics in a move to strengthen financial security, according to draft revisions submitted to the mainland’s top legislative body yesterday.

…Mr Li said the draft was revised to define pyramid selling as “organising, leading sales activities aimed at promoting goods and providing services that require participants to pay for the products or services in order to obtain membership” and “introducing a tiered system to force or prompt participants to attract new members to extract money and property, thereby disturbing public order”. If the changes are passed, people convicted of involvement in such activity could be sentenced to up to five years in jail, while ringleaders could be given even longer sentences in more serious circumstances. A regulation targeting underground banking has also been reviewed, according to Xinhua.

Illegal banks dealing in large financial transactions will be regarded as criminal organisations, the proposed amendments say. Mr Li said his committee added this line after the Legislative Affairs Office and the Public Security Ministry highlighted how underground banking could disturb and harm the financial order. Pyramid sales and underground banking have emerged as two major social problems in the recent weeks.

…Illegal banks are targets despite mainland companies of varying sizes relying on them for cash in the credit crisis. Illegal banks on the border help mainland businesspeople invest in the Hong Kong stock exchange.

Happy 2009, everyone. I will spend New Year’s Eve at D22 watching an amazing lineup of some of Beijing’s most brilliant musicians. I hope to see some of you there.

Tags: Korea

In all the worry about the trade numbers I haven’t discussed another data release last week which, until recently, would have been the most important piece of economic news for me. It was only a few months ago that we were intensely debating the cause of rising inflation in China. Now, inflation is clearly receding. PPI and CPI figures for November were released Wednesday and Thursday, and they showed an unexpectedly high decrease in inflation, with month on month numbers implying actual deflation. Year on year PPI prices rose by 2.0%, compared to 6.6% in October and around 4.5% expectations. CPI inflation declined from 4.0% in October to 2.4% in November, also well below the 3.0%expectations.

What does this say about monetary conditions? First of all let me take a radically contrarian position. I think the latest numbers, far from confirming the view that Chinese inflation in the period until this summer was caused by food supply constraints, actually indicate that the money explanation was right. Inflation in China earlier this year, in other words, was caused by too much money, not too little pork, in Ken Rogoff’s famous formulation.

For those of us in the money camp, inflation was the all-too-expected reaction to explosive money creation caused by China’s currency regime, in which the country’s central bank purchased a torrent of inflowing dollars in order to maintain the value of the currency. In order to fund the purchase of all these dollars, it created RMB, which was intermediated by the formal and informal banking systems into rapid credit growth.

For the pork camp, however, this monetary explanation of inflation was wrong. The cause of Chinese inflation, they argued, was temporary food supply constraints, including harsh winter storms and blue ear disease, which seriously affected pork and grain production. These caused food prices to surge. Inflation, in their view, was nothing more than the temporary consequence of rising food prices, and would end as soon as the supply constraints ended.

While we in the money camp of course acknowledged the sharp rise in Chinese food prices because of harvest problems and pig diseases, we felt that this was as much a coincidence as anything else (especially since food prices were rising around the world). I believed that if monetary policy in China were consistent with low inflation, the brutal surge in food prices would have caused Chinese households to divert so much spending away from non-food items that there would be significant downward pressure on non-food prices. I calculated that non-food prices should have declined by 5-7% if Chinese monetary conditions really were consistent with the 1-3% inflation targeted by the PBoC.

But non-food inflation was not negative. It was low, but we were actually seeing rising non-food inflation for most of the year while food prices were soaring. There was not even disinflation in non-food items, which is the least I would have expected if Chinese inflation was not money-based. That is why I rejected the food-supply constraint argument.

Of course based on our very different analyses, each camp had different predictions for the inflation trajectory. The money camp claimed the still-rapidly growing central bank reserves would ensure that inflation continued through the end of 2008 and into 2009. The pork camp argued that as food supply came back onto line by the end of the year, the food supply constraint would ease and inflation would quickly come down to manageable levels.

As we all know, inflation stayed high through the summer but subsided very rapidly thereafter as food prices declined sharply. In fact they declined far more rapidly than anyone predicted. Year-on-year CPI fell to 2.4% in November and year on year PPI fell even more to 2.0%. So the pork camp’s analysis must have been correct, right?

Not quite. The first clue should be the speed at which inflation fell. Last summer even the most hard-core members of the pork camp didn’t believe that the official target of 4.9% inflation for 2009 would be met. I, frankly, wrote it off as silly even to pretend it was possible (note to self: nothing is impossible). The pork camp made their food price projections based on the removal of supply constraints, and the optimists among them were arguing that we might see inflation between 5% and 6% for this year and a little lower next year.

In fact although food prices declined in line with their predictions, CPI and PPI inflation fell way below what anyone expected, and what is more, now everyone is worried about deflation in China. This to me isn’t necessarily consistent with the idea that Chinese inflation was all about food.

But there is a more technical problem with the idea that the drop in inflation was simply a consequence of declining food prices. In the standard inflation model the rapid decline in food prices should have automatically caused Chinese households to spend less on food and more on non-food consumption. If monetary policy was not deflationary, this would cause the price of non-food goods to increase as the price of food decreased.

But that didn’t happen. From September to November, CPI inflation has declined from 4.6% to 4.0% to 2.4%. As expected, food inflation declined from 9.7% to 8.5% to 5.9%.

But non-food inflation also declined. It dropped from 2.0% in September year on year to 1.6% in October to 0.6% last month. If monetary conditions were stable, just as non-food prices refused to behave the way they should have when food prices were rising, they still refuse to behave correctly when food prices are declining. This suggests to me that the pork camp still has to do a lot of explaining, or else the conclusion must be that Chinese inflation has not been caused by changes in food supply, but rather by changes in the money base.

If this is the case, it has very worrying implications. China’s reserves continue to rise, so the central bank has been continuing to create yuan at a rapid pace, but somehow money supply is contracting rapidly, as indicated by the decline in inflation. What could be happening?

Before answering, let me digress. About two months ago I had dinner with an old friend of mine, Arminio Fraga, the former head of the Brazilian central bank and one of the smartest finance guys I know. During our dinner we talked about conditions in China and I wanted his advice on monetary conditions. I had always felt that monetary aggregates in China did not seem to be explaining what was really happening in underlying money. My instinct was reinforced by a piece I had read by Ronald McKinnon and Gunther Schnabl titled “China’s Financial Conundrum and Global Imbalances” in which they say:

Why didn’t China rely more heavily on domestic financial indicators? With rapid financial transformation and very high saving, the velocity of money – whether based on M0, M1, or M2 – was (is) too unpredictable for any monetary aggregate to be useful as an intermediate target. And the velocity of money, defined as GDP/M, becomes even more difficult to predict when nominal GDP itself is subject to large revisions. Indeed nominal GDP was revised sharply upward in 2006.

Since 1990, Figure 5 shows that these monetary aggregates grew faster than nominal GDP—with M2 growing twice as fast so as to approach 200 percent of nominal GDP in 2008. The high growth in M2 was largely a natural result of China’s very high saving rate when bank deposits are the principal financial asset open to Chinese savers. Thus, the authorities had, and still have, no firm idea of what the noninflationary rate of growth in M2 should be.

I asked Arminio based on his tenure at the Brazilian central bank what he thought about the monetary aggregates (M0, M1, M2 and so on) to judge money growth. He responded that from his experience McKinnon was right and the traditional monetary aggregates were not terribly useful in evaluating money conditions. It was far more useful, he claimed, to look at credit growth.

But in China there is a big problem with the credit data. We don’t have good numbers on credit growth. We know what is happening in most parts of the formal banking system because the PBoC has fairly good numbers there, but we have only a vague idea about off-balance sheet transactions, about financing involving municipalities and provinces, and about inter-company lending. Most importantly we have very little idea about the informal banking sector.

But let’s get back to inflation. During the inflation period, officially credit growth was not too high, but there is strong evidence that during the period of explosive credit growth, when the central bank limited the amount of credit creation permitted to the banking system, the market responded by accommodating explosive growth in off-balance-sheet items and within the informal banking system. Anecdotal evidence suggests that much of China’s huge mot money inflow before this summer may have ended up in the informal banking sector. This (and the explosion in reserve accumulation) is consistent with the idea that inflation in China was money based.

It is the opposite now. Banks don’t want to lend and this implies that credit is contracting. Now that banks are not willing to lend, and companies not willing to borrow to invest (they mainly borrow if they are desperate for liquidity), credit growth is mainly being caused by government pressure to maintain credit growth. But of course credit growth in China is not just a function of the size of commercial bank portfolios. These may be growing, even if very slowly, but transactions that were once off-balance sheet may be coming back on balance sheet to give the illusion of credit growth. More worryingly, the informal banking sector, which may consist of as much as one-third of total loan assets, may be contracting rapidly. That is what the anecdotal evidence suggests. As an aside, in today’s weekly meeting of the Guanghua Students Monetary Policy Committee, one of the members, Gao Ming, reported that he had been getting a huge number of phone text messages from informal lenders offering him money. The other students agreed that they had seen a big rise in these kinds of text messages. Perhaps informal lenders are having trouble finding borrowers?

Certainly if inflation is a monetary phenomenon, this would be the implication of the near-collapse of inflation, which occurred more rapidly than even the most optimistic members of the pork camp expected. So what does this mean if true? It means that money is contracting, and perhaps at an alarming rate. Just as too-rapid money expansion until this summer was showing up as inflation, too-slow expansion (or perhaps even contraction) is showing up as disinflation and even deflation.

I can’t prove it, of course, but I think Chinese inflation is a money-based phenomenon and I am guessing that if China is experiencing deflation it is also experiencing rapid contraction in outstanding credit – much more rapid than we think. In China like in most developing countries, as I have written many times before, the structure of balance sheets tends to reinforce trends, which increases underlying volatility. We may have suddenly swung from ferocious credit expansion to ferocious credit contraction. The fear of deflation next year, in that case, is well founded.

Tags: Arminio Fraga

The stock markets had a bad day, with the SSE Composite dropping 2.1% to close at 2741.7.  Part of the reason for the decline was concern that a roughly $1 billion upcoming share sale by China South Locomotive and Rolling Stock Corp. will draw a lot of liquidity from the market (stock sales tend to be vastly oversubscribed, with investors required to put up 100% of the bid amount in cash in their stock accounts), but the decline was hastened late in the day when reports came in of a terrible attack on a police station in Xinjiang province that left 16 policemen dead.  

Here in Beijing security has become so intrusive (although sometimes it is hard to see how some of the “security” measures can have any impact on actual security) that even my Chinese friends are complaining that they feel like outsiders in their own neighborhoods, and I suspect that the Xinjiang attack will only make things worse.  Still, traffic is certainly better, and except for today the past few days have seen an improvement in the air quality.  The town is slowly starting to fill up with tourists, and areas like Houhai (the lakes north of the Forbidden City) have a real lively atmosphere.  If we aren’t completely prohibited from drinking, dancing and arguing about sports this may turn out to be a fun couple of weeks.

But the rest of China continues without the distraction of living in an Olympic city.  Yesterday’s Bloomberg had an interesting article in which they quote the Wen Wei Po newspaper as saying that, according to “lenders and market watchers it didn’t identify”, the total amount of underground lending in China exceeds RMB 10 trillion.  I don’t know how accurate this number is, but I think total loans in the system are RMB 29-30 trillion, so this suggests that loans in the informal banking sector are roughly equal to 33% of loans in the formal banking sector.  A UIBE professor last year suggested that they were equal to around 25%, so assuming they are not simply quoting each other, the numbers are consistent.

Finally, and in contrast to the panicked reports of a sharp slowdown in China leading to a surge in unemployment, an article in People’s Daily reports that, at least officially anyway, Chinese unemployment is down:  “China’s registered urban and township unemployment rate stood at four percent in the first half, down 0.2 percentage point from the same period last year, the Ministry of Human Resources and Social Security (MHRSS) said on Thursday.”  I don’t think anyone really believes that these numbers represent the actual urban jobless rate (I hear estimates that are two times or more as high), but the trend in the official unemployment number suggests that for all the talk of bankruptcies among southern exporters, it is not necessarily leading to rising unemployment.  Actually I have long argued that it is higher demand for workers that is the real culprit behind the declining fortunes of some of China’s exporters.

After a decent day Monday (up 0.7%) the market today took a beating today, with the SSE Composite closing at 2779, down 3.4% for the day.  The decline was probably partly caused by mortgage fears in the US (insurance companies and banks, who may be big holders of Freddie Mac and Fanny Mae, led the declines), but worries about a slowing domestic economy were likely to be the biggest concern. 

There has been mixed news on the whether or not inflation is still the top worry.  There have certainly been a lot of statements that suggest that the authorities are very worried about a slowdown, and even some suggestions that they are willing to put the fight against inflation on hold, but a statement released by the NDRC yesterday, in which they said that “upward pressure on prices remains strong” seemed to dampen at least some expectations that the government would loosen up on the monetary side.

I am still a monetary pessimistic.  I think the balance of opinion, or at least the opinion that matters, is tilted towards putting inflation-fighting on the back seat and worrying more about a possible slowdown.  I am worried that our inflation respite is going to be temporary, and certainly the data on money inflows doesn’t make it easy to be optimistic about the ability of the PBoC to control inflation.

On the other hand today’s Sydney Morning Herald has a very interesting article by John Garnaut (“Chinese calls for yuan rise to ease inflation”) that was sent to me by Jonathan Lerner, and I haven’t seen any other reference to the story.  The article starts out:

A GROWING number of top Chinese economists are advising their Government to consider a currency revaluation to fight persistent inflation and destabilising “hot money” capital inflows.  “The Chinese currency should be revalued as China’s productivity is increasing,” Professor Fan Gang, a member of the central bank’s monetary committee, wrote in a paper that he was to present to the China Update conference in Canberra before being held back for a last-minute meeting with the Prime Minister, Wen Jiabao.

In recent years currency revaluation has been a taboo topic among Chinese policy makers.

The article goes on the quote He Fan, the assistant director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences, telling Garnaut that “They don’t need to say they are floating the exchange rate but they can at least test the market’s view. With a one-off appreciation by 10 or 15 per cent, maybe the market will believe that’s the end of the story. But maybe the market will still not be satisfied.”

There have been more and more think-tank and quasi-official comments recently about the one-off appreciation, and I suspect that the debate is fairly intense.  Yesterday evening I was with another senior think-tanker, who I have met several times on Dialogue and who has a very sophisticated view of the Chinese economy.  He told me flatly that the only hope of protecting China from the ravages of hot money was to peg the currency.  Since pegging it at these levels would be problematic for many reasons, he said that the PBoC should “surprise” everybody by first revaluing, and then pegging.  He told me that he thought the revaluation should be 5-10%, but agreed that this might be too little.

The Sydney Morning Herald article goes on the describe something that I think is extremely important and has perhaps been under-emphasized in the debate – the destabilizing impact of excessively loose monetary policy on the banking system.  Referring to the pressures on bank profitability caused by PBoC strategies to mop up liquidity, the article says:

Mr He said the main state-owned commercial banks were already devoting between 30 per cent and 40 per cent of their assets to such loss-making endeavours. This was creating “ugly” bank balance sheets and encouraging the banks to recoup profits with “dangerous” lending policies that might ultimately jeopardise financial stability and the Government’s efforts to clean up non-performing loans

In his paper, Professor Fan writes that analysts have “correctly and convincingly” highlighted “structural distortions caused by repressed interest rates and an undervalued currency” which “may also lead to economic, financial and social problems”.  His comments are significant because Professor Fan was previously a staunch defender of the status quo. Nevertheless, a one-off revaluation is unlikely in the near term because China’s export sector is suffering from a downturn in their major developed-world markets and struggling to cope with rapidly rising input costs.

The idea of “dangerous” lending that is likely to be caused by excess control of parts of the system (their forced piling up of PBoC bills and minimum reserves) and by current monetary and credit conditions is something about which I have had a surprisingly hard time arguing, both with Chinese and with foreign analysts.  I am not sure why, since in most markets this is fairly well understood, and given the ongoing crisis in the US, the idea that seemingly smart banks can do some pretty dumb things during optimal times is getting quite a lot of newspaper coverage. 

None of this is new.  Hyman Minsky in particular, has long argued that it is impossible to protect financial systems from periodic crises because the very conditions designed to prevent instability are the ones that create the incentives for bankers to take excessive risk – usually in less well-monitored areas – that end up ensuring that at some point the system will go through a period of “adjustment” and distress.  The empirical evidence that loose monetary conditions and implicit or explicit credit guarantees lead to banking crises is also pretty ample.

I can’t prove it, of course, and no one will be able to prove it until we have our own contraction, but I would be willing to bet that over the last few years the banks and the financial sector in China have been engaging in behavior that will one day seem self-evidently dangerous.  That is both the biggest risk of a sudden revaluation and the strongest argument for doing it as soon as possible.

Speaking of monitoring the banking system, I saw another very interesting piece, this time in ChinaStakes.com (“Government Moves to Legitimize Underground Lending in Zhejiang”).  The title says it all, but here is what the article says:

In Zhejiang Province, with the most developed private companies and private capital in China, the government is trying to legitimize private capital, and set up small-sum loan companies to connect private capital with capital-hungry private companies.  The tight credit policy has driven many small and medium enterprises into hardship and even bankruptcy in coastal provinces like Zhejiang Province. Normally, formal banks, especially the state-owned banks, are reluctant to lend to private companies.

However, Zhejiang is also famous for its so-called underground banking, or back-alley banks as some analysts put it. The government has never issued lending licenses to them.  For some central bankers, like Wu Xiaoling, the former deputy governor of the People’s Bank of China, small-sum loans are an alternative under the current tight monetary policy in place in China.

So now Zhejiang is carrying out a pilot scheme for petty loan firms. If everything goes well, the first small-sum loan companies will start operations in September this year, and their experiences will help to set up more companies of this kind.  Zhejiang is the first province to react to the Guiding Opinions of the China Banking Regulatory Commission and the People’s Bank of China on the Pilot Operation of Small-Sum Loan Companies, which was released in May.

The article goes on to say:

The government has set strict limits for the establishment of small-sum loan companies in order to guarantee their development. According to the regulations in Zhejiang, investors in these loan companies should be chosen from private companies with regular management, sound credit, and are well-operated. The net assets of these companies should not be less than 50 million yuan (or 20 million yuan in less developed areas), and the asset liability ratio no higher than 70%. They should have made profits for three straight years and the total profits should be no less than 15 million yuan (or 6 million yuan in less developed areas).

The government has also banned these companies from collecting deposits or illegally raising funds from the public. Their loans should be dispersed to different businesses in small sums.

The “informal” banks are in many ways among the better-functioning parts of the financial system, although their dubious legal status means that it is probably hard for them to raise money and to collect on bad loans.  This of course raises their cost and forces them into otherwise non-economic behavior – for example I suspect that they tend to insist on short-term loans even when longer-maturities might be optimal – but at least their capital allocation process is probably better in many ways than that of the commercial banks.  Bringing them into the regulatory fold and improving their legal status will almost certainly improve China’s financial system.

Sorry for posting two longish entries on the same day, but I wasn’t able to post yesterday’s entry until this morning, and both days have had some important events worth writing about.

Last night SAFE came out with an announcement that I think many of us were openly expecting and secretly dreading.  According to today’s Xinhua (“China toughens forex receipts and export settlements”),

Stepping up the battle against “hot money” flowing into and out of China, three Chinese central governmental departments are to link their internal electronic systems from July 14 in a trial check of foreign exchange receipts and exports settlements, the State Administration of Foreign Exchange (SAFE) said Thursday.  These measures were interpreted by analysts as one of the latest efforts by the Chinese government to monitor capital flows and prevent more so-called “hot money” from flooding in and out of the country.

Exporters will now be required to place revenues in special accounts while the authorities verify that the funds were the result of genuine trade transactions.  We now begin an extended curriculum on the difficulty of eliminating hot money inflows through administrative measures.  I am reasonably confident that this new move will slow hot money inflow through the trade account in the short term while in the medium term it will have little impact (although it is worth noting parenthetically that most of our estimates for hot money don’t take these into account anyway, and if the measure only succeeds in driving hot money inflows out of the trade channel and into other channels, its main impact will have been a welcome but unintended increase transparency).  It will also create significant frictional costs for the trading sector and so dampen real trade transactions.  Finally, the new administrative measures may ultimately be used as a tool to manage trade, i.e. minimize imports, and so add to international trade tensions.

I won’t say too much about this directly because I think the press is covering it quite well (see for example Geoff Dyer’s “China in clampdown on ‘hot’ money” in today’s Financial Times), but I will say that it does suggest that there isn’t an awful lot the authorities can really do about inflows.  It is also not going to make a big difference.  Bloomberg today gives one expert’s reasoning, citing Li Youhuan, a researcher at the Chinese Academy of Social Sciences:

“Speculative money can always find loopholes,” said Li, who undertook an investigation last year into how hot money was entering China. “Inflows through service deals are even faster and simpler than via the exchange of goods. How can the regulators judge whether the prices paid for corporate identity designs, for example, are fair or not?”

As Stone & McCarthy Logan Wright pointed out in a note today:

Overall, this is likely to be the first of several attempts by financial regulators to monitor speculative capital inflows; more supervision of foreign companies’ bank accounts and registered capital may appear in the coming weeks or months. However, independently, the new SAFE restrictions on exporters are unlikely to have a significant effect on hot money flowing in through the trade account, and are likely to create cashflow difficulties for exporters already suffering from declining sales volumes and higher input costs. The measures suggest that the central government is much more likely to turn to administrative measures to target capital inflows rather than accelerating the pace of yuan appreciation (or pursuing a one-off revaluation), because controlling capital flows reflects the path of least political resistance. However, as long as market expectations for further yuan appreciation exist, speculative capital flows are likely to continue, despite the Chinese government’s attempts to tighten controls.

On a related note, two days ago Morgan Stanley published a widely-read piece by Qing Wang on hot money flows (“China: Counting Hot Money”) in which the author cautions about attributing too much of the reserve accumulation net of the trade surplus and FDI to hot money, which he refers to as the “residual” method.  In particular he points out that there are several other types of transactions that can affect the net number which have not been taken into account by most analysts estimating hot money inflows. 

First, this indicator treats some items under the current account such as remittances and income, for which high-frequency data are not available, as part of hot money flows. This tends to overstate the amount of hot money flows.  Second, this indicator is a net flow concept and fails to take into account capital outflows/inflows originating from China-based financial institutions, which are at times heavily influenced by domestic policy changes.  Third, changes in US dollar-denominated FX reserves could simply reflect changes in the cross rates between the US dollar and other major reserve currencies (e.g., euro, yen); however, this indicator attributes these valuation effects to changes in ‘hot money’ flows.

Some of his comments are fairly obvious – and most credible estimates of hot money do take them into account, but he does point out two things that are worth repeating.  First, the net numbers do not take into account capital outflow transactions, most of which officially directed:

Capital outflows originating in China are mostly carried out by domestic financial institutions and closely reflect government policy, in our view.  For instance, we think that the large amount of purchases of MLT debt securities that originated in China in 2006 reflected the special FX swap arrangements between the PBoC and several large domestic banks in 2006, under which the banks were asked to park their funds (some of which were raised from the mega bank IPOs in Hong Kong) offshore.

Wang concludes that the “residual” method of calculating hot money underestimated hot money inflows in earlier years and over estimates them currently, which, if true, suggests not that hot money inflows are not substantial but rather than they have been less volatile than previously estimated.  This is a point well worth making.

In fact much of what Wang says is reasonable, but I have some disagreements with his conclusions.  He says:

A key reason for ‘hot money’ becoming a popular issue among market participants is the concern about the potential negative impact on the economy if ‘hot money’ inflows were to turn suddenly into outflows.  The common fear is that in the event of ‘hot money’ outflows, the renminbi exchange rate would come under considerable depreciation pressure and there could be serious domestic liquidity shortages that may potentially destabilize the domestic banking system.

While these concerns are not entirely unwarranted, they are overdone, in our view.  First, despite the considerable uncertainty in the current market environment, the underlying fundamentals of the Chinese economy remain very robust, and we do not envisage circumstances that could bring about a major downgrade of investors’ medium-term outlook for the economy and thus reverse the direction of capital flows.

Second, we estimate that the potential amount of the ‘hot money’ stock is likely to be US$200-300 billion.  Even if all these funds were to leave China, this would be unlikely to generate much depreciation pressure on the renminbi exchange rate.  With US$1.8 trillion in FX reserves outstanding and rising, China should be able easily to defend the renminbi exchange rate in the event of potential outflows of a magnitude of about 15% of the total FX reserve stock.

Third, the potential negative impact of ‘hot money’ outflows on domestic liquidity can be easily mitigated as well, in our view.  With China’s current ratio for required reserves (RRR) at 17.5%, one of the highest levels in the world, the potential liquidity impact as a result of US$200-300 billion ‘hot money’ outflows could be effectively offset by the PBoC lowering the RRR.  We estimate that the liquidity impact of US$200-300 billion in outflows could be offset by a reduction in the RRR of about 500bp from 17.5% currently to 12.5%.  Even at 12.5%, the RRR level is still very high by international standards.

His first point is correct as it stands, but Latin American and other developing country experience suggests it is irrelevant.  Of course the underlying fundamentals in China seem robust.  This is almost a precondition for hot money inflows.  But in previous cases, whether we are discussing hot money inflows into Argentina in the late 1990s, or into Thailand, Malaysia, Indonesia and Korea in the three or four years before the 1997 crisis, or in Mexico in 1992-93, it was robust-seeming conditions in every case that precipitated the inflows.

These inflows themselves created the conditions for the subsequent outflows – most importantly over-extended balance sheets and unstable financial systems.  In the case of China the danger is not that hot money is pouring into a country that is clearly on the edge of disaster – it never does.  The real danger is that if conditions turn, whether because of domestic or international shocks, the inflows can reverse and exacerbate the impact of the shock.

My problem with the second point is that I think he dismisses, and very effectively, the wrong concern.  I don’t think the worry people like Logan Wright, Brad Setser and me have is simply that capital outflows could force a depreciation of the RMB one day (in my case I don’t even think it is likely).  The worry is that capital outflows could drive domestic liquidity from the financial system and expose very vulnerable balance sheets.  The idea that a financial crisis is by definition a currency crisis may be deeply established, but it is wrong.  Most financial crises historically have been domestic financial crises, and as I have said perhaps too many times, the next set of crises will more likely be domestic banking crises than external debt crises (with Argentina being, as it always has been, the honorable exception).

This also suggests what it wrong with his third point.  It is true that rising minimum reserve requirements constrains lending growth, but it is not equally true that lowering them forces lending growth.  Minimum reserve requirements are a constraint on, not a determinant of, lending volume.  If we experience the conditions in which China would suddenly see massive capital outflows, it is a pretty safe bet that banks would be more concerned about preserving liquidity than about lending as fast as they were legally permitted.  This does not even consider the impact of illiquidity on the informal banking sector, which according to one estimate (see yesterday’s entry) may comprise not too much less than one-third of total banking assets.

One final point, the biggest concern about hot money is not whether or not it is hot money by definition.  The biggest concern, for me at any rate, is its sheer size and its pro-cyclicality.  It doesn’t matter too much whether a specific inflow is illegal or otherwise constitutes someone’s definition of hot money.  What matters is whether it forces the PBoC to expand the money supply, and whether it is likely to increase or decrease underlying economic and financial volatility.  I would argue that most of the recent increases in headline reserves do both.

Certainly last night’s announcement by SAFE indicates that the PBoC is also very worried.

I was too busy to post anything Tuesday, but there wasn’t a whole lot new to say except to bemoan the stock market’s performance, again.  The SSE Composite dropped 3.1%.  Today after a rocky start it seemed to find its legs, trading up 1.8% by lunch, before giving it all up to end the day almost perfectly flat at 2701.  It is now trading almost exactly 10% below 3000, which as recently as three weeks ago was the market’s imagined government-intervention level.

The property market doesn’t seem to be doing a whole lot better, at least in Shanghai.  Two articles in today’s South China Morning Post warn that Shanghai’s property sales are down.  According to one, “The sale of new flats in Shanghai measured by floor area, plunged almost 50 per cent in the first half, and sources said the market was unlikely to turn around until September, traditionally the peak season for property sales.”  Shanghai residential prices have been under pressure for a while as a consequence.  The second article suggests that commercial property is also seeing selling pressure, although increased selling interest is not necessarily causing prices to drop:

The queue of investors seeking to sell their Shanghai properties is getting longer, leaving analysts divided over the impact of a fresh wave of disposals on the market…

“All these asset disposal plans will add uncertainty to the outlook for the investment market,” said Clement Leung Wai-ming, an executive director for China valuation at property consultant Knight Frank.  But with Shanghai residential prices holding firm despite a sharp fall in deal volumes last month and evidence that new investors are ready to step into the market, others have a more optimistic view.

I think the fact that there is so much hot money flooding into the country has made the clearing mechanism complex.  Fleeing sellers are matched with buyers flush with cash, and the market, while trending down, hasn’t really gone down as much as it might.  Needless to say, this is very worrisome (but you knew I’d say that, didn’t you?).  Property exposure is extremely high within the Chinese banking sector, and if what is propping up real estate prices, however tenuously, is hot money inflows, then we have yet another nasty little volatility machines embedded in the banks’ balance sheets. 

Why?  Because hot money, as is sometimes forgotten, is almost by definition highly pro-cyclical, and is likely to flee exactly when conditions are bad and it is needed most – just as the banks are struggling to deal with the consequences of a future financial or economic contraction, in other words, the legs are likely to be kicked out from under the real estate market.  China has too many of these busy little pro-cyclicality machines embedded in its balance sheet, which means that good conditions as well as bad conditions are likely to be exacerbated by the dynamics of the balance sheet.  Perhaps that is one of the major reasons why China has seemed like the rest of the world hopped up on super steroids.

By the way it is becoming increasingly clear that a lot of real estate developers – frozen out of the banking system – are turning to the informal banks for short-term and expensive funding.  For a long time I have been discussing and wondering about the role of the informal banks in all of this, and I said several times that I was willing to bet that the informal banking sector in China was growing rapidly, if only there where a way to measure it.  I am glad to say that over the past few weeks this has suddenly become a very hot topic, so it is getting a little easier to get a sense of its impact.  I was particularly interested by an article in today’s China Daily (“Irregular financing channels rampant”).  According to the article:

Many small and medium-sized enterprises now mainly rely on “underground” funding to finance their businesses as credit tightening measures have dried up bank loans.  Policymakers have been tightening the purse strings to fight inflation since last year. The benchmark interest rate has been raised six times, to 7.47 percent, and the reserve requirement ratio for banks raised 15 times since last year.  These measures have made it all the more difficult for SMEs to get bank loans, a vacuum promptly filled up by underground financing channels, said industry observers.

The article goes on to quote one of these informal bankers:

“A lot of small firms come to us. Only the bigger enterprises go to the banks,” said an underground lender, who declined to be named. He has lent out 10 million yuan – he declined to say how he made that kind of money – at 30 percent annual interest rate.  “Interest is not an issue. They will go bankrupt if they don’t get our short-term loans,” he said. “Our money is available at short notice. We can deliver the cash within 24 hours, while a bank loan might take at least six months. But I am only small fry, there are bigger fishes out there with more than 100 million yuan parked in underground financing.”

The article also refers to a survey conducted by Beijing’s Central University of Finance & Economics, which found that underground lending totaled 1.98 trillion yuan in 2007, equal to 28% of the amount banks lent.  This is a pretty large amount, and there is a lot of circumstantial evidence that the informal banking sector has gotten significantly larger, especially as hot money inflows seem to have grown very rapidly in the past few months at the same time that lending caps and hikes in the minimum reserve requirements have sharply curtailed loan growth in the formal banking sector.

The size and growth of the informal banking sector is not just of academic interest.  It has at least three implications for those of us worried about monetary conditions in China.  First, it makes the management of domestic monetary policy, to the extent that such a thing exists, much more difficult because the PBoC has no direct control over the informal banks.  If, for example, a lending cap on the commercial banks simply pushes loan origination off the commercial bank balance sheets and onto the informal banking sector, the lending cap can’t and won’t have much of an effect on domestic money or credit growth.  In addition, because the rate informal banks charge on loans is also beyond the reach of the regulator, the PBoC’s management of interest rates is also partially constrained (although on balance, given negative real rates and the consequent misallocation of capital, this is probably a good thing).

Second, it raises important questions about the structure of Chinese corporate balance sheets.  We don’t know for sure, but there are very good reasons to believe that loans extended by the informal banking sector are of much shorter maturity and of much higher rates than is typical for the commercial banks.  If this is true, and it almost certainly is, corporate balance sheets are much more vulnerable to an economic downturn or a sudden liquidity contraction than we might otherwise think (yet another dynamic little volatility machine embedded in China’s balance sheets).

Third, the rise of informal banks partially answers the question about where, if China is indeed being flooded by hot money, as I have been arguing since early last year, is all this money going?  Part of it is going into the informal banks.  Add the role of informal banks to the mix of rising bank deposits, the hoarding of commodities, real estate investment in secondary cities, and so on, and it is not so difficult to see where the money goes.

At the end of the China Daily article, the piece confirmed in a rather macabre way what my lunch companion last Saturday told me.  As I wrote on my Sunday blog entry:

We discussed what would happen in the case of a default – besides the proverbial visit by the man with a baseball bat he suggested, with a completely straight face, it was also likely that one of your kids might be kidnapped.

According to the China Daily article:

“Many a time, the borrowers cannot pay back,” the private lender said. “What can you do in such cases? You just have to resign yourself to your fate.”  But not all lenders give up that easily. Some can go to the extent of hiring gangs to kidnap the borrowers or their family members to recover the loan, he added.

We definitely need to think more about the informal banking sector in trying to get our arms around China’s financial risk profile. 

Besides informal banking, the other “hot” topic about which a few of us have been pounding the table for months is, of course, hot money inflows.  I think increasingly people in China – and not just at the PBoC – are waking up to the sheer magnitude of the problem.  Today’s Xinhua has an article titled “Unprecedented capital inflows test Chinese regulators.”  According to the article:

China has taken a series of increasingly aggressive measures in the past several months to blunt the impact of so-called “hot money,” amid the explosive growth of its foreign exchange reserves, which have soared beyond what can be explained by trade and investment flows.  The inflows have been so massive as to raise alarms over the country’s financial security.

The article is worth reading because it gives a sense that either there is rising concern in official circles about the impact of hot money in China or, alternatively, someone, probably in the PBoC, wants to raise such concern.  I am working on a piece, which I hope to complete soon, discussing the implications of the increasing role of hot money in China’s burgeoning reserve accumulation.  One interesting data point:  In the first quarters of 2005 and 2006, the combination of FDI and the trade surplus accounted for 60-70% of reserve accumulation.  By 2007, it accounted for only 46% of reserve accumulation.  This year, it accounted for 45% of headline reserve accumulation, but if you adjust for the “outsourced” portion of reserve accumulation (transfers to the CIC and minimum reserve redenomination), it amounted to barely 20%. 

This is a dramatic shift.  I know I have been pounding this drum over and over again quite a bit recently, but I am absolutely convinced that it is just a question of time that this, too, becomes a hot topic.  My prediction: worries about the shifting composition of China’s reserve accumulation will soon be one of the big stories in the financial pages.

As an total aside, after complaining last week that since the fuel price hike it has been almost impossible for me to find a taxi with air-conditioning here in hot, sticky Beijing, three of the four taxis I rode today were air-conditioned.  This is not a very scientific indicator, but given that taxi fares haven’t risen to match the increase in fuel costs, and their incomes must be wilting, I wonder if taxi drivers have at least come to some sort of agreement with the government.  Yesterday I had lunch with my friend Pierre Mongrue?, with the Economic Department of the French Embassy, and he thinks that there may be an agreement to subsidize or otherwise accommodate taxi drivers.  If there is, the process of managing the very complex relationships of subsidies related to fuel price caps must be a nightmare, not to mention highly distortionary.

Sorry.  My blog site was down so this Wednesday entry was posted Thursday, one day late.

I was too busy to post anything Tuesday, but there wasn’t a whole lot new to say except to bemoan the stock market’s performance, again.  The SSE Composite dropped 3.1%.  Today after a rocky start it seemed to find its legs, trading up 1.8% by lunch, before giving it all up to end the day almost perfectly flat at 2701.  It is now trading almost exactly 10% below 3000, which as recently as three weeks ago was the market’s imagined government-intervention level.

The property market doesn’t seem to be doing a whole lot better, at least in Shanghai.  Two articles in today’s South China Morning Post warn that Shanghai’s property sales are down.  According to one, “The sale of new flats in Shanghai measured by floor area, plunged almost 50 per cent in the first half, and sources said the market was unlikely to turn around until September, traditionally the peak season for property sales.”  Shanghai residential prices have been under pressure for a while as a consequence.  The second article suggests that commercial property is also seeing selling pressure, although increased selling interest is not necessarily causing prices to drop:

The queue of investors seeking to sell their Shanghai properties is getting longer, leaving analysts divided over the impact of a fresh wave of disposals on the market…

“All these asset disposal plans will add uncertainty to the outlook for the investment market,” said Clement Leung Wai-ming, an executive director for China valuation at property consultant Knight Frank.  But with Shanghai residential prices holding firm despite a sharp fall in deal volumes last month and evidence that new investors are ready to step into the market, others have a more optimistic view.

I think the fact that there is so much hot money flooding into the country has made the clearing mechanism complex.  Fleeing sellers are matched with buyers flush with cash, and the market, while trending down, hasn’t really gone down as much as it might.  Needless to say, this is very worrisome (but you knew I’d say that, didn’t you?).  Property exposure is extremely high within the Chinese banking sector, and if what is propping up real estate prices, however tenuously, is hot money inflows, then we have yet another nasty little volatility machines embedded in the banks’ balance sheets. 

Why?  Because hot money, as is sometimes forgotten, is almost by definition highly pro-cyclical, and is likely to flee exactly when conditions are bad and it is needed most – just as the banks are struggling to deal with the consequences of a future financial or economic contraction, in other words, the legs are likely to be kicked out from under the real estate market.  China has too many of these busy little pro-cyclicality machines embedded in its balance sheet, which means that good conditions as well as bad conditions are likely to be exacerbated by the dynamics of the balance sheet.  Perhaps that is one of the major reasons why China has seemed like the rest of the world hopped up on super steroids.

By the way it is becoming increasingly clear that a lot of real estate developers – frozen out of the banking system – are turning to the informal banks for short-term and expensive funding.  For a long time I have been discussing and wondering about the role of the informal banks in all of this, and I said several times that I was willing to bet that the informal banking sector in China was growing rapidly, if only there where a way to measure it.  I am glad to say that over the past few weeks this has suddenly become a very hot topic, so it is getting a little easier to get a sense of its impact.  I was particularly interested by an article in today’s China Daily (“Irregular financing channels rampant”).  According to the article:

Many small and medium-sized enterprises now mainly rely on “underground” funding to finance their businesses as credit tightening measures have dried up bank loans.  Policymakers have been tightening the purse strings to fight inflation since last year. The benchmark interest rate has been raised six times, to 7.47 percent, and the reserve requirement ratio for banks raised 15 times since last year.  These measures have made it all the more difficult for SMEs to get bank loans, a vacuum promptly filled up by underground financing channels, said industry observers.

The article goes on to quote one of these informal bankers:

“A lot of small firms come to us. Only the bigger enterprises go to the banks,” said an underground lender, who declined to be named. He has lent out 10 million yuan – he declined to say how he made that kind of money – at 30 percent annual interest rate.  “Interest is not an issue. They will go bankrupt if they don’t get our short-term loans,” he said. “Our money is available at short notice. We can deliver the cash within 24 hours, while a bank loan might take at least six months. But I am only small fry, there are bigger fishes out there with more than 100 million yuan parked in underground financing.”

The article also refers to a survey conducted by Beijing’s Central University of Finance & Economics, which found that underground lending totaled 1.98 trillion yuan in 2007, equal to 28% of the amount banks lent.  This is a pretty large amount, and there is a lot of circumstantial evidence that the informal banking sector has gotten significantly larger, especially as hot money inflows seem to have grown very rapidly in the past few months at the same time that lending caps and hikes in the minimum reserve requirements have sharply curtailed loan growth in the formal banking sector.

The size and growth of the informal banking sector is not just of academic interest.  It has at least three implications for those of us worried about monetary conditions in China.  First, it makes the management of domestic monetary policy, to the extent that such a thing exists, much more difficult because the PBoC has no direct control over the informal banks.  If, for example, a lending cap on the commercial banks simply pushes loan origination off the commercial bank balance sheets and onto the informal banking sector, the lending cap can’t and won’t have much of an effect on domestic money or credit growth.  In addition, because the rate informal banks charge on loans is also beyond the reach of the regulator, the PBoC’s management of interest rates is also partially constrained (although on balance, given negative real rates and the consequent misallocation of capital, this is probably a good thing).

Second, it raises important questions about the structure of Chinese corporate balance sheets.  We don’t know for sure, but there are very good reasons to believe that loans extended by the informal banking sector are of much shorter maturity and of much higher rates than is typical for the commercial banks.  If this is true, and it almost certainly is, corporate balance sheets are much more vulnerable to an economic downturn or a sudden liquidity contraction than we might otherwise think (yet another dynamic little volatility machine embedded in China’s balance sheets).

Third, the rise of informal banks partially answers the question about where, if China is indeed being flooded by hot money, as I have been arguing since early last year, is all this money going?  Part of it is going into the informal banks.  Add the role of informal banks to the mix of rising bank deposits, the hoarding of commodities, real estate investment in secondary cities, and so on, and it is not so difficult to see where the money goes.

At the end of the China Daily article, the piece confirmed in a rather macabre way what my lunch companion last Saturday told me.  As I wrote on my Sunday blog entry:

We discussed what would happen in the case of a default – besides the proverbial visit by the man with a baseball bat he suggested, with a completely straight face, it was also likely that one of your kids might be kidnapped.

According to the China Daily article:

“Many a time, the borrowers cannot pay back,” the private lender said. “What can you do in such cases? You just have to resign yourself to your fate.”  But not all lenders give up that easily. Some can go to the extent of hiring gangs to kidnap the borrowers or their family members to recover the loan, he added.

We definitely need to think more about the informal banking sector in trying to get our arms around China’s financial risk profile. 

Besides informal banking, the other “hot” topic about which a few of us have been pounding the table for months is, of course, hot money inflows.  I think increasingly people in China – and not just at the PBoC – are waking up to the sheer magnitude of the problem.  Today’s Xinhua has an article titled “Unprecedented capital inflows test Chinese regulators.”  According to the article:

China has taken a series of increasingly aggressive measures in the past several months to blunt the impact of so-called “hot money,” amid the explosive growth of its foreign exchange reserves, which have soared beyond what can be explained by trade and investment flows.  The inflows have been so massive as to raise alarms over the country’s financial security.

The article is worth reading because it gives a sense that either there is rising concern in official circles about the impact of hot money in China or, alternatively, someone, probably in the PBoC, wants to raise such concern.  I am working on a piece, which I hope to complete soon, discussing the implications of the increasing role of hot money in China’s burgeoning reserve accumulation.  One interesting data point:  In the first quarters of 2005 and 2006, the combination of FDI and the trade surplus accounted for 60-70% of reserve accumulation.  By 2007, it accounted for only 46% of reserve accumulation.  This year, it accounted for 45% of headline reserve accumulation, but if you adjust for the “outsourced” portion of reserve accumulation (transfers to the CIC and minimum reserve redenomination), it amounted to barely 20%. 

This is a dramatic shift.  I know I have been pounding this drum over and over again quite a bit recently, but I am absolutely convinced that it is just a question of time that this, too, becomes a hot topic.  My prediction: worries about the shifting composition of China’s reserve accumulation will soon be one of the big stories in the financial pages.

As an total aside, after complaining last week that since the fuel price hike it has been almost impossible for me to find a taxi with air-conditioning here in hot, sticky Beijing, three of the four taxis I rode today were air-conditioned.  This is not a very scientific indicator, but given that taxi fares haven’t risen to match the increase in fuel costs, and their incomes must be wilting, I wonder if taxi drivers have at least come to some sort of agreement with the government.  Yesterday I had lunch with my friend Pierre Mongrue?, with the Economic Department of the French Embassy, and he thinks that there may be an agreement to subsidize or otherwise accommodate taxi drivers.  If there is, the process of managing the very complex relationships of subsidies related to fuel price caps must be a nightmare, not to mention highly distortionary.

After yesterday’s stock market excitement, the government “quashed” rumors today that they were going to relax prices on refined oil products.  According to China Daily, “the National Development and Reform Commission (NDRC), China’s economic planning agency, said rumors that the authorities plan to relax domestic oil and gas price controls are baseless.” The Shanghai Securities News, the official paper of the stock exchange, quoted an unidentified government official as saying that relaxing the pricing regime would hinder earthquake relief and reconstruction.

What may have started the rumors yesterday were indications that the government may instead help oil companies by reviewing the windfall profit tax imposed on all upstream oil producers.  Apparently PetroChina lat week appealed to the government for just such a review.  It is worth noting that the government is likely to be – and for good reason – very secretive about any plans to change oil prices since this is only likely to encourage hoarding in the short term.  Shortages continue to be a problem and low domestic oil prices – at roughly one-third the world price – have done nothing to stimulate energy conservation.  I think the problems of hoarding, shortages and smuggling are only going to get worse over the next few months, especially as the serious reconstruction in Sichuan kicks in, and we will see a resurgence of these rumors about relaxing price freezes from time to time.  It cannot be easy for the government to cope with the consequences of maintaining low domestic oil prices, and it certainly isn’t cheap.

The stock market reacted very strangely today to all of this.  The SSE Composite opened down and lost 2.1% from yesterday’s close within the first thirty minutes of trading, before bouncing around for much of the morning within a 1-1/2% trading band.  It suddenly shot up in the early afternoon to a few points above yesterday’s close, before collapsing in the last 90 minutes to 3586, down 1.65% for the day.  Neither I nor my student Shang Ning was able to get much of an explanation for the sharp ups and downs today.  This has the feel of a very uncertain market chasing its own tail.

Meanwhile there was an interesting article in today’s South China Morning Post about the increased cost of converting HK dollars into RMB.  Bank of China, the city’s RMB clearing bank, widened the spread between the buy and sell rates for the RMB early this month from 10 basis points to 75 basis points.  This was reportedly done because the PBoC was worried that increasing demand for RMB in Hong Kong could affect its exchange management and its domestic monetary policy.

Sure enough, the exchange volume dropped significantly since the move, but the newspaper report quotes Joseph Yam Chi-Wong, the chief executive of the Hong Kong Monetary Authority, as saying that “some transactions may shift to money exchangers or even through underground channels if people are very sensitive to the buy-sell spread.”  They may shift?  I think it is a dead certainty that money is shifting to informal channels.  After all there is plenty of evidence that hot money inflows are high and increasing, and if there is a slowdown in the formal channels for RMB purchases, what else can one assume?

Along that line I missed a very interesting article in the April 23 edition of a local magazine, The Economic Observer.  The article, titled “Chinese Firms Tapping Informal Loan Networks,” discusses one of the things I have been wondering about a lot on this blog.  I have always assumed that one of the consequences of the stricter lending caps imposed this year would simply be to move borrowing out of the formal banking system and into less formal borrowing channels, and I had heard anecdotal evidence that this was indeed happening.  Apparently some economists at the All-China Federation of Industry and Commerce have been doing their own work on the subject.

Research by the Federation estimated that Chinese companies raised some 800 billion yuan through informal channels last year, among which researcher Chen Yongjie said over 20 billion yuan likely came from Wenzhou.  Businesses that raised money in this fashion would likely be charged a 5% monthly interest rate, amounting to around 60% in one year.

According to Chen, over five million private businesses made up 70% of China’s total, making up 65% of China’s GDP.  But despite the importance of this segment to Chinese industry, Chen’s data indicated that the proportion of loans from banks to them decreased over the past three years. The proportion of short-term loans to private business was about 11% in 2005, but only 9% in 2006.  China Society of Private Economic Research chairman Bao Yujun had spent two weeks investigating in Shaoxing, Wenzhou and nearby regions, and discovered that underground fundraising was indeed gaining momentum in Wenzhou. 

Despite the fact that underground fundraising goes against regulations made by financial supervisory bodies in the Chinese central government, the local governments were turning a blind eye.   Bao spoke with a prominent politician of one city in Zhejiang who stressed that there was no way they could clamp down because businesses had to survive and that locals had to remain employed.

Wenzhou, for those who don’t know, is a city in the south famous both for the ferocious entrepreneurialism of its citizens and for its extensive informal banking sector – with the second characteristic probably not unrelated to the first.  The point the researchers are making is that as small businesses in China grow, they are getting less and less help from the large commercial bank, who prefer to concentrate their now-limited lending power to loans to the large SOEs – yet another way in which China’s financial system fails miserably in delivering capital to its most efficient users. 

Not surprisingly, these private companies are turning to the informal banks for funding, in spite of borrowing costs as high, according to the article, as 5% a month, which they describe as 60% a year but which I would qualify as 80% a year if correctly compounded (which at least gives some idea of the profitability both of the private companies and of the informal banking sector).  

The worrier in me would make two points about this – besides the obvious one about how the banking system misallocates capital.  First, such high borrowing rates can spell catastrophe if the economy were to suffer a sharp slowdown since borrowing at this rate must require optimal economic and profit conditions to be justified.  Second, any attempt to measure real loan expansion in China is likely to be overly conservative if we ignore the impact of these informal lending institutions.  Credit growth is almost certainly higher in China than what the numbers from the commercial banks suggest.