Once again I am starting to hear investors tell me that they have been advised by bank analysts not to worry too much about the impact of a banking crisis in China. According to this argument, China has developed a very efficient and low-cost way to address banking crises, and the proof is that China’s last banking crisis, which occurred only a decade ago, was quickly and easily resolved. I am afraid this argument makes absoutely no sense and is based on an inability to understand how the crisis was actually resolved.
Throughout modern history, and in nearly every economic system, whether we are talking about China, the US, France, Brazil or any other country, there has really only been one meaningful way to resolve banking crises. Whenever non-performing loans or contingent liabilities surge to the point where the solvency of the banking system is threatened, the regulators ensure that wealth is transferred in sufficient amounts from the household sector to borrowers or banks to replenish bank capital and bring them back to solvency. The household sector, in other words, always pays to clean up the banks.
There are many ways to make them pay. In some cases, and certainly in the US before the 1930s, banks simply defaulted and their depositors absorbed the full loss. In that case it was the actual bank depositors, mainly households, who directly bore the full cost of the losses, in the form of reduced, or sometimes no, repayment of their deposits.
Largely because this kind of system creates incentives for bank runs, regulators developed alternative systems, by which governments guaranteed deposits and otherwise bailed out the banks, and paid for the bailout by raising taxes. In that case the household sector still paid for the losses, but they did so largely in the form of taxes, and the losses were spread throughout the population.
Of course this way of bailing out the banks is politically unpopular and always leads to uncomfortable calls to punish the banks for their behavior. If the regulators are given a longer amount of time during which to clean up the banks, they can use other, less obvious and so less politically unpopular, ways to do the same thing, for example by managing interest rates. In the US and Europe it is fairly standard for the central bank to engineer a steep yield curve by forcing down short-term rates. Since banks borrow short from their depositors and lend long to their customers, the banks are effectively guaranteed a spread, at the expense of course of depositors. Over many years, the depositors end up recapitalizing the banks, usually without realizing it.
There are two additional ways used in countries, like China, with highly controlled financial systems. One is to mandate a wide spread between the lending and deposit rates. In China that spread has been an extremely high 3.0-3.5 percentage points. The other, and more effective, way is to force down the lending and deposit rates sharply in order to minimize the loan burden and to spur investment. This is exactly what China did in the past decade. These low interest rates help resolve non-performing loans by granting continual debt forgiveness to borrowers.
How so? Because if interest rates are set at a level lower than the natural rate, every year the borrower is effectively granted debt forgiveness equal to the difference between the two. By most standards, even ignoring the borrower’s credit risk, the lending rate in China during the past decade is likely to have been anywhere from 4 to 6 percentage points too low. Over five or ten years, or more, this is an awful lot of debt forgiveness.
These all sound like radically different ways of addressing insolvent banking systems, but make no mistake, they are all simply different ways of spreading the cost of bank insolvency among households.
With all the concern generated by China’s recent minimum reserve hikes and the controversy over 2011 lending quotas, it is important to remember this in the face of the widely-held but wildly incorrect belief that China was able to grow out of its last banking crisis at a relatively low cost to the economy. Why this belief? Because ten years ago, the share of non-performing loans in the Chinese banking system was estimated to range from 20 percent to 40 percent of total loans.
Within the decade, however, this once-staggering share of bad loans had shrunk dramatically to a manageable level, wihout anything resembling a Western-style banking crisis. Many analysts believe that it was combination of explicit steps to recapitalize the banks — directly by injecting capital and indirectly by purchasing bad loans at very high prices — and very rapid GDP growth, matched by even more rapid loan growth, that resolved China’s banking crisis.
In that case, these analysts say, why worry? If there were another sharp rise in non-performing loans – as many, including Beijing’s banking regulators, expect – China would easily grow out of it again using the same combination of factors, and the cost to the economy would once again be minimal.
But they would be wrong. In fact the cost of cleaning up the last banking crisis was very high, much higher than simply calculating the explicit cost of recapitalizing the banks by direct and indirect equity infusions, and so will the cost of the next one be. The combination of implicit debt forgiveness and the wide spread between the lending and deposit rate has been a very large transfer of wealth from household depositors to banks and borrowers. This transfer is, effectively, a large hidden tax on household income, and it is this transfer that cleaned up the last banking mess.
It is not at all surprising, then, that over the past decade growth in China’s gross domestic product, powered by very cheap lending rates, has substantially exceeded the growth in household income, which was held back by this large hidden tax. It is also not at all surprising that household consumption has declined over the decade as a share of gross national product from a very low 45 percent at the beginning of the decade to an astonishingly low 36 percent last year.
This is how China’s last banking crisis was resolved. It did not result in a collapse in the banking system, but it nonetheless came with a heavy cost. The banking crisis in China resulted in a collapse (and there is no other word for it) in household consumption as a share of the economy.
This is why the People’s Bank of China is so worried about another surge in non-performing loans. If the household sector is forced once again to clean up a banking mess, this will make China even more reliant for growth on the trade surplus and on investment, and that is something many in Beijing, including the PBoC, do not want to see.
Remember that there is no such thing as a painless banking crisis and anyone who suggests otherwise should not be taken very seriously. There is always a significant cost, and the cost is almost always borne one way or the other by the household sector. In China, with its already too-low household consumption, it will be very risky to force households to clean up yet another surge in non-performing loans. It would only make it more difficult than ever for China to achieve the rebalancing its economy so urgently needs.
This is an abbreviated version of the newsletter that went out Monday. Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at chinfinpettis@yahoo.com, stating your affiliation, please. Investors who are clients of Shenyin Wanguo Securities (HK) will already receive the newsletter. Investors who are not clients but who want to buy a subscription should write to me at that address.
China needs a large trade surplus to employ their labor force. Although the labor pool growth is expected to be flat over the next decade There is still the question on how they could they can stoke demand without excessively cheap consumer loans or incentives as almost all demand dominated economies do. I see a long period of falling consumer and asset prices in China until it balances out with wages and real demand
Back in July you said “in China, even if you believe that all the NPLs currently in the banking system have been correctly identified (a claim which few Chinese bankers believe), no one doubts we are about to see a surge in NPLs thanks to the out-of-control lending expansion of the past two years. But things are even worse than the nominal numbers imply”.
I think that you mean by “risky” that the current regime would be provoking revolt by the Chinese public if households are forced to absorb the losses from the current batch of NPLs.
Even in its new, abbreviated form, your analysis is still very enlightening. Thanks very much for continuing to share your views at no charge.
The ongoing theme of the posts here seems to be that bank bailouts are never painless. However aren’t some bailouts much worse than others? The ongoing difficulties in the developed economies seems to be a crisis not only of just hard numbers but of confidence. If a crisis of confidence can be avoided then the crisis of hard numbers isn’t really so bad, in relative terms – essentially your options would be a few years of very fast growth followed by a few years of slow growth while the NPLs are cleaned up, versus slow, steady growth throughout the entire period. I would be interested in a comparison of well managed bailouts that didn’t result in a loss of confidence, didn’t one of the nordic countries (Sweden or Denmark) do one of those in the 1990s?
Also, maybe some clarification is in order as to who exactly “the households” are. I get the idea that depositors will eventually pay through the interest rate spread, but who are the depositors? I have a feeling that in the same way your average lamb kebab vendor isn’t the basis for China’s growth, they don’t necessarily own the majority of deposits, either?
I have been told that during the finantial crisis in the nineties in Sweden, during bank nationalization, shareholders assumed a big part of the loss.
But I would ask, why is it anathema, to make bondholders take some of the losses through debt reestructuring?
Didn’t one of the Scandinavian countries take a different approach in the mid to late 90′s? Instead of leaving management & the shareholders whole they wiped them out and nationalized the banks. Why would China or any other nation want to support the management and shareholders of insolvent banks. The approach you describe to resolving this situation is not in the interest households.
Just a bit of anecdotal information. I was talking to a guy who maybe makes about 50k US$. He lived in Shanghai for a few years. Must have bought his condo in Shanghai about in 2006 or 2007. After Tripling or Quadrupling in value since he has decided to cash out at 800k-1 million. He said a lot of his neighbors (foreign nationals) are doing the same. Mentioned it Feels a lot like 2005 or 2006 in the US market.
DavidW and Ignacio. Bondholders and Shareholders are ultimately households either directly or through their pension fund or even their local government. So Mr Pettis assertion is right, it is always households who pay, even in Sweden at the time.
The right question to ask is WHICH households are going to pay : the top 1% wealthiest or the median (amazingly, China and the US have roughly the same Gini coefficient) ? the highly connected and powerful party member (in China) or Wall/Street Washington insider (in the US) or the vulgus pecum ? the foreigner or the domestic ?
This is more or less what is happening in the US, albeit under a different name.
Interest rates at banks are less than 1%, and while long-term rates like mortgages are still below 5%, credit card interest is typically in the 15% range, even for those with good credit.
I personally know people who used to earn several hundred dollars a month in interest income, and now earn practically nothing. For anyone with a savings, this is the same as a raise in taxes.
Prof Pettis
Might be due to the summarised nature of the post but rather surprised that you didn’t mention the other side of NPLs, that any attempt to “correct” the situation and bring rates up to any sensible level would have a devastating effect on former SOEs and small businesses. If the government allows these businesses to take the hit, they will unleash misery on households too considering that these businesses are also employers, a greater increase in labour dissatisfaction and things could get hairy.
@charles
agree about the bondholder and shareholders part. of course, it might please popular sentiment to think that the greasy palms “whacked” by the resolution are going to be those of the wealthiest, unfortunately with pension funds in the equation, the pain is probably going to be widespread. Ironically, considering the fact that the wealthiest 1% are usually those with access to ahem “reduced tax exposure” advice/strategies, they probably get less of the pain. As for nationalization and recapitalisation, guess whose money the government is using, take about getting hit front and back. If you have access to prof Pettis’ earlier posts, look at the one on a primer on defaulting, usually the one left crying over spilt milk is the one with the least bargaining power.
there is an article in the NYT that has some bearing on the question of whether it is wise to make the foreigner pay(the part about risks perceived of investing in Russia), it’s on Russia’s efforts to raise funding, happy reading. http://www.nytimes.com/2011/01/25/business/global/25rusecon.html?_r=1&ref=business
“How so? Because if interest rates are set at a level lower than the natural rate, every year the borrower is effectively granted debt forgiveness equal to the difference between the two”
Could someone explain this term “the natural rate”?
Scott, I don’t really look at it that way. The household sector will continue paying to clean up the banks, but as long as their overall income is still rising quickly, I don’t see any risk of consequent social instability. For me the risk is about the adjustment process. By definition in China adjustment means that household consumption grows faster than GDP. This can happen either with a surge in household consumption or with a sharp drop in GDP growth. That is why I think putting additional downward pressure on household income is risky.
Throatwarbler, yes, by slowing down the NPL recognition process Chinese banks (and Japanese banks before them) are able to avoid crises of confidence. This is not all good, however. The great advantage of liquidity crises is that they force liquidations and write-downs, which may be necessary for the capital allocation process to begin functioning effectively again. In a sense there may be a trade-off between short-term social pain and long-term slower growth.
Ignacio, bondholders certainly should take up some of the pain, but banks fund themselves mainly by deposits, not bonds. Also to the extent that households, other banks, or the government holds those bonds, the cost ultimately goes back to households.
DavidW, I am not sure there is a meaningful distinction in China between the government on the one hand and managers and shareholders on the other. The government is the biggest shareholder, it determines all the top managers, and it largely directs lending policy.
Eddies, yes, ultimately in every country households pay to clean up the banks, including in the US.
Judy, actually I have mentioned that many times in many posts. I put it a little differently. If you want to know the real level of NPLs you need to raise interest rates to a “fair” level and then calculate the amount of NPLs, which will be much, much higher.
Julia, in this context by a “natural” rate I simply mean a rate in which savers and borrowers can get an equitable, risk-adjusted share of growth. In other words of the return on capital is 10%, but depositors are forced to lend money to borrowers at 5%, the borrowers see a constantly increasing share of wealth and the depositors get a constantly decreasing share of wealth. In most countries that don’t have distorted or repressed financial markets, that means that the natural rate is broadly equal to the nominal GDP growth rate, adjusted for distortions in GDP growth rates. I don’t know what that number in China is, but it has probably been over the past decade between 400 and 800 basis points higher than the lending rate.
Prof Pettis
Naturally if rates are raised, NPLs will increase, simply because interest payments cannot be met by the borrower. What really interests me is the conundrum, if these NPLs weren’t “made” (that is, credit wasn’t made available), some of these SOEs and small businesses would be out of business, along with their employees. Yet, as you point out quite frequently, suppressed interest rates represent a shift of income from the households to businesses. However, it could be a vicious cycle if interest rates were “reasonable” and these borrowers went out of business, unemployment rockets and income for these unemployed are effectively cut off. Perhaps, it really isn’t a choice but rather the only way to sustain an unsustainable position?
Prof Pettis
Sorry, one point: yes, noted that the points regarding the real rate of NPLs and consequences of NPLs unravelling were made in previous posts. Was just wondering if you had any new insights in the chain of consequences in view of the recent economic or political developments.
Michael,
This reminds me of Nicholas Lardy’s highly mistaken book about the situation in the PRC banking system in the 1990s. Of course, then the banks were simply agencies of the states, the legal framework for insolvency was hardly developed and the provinces had much more control over the local bank branches. And there was no credit methodology. Not much earlier, all banks had been part of the PoBC and were an important link in the (communist) central planning system: essentially the agency that would disburse according to plan and retain according to plan, more or less like the finance department of a large corporation. Their “clients” were also agencies of the state, factories dressed up as enterprises. As such, claims on the banks were claims on the state. Whatever bail out took place was an internal allocation decision of the state, with strong political elements.
The primary function of the NPLs was to subsidize industries that had trouble adjusting to an environment where the market was slowly replacing planning and where supply and demand for the individual enterprise had become far more unpredictable, while the social functions of the enterprises (housing, medical, education etc that were payments-in-kind to workers were often not yet curtailed.
The result (and probably an intended consequence) of the NPL clean up and subsequent semi-privatization of the SOE banks was (1) a much higher degree of financial centralization, (a refocused PoBC, Central Huijin, CDRC, etc) a centrally driven rationalization of the SOE portfolio (AMCs, SASAC) and in general more scope for management of large industrial firms by dedicated professionals rather than by politicians and generalist bureacrats (although no PRC manager or bureaucrat can ignore politics). Meanwhile banking was professionalized, bank accounting systems were computerized, much more decision making taken away from local politicians.
The Chinese response to the GFC was partially a throwback to the “communist” approach and partially a pause in the process of adjustment ans shake-out othe SOE world. The NPLs that will result this time are true NPLs and the process that will be applied will look much more Western (there was no property law before 2005, hence insolvency was a joke, mainly a way to secure the social plan for an enterprise that had lost its ability to provide services to its employees and politicians). And this time consumers will be a different sort of problem. Company housing etc has largely gone but in its place people have borrowed for their houses and someone has to make sure that they stay happy and calm.
All in all then, I agree that interest supplession has played an important part in rebuilding bank capitals (at the time a mere bookkeeping entry) without formally burdening the State budget, or the provinces, too much. But the problem then was a totally different one from now. This time the banks will have to raise capital if they threaten their Basle ratios, not only from Huijin and Huijin from the state council (and the the foreign authorities that pay attention to the Basle ratios will no longer attach value to “capital” raised within the Huijin subsidiaries as has been done so far). Assuming that eventually the state would allow Huijin to use the resources of CIC (Huijin’s parent) for propping up the State stakes, who will buy the “private” portions of future capital raisings?
The interesting thing is that here we have a government that will have three options: (1) tell the banks to lend more to companies with liquidity problems (a sort of debtor in possession financing with Chinese characteristics) and be fairly generous at that. Due to the lack of transparency that may work, if the firms themselves are monitored from now on (of course all of the property developers will remain officially solvent, except the ones whose stakeholders deserve punishment in 2012)
(2) run a large experiment with a real market economy insolvency process, recapitalize the banks and raise the state stake (which would create severe regulatory problems for BOC and ICBC in certain essential jurisdictions) when private investor sit out (3) cover everything up and use diplomacy to keep the Basle hawks abroad quiet.
In any event, the Chinese consumer will foot the bill and no one will lose a penny on his deposits with the SOE banks…
Maybe I should have added that the worst hit segment of the Chinese economy (if a severe slowdown in GDP growth (caused by declining net exports) cannot be avoided) as it is structured now, would be the privately owned and not so well connected oes. And maybe the ones with only local connections (probably the vast bulk of “private” again property developments outside the key industrial provinces and cities. They should be the first to be cut off and thrown back to the informal banking system with its harsh debtor environment. In general then, that would mean that the State sector should become relatively more important, and within that the Centre also. That is an interesting backdrop for the maybe not so modest changing of the guard that is coming up as it may also imply a further imbalance between “core and periphery”. It will be really fascinating to see how this will be handled by an anachronistic political apparatus operating in a pretty modern society.
Where does that leave the foreign buyer of Chinese securities?
It remind me of what happened in Brasil mention in Friedman’s book. The government used high inflation police to pay the debt. Then the dead circle started, deposit rate plunged and the inflation rate surged.