Things have been so busy this past week with various writing commitments and with the celebration of the third anniversary of my music club (four amazing shows with some of Beijing’s greatest artists and a lot of support and coverage from local music scene participants an the press) that I have been neglecting my blog. For today’s entry I don’t have any major points to make but I did want to take a look at some of the anecdotal information we are getting about the bank-part of the fiscal stimulus package.
The context is last week’s post in which I argued that the almost certain reversal over the next few years of American ability to grow consumption at a faster rate than GDP will put huge pressure on the Asian development model, and will require Asian consumption to grow much faster than Asian GDP. However if the current loan explosion is mismanaged, this may itself sharply constrain Chinese consumption growth, thus locking China into a long transition period of turgid growth.
In that light two weeks ago The Economic Observer, one of the better local newspapers, had an interesting article titled “Millions of Small Businesses Still Starved of Credit”. The growth of smaller businesses, many of which are in the service industry, is one important way for Chinese net consumption to grow, but it seems that their ability to obtain financing is being sharply limited by formal or informal policies that are driving capital into the investment sector. The article suggested that even with the explosive loan growth in the banking system, smaller companies are finding it extremely difficult to get loans.
New loans in China for the first quarter of this year would amount to nearly 4.6 trillion yuan, but behind the staggering figure, millions of small and medium-sized businesses nationwide were still struggling to raise funds.
Data from the National Association of Industry and Commerce (NAIC) showed that in January of this year, private firms had 421 billion yuan in short-term loans, a 700 million yuan decrease from December 2008. That was despite 400 billion yuan in new short-term loans released that month.
The article goes on to mention a survey of businesses in Chongqing that indicated that 82% of small and medium-sized businesses there considered the lack of funds the main hindrance to their development. Quoting Chen Yongjie, an official with the National Association of Industry and Commerce, the article goes on:
The Chinese government has recently pushed measures to solve financing problems for small and medium-sized businesses – for example, China’s Banking Regulatory Commission has required banks to open loan departments exclusively for small companies. But Chen said it was hard to tell how effective these measures would be: “What we can see clearly now from the statistics is that loans for small and medium-sized businesses are still dropping.”
It would be normally be surprising that loans are expanding so rapidly (we have already increased net new lending in the first quarter of 2009 by more than all of last year’s loan increase) while whole sectors of the economy are struggling to find financing, but my friend Dan Rosen sent me a Bloomberg article from Friday with a line which he found very funny and a tad startling. According to the article:
The largest borrower in the quarter was government-owned China Aviation Industry Corp., or AVIC, the nation’s biggest aerospace company. The Beijing-based company received 236 billion yuan from 11 Chinese banks, including ICBC, China Construction and Bank of China. It won another 100 billion yuan of credit from Export-Import Bank of China on April 16, without specifying how the money will be used.
AVIC General Manager Lin Zuoming said in an April 16 interview with Beijing-based newspaper Economic Observer that his biggest worry is how to allocate the borrowings to increase returns.
It’s the last line, of course, which Dan marked out. The largest single borrower, it turns out, has taken out around $35 billion in loans but doesn’t seem terribly certain about why he borrowed the money. I don’t want to read too much into a single throwaway line, but it is certainly consistent with all the stories and rumors we hear about banks lending not because borrowers need money for specific (hopefully profitable) projects but rather because they want to show loan growth, and the safest way to do that is to convince large companies and projects with explicit or implicit government guarantees to borrow massive amounts of money. Of course it helps that managers aren’t terribly concerned about creating value for their shareholders, but this is almost certainly a recipe for future growth in NPLs.
Obviously I (along with most of the readers of my blog) am not the only ones to realize this. Friday’s South China Morning Post had this to say:
Citic Bank Corp, the country’s seventh-largest lender, is optimistic about this year’s earnings outlook and is reining in loan growth to safeguard against a rise in bad loans. Chief executive Chen Xiaoxian said the bank would adopt stricter loan checks and had sent inspectors to those branches that had recorded a surge in discounted bill financing in the first quarter. “Banks need to take more forceful actions to increase risk controls,” he told reporters.
The article goes on to say:
Total lending by mainland banks in the first quarter reached a record 4.58 trillion yuan, close to the government’s minimum target for the whole year of 5 trillion yuan. Asked about his top concern, Mr Chen said: “Of course, it is asset quality given such fast loan growth.”
Mr Chen called the surge unsustainable. He did not disclose how much Citic Bank had lent in the first three months, but he said the pace would slow. “No matter how complicated your businesses are, you must clearly know the default rate,” he said of lessons learned from the global financial crisis.
Of course Mr. Chen is right. The current rate of loan growth is unsustainable and the biggest concern must be the risk of a sharp rise in NPLs. One would expect that all of this would quickly cause the PBoC to put the brakes on lending. The always intelligent Jim Walker of Asianomics thinks this will happen, but is nonetheless so worried about continued loan expansion he asks in an April 14 report:
Exactly why is this process dangerous?
First of all, China has an extremely high M2 to GDP ratio to begin with. As Figure 2 shows, M2 in 2008 already represented 158% of GDP. Compare this with money conditions in the US where M2 accounts for just 54% of GDP (the US ratio is read off the left-hand scale). If the US’ monetary easing efforts are such that investors are convinced that the dollar is no longer available reserve currency then the conclusion must be the same as regards the renminbi – only much more so. The only reason that the renminbi is not nose-diving in world currency markets is because domestic economic actors are not allowed to sell it.
For Walker, the explosive growth in lending is exacerbating what was already a very big problem, China’s huge bank-funded overinvestment. He goes on:
The second word of warning is that this breakneck monetary expansion will have to cease soon. The PBoC says that it will support economic growth through easy monetary conditions. It has certainly been true to its word so far but the problem will quickly become one of having a ‘tiger by the tail’. In Hayek’s analysis of economic growth he concluded that the only way an economic system hooked on credit could maintain its growth rate was for it to add ever increasing amounts of credit to that already existing. Adding the same amount of credit would result in recession-like conditions.
This, in his view, was the road to hyperinflation. The alternative, putting the brakes on monetary expansion, would lead to economic depression. On the assumption that Beijing will not wish to risk a hyperinflationary outcome we suspect that it will slam the brakes on the banks (which are clearly out of control already) within the next few months, regardless of the comments being made by the PBoC today. The next move in monetary policymaking in China will be to tighten, a move that will be badly received by markets that are already starved off profits.
Perhaps, but most analysts are betting against Walker. Xinxin Li of the Observatory Group points out that Wednesday’s decision by the State Council (effectively the equivalent of the executive cabinet) to reduce the capital ratio requirement for financing capital spending for infrastructure “is a further effort by the central government to implement its massive fiscal stimulus plan, in order to boost investment demand and support economic growth.” In his opinion the current policy environment “makes any hawkish statement from the PBoC politically incorrect. Just a couple of days ago, Vice Premier Li Keqiang said that the global financial crisis is having a deeper impact on the Chinese economy, showing that the top leaders are unlikely to drop their guard on the economic difficulties until Chinese economy firmly is on a recovery track..” In his April 28 report he concludes:
While the PBoC is concerned about the current pace of money expansion, it is unlikely to impose tightening measures to slow lending growth in the near term, due to an unclear economic outlook and the political priority on economic growth. China’s loose monetary conditions will likely persist in Q2.
The problem here is that Jim Walker’s analysis may be right but Xinxin Li’s prediction may also turn out to be right (and I suspect that Li doesn’t necessarily disagree with Walker’s analysis). Just because there is an urgent need for a policy doesn’t mean that it will happen. I remember that in early 2007 I argued aggressively that the PBoC would have to engineer a maxi-revaluation of the RMB because a slow revaluation would create huge hot money problems for the country. Of course the maxi-revaluation didn’t happen, and many of my friends seem to find my very wrong prediction a never-boring topic of conversation, but I defend myself by saying the analysis was correct, the prediction of huge hot money inflows was also correct, and soon enough the warnings about how destabilizing these inflows will be will also turn out to be correct. The global crisis intervened, and we will now see that China’s failure to have adjusted the currency much earlier, as a way of accelerating the transition from export growth to domestic-consumption growth when conditions were so good, will have a very painful cost.
So even if Jim Walker is right in that Beijing has no choice but to slow loan growth, he can still be wrong about assuming that they will. That of course would be the worst possible outcome.
Before ending, I wanted to cite a line from my friend Justin Winkle, who was responding to the comment discussed above that Dan Rosen found funny and startling. I am sure this has absolutely nothing to do with the topic under consideration, but here it is anyway.
My quote of the year is a line from Lewis Carroll appropriated by my stockbroker to describe the global economy: “If you don’t know where you are going, any road will get you there.”
As long as I am doing literary allusions I was just rereading PG Wodehouse’s classic Joy in the Morning, in which Lord Worplesdon explains to Bertie Wooster, in one of their very rare moments of camaraderie, why an American businessman they know seems so easily startled:
“Odd, this neurotic tendency in the American businessman. Can you account for it? I can. Too much coffee.”
“Coffee?”
”That and the New Deal. Over in America, it appears, life for the businessman is one long series of large cups of coffee punctuated with shocks from the New Deal.
I guess you can find economic history in the oddest places.
So I guess we’re going to see more stimulus, more crappy loans, banks getting recapitalized and no significant return to the export orgy in the private sector to bail out everyone else in China. Wow, this is like 2000 all over again just a lot more severe and the end game is that China ends up with a bunch of crappy banks, crappy SOEs which can’t manage their assets efficiently and bears a lot more resemblance to most emerging market countries. Depressing.
Michael,
What would be the counter-argument of someone with a sanguine view of the difference in M2/GDP figures Jim Walker cites? That it’s merely the difference between a rapidly growing economy and a mature one?
Congratulations on the anniversary, and thanks for the blog.
Michael (or other readers)- given the lack of transparency in the Chinese banking system and what looks to be a combination of policies that could contribute to serious stress, what in the past has triggered the realization that China’s banks need restructuring, and how long did it take for bankers, and separately policy makers, to appreciate the depth of the crisis?
Over the past cycle Chinese banks made loans that were based around economic incentives that encouraged increasing misallocations of capital to areas of the economy that were unsustainable (in my view the primary driver of this was the currency policy, though a number of other China-specific factors, such as the cozy relationship between banks and SOEs at the expense of small entrepreneurs are also sources of vulnerability). On top of this the PBOC is forcing a huge expansion of credit, yet the incentives for this credit to be properly allocated still are not in place, and will be directed to many areas which the stimulus package encourages that will be ultimately unsustainable. This Bloomberg story today is particularly alarming: http://www.bloomberg.com/apps/news?pid=20601087&sid=abYPdEFx.DPw&refer=home
If there is any area of the world economy that does not need any new supply it is shipping. My belief is that trade imbalances will be permanently lower, and it will be a long time before world trade comes close to where it was over the past cycle. I don’t think this necessarily because of a rise of anti-trade legislation around the world, but simply because a large proportion of the trade was represented by by a world catering to US consumption via “labor arbitrage” encouraged by weak-currency policies around the globe. That world is gone. Going forward exports as a percentage of US GDP will of course be higher and even if world trade recovers a large part of it will be from the US shipping goods abroad in a higher percentage of ships that in the past came to the US with nothing to take back. This doesn’t require new ships, it just means that the voyage back to Asia won’t be as empty as it was before. And it certainly doesn’t require new shipping capacity in China.
Regarding China’s vulnerabilities though, I wonder if one can play the devil’s advocate: Sure China’s economy grew imbalanced, but it grew so quickly and will continue to have relatively high growth rates going forward, so in a sense China can grow its way out of some of its misallocation of capital problems. I don’t necessarily believe this view, and of course there are path dependancies between the state of the banking system and China’s future potential growth rate, but how would you approach gauging both sides (ie. past misallocation of capital vs future potential growth rate (although that of course depends on not continuing to push on those misallocations of capital))?
Michael, one other point related to what I said before (and what you’ve said in the original post) which I thought is worth making explicit: China obviously needs to restructure its growth model. The government is encouraging considerable loan growth. However due to the state of the world banks have a bigger incentive than ever to direct that growth towards SOEs and other businesses that are implicitly government backed. This is because these enterprises are considered the safest, even though their future cash flows may be anything but (perhaps a bit analogous to Fannie/Freddie). The problem is that all these companies evolved and generally cater to the previous export-driven growth model. At the very time when China needs new enterprises to take the lead and cater to consumption as part of restructuring, funds are disproportionately being directed towards arguably the most rigid parts of the economy.
I’m glad to see you referencing Jim Walker. Austrian economic theory has a lot to offer for the analysis of China’s economy. The theory of malinvestment in a credit boom is key.
The general idea is that while credit is booming, decision-makers are fooled into thinking that they are investing in positive NPV projects. In the absence of artificially stimulated credit, they would be negative NPV projects. Eventually, the law of large numbers causes the credit boom to end, and the negative NPV projects which had seemed to carry the economy forward, turn out to be white elephants, and the weak collateral behind bad loans.
The Bloomberg article sharpe_mind cites is almost as funny as Michael’s. China Shipping, according to Bloomberg, “avoided the worst of the collapse in [dry-bulk shipping] rates because of its dominance on domestic routes.” The article goes on to say that lucky China Shipping’s 1Q2009 profits therefore only fell by 81% notwithstanding the rate of decline of hmmmm…81%.
” ‘We’ll never give up on new investments,’ Vice Chairman Zhang Guofa said in an April 30 interview in Shanghai. He declined to say how many [new] vessels the company would add.”
The situation in China is getting crazy. The credit bubble will soon explode creating a situation like what had happened in the US. Looking at the China and the Hong Kong stock markets these days things are getting too hot. When every Tom, Dick and Harry are shouting “buy” it is time to sell. History keeps on repeating itself. It will only take one or two negative news to burst the bubble!! There are many schools of thought going around these days that “Sell in May and go away” adage will not happen this year. Well, let’s see whay will happen. I am not going to bet on a few hundred points upside potential as I am not prepared to take the downside risk when it happened.The downside risk will be more than a few hundred points!!
Share Mind and Prof. Pettis:
The questions you raise about capital misallocation lie at the heart of Krugman’s criticisms about the Asian Developmental Model : capital wasteage and hence very high ICORs (c.f. Martin Wolf). This shows up in lousy banks and NPLs, but as we know this can be hidden by rapid growth on steroids and an undervalued currency.
The WB and OECD studies show strong profitability, good TFP and high rates of return since the late 1990s tempering many views of capital wasteage. Bosworth’s and Collins work also shows trend improvements in TFP but are a bit dated.
Many studies suggest that one reason for China’s very high ICOR compared with earlier Asian developers was the need to build infra-structure.
Have you seen any RECENT serious studies on trend TFP and rates of return on equity (preferably by sector, matched firm data and cyclically adjusted)? They would help to shed light on these vexing questions.
regards James
There’s one thing I find intriguing about ICBC’s Q1 financials:
Yes, loans grew very fast.
But deposits from (non-bank) customers grew even faster in absolute terms.
So apparently, people are saving like crazy, and ICBC was simply channeling those additional savings into loans.
In 2006 when the medium-long term tech plan came out it was a sign of things to come. A large part of the S&T funding went to SOE, because:
1) They were partners that would act on political motivated decisions, if the Party called for it 2) They had State backing, which ensured the stability of long term S&T projects 3) In large parts of the tech plans draft process the large SOEs had representatives in key positions. 4) The growing nationalism that has become the main ideology for the leadership since the late 1990ies tends to move towards large SOE that seem more loyal then the SME, who often have relations to foreigners or foreign technology.
The connection between the 2006 tech funding patterns and the 1st quarter 2009 lending policies of Chinese banks is the similarity in the approach. The problem with the 2006 tech funding patterns is that OECD and other observers of Chinese S&T conclude that the BERD (Expenditure on R&D in the Business Enterprise Sector) has been going up the last 10 to 15 years, but are SOE really businesses or political entities? and more important are they the ones that should conduct all Chinese S&T?
The new political development in China seems to be that when ever the Party takes one step towards opening up in an area, it takes three steps towards bringing in a nationalist perspective to the issues in that area. This renders any and all opposing arguments invalid, because no one was to be unpatriotic. So the bank leads money to the SOE, because it’s safe and in line with good nationalistic policies.
Too much state directed credit, excessive liquidity might ( not necessarily) have long term consequence such as asset bubble, mis-allocation of capital and Bank NPL, even seeding next financial crisis need government bail out. Or China might grow out of it, who the hell knows.
But alternatively, leaving market to itself resulted similar chaos and result, somebody proved loose FED monetary policies are responsible for Derepsssion and latest financial meltdown. But without central bank, treasuries fiscal policies, financial chaos also happened regularly.
Austrian school are market fundamentalism, their belife that leaving to themselves, market forces will work out necessary adjustment and minimizing boom-bust are political-economic utopia just like communism; Gold standard will be best monetary arrangement, besides treasury, central bank managing money supply is the worst enemy of economic stability? so should major power subject money supply to Gold output?? All these are just pure theoretical construct without any empirical foundation, it is probably worse than Maxism,Keynism or Monetarist theory, at least those are already discredited and we knew why they dont work.
In a sense, Austrian schools represents economic equivalent of Taoism, Oasis of harmonious prosperity by leaving everyting alone. Laozi said: ” managing state affairs like subtlly cooking a tiny fish”
As Chicago school are left in Shame and Keynism on the rise, there seem a chaotic vacuum in mainstream macro economics.
All main stream are discredited , so people tried radicals.
But, honestly, who said collective human endeavor, irrationality on mass scale can be predicted and managed scientifically?? Anybody explain holocaust to me ?
Austrian school would said US government-FED caused great depression, might be partially responsible ?
How do we reconcile AVIC getting so much money, which should be viewed as government support, while at the same time the government encouraging the cancelling of orders from Boeing and Airbus?
This is nothing more than more of the same. China has no interest in two way trade.
http://seattletimes.nwsource.com/html/businesstechnology/2008488576_airline100.html
I’m not sure that SOE directed lending is such a bad thing. If you want to create consumer based services then you have to put money in the hands of consumers, and increasing lending to SOE’s and increasing lending for infrastructure should get money in the hands of consumers that can then spend money to create new services.
The Chinese banking system is just not set up right now to loan money to small-medium enterprises, so the logical thing to use government funded infrastructure projects and loans to large enterprises so that money will trickle down and create small/medium sized consumer service industries.
The ideal situation is that if you had a Chinese banking and financial system that is supportive of SME’s. We don’t. We aren’t going to get one next year. If we try hard, we might have one in two or three years, but letting the economy fall apart to create a new system in three years won’t work, because if you blow up the current system, you’ll never be in a position to refocus lending, and you will encourage the worst aspects of the current system.
Given what we have, I think it is a horrible mistake to reduce lending. If you reduce lending, the large enterprises are going to survive since they have massive capital reserves. It’s the small service industries that are going to get crushed, and if you crush the existing small service companies, you aren’t going to have any banks willing to lend money to them.
I just don’t see how contracting the economy and restricting lending is going to help create consumer demand or encourage the growth of SME’s. If you want people to spend money on discretionary consumer spending, the last thing that you want is to throw people out of work, and increasing unemployment is just going to convince people to save more, not less. It’s going to crush existing small businesses, and then it’s going to make the banks even more hesitant about lending to them, and it’s going to make the unhealthy bias for banks to loan to big companies even worse. Banks loan to big Chinese companies because big companies are more able to withstand a downturn because they have more capital and more political connections.
What happened in the 1990′s when the government flooded money into the SOE’s was that much of this money went in the end to creating small and medium services businesses that were able to absorb the layoffs from the SOE’s. Once the SOE’s off-loaded millions of workers to the SME’s, they started to become profitable. Contrast what happened in Russia in which by contracting the economy, Yeltsin make big companies with political connections even more important.
What China needs is fewer concrete and steel factories and more food carts, beauty salons, cheap hotels, and green grocers. The financial system is too heavily biased toward manufacturing, toward large companies, toward state owned companies, toward infrastructure creates, toward capital intensive industries. This needs to be fixed, but I don’t see how contracting the economy and creating unemployment is going to fix it.
James: The questions you raise about capital misallocation lie at the heart of Krugman’s criticisms about the Asian Developmental Model : capital wasteage and hence very high ICORs (c.f. Martin Wolf). This shows up in lousy banks and NPLs, but as we know this can be hidden by rapid growth on steroids and an undervalued currency.
My view is this:
1) The Asian development model (which resembles the Soviet development model) works at a certain stage of development. It’s not that rapid growth hides capital misallocation, it’s that at a certain state of growth, good capital allocation is not terribly important. You get lousy banks and NPL’s and general economic problems once you reach the point in which capital allocation becomes important, and China is not going to hit that point for another decade.
2) It’s extremely misleading to talk about an Asian development model since is implies that Japan, South Korea, and China are very similar when there are significant and important differences between them. One is that a deep problem with the Asian/Soviet model is low cost of capital which results in overinvestment in heavy industry and manufacturing. China just does not have this problem. Capital is not particularly cheap, and where you do see overinvestment is in labor-intensive light industry and manufacturing and in infrastructure projects.
If you look at a large Japanese company and a large Chinese company, they are very, very different. A large Japanese company tends to be a vertically integrated enterprise which is part of linked set of suppliers centered around a bank. By contrast, a large Chinese company tends to be a cluster of totally unrelated enterprises that share a common pool of capital from retained earnings. Chinese companies do very badly in vertical industries.
The point that I’m making is that viewing the Chinese economy as an example of an “Asian development” model will lead to some very serious economic mistakes. China-2009 is just not Japan-1990 and it’s unwise to treat it as such.
A. West: Austrian economic theory has a lot to offer for the analysis of China’s economy. The theory of malinvestment in a credit boom is key.
I think Austrian economic theory has a good explanation of what happens in a credit boom, however it has a very bad explanation of what happens in a credit bust, and how to fix it. The problem is that greed becomes fear, and just as in a credit boom people are far, far too willing to lend, in a credit bust, people are irrationally unwilling or unable to lend to projects with decent returns.
sharpe_mind: The problem is that all these companies evolved and generally cater to the previous export-driven growth model.
That’s the problem with this explanation. With some exceptions (like ports and shipping), they generally didn’t.
“The context is last week’s post in which I argued that the almost certain reversal over the next few years of American ability to grow consumption at a faster rate than GDP will put huge pressure on the Asian development model, and will require Asian consumption to grow much faster than Asian GDP.”
At the heart of this observation is the notion of path dependencies, and we should all go back and re-read Alwyn Young’s classic on the subject as it applies to China. Policy distortions get more distortions, and it becomes increasingly hard to undo them. So, keep lending to SOEs (and if you net out upstream monopolies, they are way short on the reserves twofish loves to drone on about), or unemployed factory workers in the US who want a new Escalade, and see what happens. We’re half way there.
Bob, it is certainly a little unfair, as you implicitly point out, to compare M2 in China and the US because the US financial system is radically different and is not bank centered to nearly the same extent as in China. Better comparisons may be made with other bank-centered Asian during “healthy” periods. I don’t have numbers in front of me but I am pretty sure that China is still relatively high. I think the important point is that high growth rates are even riskier when they start from high base levels.
BCG, you have identified some of the very funny points about the Bloomberg article that I also underlined. I have had much experience in this and let me offer a prediction. In retrospect, after a few years when it becomes clear to even the thickets how a difficult transition was made worse, many analysts will point to the statements made in the two cited Bloomberg articles and ask confoundedly, “Given statement like these how could people not have known what was going to happen?”
Chan-Lee, Krugman’s criticisms in “The Myth of Asia’s Miracle”, which were actually based on Alvyn Young’s work which Zhige references below, are very relevant here. I haven’t seen good recent work on TFP but am keeping my eyes open.
Sharp_mind, every “globalization” period in history saw a steep surge in international trade followed, after the adjustment crisis, by a very sharp decline, as we are seeing now. Following the decline it took many, many years to reach the previous peak. I agree with you that the last thing the world needs is more shipping capacity – from previous experiences, and so far we do not seem to behaving any differently, it is like to be decades before we use up current capacity.
As for your second point, we have to be careful about not getting into circular reasoning. We cannot say that China will continue to grow quickly because NPLs will turn out not to be a problem, and that NPLs will turn out not to be a problem because China will grow quickly out of the cost cleaning them up. The last NPL cycle is likely to be very different from the next because of at least two things. First, the last cycle occurred during a period of explosive liquidity-generated asset bubbles and sharp US and global GDP growth, combined most importantly with surging consumer credit in the US, which meant that countries that bet very heavily on what I called the Asian development model were given a “Get out of jail free” card (for those non-Westerners who don’t know what I mean, I am referring to one of the wild cards from the very popular game of Monopoly). I am pretty sure this time around they will not be able to count on this. Second, China started the last NPL clean-up with almost zero debt. Following the clean up Chinese debt officially reached around 20% of GDP but may actually be higher than 40% if we include guaranteed AMC debt, unrecorded and uncollectible debt at the provincial and municipal level, and other unrecorded contingent liabilities still within the banking system. This will sharply constrain their ability to fund a clean up.
Thomas, actually it is probably the reverse. Many of the loans were made not because the borrowers had projects that needed funding but rather because lenders needed to make loans. Much of the lending simply was redeposited back in the banks. In earlier posts I have discussed how banks were willing to eat the cost, and even run negative carry in some cases, to encourage companies to borrow unnecessarily.
Isaac, although perhaps the argument has been made I don’t think anyone has “proved” that loose monetary policies by the Fed created the Great Depression. In fact the most cited works, especially Friedman’s and Schwarz’s book, argue the opposite. As for the rest of your comment, you may be right, and I certainly don’t consider myself to be enough of an expert on Austrian economics to defend or reject the entire theoretical framework, but the Austrians have made some very telling points and accurate predictions in the past and their descriptions and criticisms of the capital misallocation process are, I think, pretty useful and profound.
Twofish, arguing that there is a reason why the system is not working effectively is not the same as arguing that system is not working ineffectively. I agree that if the Chinese financial system were better at allocating capital to create net demand, it might be able to do so efficiently, but it isn’t, and the consequences are nonetheless likely to be painful. By the way, I never said that “contracting the economy and restricting lending is going to help create consumer demand or encourage the growth of SME’s.” What I said was very different – that the policies upon which they are embarking are likely to make the distortions worse. You continue to make the standard confusion that most people make between creating net demand and creating total demand. Policies that increase total demand while contracting net demand are only going to increase the overcapacity problem, and sooner or later it will have to be resolved.
Zhige, yes, distortions create the need for further distortions, until they finally get resolved, usually in a very ugly way. In that context I recommend (as I have before) Adam Tooze’s brilliant (and hefty) “The Wages of Destruction”, a recently-published book on Nazi Germany’s economic policymaking. One of the many things that is so good about the book is the recounting of how Nazi centralized economic policies aimed at resolving distortions bureaucratically simply created even deeper distortions elsewhere in the system, that were then also resolved bureaucratically, and so on until the economic system was so unwieldy, so complex, and so difficult to reform without a massive and very painful short term adjustment that reform became almost impossible.
One thing that I think Tooze persuasively argues, as an aside, is that the German attacks on eastern Europe that precipitated the war occurred four years earlier than the German generals wanted and were prepared for because by 1939 it became clear that the whole system was unsustainable and on the verge of breaking down. This has nothing to do with the topic of my blog, of course, but I always recommend to my students that they read every good book they can find on economic history (whether or not the immediate topic is of interest to them since all economic and financial history is relevant) and this is definitely one of them.
Quote Michael: “Much of the lending simply was redeposited back in the banks.”
I hadn’t thought about it that way, but yes, your point makes perfect sense.
Quote Michael: “banks were willing to eat the cost, and even run negative carry in some cases.”
I find this part a bit hard to follow: Aren’t lending and deposit rates regulated, i.e. the bank has to charge much more on the loan than it receives on the deposit? How can the banks channel funds to the borrowers to offer them a “negative carry”?
Thomas, yes they are regulated but — things happen. In January and February this “arbitrage” occurred because the (non-controlled) bill discount rate was anywhere from 20 to 50 bps below the short term deposit rate, so companies were encouraged to discount bills and deposit the funds in banks, which meant that essentially banks were paying companies a small fee in order to grow their loan books.
When the PBoC stepped hard on these transactions in late February and March they declined substantially, but there were persistent rumors that companies that took out loans and deposited the proceeds would be able to prepay their loans very early and all interest would be forgiven. Again the net result was that banks “paid” companies to take money and convert them into deposits. I think the PBoC is now examining these transactions. The lesson, of course, is that if you create strong political incentives for banks to make non-economic transactions, they will do so.
I discuss these in February and March posts.
@Michael,
thanks for pointing that out.
By the way, I checked the ICBC Q1 report, and the position “due to customers” increased by 890 bn RMB, whereas “loans and advances to customers” increased by only 640 bn RMB. So deposit growth was much stronger than loan growth. But in any case, that’s a March 31 snapshot, and doesn’t capture anything that happened during the quarter. It is true that ICBC’s interest margin contracted quite a bit (interest income went down, but interest expense went up), which seems to fit with what you are saying.
Michael,
From what I can learn via Google, it sounds like China’s M2 was growing about 15-17% yoy in 2008 and now is growing 25%.
James Hamilton has a post up from 2006 where he explores the correlation between M2 and inflation. He has a graph that shows 10-year average M2 growth exhibits a close link with 10-year average nominal GNP growth (real GNP plus inflation), but a poor link with real GNP growth. So over ten years, M2 growth above real GNP growth will show up as inflation.
( http://www.econbrowser.com/archives/2006/05/m2_and_inflatio.html )
From his piece, and what I read elsewhere, it sounds like the short-term correlation is hard to detect.
This brings to mind something I’ve been looking at a lot recently–the comparisons of the present situation in the U.S. to the 1974-75 downturn. I think there were two mitigating factors in 1974-75: duration and inflation. Unemployment spiked incredibly high, but did so quickly and recovered almost as quickly.
But I think inflation is the key difference. Except for equities, most assets rose in value, both for households and businesses. And layoffs were deep, but for the other 92% of workers, wages were rising, less than inflation perhaps, but decreasing the debt ratios.
Might that not be what China’s reckoning would look like? The non-performing loans will come to a head in a few years, but so might very high inflation, mitigating the cost of clean-up?
China needs to do something about this small business problem. Small businesses are the engine of economic growth here, and I assume they are there too (that’s “the power of small”). But as you and others have pointed out here, China is not as centered on banking. So maybe small businesses have a different role there too.
An interesting new data point on lending to SMEs in a new China Reality survey of regional bank branches out yesterday. Loans to SMEs increased 23% yr-yr in Mar 09 after increasing just 4% yr-yr in Jan 09 and are now (Mar) about 24% of total loans, up 1 pp from Jan.
Two other points I found eye-catching:
(1) loan applications were up 85% yr-yr in 1Q09.
(2) working capital loans were the most frequently applied for (70% of applications), followed by bill-discounting (16% – isn’t this a working capital loan if it’s not a carry trade as discussed?) and fixed asset investment (14%).
This breakdown is by type of application, not the amount requested or committed, so the disparity may not be as big and (to me at least) strange as it first looks, esp against unstoppable FAI growth.
Maybe someone else can synthesize these and the other anecdotes mentioned here into some meaningful conclusions. After a few tries, I don’t think I know enough to go further than:
(1) loan growth like this can only come at the expense of credit/risk management. Without digging out financials, the only place I can think of where loans grew at this pace (in this cycle) is Kazakhstan. That’s working out GREAT.
(2) a lot of people need working capital and I’d like to know what they need it for.
The most recent (CLSA) PMI maybe suggests a need to buy inventory, but if so barely. I think it would be a reach to say that there is sufficient evidence of domestic demand to call a big working capital shortage anything but negative (driven by sales/inventory/collection problems) to neutral (the demand materializes before such problems).
(3) an 85% increase in loan applications doesn’t reconcile in a sensible way with giving money to people who don’t know what to do with it.
Michael, any chance you’ll post your list of top 10 economic history books?
Michael- why would debt of 40% of GDP be particularly constraining? That is among the lowest in the world.
BCG, I don’t know enough about the “loan application” numbers to be able to parse them. Needless to say around here things are not always what they seem. As for your last point, one of these days I might post my “10 Best Economic History Books” list, but there are so many great books that it would a painful process to narrow them down.
Sharpe_Mind, my point is not that Chinese debt at 40% (at least — it is likely to be more) is a problem today. More serious is that they dealt with the last crisis in effect by growing debt from nearly zero to above 40%, and even this understates the cost because several years of over 10% growth makes what were once large numbers much smaller.
In a brave new world of declining fiscal revenues, rising fiscal expenses, and much slower expected growth rates, another surge in NPLs might be far more difficult to deal with when the debt base is already 40% of GDP. Remember that in 1990 Japan’s debt as a share of GDP was negligible, but by the end of the decade, and largely as a consequence of cleaning up the banking system, it significantly exceeded 100% of GDP. Banking messes can be costly, and if you’re going to wade into one its best to do so with a very strong balance sheet.
401(K)s hit by withdrawal freezes.
http://online.wsj.com/article/SB124148012581385199.html
What is going on here? Will this lead to another major scandal/collapse in the US financial landscape?
Prof Pettis
I was wondering do you have any figures for the 1999 initial bonds issued by the AMCs to the banks? I cannot find a value for the Great Wall / ABC Bond.
Also, it appears to me that the PBOC / AMCs stopped issuing good data on disosal / cash disposal etc for these NPLs around 2004 / 6. It seems that Huarong, Great Wall and maybe even Orient were not even making interest payments on their bonds… Cinda seemed to be doing better at first, but the low hanging fruit / ice cream theories suggest that the whole thing went pretty badly.
Do you that the Ministry of Finance will indeed pay off the principal of the bonds when they mature this year and next (as CCB, BOC and ICBC state in their account notes)? Or will a new bond be issued to delay the problem another 10years or so?
Also may I thank you for writing with such clarity and accessible sophistication on these subjects. I am sure I am not alone in wishing for a book in the near future!