Is China having a financial crisis?on Friday, 28 June 2013. Posted in Investing in China, Investments
In case you didn’t notice, China almost had a financial crisis last week. With Wimbledon on and the overseas business press distracted by Bernanke/quantitative easing we can understand how you missed it. But did China really almost have a financial crisis last week?
If so, what the hell was the People’s Bank of China (PBOC) thinking letting things get crazy for a couple of days before stepping in?
So was it a crisis?
Well, pretty close by western measures. Last week Chinese banks stopped trusting each other. The rate they charged each other rocketed from 4% to 13% in a few days. That is almost exactly the type of thing seen during the two week period when Lehman went broke back in those happy times called “The Financial Crisis of 2008”. Those rates happen because the banks with some spare cash that day don’t trust the other banks not to go broke. We’ll let other speculate on the proximate causes of the crunch and focus on the why.
The strange thing is all these banks are state owned. So they, implicitly, should have the full backing of the government and be considered “risk free”. So why the distrust and where was the PBOC (the central bank of China – PBOC) when this was happening? Napping? The central government never naps and never has oversights like this. It was completely intentional, so what were they trying to achieve?
What the hell is the PBOC doing?
A little teaspoon of market discipline. That’s what. And a sorely needed and long overdue teaspoon at that. Not that they are saying that, nor will they, so we are left to speculate, like the rest of the financial press on the real reasons. Chinese communication is highly context specific, so you need to read between the lines and understand the environment to understand what is going on.
- Chinese banks dominate China. They constitute 98% of lending. Foreign banks have 2% combined.
- Chinese banks now and historically were funding channels for State Owned Enterprises (SOEs).
- To keep costs down, interest rates were capped. (helping create Chinese “wealth management products”, black market banks as well as a property bubble.)
The Chinese government is huge. The central government and local governments disagree on many things, but let’s start with the local government’s perspective.
- Many developers and companies probably owe their entire success to subsidized lending from Chinese SOE banks. Those unconnected miss out. Cheap lending is the secret sauce of Chinese SOEs and national champions like Huawei, Haier and even Lenovo.
- Lending from Chinese banks often ends up with local champions, project companies, but still controlled by the local government. It is like a husband lending money to his wife. It stays within the family, this is good news of a sort since it is pretty much in the Chinese government’s control how this whole thing plays out. Keep this in mind. It does also mean that many people lend with little thought to the ability to repay the loan. More on moral hazard later.
- Local governments like strong property prices because they make their income from selling property to developers. So they actively subvert the Central government’s policy intentions.
- Local governments aren’t so keen to reduce their reliance on the present system for a variety of reasons. Less patronage, chance for kick-backs, ease of achieving “economic growth” goals to name a few.
Central Government’s perspective is a little different.
- These lending channels came in very handy as the government forced banks to lend during the financial crisis, thus helping China avoid any sort of cash crunch. Foreign banks however reduced assets (i.e. called in their loans) and contributed to the cash crunch. This is STILL going on in Europe right now, but that’s another story.
- The PBOC and central government is worried that this sort of pump priming is becoming a habit, and a nasty one at that. It creates perverse incentives. Is incredibly wasteful of resources (ghost towns and cities anyone?) and crowds out real private sector investment, is probably a big cause of corruption and also local government land theft (hello township riot!) so local government officials can develop their pet projects or sell to developers.
- The PBOC and central government has been trying to cool both credit growth (lending) as well as the property market with administrative measures. These have worked with minimal success and the property market continues to rise, from crazy high to stone-cold-crazy high.
- High house prices are a cause for concern for the central government. The average manual worker to put aside his income for 250 years to afford a decent property (an exaggeration, but only slightly because no-one can save 100% of their income for 15-20 years to buy a property). Understandably causing some discontent amongst lower class Chinese guys who are trying to buy a house and secure a girl for marriage. Unhappy young fellows is an excellent way to help create a revolution throughout history, and the central government understands this well.
- A property tax on an annual basis is clearly needed and has been in slow gestation for the last couple of years. The delays in this area are probably caused by the lobbying of vested interests such as developers (the dominant form of billionaire), local governments, and the connected who are sitting on piles of unoccupied real estate.
- The only sector of the Chinese economy that has enjoyed any kind of opening since Zhu Rongji (bless his cotton socks) and China’s WTO entry in 2001 has been the securities and banking industry. At times this has seemed glacial, but in recent years has started speeding up again as this Economist article argues.
But isn’t the central government in China all powerful? Well yes, but not quite. There are other power bases.
- The unmentioned actor in this play is the State Owned Enterprises. Although they don’t have a formal political ranking, they do in actual fact have a huge influence. Sinopec has 370,000 employees and it is not one of the biggest by employment. These companies have more influence than provincial governments (evidenced by pollution). This influence extends all the way up to the parts of the central government itself.
- State Owned Enterprises are also, by far, the biggest beneficiary of the present system of allocating discounted long term and patient capital. Do you think that is a habit they are going to give up without a fight?
This is hopefully enough background to provide a pretty clear picture of the situation in China. We believe, the Central Chinese Government has started to use some of the leverage at its disposal to gain control of the reform process. Holding off funding from time to time to show where the weakness is the system is, and shame it aggressively. The PBOC wants to put more market forces into the economy and weaken the expectation of full backing by the central government.
Ultimately, the PBOC will always step in, in the face of a systemic crisis. This does create the problem of moral hazard in a lending system. A hazard the government is trying to control amongst others. It does seem however that the PBOC, will, from time to time, allow one or two smaller banks or finance companies to go broke. This reduces the risk of moral hazard and influences the economy in two important ways. One a matter of policy influence and one a matter of market impact.
Why? To influence the system in the short term.
It is a financial form of the Chinese expression “Kill the rooster to scare the monkey”. Showing the system that it will let them swing in the breeze for a couple of days is a good motivator and welcome. Don’t underestimate the power of shame in Chinese society to influence behaviour. Avoiding losing face is one of the most powerful motivators that exist here. More than edicts from Beijing and more than prison. It is a great way to cool the market down without a hard to administer edict.
Why the need to go this way? To win the argument.
If you have been in China before and after 2008 you will have noticed a real difference in the attitude of the Chinese government. The word I’d use today is “arrogance”. It wasn’t always like this, in fact old trade missions in the 1990s were about learning and studying. There is a real and animated belief in many parts of the Chinese government today that the “China system” is better. Totally superior to the US system or foreign systems. This includes the combination of SOEs, government direction and funding channels of the banks. Any claims to the contrary are evidence of “anti-Chinese bias” or that the critic “doesn’t understand China”.
The US financial crisis is considered to be evidence par excellence of the failure of the “western model”. By not brushing problems under the carpet the central government can ably demonstrate that this is false. Problems do indeed exist in the China model too. Showing the ugly losses that can and do happen, will help demonstrate that publicly and privately. This is a debate the reformist can and should win.
Deng and Zhu Rongji reborn
So in essence the little debacle last week is a warning shot across the bow of the present system. The most visible display of power in action for market based reforms. It is heartening that this battle is even taking place. Myself, like many long term China watchers, have despaired at the power grab of SOEs over the last 5-8 years. The pushing back of the private sector. This time, it is the reformists fighting back. It won’t be easy.
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