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Tuesday, Oct. 18, 2011
Economic trouble in China
The decision of China's sovereign wealth fund to buy shares of four of the country's biggest banks is a warning signal. The move to prop up the plummeting value of those institutions is intended to boost confidence; instead, it has highlighted the many unknowns that dominate the country's financial system. China's leaders (and bankers) are understandably nervous about shedding more light on its dark corners, but failure to do so will only increase the pain when a future shock comes.
Many observers insist that China's economic dynamism is unsustainable. Double-digit growth is easy — with the right policies — when starting from a low base. The trick is maintaining that pace. Rapid growth often sows the seeds of its own undoing as prices increase, inflation takes root and bubbles pop up. This natural process has been accelerated by the massive $600 billion stimulus that the Chinese government pumped into the economy in 2009 after the global downturn. Much of that money appears to have been misspent and the banks — the instrument of that stimulus — have to account for the losses.
Chinese central government officials understand the problem. But they have limited power to control an economy of China's size. Local officials have plenty of incentives to disregard directives from Beijing to slow lending. Growth provides jobs, creates taxes, enhances their own standing at home and in the party hierarchy (and puts money into the pockets of the more corrupt individuals). In honest moments, top Chinese officials concede that they cannot trust statistics from local and provincial governments and in the absence of accurate information, they cannot make policy.
As Japan knows well, a functioning economy requires healthy banks. It was the deadweight of nonperforming assets in the Japanese financial system that was most responsible for the "lost decade" of the 1990s. The refusal of Japan's banks to discard those balance sheet liabilities sapped the entire economy. There is concern that China faces a similar problem: banks are reluctant to reveal the size of their losses for fear of triggering runs.
The problem should be familiar. Chinese banks have loaned heavily to real estate developers, often taking land as collateral. If prices fall — some say the question is "when," not if — the banks will face solvency issues. One recent estimate says Chinese losses could reach as high as 60 percent of bank equity capital if local governments and real estate companies do not pay back their loans. The anticipation of such a development has been pushing Chinese share prices down. The market has fallen 23 percent since April and hit a 30-month closing low at the beginning of last week. Chinese authorities worry that fear of a downturn could become a self-fulfilling prophecy, and the action last week was designed to turn the tide.
Another problem is the growing number of unofficial financial intermediaries that promise big returns. With banks offering modest interest rates for deposits, shadowy companies that offer double-digit returns are finding ample contributors. One expert estimates that the growth of credit in China may be 50 percent higher than official numbers show. These companies are not regulated, meaning that money floods into already frothy markets and that there is no guarantee that investors will get promised returns. This introduces more instability into the Chinese economy.
To change the dynamic, last week, Central Huijin Investment bought $31 million in shares in the big four Chinese banks — Agricultural Bank of China, Industrial and Commercial Bank of China, China Construction Bank Corporation and Bank of China. That sum was a mere 0.5 percent of the total daily trading volume in Shanghai, and as Huijin was already the largest shareholder of the big four, the purchases made almost no difference in ownership. But it signaled markets that the government is standing behind its banks, a move that should reinstate confidence.
Three years ago, in the aftermath of the collapse of Lehman Brothers, Chinese stock prices were plummeting and a similar move by Huijin sparked an 18 percent two-day rally in the Shanghai market. Last week's purchases moved the market again, but the gains were slight. Markets know Beijing has fewer options today.
The Huijin intervention three years ago was the first in an array of measures that stimulated the entire Chinese economy. Today, with inflation already at worryingly high levels, there is little prospect of such a boost.
Fortunately, Beijing has other options. It has tightened credit through a variety of means in recent months to slow inflation. The government could declare victory, relax some of those measures and lower interest rates. Other instruments could be used to invest in shares, such as the country's national pension fund or the savings held by insurance companies.
The question now is whether the market decline is a sign of weakness in the fundamentals or merely a loss of confidence. If it is the latter, then the Chinese government's actions could stem the tide. China has massive financial reserves and plenty of tools to signal its resolve.
If, the problem is more than atmospherics, then games will not suffice. At some point, the economy must adjust. Investors will have to take losses. Unfortunately, many of those "investors" are ordinary citizens who have never known such reversals. It is a sobering thought for decision makers in Beijing — and the rest of the world: Who knows what will happen if the Chinese economy, the last bastion of global energy, begins to slow?