China’s coming crisis … notes from my speech at AmCham

I will be giving an early morning speech to the Financial Services Group at the American Chamber of Commerce (AmCham) in Singapore on Tuesday 18 October, 2011

The following is the outline of what I am going to be saying (to be augmented with a few data slides, being put together by my colleagues separately)…..

Key issues facing China today:
– excess liquidity in the system (but there is a need to separate hot money from actual savings)
– elusive real return so far (despite inflation monetary policy real interest rate is managed artificially to keep costs of domestic funding low for the banks)
– because of persistent negative interest rates – consumers, SOEs and businesses have been speculating in financial and real assets including:
o stock market
o property
o private lending/investments by corporates and SOEs and wealthy individuals (household share of alternative investments now 7% in 2011 from 2% in 2009 – underground lending estimated to be as high as 20% of bank lending – BOAML, — PBOC survey in Wenzhou in August 2011 showed the 20% of private lending went into real estate)
– as of right now, the liberalisation of the renminbi is continuing unabated – last week’s announcement on allowing inward rmb FDI (implication?) – “the Chinese central bank’s balance sheet resembles that of a hedge fund buying dollars and short-selling the yuan,” Rickards, former Long Term Capital Management.

Corollary:
– Not enough investible assets in China except property and stocks – so the surface level correction will be swift, and painful but not unbearable:
o stock market has already been under-performing – need to determine at which points will the govt intervene
o financial asset valuations namely property will experience sharp correction if valued immediately.
– dismantling of the trust companies world (data), especially the part that is owned by the banks themselves will show up many of the politically connected lending that has been taking place
– fraudulent schemes will show up – many ponzi-like schemes in China masquerading as wealth management products sold by approved financial advisors, some linked to financial institutions directly
– unfortunately, I do see some smaller Chinese banks that were genuinely exposed to the SME sector going under or becoming seriously weaker because of the weakness of the SME/SOE sectors and because the access of these banks to counter-party credit was very weak to begin with.
– foreign banks already downscaling their China operations – whether because of downside risks in their home countries or in China – so competition for deposits will be cooling off
– Reminbi will actually fall on a trade weighted basis against the dollar if liberalised any further immediately.

Factors that we will want to monitor:
– will the Chinese government allow some SOEs to fail? need to pick winners and losers – work already underway by the PBOC to expose the weaknesses of the SOE sector, nowithstanding that the work has been unpopular in some segments within government
– will the work already under way – what I call the “Wenzhou effect” – to rectify negligence of the SME industry start to bear fruit in terms of banks actually lending to this sector and the government set up guarantees to support them?
– real usage of rmb in international trade might actually rise dramatically as its upside potential as an investment currency is weakened – forcing international banks to refocus their RMB strategies away from investment products and back towards trade
– will China be forced into a Plaza Accord?
o US will use same formula as always – it will not be unilateral … so, who the other countries are that think the RMB is undervalued will be interesting to watch….
o if a Plaza Accord is struck… China will need to replay the Japan story and ask how long can it maintain high interest rates?
o missing/weak “corporate juggernauts pillar” that Japan had when it floated its currency – differences in China and Japan’s ability to maintain their external economies successfully will be instructive

Data that we will need to monitor for what it will tell us about China’s ability to withstand its foreboding crisis:
– trends in M1 in circulation – the velocity of money is an under-estimated contributor to domestic economic growth in East Asian economies – these are still cash-based economies – the more money circulating in the domestic economy, sans inflation, the better – coupled with trends in actual savings and domestic deposits – propensity to save in cash will be triggered faster in China than in the US and this will influence behaviour not monitored at the monetary level
– Shifts in deposit composition of banks – if there is an SOE fallout, it does appear that the government has been setting itself up to deal with it – shifts from SOE deposits to consumer deposits will change winners and losers in domestic banking system – my guess is that consumers will go for Big Four banks – there will be weaker banks at the lower end of the city commercial segment that will be hard pressed for liquidity
– The state’s ability to withstand any shorting of the Chinese economy – it is assured if we look at the following data:
o the Chinese banking system can technically sit on a lot more NPLs than it does right now (NLP data, Huirong’s data)
o the state’s ability to prop up stock market
o the state’s ability to withstand a currency attack
– Scope for productivity gains – at the personal income, and supply chain levels – that can ameliorate the risks of a slowdown is still very positive for China

Unfinished business:
– bank lending for high interest environment not set up yet – risk management culture still nascent – crony capitalism still prevalent model for lending – in high interest environment the state is the borrower of last resort
– The state is completely exposed in its ability to withstand the social and political downside of China’s weakened export sector
o job losses
o mass inter-regional re-migration
o not sufficient laws to handle SME defaults

Is China heading for a Lost Decade already?
– Not necessarily, some differences from the Japanese experience are as follows:

xxxx This is supposed to be a side-by-side table but I don't know how to insert a table into wordpress xxxxxxx

Japan
Banks Consumer Credit – always under-developed – hence high savings (in fact consumer spending is underwritten by non-bank sector, Just as SME lending in China is underwritten by non-bank sector)

Bank credit to SMEs always well developed – albeit through a series of intermediaries – also highly developed supply chain financing

Export driven corporate sector was able continue by being under-leveraged and profit driven

High liabilities, with little productive sectors to invest in domestically, so the local governments focused on unproductive infrastructure Bank credit to consumers relatively developed – but still in essence a high savings country

China
Bank credit to SMEs –can still be built on – more a reallocation problem than a capacity problem – nascent supply chain financing

China’s corporate export sector is still (and may always be) a cost-driven play, which puts it in competition with many players in other emerging countries – no real upside on current model

High liabilities, in an emerging market country with many unrealised domestic investment potential

end of tablexxxxxxx

Potential positive note for long term players in China, if after a 2-3 painful interlude:
– rise of the SMEs as an economic force with proper access to capital, not just a low cost factory
– greater differentiation between domestic financial institutions, with winners and losers, based on profile of funding base
– pent up consumer spending (freed from false asset inflation)

Western models over-estimate the role of credit in stimulating economic growth, and under-estimate the role of corporate and consumer liabilities – Krugman calls it the Liquidity Trap, and Richard Koo called the Japanese experience a Balance Sheet Recession. I sincerely believe that being a developing country, the Chinese have the ability to break through where the Japanese could not, and that is to deploy high savings and liabilities to productive investment opportunities that are still there, but under-invested in because of easy money during the good years.

Finally, there are still factors that can threaten a positive outcome, as unfortunately life is a moving target:
– Political fallout of the moderates/liberals versus the conservatives
– Unmanageable social unrest
– prolonged recession in export markets

End of speech

On Twitter     @EmmanuelDaniel


Comments

  1. Arguably, interest rates are too low and have been too low for a few years.A lttile inflation would go a long way to solving the current economic crisis and help deal with the debt problem. A lttile inflation can be introduced by increasing the money supply. The Fed can create money and then use it to purchase government bonds, for example. This would eventually cause interest rates to rise to more normal levels, would retire some of the government debt, and would put more money in circulation.Currently, a lot of companies and banks are just sitting on their money. If inflation were higher, they would need to invest that money in order to retain its value. Also, inflation makes any debts smaller in comparison to the economy as a whole. Inflation would bring about a rise in housing prices and so fewer mortgages would be underwater.

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