Since this is a very long post, it may make sense first to provide a quick summary of what I am going to argue. As I have discussed often in earlier posts, pessimists are starting to worry about excessive debt levels in China, about which they are very right to worry, and many are predicting a banking or financial collapse, which I think is much less likely. Optimists, on the other hand, are blithely discounting the problem of rising NPLs and insisting that they create little risk to Chinese growth. Their proof? A decade ago China had a huge surge in NPLs, the cleaning up of which was to cost China 40% of GDP and a possible banking collapse, and yet, they claim, nothing bad happened. The doomsayers were wrong, the last banking crisis was easily managed, and Chinese growth surged.
But although I think the pessimists are wrong to expect a banking collapse, the optimists are nonetheless very mistaken, largely because they implicitly assumed away the cost of the bank recapitalization. In fact China paid a very high price for its banking crisis. The cost didn’t come in the form of a banking collapse but rather in the form of a collapse in consumption growth as households were forced to pay for the enormous cleanup bill.
When US leverage was rising and the world growing quickly, the cost of that collapse in consumption was easily masked by China’s surging trade surplus, but it was real nonetheless. The bank recapitalization resulted in a brutal exacerbation of China’s already unbalanced growth model, and made it all the more vital for consumption in China to surge, especially as the world’s appetite for Chinese trade surpluses is dwindling rapidly. As happened in Japan after 1990, when households were forced to clean up their own massively insolvent banks, the consequence could be a slowdown in consumption growth just as the country is being forced to rebalance its economy towards consumption.
If there is another surge in NPLs and government debt, once again the banks will need to be recapitalized, but the cost this time will be much more difficult to manage. If NPLs surge, in other words, don’t expect a banking collapse. Expect further downward pressure on consumption growth.
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Since 2004-5, I have been arguing that the Chinese national balance sheet includes a lot more debt than most analysts realize, and that it is structured in a way that I defined as “inverted” in my book, The Volatility Machine. Among other things, inverted debt structures tend to result in a surge in debt at the worst possible time, when the economy is already struggling, usually through an explosion in contingent liabilities.
This means that even if countries with inverted balance sheets don’t currently have very high debt levels, in many cases they should nonetheless be considered and analyzed as highly leveraged because at exactly the time when leverage becomes a worry, debt levels will automatically rise. This is why I have argued (predicted?) for the past five years that “within a few months” the market was going to become obsessed with China‘s debt structure.
Unless you define a “few” months as forty to sixty months, clearly I have been wrong for many years – calling things way too early is perhaps an occupational hazard for those who read too much financial history – but it seems that debt levels are finally becoming an issue. In the past six months the market has become much more passionate about figuring out what China‘s debt structure really looks like, and much more worried with what it sees.There is widespread recognition that Beijing‘s total debt is not the 20-25% officially recorded, but a lot higher.
In fact going through my calculations I think it is hard to come up with a number less than 60-70% of GDP, perhaps much more, and this is almost certain to rise sharply in the next few years. And there may be stuff out there that I haven’t even considered: For example just how much bad debt is there in the SOEs? Are all current non-performing loans in the banking system correctly identified? How sensitive are NPLs to rising interest rates, or to a rising RMB? Is the PBoC currently solvent, and what would be the impact on net indebtedness of a currency revaluation? Is there municipal and provincial indebtedness that has not been captured in the visible debt, including the guaranteed funding vehicles that Victor Shih famously identified? How much bank debt is collateralized by potentially overvalued real estate? I could go on.
But although there are definitely things to worry about when we examine China‘s balance sheet, I wonder if now the worriers, after ignoring the problem for so long, may not be getting a little overexcited about the consequences, or at least about the wrong consequences. Beijing definitely has a lot of debt, and much of it inverted and so highly pro-cyclical, and normally this is a toxic combination, but there are also some stabilizing factors within the country’s balance sheet that are being ignored. A number of very smart people are now warning that China is on the verge of a banking or financial collapse, but I don’t think this is likely.
Rising NPLs? No problem
Let me quickly insist that I am not in those camps that argue that the problem is much less severe than we think, or that China can costlessly grow its way out of the debt as easily in the future as it has in the past. This last point is one that is made very often, I think, by the more optimistic of China analysts,who have pointed out perhaps too many times that the last surge in non-performing loans a decade ago was also widely cited by doomsters as a sign of impending collapse. And yet, they cheerfully claim, nothing terrible happened – China grew its way out of the loan mess at little apparent cost, and it can do so again.
Even The Economist, a lot more skeptcial about miracle cures when it discusses other countries, takes the view that China‘s last banking crisis was relatively painless. They also have been resistant to claims that debt levels are much higher than reported, and recently approvingly quoted one analyst as saying that the very worst-case scenario was debt levels of less than 40-50% of GDP (with which I strongly disagree). In fact I was reading an issue from, I think January, in which, after expressing a great deal of doubt in one article about the higher debt numbers some analysts were proposing for China, just a few pages later, in an article about bad debt in the US, approvingly quoted Carmen Rheinhart (co-author of This Times is Different) as saying that contingent debt levels almost always turn out to be worse than even the pessimists expected. Their skepticism is pretty variable, I guess.
But while there is certainly a legitimate and intelligent debate about how much Chinese government and bank debt there really is, the commonly-repeated argument – that high debt levels don’t matter and the doomsayers are wrong to worry because they were wrong in the past – does not qualify, for me anyway, as a very plausible argument. I think anyone who makes this claim has failed to understand how Beijing paid for its earlier banking crises. In fact the cost of resolving the previous surges in non-performing loans actually exacerbated China‘s domestic imbalances and left China in a perilous position, and the current build-up of bad debt may very well do more of the same.
How so? The first and most obvious point to make is that if a highly insolvent banking system is cleaned up, you cannot simply assume away the cost without identifying who actually paid for it. Here is where the confusion resides. The optimists perhaps assume that the only way that a banking crisis gets resolved is through a banking collapse or an explicit bailout. Since there was no banking collapse in China in the past decade, and what looked like a fairly small and manageable bailout, then clearly there was no real banking crisis, right?
Not necessarily. There are many ways to resolve banking crises, some more visibly and some less so – just no way to resolve them costlessly, and the key is to figure out the true cost and how it was paid. As I see it there were mainly three sets of tools Beijing used to manage the sharp increases in bad loans that threatened the banking system a decade ago, and of the three, the two most important were not explicit and so not easily measured or noticed. All of these required forcing down interest rates so as to pass the bulk of the cost onto bank depositors, and so all of these had an adverse impact on the quality of Chinese growth. In other words the previous cost of the banking crisis was not a banking collapse, but that doesn’t mean the cost was easy to absorb.
The role of interest rates
The first of the three tools used to manage the banking crisis involved reducing the accumulation rate of NPLs, basically by keeping borrowing rates low. The PBoC actually has been explicit about this policy. Low borrowing costs make it easier for struggling businesses to roll over the debt, and effectively reduce the real value of debt payments. This slows the growth of NPLs by passing on part of the cost to someone else.
Remember that if you reduce the coupon payment on a loan, it is economically the same thing as forgiving part of the principle amount, but this forgiveness is effectively disguised. Those who remember the Brady debt restructurings of the 1990s fully understand how this works. In the main Brady restructurings, creditors were offered equivalent exchanges in which either principle was explicitly forgiven (the so-called Discount Bonds) or, alternatively, for those who found it difficult to recognize or acknowledge the principle discount, coupons were set at very low fixed rates (the Par Bonds). Similarly, by repressing interest rates, the PBoC was able to transfer part of the principle cost onto the banks that made the loans and so obtain debt forgiveness for the borrowers.
But while this helped the borrowers, it did not of course help the banks – unless the banks themselves were able to push the cost onto depositors, which of course they did. The PBoC repressed both lending rates and deposit rates to allow struggling borrowers debt forgiveness and some breathing space. Of course households paid for this in the form of very low returns on their savings (and with few alternative investment opportunities, they had no choice but to accept the cost).
The second of the three sets of policy tools, and the only very explicit one, involved infusing the banks with additional equity. Part of this occurred directly with the sale of bank equity to government institutions, and part of this capital infusion occurred indirectly by creating AMCs to purchase bad loans at well above their liquidation value. In both cases the capital infusion was financed by government borrowing, which at artificially low rates, to repeat what I said above, has the effect of passing the repayment burden onto lenders. Since most of these bonds were held by banks, once again the cost of the capital infusion was passed on through the banks to depositors. (As an aside, because equity infusions were so explicit, and because the banks are no longer fully owned by the government and are even partly owned by foreigners, I suspect future recourse to this particular form of recapitalization may be limited.)
Finally and most importantly, the third way of cleaning up the banking crisis involved the central bank mandating a wide spread – probably around 1.5 to 2.5 percentage points more than the normal spread – between the bank lending and the deposit rate, which increased bank profitability substantially and so helped to recapitalize the banks. In other words not only were depositors “taxed” for the clean-up by having to fund the very low lending rates, but they were taxed a second time to guarantee sufficient bank profitability to rebuild capital. With all these transfers from the household sector to the banks, amounting to several percentage points of GDP every year, households were forced to clean up the Chinese banking system.
Beijing‘s strategy to clean up the banks was very successful, and certainly prevented the banking crisis that many expected, but there was nonetheless a significant cost to the economy. The bailout implicitly required that bank depositors subsidize the cleaning up of the banking industry. This in effect represented a large transfer of income from the household sector to the banks, to government and to businesses, equal annually to several percentage points .
NPLs and household consumption
How much was the value of the transfer? It’s hard to say, but we can make some estimates. Over the past decade nominal lending rates in China have been about 6% while nominal GDP growth rates have been 14%. Economic theory tells us that nominal interest rates should be equal to nominal GDP growth rates if providers of capital are to earn their fair share of growth, and in fact in developed countries the relationship holds pretty well. However Jonathan Anderson at UBS put together a very interesting analysis in a November 12, 2009, report that argued that it was wrong to assume Chinese nomnal interest rats should be equal to its nominal growth rate. He looked at the case of other developing countries and found that there was no obvious relationship between the two.
But I am not convinced. First off, if nominal interest rates are much lower than nominal growth rates, then almost by definition the providers of capital are getting less than their share of the benefits. Since the providers in China are mainly households, and the users of capital are businesses, speculators, and the government, this must represent a real transfer of wealth from households – which I think Anderson acknowledges, although he argues that the high savings rate is an independent variable that drives the low interest rate, whereas I think that it is one of the consequences of low interest rates and other policies that force households to subsidize production (and so force up the gap between production and consumption, which is the savings rates).
Secondly, his sample includes a lot of developing countries with closed or sticky capital accounts, and who intervene in their currencies, most especially the countries that followed the so-called Asian development model. These countries have systematically repressed interest rates – in fact that is for me one of the definitions of the Asian development model. This makes their inclusion in a statistical sample to determine the “correct” level of interest rates very questionable. He also includes a lot of OPEC countries who for totally different, and explainable, reasons have very low interest rates, and these too create a downward bias in the statistical sample.
Finally from his own numbers, even with the possibility of significant statistical bias, I would say that there does seem to be a reasonable relationship between nominal interest rates and nominal growth rates. On average nominal interest rates have been roughly two-thirds of nominal growth rates, although there is wide dispersion around the mean, which we would expect if interest rates were repressed. With nominal growth rates of 14% during the past decade, this implies that nominal interest rats should have been nearly 10% or a little less, versus the actual 6%.
This is not a very scientific way of going about it, but my very back-of-the-envelope estimate suggests that interest rates in China, without financial repression, would have probably been anywhere from 300 to 800 basis points lower than the appropriate equilibrium level during the past decade. Add this to the excess spread between deposit and lending rates, which is anywhere from 150 to 250 basis points, and we could easily argue that the deposit rate is at least 450 basis point lower than it should be, and perhaps an awful lot more.
How much is that in GDP terms? A quick call to my friend Logan Wright at Medley Advisors gave me the following data. Total banking deposits in China are around RMB 64 trillion. Around 60% of the total represent household deposits (an estimate, since there is some ambiguity in the numbers). Total GDP is nearly RMB 34 trillion. Inputting all of that into my trusty Excel Spreadsheet suggests that at a minimum, households have “paid” in form of excessively low rates on their deposits a minimum of 5% of GDP every year, and possibly up to two times that amount, during the past decade.
This is, to me, an astonishing number. Every year households may have transferred at least 5% of GDP to the banks, and possibly a lot more. Now of course they are paying for a many other things than simply recapitalizing the banks. They are also paying to keep the cost of capital low so as to make viable a whole series of investments – manufacturing investments, real estate investments, infrastructure investments, PBoC sterilization bills, other government bonds, etc – that might be considered non-economic investments and that would otherwise show negative returns (in fact excessively low interest rates, as the various recent US bubbles clearly indicate, almost always lead to misallocated investment). But since a lot of this investment occurs through the banking system anyway (for example banks directly or indirectly buy most sterilization bills), much of this ends up as part of the bank clean-up.
By the way forcing unlucky households to clean up the banks is pretty standard in the annals of banking crises, and for example has occurred in the US with the recent bank bailouts (which of course were paid for with taxpayer money), but not only was China’s total bill over many years much higher, because of its domestic distortions the impact in China was worse than it would have been in the US (because forcibly reducing consumption in China is much worse than doing the same might be in the US). Added to the other major transfers from the household sector (the undervalued exchange rate, and slow wage growth relative to productivity growth), and given the sheer size of the clean-up, it is perhaps not surprising that during the period of the bailout, household income, already a relatively low share of GDP, declined to alarming levels. This happened even in spite of explicit and much-publicized attempts by Beijing to raise the household consumption share of GDP.
This, then, is the real risk of another bout of rising non-performing loans in China. It is not that China‘s banks are likely to collapse. It is illiquidity that causes bank collapses, and unless capital controls are sharply undermined we are not likely to see this happen in China. Debt levels are certainly high and highly pro-cyclical, but even if the banks are insolvent Beijing largely controls domestic funding and domestic interest rates and can protect itself from the bank runs that plagued US and European banks. We saw the same thing in Japan thirty years ago, when it was able to fund the massive banking bailout and soaring government debt levels, to what would earlier have seemed like unimaginable levels. Like Tokyo in the 1990s, Beijing is in a strong position to continue to fund its rising bank-related liabilities and will not have a debt problem any time soon. Government debt levels are indeed very high, but they can go much higher.
This doesn’t mean however that we don’t need to worry about the debt, and it certainly does not mean that if China runs up more bad loans as a consequence of the recent lending spree it will simply “grow” its way out. In the past China could certainly grow its way out, even with household consumption declining as a share of GDP, because one effect of declining relative consumption – a rising savings rate along with a rising trade surplus – was easily absorbed by a rapidly growing world economy. As long as debt levels in the US and other deficit countries could easily rise to counteract the adverse employment effect, the world, and especially the US, had no trouble with absorbing China‘s rising trade surpluses.
Rebalancing household consumption
Things may be very different now. Unemployment is high in trade-deficit countries and debt levels are being forced down. If the world can no longer absorb rising trade deficits, and especially if over the next few years trade tensions increase, China must reduce its excessive reliance on exports and investment to fuel its continued growth. The only healthy way it can do so is if household consumption rises as a share of GDP because of surging consumption.
And household consumption will indeed rise as a share of GDP – with such a low current level of household consumption, and rising global concern over the employment effects of China‘s trade surplus, China has no choice. But since growth in household consumption has always been constrained by the growth in household income, it may be unreasonable to expect a surge in consumption when households are also required to clean up another sharp increase in non-performing loans.
So as a consequence of the global crisis, China‘s growth will rely more than ever on the growth of household consumption. The good way this can happen is by a surge in household consumption that will allow economic growth to remain high. The bad way is by lower growth in household consumption matched by a very sharp decline in economic growth. If the worriers are right, and non-performing loans surge, China can nonetheless easily avoid a banking collapse, but that does not mean the cost of cleaning up the banks will be negligible. On the contrary, it will put even more downward pressure on low-consuming Chinese households and will make the inevitable rebalancing of China‘s economy much more difficult than many expect.
As I discussed in a posting last month, Japan showed how difficult. In the past two decades Japanese consumption growth has slowed from its headier pace of the 1980s. Consumption growth has limped along at 1-2% annually from 1990 to now as Japanese households were forced indirectly to clean up their own bad loans using almost identical mechanisms – repressed interest rates and an undervalued currency. Whereas in the 1980s, when Japanese economic growth exceeded its consumption growth thanks to its large and rising trade surplus, in the past two decades Japan’s economic growth – less than 0.5% annually – has been less than its consumption growth as Japan slowly and painfully rebalanced its economy towards consumption.
Likewise perhaps with China. Unless the rest of the world is willing to absorb rising trade deficits and supply it with rising trade surpluses, rebalancing for China means that instead of being the lower limit of economic growth, consumption growth will now be the upper limit. If future Chinese consumption growth also slows, as it did in Japan, because households are forced to foot the new bad-debt bill, we may see the real cost of the current explosion in bad loans – several years of sub-par growth.
It turns out that banking crises might not be costless, even if they don’t lead to banking collapses. In the case of China they may instead lead to a collapse in consumption growth. As part of the trade dispute that China is facing with the rest of the world, this should give some indication of how little room China has for its adjustment. Anyone who is too impatient with the glacial pace of Chinese adjustment must recognize just how difficult it will be for China quickly to reorient its economy towards household consumption. The risk is that China, like Japan in the 1990s, will rebalance in the form of a sharp contraction in GDP growth as households struggle to pay for the misallocated lending boom.
I have meant to comment several times to tell you that the current entry is the best yet, but you keep surpassing it. But this entry is going to be very hard to surpass. You have managed to take a very complex and even counterintuitive subject and explain it brilliantly and, what is much harder, clearly. Like your post “What the PBoC Cannot Do with its Reserves,” this goes far beyond China and in fact becomes a very good post for understanding global finance in general. It will also become required reading for my class on development economics. I know you have heard this before, but you really should consider revising some of these posts and putting them in a book that will help readers understand not just China but the whole global financial system. This is a brilliant essay and should be widely read.
“That Which Is Seen, and That Which Is Not Seen”, Chinese Financial System Edition ! Again a brilliant post.
The historical perspective is very helpful. Thanks.
Do the events of a decade ago help to see when all this might play out? Perhaps we might see demand start to slow later this year?
More seriously, I think that your post is not only relevant for China, but for most of the industrial world too. The Financial Sector as a share of the economy has grown substantially in the last 20 years everywhere. If it was not due to loan margin increase, it was due to size increase (for a household, at current low rates, paying 150 bps interest margin on a loan 4 times its annual income is transfering the same money to the banking sector than paying 300 bps interest on a loan only twice its annual income). We also witnessed a stagnation of the median real wage in the last decade that mirrored the depression of the Chinese middle class income. Indeed the last decade was simply a guilded age worldwide, only for the benefit of the upper decile of society. The problem is that there is a limit to what the middle class can absorb, and this limit is close. If there is no growth worldwide, because the middle class cannot consume because of low income, and is not willing to borrow because of debt revulsion, “growing out” of the bad debt will not be an option. Deflation will set in.
China needs to set up a solid social security system, or the same ponzi scheme as U.S. has, for it’s citizens to start spend. With housing bubble, the expenditure has increased a lot, which, surprisingly, not many people are mentioning in the western world. Though, you cannot expect China to spend at U.S. level, which led to the Great Recession. Given the share of China economy, whatever China do cannot save the world or the U.S. It only consumes less than 10% of what U.S. does. The debt to GDP ratio in China is still small, compare to U.S. Contraction of GDP would happen if it’s currency appreciates too much as Japan did in 1990s.
I am an IT consultant working in US. WOW, no one could have explained chinas global economics better than Professor Pettis. US financial crisis taught me how US financial system works. I was talking to couple of B school friends about Professores topics who were from top schools and they are really clueless. Sorry I am not bashing them but thats the fact. Keep up the good work professor. I feel like attending a free economic class every week.
Also a request to Mr. Pettis. Can you post an article about todays FIAT currency system and how its going to affect China or other countries in the long run. What would be the replacement? Buffet never answers that question. Bernanke never answers that question. This week Geithner was in India and one of the channel CEO asked that qustion about the fiat currency he also did not answer the question either.
For readers interest I am a big fan of professor Simons and he explains US financial system very well.
http://baselinescenario.com/
What’s missing from your analysis are profits. China’s “excess savings” over the last few years are pretty much entirely rising profits in the SOE sector. Given that capitalism is a system that rest on profits, the old adage, that you can’t have too much of a good thing applies.
China cannot have too much savings or profits in other words. Take you description of how the savings of the workers/small farmers/middle class are paid way below the rate of profit, that too is no bad thing for Chinese capitalism.
If the rate or interest is the price of money, when there is abundant money, abundant savings, abundant profits, then rates of interest will be low. This in turn cheapens the price of capital, in turn boosting profit rates for capitalists.
All in all you have the virtuous cycle on display at present.
Are there masses of NPLs? Certainly given that there is a financial cycle and a business cycle, in a few years when things turn down again, as profits fall and the economy slows, masses of NPLs will be revealed. But at present with profits rising exponentially, with the fastest recovery of any recession since WWII currently underway, then that hardly applies now does it?
most of china’s NPLs at the end of the 90-ties were accumulated in the prior 5 years when the economy grew twofold. in the subsequent 10 years the economy grew twofold again and the problem was no longer equal to 40% ot GDP but rather 10%. still a problem, but china outgrew it. what is clear is that the rate of growth slows down twofold.
can we now expect china to continue growing at 10% per year for another 10 years, given that the global economy is so different now? and given that the rate of growth is slowing rapidly? in what direction china could grow? domestically, the consumption is significantly contrained by the low wages, growth of exports to developed countries seems so yesterday. raising wages to increase domestic demand would hurt exports. further fixed investments growth seems highly unlikely as well due to the huge overcapacity.
The household sector is discussed in terms of being providers of capital but what about returns that might have accrued to the household sector in terms of real estate/stock investments? And, what about trickle down from export sector profits to the household sector – not sure how that is measured?
GFW has blocked Professor Pettis’s website for several years in China.
Michael,
A very ambitious post. In the 1990s Nicholas Lardy wrote a pretty naive book on the problems of the Chinese financial system that simply ignored the unusual institutional and political setting of the Chinese banking system. In those days the banks were not even proper corporations (in legal terms). So all claims were liabilities of the state. Of course those liabilities were not recorded as state debt in the IFS, but, in legal terms, they were. And state debt denominated in local , non convertible currency, is risk-free in local currency terms. So all the talk about a bank collapse was simply nonsense and basically protecting market economy values on a fundamentally different economic system.
This time the policy space of the government is much narrower, because the banks are no longer departments of the state, they are independent legal; persons under China’s corporate law. There is no formal obligation on the State to bail them out (of course the state will but this time it will be a favor to the banks’ stakeholders and a cause for investigations, a favorite instrument of inter-party politics).
The banks will have to be able to recover aggressively, or show no losses (a nice task for the accountants), since losses will have two important effects: (1) on the share price and (2) on the balance of state- and private participation in the upcoming recapitalization. Maybe the charade around Huijin/CIC’s capital increase is related to the procedures being followed to arrive at an outcome that stays clear of harming or embarrassing the current executive (failed equity raisings in the “private” sector) and increasing the State share (and jeopardising several useful myths about the Chinese SOE banks that have evolved during the past few years (internationsl rankings, impressions of strength etc).
The best would of course be to simply not recognize NPLs but that may not satisfy everyone either (especially those who did not have their snouts in the trough) and is maybe a bit too cavalier vis a vis international accounting conventions and the Basle accords. Second best might be to mobilize a consortium of solvent SOEs that would buy bad debt (probably everyone knows what is bad) and move it -costlessly- of the banks’ balance sheet, in order to make a private contribution to the banks’ equity replenishment feasible. Other options are much messier for both the state and the private investors, who are not all laobaixing
Professor Pettis:
Many thanks for a brilliant exposé on the “hidden” costs of financial suppression. As you say, this feature of the Asian Developmental Model is often overlooked — and this tax on households is very big.
My question is how can one measure its magnitude? The rule of thumb comparing nominal interest rates to nominal GDP seems fine when prices proxy opportunity or resource costs.
But does this reasoning hold in the face of huge excess supplies of labour whose shadow price is around zero?
Do these circumstances permit one to argue that financial suppression is tolerable — because it delivered rapidly growing GDP and consumption in ABSOLUTE terms — thereby lowering poverty and social political stability? To be sure, this model has limits and is now dead, but what can economists propose to replace it? best regards James
Terrific post. The anticipation of future growth in China does seem to unhinge many people. Even the silliest investment can be made to seem rock solid if 10 percent plus growth is assumed ad infinitum. Of course, these very blithe assumptions themselves start to undermine long term growth prospects, I think Hyman Minsky had a theory about that…
BTW, my trip to your childhood country was terrific, the people were open and friendly. There were only a few sign of economic distress visible from a tourist’s perspective; an umployment protest in Cadiz, a few stalled construction projects and a fellow we met who’d reinlisted in the Army after nine years to get Euro’s to pay off his Budapest development company’s loans.
Might increased financing costs on SOEs to push them into the red? If I recall correctly, the margins are so thin that rising rates might not be able to be absorbed.
Good post. I love the interest rats!
Is there any problem with calling the suppressed interest rates and suppressed currency massive hidden taxes on households? To me, the central government seems to have found an elegant way of broadly taxing all Chinese in a manner which is difficult to evade, is probably somewhat progressive, and is virtually invisible to your average Chinese. What are saving deposit interest rates in China versus Brasil or India? What are loan rates in China versus Brasil or India (or Wenzhou for people or businesses without connections). I also feel that much of the revenue has since been squandered on subsidizing state-owned companies and dubious capital projects (not all by any means). If this is the case it will presumably be difficult for China to allow citizens alternative investments or loosen up foreign currency controls as it would result in a significant loss of real revenue to the state.
John, what is “GFW”?
Another question Michael, what alternatives do Chinese savers have? And what are the implications of savers adopting them?
Real estate looks to be in bubble territory along with commodities. Real Estate in particular might have some of its own worries (short lifespan due to quality issues)…….
http://www.chinadaily.com.cn/china/2010-04/06/content_9687545.htm
One of your best, thank you for focusing on one of the most interesting and often left points in China’s structural financial system.
Paul,
I think pettis mentioned this book several times: http://www.amazon.com/gp/product/0195101138/ref=oss_product
Basically suggesting that, among other things, the rise of lower-class politics has made adjustments/liquidations of the kind made prior to World War I Gold-standard economies impossible.
Another great post, thank you.
If the capital providers receive return rate lower than GDP growth rate, then who receives the higher rate of return than GDP growth rate? Output is a function of capital and labor. It is clear from your analysis that labor is receiving the higher rate of return. Given the path China takes to develop, labor-intensive industries and massive migration from rural areas to cities also re-affirm that this policy is to accomadate the huge demand for employment in China.
Yes, households sacrificed interest income, on other hand, employment growth and job income are the compensation for this policy.
Apparently, it might be the time that balance between these two is near.
Professor Pettis,
Great post as always. I do have a question related to this topic, which I was hoping you might be able to address. Assume for a minute that China instead chose the path of allowing NPLs to simply default without the public rescue that actually took place. Obviously this would have created extreme hardship and could have resulted in the financial collpase everyone is so worried about. However, assume they grew out of this situation and resumed the growth we’ve seen over the past decade. Would deposit rates still have been kept artificially low, with spreads so high in order to fund expansion?
I guess the larger question is whether China’s suppression of consumption is an inevitable policy decision to fund such robust growth or simply their choice of how to handle a deteriorating banking system. It seems logical that China will choose a similar path as loan continue going bad, but I’m curious about the consequences of this alternative path in both the collapse and recovery of such a situation.
China actually grew five fold over the last decade when you factor in currency appreciation. It seems highly implausible that it will only grow twofold over the next decade, especially given that with the re-orientation of the economy towards the domestic market then the Yuan will be allowed to float upwards again possibly as soon as April (depending on which rumour you listen to.)
Great article. They say “all debts must be paid, whether by the debtors or the debtees”. How about “other classes of citizens” as well, or simply absorbed as false savings. While it would appear that false savings probably represent the most harmless short term resolution, over the long term, it too will fail. Eventually, the savers will wake up to the fact that their savings are not matched to productive capitals but are merely claims on the future production of descendants of a generation of lazy and unproductive people.
Brilliant post, professor. I know that the Chinese government has been using artificially repressed interest rate to steal the wealth from household in order to compensate bank loss, but I was still astonished at your back-of-envelope estimate – were the 5% of GDP used on household consumption annually instead, there’s no way the Chinese economy could be so distorted as it is today.
It seems that China is indeed heading the way which led to Japan’s lost decades but with a much lower per capita GDP. I’m pessimistic about China would be able to rebalance within the coming years because below-par growth rate would result in more and more problems and less solutions that the government would face. Hope Geithner’s meeting with Wang Qishan would bring back the badly needed coordination between China and US.
Great post. Minor nitpick: I think you meant “principal” where you wrote “principle.”
Since all the NPLs are domestic, I guess the printing press will pay the bad loans?
Professor,
Thank you for your shrewd perspective on the relationship between households and NPLs.
I don’t argue against your argument on the wealth transfer from households to banks in solving NPLs through low interest rates. But I’m wondering what causes NPLs. If the underlying economy is in a bad situation, many companies go bust and NPLs pile up. So, as long as the economy goes well, NPLs can be solved and the households can enjoy the benefit of booming economy. Japan, as you write, has endured sluggish growth since the 1990′s, but I’m not sure how much of it is due to NPLs. In fact, even after banks recovered from the mess of NPLs, Japan’s economy didn’t come back well. Therefore, I think that stagnant economy caused anemic consumption growth, and NPLs are only the symptom of stagnant economy, not the cause of feeble consumption.
Very worrying analysis, especially in conjunction with what I’ve been reading about the fragility of export-sector profitability and about overinvestment in both (mainly SOE) export-industry production capacity and real estate.
Not only will the Chinese household sector NOT pick up any slack in world consumption, it looks likely China will experience major economic pain soon.
Dear Dr Pettis
Your view on NPL’s seems to be precisely the reason the Chinese have avoided RMD revaluation.
RMB to dollar was 1.5 in the early 1980′s
RMB to dollar to today?
The RMB is wildly overvalued and Asset price collapse in housing could be the match for the kindling
I meant to say RMB is wildly undervalued
China Appears Set to Make Currency More Flexible
http://www.nytimes.com/2010/04/09/business/global/09yuan.html?hp
Wow, the government reacted quicker than expected to this problem.
Professor,
Didn’t the US go through some similar version of it in the aftermath of the tech bubble, and still going through it today? The depositors are also getting virtually zero return as the Fed keeps the short rate low. There may have been a lot more outlet for savings in a better developed capital market, but it didn’t prevent people from massively misallocating capital in artificially distorted asset market anyway. In fact it forced investors to leverage up in search of incremental yield in the absence of true growth. Let’s not forget that the epicenter of this massive financial failure is in the US.
How much do you attribute the massive trade surplus, true improvement in productivity, as well as the resultant attraction of capital in flow in helping China to solve the NPL crisis from a decade ago, i.e. a combination of true growth and a degree of mercantilism helped China grow out of its problem? It’s hard to quantify exactly in what proportion each of these factors has contributed in helping to solve the last round of NPL problem in China, but doesn’t it seem that meaningful subsidization by the savers to the banks is not a unique Chinese phenomena in the last decade? And the difference in magnitude is several percentage of GDP per year in the end of the day. But starting from a very low base, there was a lot more true economic development in China over the last several decade than anywhere else in the world, and the magnitude of that development overshadows the subsidization?
Can China grow its way out of this round of problem as well, and hopefully suffer less pain than the large potential NPL would imply for a more developed economy? Productivity can still develop a lot more if government allows it.
Pretty nice article and very Good logic. One bad thing is the professor should not mention the country name. If you want to name the country name, it is better to check the fact. If you want to hear two sides of the story. Here is the other side of the story.
First let us talking about the China’s last banking crisis because professor use it to back his view. It is more complicated. I am trying to get it short. Before 1980s, there is only one bank in China, PBOC. 1980’s reform divided PBOC into central back and several commercial banks. At that time all the industry owned by government, those SOE got funding from Treasury’s budget not from bank. To reform this, the budget funding got cut and SOE began to get loan from banking. But they still view it as budget and have nothing in mind they need to repay the loan. That is where most of NPL came from.
In 1990s, Zhu, Rongji began his reform. He want SOE to go public to issue stocks. To do that, they divided the SOE into good part and bad part. The good part got no debt, got all the assets. The bad part got all the standing loans and retired workers. Sounds familiar in this crisis. ?.
So this make NPL issue even worse because the SOEs will transfer all their loans to the bad part, be it bad or good. The NPL got ballooned. I have personal experience on this big event. After SOEs became public traded companies, it is turn for state banks. But all these banks got NPL issue, so to fix this, Zhu create AMC to purchase bad loans from banks. Professor is right about this. But what he does not know is the offered price is not good and bank did not want to sell it. Then Zhu ordered the bank to sell those NPLs to AMC so bank can go IPO on schedule. AMC outsourcing the NPL collection to Wall Street and they earned a pretty good profit from it. The story is this, Chinese people used to think if you owe 100 dollars, you need to at least pay back 100. If you can not payback 100, you are dead. People do not want to be dead, so they flee to places you can not find him. When someone approached them said you can pay 20/30 dollars back and you are free of this debt. Most of them will pay.
That is why the banks wanted to handle NPL themselves but Zhu do not want to wait. He got only one term so he wanted to solve the NPL issue in his term. Without AMC, those banks can easily solve it themselves. Before 2000, the PBOC regulate the loan interest. The spread is about 2-3 percent and all loans should be issued at the same interest rate. Which is much below the market interest rate. So banks can not get enough profit to cover their NPL. Only after the banks IPO, the spread was increased by PBOC. It is still not market interest rate but much better than before and enough to absorb the NPL.
So what I want to say is that crisis is not a real one and you can not say China will have another banking crisis because they had one before. That is not true and not happened. China banks now have the most strict rule about NPL. If NPL rise to certain amount, the branch manager will get fired and basically end his career. The employee who handle the NPL will get fired too. Just image this happened in US, you will see a lot of bank managers flip burger now.
Then I will share you my story. Chinese bank right now still have a ceiling of interest rate. So if you are lucky you can get it. It is pretty good deal. The banks normally do not give loan to small and middle size business. The only exception is if you are classified as export enterprise and you got one export contact on hand. If you got one US contract, you can get 80% or 90% percent of the contract amount for loans. With this money, you can pay bill, buy raw materials and pay the labors, pay the rent and maintain the equipment. If got contact that from Thailand or Brazil, you may get 30%. If the contact is from Beijing or Sichuan, you are on your own. For my business, we import a lot of material so we need a lot of money to stay in business. I have to export to US to get some help from bank. So you can guess, normally the US customer get the best deal. But it is also good for us. For example I got 1 million USD contract. I can take it to bank to get 900K three month loan if lucky. Then I shipping the freight in one month(All US contract got top priority). Got money after two week. That means I got kind of free loan for one and half month which I can funding my business with other customers. I used my profit to expand business, no long term loan from bank. And I can tell you, all Chinese private business expend like this. We expend using our profits. I guess that answers who get profit from the economic growth.
This is before year 2007 or before Fall of 2007. From later of 2006, Wen started to tight the credit. So from Fall of 2007, even with US contract, I can not get loan from bank. In order to survive, I need to go to underground loaners to get loan. The interest, if he is you brother-in-law, you may be lucky to get 40% loan. I took loan for 15% monthly interest. So in early 2008, thousand of thousands business closed in Yangzi delta. The business in Guangdong provenience can hold on because most of factory owner are from Taiwan or Hong Kong. They can get loan from Taiwan and Hong Kong. So the most difficult time for us is spring 2008 and summer 2008. In summer 2008, Wen claimed the economy successfully cooled down. Then we got this financial crisis. Even Taiwan and Hong Kong businessman can not get loan from their banks. So it is a prefect storm to China. Then Wen took a U turn on November. So in Q4 2008 and Q1 2009, our conditions got improved. Why? The bank called us to offer loans. With a US contract I can get 100% loan. I can use my factory as collateral. Before the bank only accept house as collateral.
So what a normal people will do is, to borrow the 10% interest loan from bank to re-pay the 50-60% interest loan from underground creditor. If the bank still willing to loan you, good, just borrow it and saving it in bank because you will need it someday and 10% is pretty cheap. That is why the loan expands a lot in 2009.
So when I see a lot of West economists worrying about rapid growth of Chinese loan in 2009 and worry about the bad loan bla bla the only thing I can say you need to learn some Chinese. In China, loan is always scarce resource, so you will never miss the opportunity to get the loan. The bank also got incentive to lend out money. Because people knew Wen will tight credit in one or two year. For example, if bank loan me 1million dollar for one year last spring. Then If the PBOC tight credit and issue loan quote again this spring. The bank got my loan back and can issue another 1M dollar loan because the loan quote is already there. Will my loan be a NPL, I highly doubt it.
Keep it in mind, in China, there is basically no consumer loan except housing loan. And the total consumer loan percentage is about 15% at most. When people buy a house, the down payment is 20% with no exception. Repay the loan is a family thing, both family working on repay the loan because Chinese sort of regards owe bank money a shameful thing. Most loans, perhaps more than 90%, repay ahead of schedule.
Also want to make some point:
1, about China depends on export for economic growth.
That may be true as before. But it is not true right now. The first two month China’s trade surplus drop 50%, and may get deficit on March. The China trade surplus is 4% of GDP, so that means at least a negative 2% GDP impact for Q1. The Q1 number will be shock to the world. I can see it from my business and my friend’s business. The growth is phenomenal and are all domestic. The GDP may grow 12% in Q1. So that means domestic demand drives 14%.
Also the US trade is about 12% of total Chinese trade and 17% of Chinese export.
2, About China do not consume.
I do not think so. Professor is from Beijing University. So it is not difficult to check China’s market. The car sold China in Q1 is more than US and Japan combined. So is that a weak consumption?
I guess a lot of person miss understanding China is lost in statistic. The China got a different statistic system as US. The term may be the same but the meaning is total different. The consumption in US includes service consumption like health care, education, law service, rent etc. The rent along will be 10% of US GDP. The China consumption number does not include service consumption. The Chinese consumption number includes retail sales and hotel and restaurant not included any service retail. Chinese do not regard that as consumption. In US, health care is 17% of GDP, rent is 10% of GDP and you got a huge finance sector, that is consumption too. If you excluded those service consumption, US and China basically shows not much GDP percentage difference in “Real” consumption term or Chinese term of consumption
3, About RMB exchange.
As a business man, I really do not care about RMB exchange. My biggest cost is financial cost. If the government can let get the bank loan and I can get 10% instead of 40%-50%, who cares about the RMB exchange rate. Be it 5 or 4, we can still survive. I do not care who my customer is. I can get higher margin when I sell to domestic customer.
WILU : MANY THANKS for your “on the ground” experience of how China’s SMEs survive and prosper in a credit constained economy.
Your description of how you finance your business via family, friends and money lenders and then roll over loans when bank credit is available is terrific.
The parallel financial system is completely missing from academic discussions — despite its obvious impact on behaviour and outcomes. regards James
wliu,
Keep commenting!
thanks a lot to wliu for his very precious and ligthening comments about the difference between academical approch and practical experience
@wliu
I have a few questions:
1. Do you think there is a housing bubble in China, and if so, is a crash (rapid price drop) scenario possible or likely?
2. Assuming housing is in a bubble, what would the impact on the banking sector be if the bubble bursts?
Thanks.
wliu,
Are you saying that in determining the national accounts (GDP), the NBS does not include services in the identity: Y = C + I + G + (X ? M)? Then why does the NBS include services in its CPI calculation? Could you give us a reference for your assertion?
Also, I do not doubt that you and your counterparts are seeing a great deal of economic activity, nor that when an SME owner has the opportunity to get a loan, it is taken. However, if many economic players have taken loans during the stimulus activity without a near-term productive use for the money, then you have defined the basis for a bubble. Such funds will then find their way into speculative assets, won’t they? Is that not what we are seeing? Stockpiling of commodities could explain a swing to a trade deficit, and the drop off of external demand, although slowly recovering, does not seem to be doing so rapidly enough to get to pre-crisis levels anytime soon. As the government withdraws the punchbowl, many of those who have grabbed such nonproductive monies will face a problem.
Y = C + I + G + (X – M)
wliu,
Great job!
Your posts go a long way to explain why the academic world and western pundits have kept missing the mark about Chinese economy. Every time I read their comments, I kept shaking my heads. Occasionally, I would jump in to debate and clarify, as I did a few times in Pettis’s blog.
Most of the times, the problem can be attributed to lack of understanding of how the real economy in China works, besides obvious bias.
There are significant differences in how China’s economy works from western economies – the role of government, the state sector, the financial systems and the monetary policy. Many of the statistics are interpreted differently from comparable western or standard economics textbook numbers (as I argued a few months ago in this blog about China’s GDP, its service sector and its consumption).
Right now, I’m seeing the commentators and pundits are falling behind and largely missing the recent trends in China’s economy again this week. This RMB exchange rate debate is a big dis-attraction and waste of time for many smart people. Despite the difficulties, China’s economy is changing and adapting – or rebalancing to borrow the buzzword.
Correction from my last post:
“Right now, I’m seeing the commentators and pundits are falling behind and largely missing the recent trends in China’s economy again this week.”
Should be:
“Right now, I’m seeing the commentators and pundits are falling behind and largely missing the recent trends in China’s economy again.”
Thanks for the comments, wliu. Glad to see at least some make it through the GFW.
Since the global recession, most growth in China has come from Infrastructure/Construction/Real Estate. Prior growth came from Exports. Exports are not likley to be much help going forward and it appears that too many buildings/factories have been built. Ordos, the Ghost City, is one example. They mention that people continue to buy housing even though it is not occupied because housing always goes up. Does that sound familiar? Looks to me like a real estate bubble which is also a banking problem.
In my eyes, there are three types of enterprise in China. One is MNC, one is companies from Taiwan and Hong Kang. The third is domestic industries most of them SME. SOE is in different league and they do not export much so make thing simple, I will just talking about these three types.
The crisis hit these three types of enterprise pretty differently. In 2006, Wen started to cool down the economy. He raised interest rate 6 or 7 time in 2007. I can not remember exactly the number because it is irrelevant to me anyway. PBOC raised CRR multiple time to 15%, that means for every dollar the bank got from deposit, they need to save 15 cents to PBOC. The current CRR is about 10%. Again, it may not accurate because I did not check. Then they finally send every bank a loan quote and every bank must not exceeds it. This hit the domestic companies very hard just as I mentioned in the above post. So in late 2007 and early 2008, the domestic company suffer a lot. Thousand of thousand companies closed. You either use your own money or borrow 60%-80% loan from underground creditors to run your business. Many owners just simply closed the factory and went to Beijing to watch Olympics. YangZi delta got hit pretty hard at that time. Like Zhejiang, Jiangsu province.
At the same time, MNC and Taiwan or Hong Gong companies were doing fine. First, they can still get money from bank because they are supposed to be the good customer with good credit. Second, they can go back to their local bank in US, Japan, Taiwan or Hong Kong to get loan. So every time PBOC tight credit, domestic companies suffers and MNC and Taiwan or Hong Kong got benefit from it because we can not compete with them at that time. So Guangdong is doing ok at that time because majority of Guangdong factories owner by Taiwan or Hong Kong people and worked only for foreign market.
Then September came, suddenly everyone can not get credit, be it MNC or Taiwan or Hong Kong. And foreign market collapsed. This time, a lot of Taiwan and Hong Kong companies closed their factories in Guangdong. This time Guangdong suffer.
Then on November, Wen’s U turn came. Banks started to call people to ask people if they want to get loan from their bank. Now domestic companies can get loan and we have the market because most of us serves the domestic market not foreign market. Most MNC produced in China for their own market. Taiwan and Hong Kong owned factories also serves foreign market. Although they speak the same language but there is big culture difference here. There is no way for them to fully understand mighty China market like domestic companies. Normally they would not bother to go to domestic market because they are more familiar with foreign market and they are good at dealing with foreigner customers. They are the backbone for export economy. This time, although the banks are more willing to give them loans. But they can not find customers. Their old customers in West market can not put orders and they do not have channels in Chinese market. So they suffer a lot in late 2008 and early 2009. This time we are doing fine.
I am not a good English writer. So let us put it this way:
MNC: Depend on foreign market also sales a lot to domestic market. Can get finance everywhere. They are like the eldest Son in the family. The China government like them, the Chinese bank like them. They have huge lobby power to government. Got hit after September 2008.
Taiwan and Hong Kong: Second Son in the family. Can get finance from Chinese banks, Taiwan or
Hong Kong. Most depend on foreign market. Ipod was manufactured by Taiwan company in China. Also the Walmart stuff. The got hit the hardest since September 2008. They also got some kind of lobby power because China government wants Hong Kong doing well and want Taiwan back to China.
Domestic: The step-son in the family. Limited access to bank loans. Mostly depend on domestic market.
Got hit hard since 2007. Recovery since pretty quick after November 2008.
Basically that is the situation here. About the exchange rate, we really do not care about the exchange rate. We have domestic market. If foreigners want to do business with us, that is great. If not, that is ok. Our biggest cost is finance cost. If you pay 40% interest, do you bother about the 5 or 10% exchange rate rising?
In China, a lot of people want the floating RMB. I guess PBOC also wants it. It is the mighty Ministry of Commerce wants to defend RMB. They claimed to do it to protect Chinese interest. Definitely not my interest. It is the interests of MNC and Taiwan or Hong Kong companies. My interest is get loan at 10% or even 20% interest. It is the MNC and Taiwan or Hong Kong companies interest to keep RMB undervalued so they can lower their labor cost to subside huge distribution cost in West markets. They got tremendous lobby power. China is not a democratic country so officials got no defense on these lobbyists. They do not even aware who is lobbyist who is not. The current minister of Commerce, Chen, Deming is former mayor of SuZhou. Suzhou is major manufacturing hub for Taiwanese companies and Chen got promotes because his excellent job in Suzhou to started it. So it is not surprise for him to defend this export economy.
James,
“The parallel financial system is completely missing from academic discussions — despite its obvious impact on behaviour and outcomes. regards James”
I have not seen anything specific in the english language China literature, but for instance in discussions of Korea’s development model (Meredith Woo-Cummings, various works) the role of the informal financial system is a recurring topic. The formal system advantages the firms/entrepreneurs deemed important (for development, politics, bribes, whatever) andthat may not be efficient (but it could, under certain conditions) and tends to create problems for the future when the country reaches a certain stage where firms need to stand on their own feet (because of economic openness, WTO, etc). The magic of the informal system (when not operated by a cartel) that it can be the ideal Darwinian allocator of finance for small business. Which does not make it popular with small business. For a system like the PRC, the informal system is one of several exhaust valves, maybe an area of patronage (Godfather style) maybe a link in a money laundering chain, etc. Maybe the informal system is not all that benevolent there, and then who would be interested in writing about it academically? Westerners? they would quickly see their visiting/research priviliges curtailed. Chinese? It depends who and what you are accusing. If ennemies of the state/party do this, no doubt that could lead to published work. Still, an interesting topic.
Baychev, I am not sure I would say that China “outgrew” its NPL problem. What I have tried to show above is that it amortized the NPLs through transfers from the household sector. If you pay down debt, you are always likely to outgrow it.
JB, a very small share of Chinese household financial wealth is held in the form of stocks or housing. Most of it is bank deposits.
Rien, if SOEs buy the NPLs at face that would work only if the losses weren’t then transferred to households in some other way. I worry that NPLs would either be given “free” financing or would be able to pass on the costs by raising retail prices in a monopolistic environment. In my opinion the only “costless” way to solve the problem — costless for the household sector, that it, would be for the government to transfer SOE ownership to the household sector, either directly, in the from of privatization coupons, or indirectly by selling them and using the proceeds to pay down debt, or to transfer ownership to the pension funds. I suspect that this, however, will be politically very difficult.
James, I think financial repression can be a great growth strategy if your are rapidly urbanizing and more worried about unemployment than about household income. This clearly was the case of China and most of the other Asian development countries. The problem is that if you are too big you run into balance of payments constraints, as Japan in the 1980s and China today suggest. Financial repsression requires that you absorb net demand from other countries to generate rapid growth, but once you are big enough that this will have serious adverse effects on the employment levels in those other countries, then you run into the problem of trade disputes.
Glen, households have few investment alternatives, which is a prerequisite for financial repression.
Muwabi, if the borrowers were allowed to default, that would have simply thrown the problem fully into the banking system the government would have still had to choose between letting the banking system collapse or finding a way of recapitalizing them.
Wilu, you may want to check the facts too, and perhaps speak to bankers involved in the NPLs. The price the AMCs paid for the NPLs were many times the ultimate liquidation cost. Even the government recognizes that the AMCs are bankrupt, so the idea that these loans were likely to be repaid at 100% is far from the actual experience. On average the loans have been liquidated at 22%, and most people believe that only the best loans have been liquidated — the rest are much worse. Your explanation of the resolution of the banking crisis is very different from the explanation given by any of the bankers involved, and certainly very different from what policymakers have said. You are also completely confusing aggregate lending with lending to SMEs. It is widely known that SMEs have tremendous difficulty in raising loans. This is not because lending in China is tight. Lending in China is incredibly loose, but loans are monopolized by SOEs and large manufacturers. Finally I am very surprised by your claims about NPLs. I had dinner two nights ago with the chief economist of one of the Big 4 banks, who like you claims to be Chinese and to speak Chinese, and he would find your comments a little surprising. So apparently would the PBoC, who has very publicly warned about a surge in NPLs and is forcing banks to raise capital for just that reason.
James, I am not sure why you would say that the parallel banking system is completely missing from academic discussions. On what do you base this? As someone who spends a lot of time looking at China’s financial system I would have never come to that conclusion. On the contrary, I would point out that it is discussed in most academic analyses of China’s financial system and has even been the subject of a couple of good books. It has been widely discussed on this blog and has been a topic among financial economists for a long time. In 2007 a researcher at a Chinese university estimated that up to 25% of total loans are made in the informal sector. I suspect that the only way one would imagine that “pundits” (why always “pundits”?) aren’t looking at the issue is if most of one’s information on pundit research comes from the major foreign dailies. Probably not the best source.
Rien, actually, as I mention above, there is a lot of work done on the informal banking sector and some very good research. In my PBoC class, in which only 15 students are permitted to join and everyone must have a special topic of key importance that he must cover every week, one student is dedicated only to keeping tabs on the informal banks (the PBoC branch in Wenzhou, for example, is a very important source of information), and another has as part of his portfolio the relationship between the informal and formal banks. Not surprisingly, they find a lot of information in local newspapers — some of which actually advertise deposit rates in the supposedly illegal informal banks. There have been several conferences on the topic, and one of my PhD students will even be doing his research on the so-called “chop shops” of the 1920s and 930s and their relevance to the informal banking sector today. This is not at all an obscure area of research.
What I worry about most is the light speed that China is developing. An economic system must make progress in many areas at the same time to remain in balance. Regulatory institutions must progress, legal framework must progress, monetary institutions must mature, etc, all relatively at the same speed less there be pain. As China evolves more towards a true market economy where investment decisions are made more by ROI and less by trying to read the tea leaves of government policy, analysts will have to become must better than the current crop who just “put their faith in the party”.
Working in the banking area for a large state owned bank, I can tell you that the risk evaluation methods in China are frightful. Few have any ability to analyze financial statements. Chinese politeness keeps analysts from asking hard questions of borrowers. Regulators are even more pathetic. Absolutely clueless in how to evaluate a company. Follow policy…loan to value (even though value is based on appraisals controlled by the borrower) and you won’t be criticized.
Let’s all remember that China’s privatization of real estate is less than 15 years. Prior to that citizens were granted residential spaces on a sort of lease basis. These guys have never seen a downturn. No concept of negative equity. “If we build it they will come”.
The banks were recapitalized in 1999 and then again in 2004. NPLs were choking them…and that was in a good economy. Many of the big banks just rolled the 10 year bonds they took back from the asset management companies in exchange for the bad loans. That tells you about the collectability of those assets.
After 1999 and 2004, you’d think the banks would have learned better risk management. But corporate and project evaluation is still poor. Few banks have active problem management units. While they may have problem loan groups, those groups are more like liquidators or passive baby sitters. Loan structures have few triggers to allow for any kind of risk management prior to payment default. It’s all about volume.
1999 and 2004 were healthy growth years. What happens this time if the economy turns down? Watch out! Bank of China’s loan portfolio grew 47% in 2009 alone! The President of CCB says “we will have prudent growth in 2010 at 21%”. 21%! if a bank in the west organically grew its portfolio at 21%, the regulators would be all over it. I fear there will be huge NPLs this time around, little recognition in advance, little analytical talent to evaluate.
Also, this time around many of the Banks are listed. Does that create an additional complexity?
How do you move away from a capital allocation system where everyone sits around trying to figure out what the government will do next…what industry to support (airlines or high speed rail for example?) What firms will be picked as survivors by government in the forced industry consolidation? I don’t know how you gradually move away from this. It kind of seems binary.
I heard a great story about steel companies. Everyone knows the government will force some shotgun marriages in order to curtail small inefficient producers in order to achieve its primary objective of taking some capacity out of the system. So, all the steel companies are expanding like mad because they want to be the biggest on the “day of the wedding” because the theory is that the bigger firm will be the survivor. Thus, firms are doing exactly what the government is trying to prevent! Not sure if this is completely true. But the fact that the government uses the banks to be the controlling force in who gets capital to expand suggests that they cannot control the firms or local governments directly.
Loans in China are entering a new phase as I see it.
The trial and error approach that has been used so far seems to be working, but the price of error is increasing.
As China enters into new sophisticated production techniques and R&D work the price of error will not just be an empty apartment building or an unused road. It will be pricey research tests, unutilised and uncapitalized research results.
The price of a high tech research error is way higher then that of a low tech fixed asset lying idle.
China no longer has the U.S or E.U consumers to help give return on fixed asses. Even if low tech exports picks up again it is unlikely that anyone will consume at the same rate as before, the trade tensions will also make it hard on low tech export and there are a many new competitors raising other places in South East Asia, in India and in the Middle East waiting to have a go at low cost production.
This means China has to succeed in part with its latest tech program/investment in S&T from 2006 in order to have a chance of getting the export going again. But doing high tech research is different from building a road or an apartment complex, it takes huge investments and in many cases it creates jobless growth if it succeeds.
The Chinese consumer and the Chinese state will carry growth a long way, but they can not replace the worlds two largest economies, so China has to invent new products for the U.S and the E.U and it has to do so on it own for the first time, as it enters areas where others have not been before and thus not have the luxury of avoiding other peoples mistakes. The price of growth is going up.
So instead of looking at all the roads, railways and buildings in China maybe one should look at the strengthening of the national Chinese innovation system, as it has to bring in a fair share of future GDP growth. What did the national innovation system get out of this og last years fixed assets investment? From what I have seen not that much yet and that should worry more then the return on a railway fixed asset investment.
The Chinese state has to start inventing and stop building if they want more then 8 % GDP growth a year, If they succeed then this will the century of state driven innovation.
My point being that this year and last years loose monetary policies created bad loans in the wrong neck of the woods. The SOE should have put their money in R&D, but they bought cars, real estate and stocks for it instead. Only the SOE have the capacity to maintain 96 R&D NPL out of a 100 loans and make the remaining 4 loans into great business.
Still we all know that fixed assets in China will give great returns in the next 10 years. I better be true, because with the bet the Chinese government is making there is no room for lukewarm returns.
Michael,
“Rien, if SOEs buy the NPLs at face that would work only if the losses weren’t then transferred to households in some other way. I worry that NPLs would either be given “free” financing or would be able to pass on the costs by raising retail prices in a monopolistic environment. In my opinion the only “costless” way to solve the problem”
I looked at it from the point of view of who has the capacity to act or is represented. I.e. the cheapest solution for the elite. Consumers are comparatively passive/constrained in this political economy, imo.
As to the informal system in China, have you got literature you can share (not so much about the quasi-legal finance companies that are beginning to be part of the landscape) ? I am more used to the term informal banking as a euphemism for businesses that conduct (always unlicensed and unsupervised) finance activities like high margin lending, debt collection, money laundering and informal transfer systems. In China there is clearly room for (benevolent) unlicensed but not necessarily criminal or crime-linked “informal banking”. Nevertheless the experiments monitored by the PBoC (why not the CBRC?) and included in students’ academic work are of course very appropriate, also given the enormous amounts that have been transferred recently from the formal banking system and may end up being on-lent outside Beijing’s control.
A Chinese taxpayer bailout of the Chinese SOE banking sector certainly represents a huge misallocation of capital, but at least any bailout would be for a pseudo government agency with other mandates such as promoting industrialization, infrastructure, and employment. In stark contrast, the US Treasury and Federal Reserve expressly bailout private sector entities due to entirely political considerations. The Bernanke Fed continues to provide politically connected Goldman Sachs with “free capital” at 0% interest. Citicorp, Goldman Sachs, AIG were permitted to dump their subprime wastepaper on to the balance sheet of bankrupt Fannie Mae and Freddie Mac owned by the US taxpayer. There continues to be a complete lack of transparency of inside deals between the Federal Reserve, Wall Street banks, and large politically connected Hedge Funds. Trillions of US taxpayer dollars have been laundered; it’s more of the same, privatize the profits, and socialize the losses.
I enjoy reading these posts and tryng to understand the underlying complexities. What I still have difficulty wrapping my mind around is the idea that China’s household savings rate is “high” due to (or despite) low interest rates and America’s household savings rate is low due to low interest rates. Japan was able to increase its domestic consumption, allbeit slowly, in the face of low interest rates but China won’t be able to.
Anders,
Interesting thoughts. But communist systems and China in particular are terrible at innovation. You have problems of both system (no incentives) and culture (ingrained fraud).
Dr. Pettis,
Congratulations on your web site redesign! I was getting a little worried when you were offline for a few days.
Hua Qiao- Well put. Very well put. I look forward to reading your comments in the future.
Michael, I think what you are missing is the ceasing of mal-investment after the bubble bursts. Chinese consumption couldn’t begin to grow fast enough to absorb the slowing pace of construction and industrialization that would acompany such a situation. In the US, it isn’t only the cost of cleaning up the bad debt, but the ceasing of the excesses that went along with the bad debt. From what I understand, something along the lines of 59% of Chinese GDP is speculative and expansive investment and much of this is bad or misdirected investment. Andy Xie says China is closer to being built out than most Westerners could begin to imagine. Since most of us have heard about China being able to march armies into the sea 2 by 2 forever and never run out of people, it is hard to imagine they could ever house all their people. If they stopped building empty buildings, we would see massive dislocation. If they don’t stop, they are going to have more empty buildings, trillions in wasted resources and capacity that will never be used. 25 years after the building stopped in the mid 1980′s, Downtown Dallas still has a 30% vacancy rate. The population of the DFW area has increased 50% since then. There hasn’t been another skyscraper built in the CBD since.
Nice article. One quibble, I think you mean ‘principal’ and not ‘principle’ in many instances above.
Hello Mr Pettis
Glad to see you back online and in one piece – for some reason, your server sent out the message that your website was bieng “suspended” last week – and thought you had finally riled someone really badly.
NPLs have been endemic in the Chinese economy for such a long time, partly because of the SOE problem but partly because of its reorientation towards market economy.The overly loose credit policy(further justified by the credit crisis of the past couple of years) and all the sabre rattling of regulatory authorities from time to time only means that any serious attempts to rectify the problem are about as elusive as ever.
Victor Shih’s guaranteed funding vehicles (referred to in one of your posts in 2009?) an approximate measure of municipal and provincial indebtedness not captured in the visible debt – if memory serves, it was about the speculative inflows in the Chinese economy that was adding fuel to an overheated economy – is a lot more worrying than anything else because we all know how transparent things are at levels other than central government. (and yes, that as sarcastic). Of course, no one’s worrying about what’s underneath the carpet till it affects their breathing and am betting that;s going to be sooner than later, maybe end 2010, early 2011 when things get really ugly?
Question is is there even a nice middle path out of the potential mess?
I’m very pleased this blog is back up! If it were available I might be interested in an electronic or even a paper copy of the essays incl relevant comments.
Your insights are always terrific – wish you would come home and start same analysis framework on the USA.
We have a massive blind spot as Minsky like – accounting identities – flow of funds stuff is almost non-existent in investment management fields, and found now usually incorrectly applied to ratinionalize socialisitic political programs.
Could every third or fourth of your essays be on the USA? Though you started there wiht USA consumption/savings just it is in context of China, usually.
Wonderful material.
http://www.21cbh.com/HTML/2010-4-13/5MMDAwMDE3MjQ5Mg.html
This is an extremely interesting read from ICBC’s president. It provides serious thoughts of the way that Chinese banks can grow loans in a sustainable manner: securitization(!). Not only does it address the need for securitization but it also lays down framework on some specific implementations, such as how to deal with moral hazard, migration of accounting treatment, real risk transfer etc. This is probably warming up the political environment to revive and standardize that business.
Michael,
I recently became aware of your website and great essays. One day I would like to read your views on what I believe is the disappearing middle class in many of the developed countries. Some dispute this is actually occurring. I would like to read your views. If this is actually happening, there are undoubtedly huge social repercussions.
Best regards,
Anthony