China Bank Crackdown May Be Too Late
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30 August 2010. By David Caploe PhD, Chief Political Economist, EconomyWatch.com.
Regular readers of this site know that, at this point in history,
with the US and EU on the early downside of what is going to be a long bad trip for both,
30 August 2010. By David Caploe PhD, Chief Political Economist, EconomyWatch.com.
Regular readers of this site know that, at this point in history,
with the US and EU on the early downside of what is going to be a long bad trip for both,
we have considered what happens in China to be the key to the immediate future of the world economy.
This is NOT because China has YET become the CENTER of the world political economy,
which will remain in the US, for a variety of reasons, for the foreseeable future.
Nevertheless, ever since Black September 2008, China –
HAVE been the bright spots of the global economic scene.
That said, the pace of growth in China throughout 2009 and the first quarter of 2010
was so frenetic that almost all observers have considered it unsustainable –
which is a view the Chinese political leadership seemed to share –
and the general view has been there was going to be some kind of slowdown.
The question has been “what KIND of slowdown” ???
Is it going to be the total “Black Swan bust” predicted by people like Andy Xie and Vitaliy Katsenelson ???
Or would it be the “soft landing” we have consistently predicted ???
Or were both those views wrong, and it was basically going to be full steam ahead, albeit at a slightly lowered rate than before ???
In this context, the recent crackdown on banks and other financial institutions by the Chinese government
is a potential development of major proportions,
which could hold the key to the immediate future of not just the Chinese, but also East / Asian and world economies as well.
Let’s start with an anecdotal illustration of the situation to which the government was responding.
Disappointed with his low “official” savings deposit rate,
a 29-year-old chemical company salesman named Zhang Zhenlei says
he took $19,000 out of his savings account last November
and bought into a higher-yielding investment trust through his bank’s wealth management division.
The money, the bank told him, would help finance two government highway and infrastructure projects.
“They told me the details and which companies would get the loans,” Mr. Zhang said.
“And they told me the risk was under control.”
But last month, the China Banking Regulatory Commission issued a sharp warning,
ordering investment trust companies to stop selling such products in cooperation with banks.
Regulators were apparently worried that banks and trusts were forming partnerships
and using products to, in effect, finance loans without calling them loans.
The government evidently suspected that banks were using such maneuvers
to evade rules put in place this year to rein in rampant lending and excess credit.
Those conditions have been cited as a reason for rising property prices and overall inflation.
Regulators, suspecting that banks and trusts are secretly repackaging old loans and moving them off bank balance sheets,
are concerned that financial institutions in China may have engaged
in the same sort of financial engineering that got Western banks into trouble,
which was, of course, EXACTLY what we said when we first found out about these practices.
On Aug. 10, government overseers acted again,
ordering banks to move any off-balance-sheet loans back onto their books
and to make provisions to safeguard against a rise in bad loans,
according to a copy of the government order given to The New York Times by an industry expert.
Several weeks ago, the Fitch credit rating agency warned that
such off-balance-sheet deals were understating the size of bank lending in China and
thereby masking the risks associated with an increase in dodgy loans.
Fitch estimates that Chinese banks had about $350 billion in trust-related products on their balance sheets at the end of June,
and that much of that lending had not been publicly disclosed.
“Regardless of how the transaction is structured,
credit is disappearing from bank balance sheets,
resulting in pervasive understatement of credit growth,”
a Fitch analyst, Charlene Chu, wrote in a June presentation.
“Credit risk has not disappeared but merely been transferred to investors.”
The off-balance-sheet deals are raising warning flags about the nature of a slowdown here.
While China’s economy remains robust —
it overtook Japan in the second quarter to become the world’s second-largest economy, behind the United States —
analysts worry that a surge in bank lending last year and early this year
might have led to wasteful spending on infrastructure and real estate projects.
In recent years, the government has been trying to harness what it deems wasteful spending:
“luxurious” local government buildings, highways to nowhere,
and so-called image projects constructed in poverty-stricken areas.
The basis for these worries was laid last year,
after the government encouraged aggressive lending as part of a huge economic stimulus package.
The result was a record $1.4 trillion in new bank loans in 2009,
about double the previous year.
Some analysts fear the sharp increase in lending
included many bad loans that will begin to show up over the next few years.
Aware of the risks, Chinese regulators are pressing state-run banks
to raise billions of dollars in capital to cushion any downturn —
a task that could be complicated by any perceptions among private investors
that the banks are exposed to a lot of risky debt.
Beijing is now trying to restrict lending and
ease asset price inflation without setting off a slowdown.
“They’re stuck in a policy bind,”
says Michael Pettis, a professor of finance at Peking University in Beijing,
noting China’s heavy dependence on investment-driven growth.
“They have to choose between cleaning things up and maintaining high growth.”
Or they could do what the US / EU / and Japan have been doing –
which is NEITHER cleaning up NOR maintaining high growth 😉 .
Pushing in the opposite direction, not surprisingly, are banks and investment trusts,
which want to continue pumping money into the economy to bolster their profits.
Analysts say they have been adept at evading the rules with clever and complex financial products.
Even though most banks contacted said they had stopped offering such products,
several said they had found ways to continue to sell them.
Uhhh, does that sound like a contradiction to you – or is it just me ???
For precisely that reason, analysts say it is unclear just how pervasive such products are.
Something similar happened here in the 1990s,
when aggressive financing by banks and investment trusts
led to big losses, huge bankruptcies and new regulations.
Chinese banks appear to be stronger this time around.
Over the last decade, huge restructuring and government recapitalization efforts
allowed the big state banks to clean up their balance sheets and
eventually raise billions of dollars in public stock offerings.
Still, analysts say the lack of transparency about lending
makes it difficult for investors and regulators to assess the risks facing some banks.
“Essentially what you had was a bank using a trust company
to package that bank’s own loans into a wealth management product,
which was then sold to its own customers,”
says Jason Bedford, a manager at KPMG in Beijing.
“The problem is you don’t have a clear transfer of risk off of the balance sheet.”
With the help of trusts, banks are repackaging loans as investments, analysts say,
thereby making room to issue additional loans.
And trusts are turning to wealthy bank clients to raise new capital.
Banking customers are also contributing to the continued use of
partnerships between banks and investment trusts, analysts say.
These customers, which include corporate clients,
have been frustrated with the low yields they earn on savings deposit — close to 2 percent —
and with the dearth of alternative investment options.
Higher-yielding investment trusts were seen as ideal.
“Banks have a lot of demands from high-net-worth depositors,”
particularly big corporate accounts, Mr. Bedford at KPMG said.
Stephen Green, a Shanghai-based analyst at Standard Chartered Bank, describes
investment trusts as financial intermediaries,
filling in gaps in the financial markets and acting as a jack of all trades —
part hedge fund, mutual fund, private equity firm and bank lender.
Trusts are also a vital source of financing for private companies, and,
lately, real estate developers, which often have a difficult time securing loans from state-owned banks —
largely because the government is trying to restrain real estate development.
But many investment trusts are state-owned, and they often finance state infrastructure projects.
For instance, the Xi’an Trust,
which is owned by the government in the city of Xi’an,
is providing money for land, water and electricity projects
to build a new high-tech base for the city.
For wealthy investors like Zhang Zhenlei, though,
investment trusts offer attractive interest rates,
about double the savings deposit rate.
Mr. Zhang, who is a V.I.P. client at his state-owned bank, says
he spent a half hour filling out paperwork so that
he could invest in a trust and help finance an infrastructure company in Inner Mongolia
and also a highway development company in southern China’s Guangdong Province.
“It turned out very well,” says Mr. Zhang,
who has already gotten his money back, with interest payments,
after the six-month lockup period ended.
Although, as we know from the Madoff and other Ponzi-type scandals,
it could simply be money brought in from NEW “investors.”
As for the crackdown on trust products, regulators may have difficulty, analysts say.
A wealth manager at I.C.B.C., one of China’s biggest state-owned banks,
was offering investment trusts to banking clients not so long ago,
according to this article in the New York Times.
“Now we have a 57-day trust product with a yield rate of 2.6 percent,”
the manager told one prospective client over the phone.
“It’s available from today. Though financial products aren’t authorized for principal to be guaranteed,
usually we can orally guarantee your principal.”
Hmmmm … that doesn’t sound so good –
especially given its similarities with the sort of rhetoric flying around Wall Street in the pre-Black September period.
So for the sake of not just the Chinese, but the entire world, economy,
let’s hope the crackdown on this kind of maneuver works.
Because if it turns out the Chinese financial sector has become too structurally committed
to the same kind of tricks that produced Lehman’s infamous Repo 105 –
and the other insidious components of the Black September 2008 debacle –
then the “China bust” scenario may indeed come to pass –
and that would indeed be a disaster, not just for China but the entire world.
David Caploe PhD
Chief Political Economist
EconomyWatch.com
President / acalaha.com
