Is China Headed for a Meltdown (yes, another article...)

[newinvestor]

... but this one has a different approach:

globalpost.com/dispatch/china/110108/global-economy-china-economy-loans?page=0,0

BOSTON — Over the past several years, China has been the engine of global growth and the world’s most important creditor. Its economy muscled its way through the financial crisis largely unscathed. When bad debt knocked Western banks to their knees, China emerged as the global creditor of last resort, financing the U.S. government’s massive bailout programs.

But now, experts are warning that China’s red-hot economy is catching a contagion of its own. The country is increasingly awash in runaway loans, a development that could have serious implications for China and the global economy.

The situation has become so precarious that Fitch Ratings, a global credit analysis firm, issued a report last month revealing a litany of messy banking practices associated with aggressive Chinese loan making. The report stated that these practices — involving transferring loans off of banks’ books — constitute “the most disconcerting trend Fitch has observed in China’s banking sector in recent years.”

Credit is the lifeblood of an economy, the vital fuel of the marketplace. But too much credit can derail an economy. And that’s what China is now confronting.

In 2010, central planners struggled to restrain the unbridled banking sector. They capped lending at 7.5 trillion renminbi (about $1.1 trillion). That failed. Instead, lending exceeded an estimated $2 trillion, according to China Confidential, a research service connected to the Financial Times. That’s more than $1,500 for every Chinese citizen, a substantial sum in a country with a (nominal) per-capita income of about $4,000.

The credit explosion is fueling inflation. That’s a worrying development for a government whose legitimacy relies on improving living standards year after year. Rising prices triggered unrest in China in the run-up to the 1989 Tiananmen Square massacre; now with rice jumping as much as 30 percent, officials are wary of renewed discontent.

It’s also possible that this excessive lending could cause a financial crisis — especially since nearly half of the new loans are being made in a subterranean world of opaque, unregulated finance. And given the U.S. government’s addiction to huge loans from the Chinese government, there could be a significant impact stateside if Beijing were to need to divert its financial might toward rescuing its own banks.

The runaway loan problem stems from China’s quirky socialist-market approach to managing its economy. To grasp the predicament, it’s important to understand how Beijing strays from the usual market management practices.

In capitalist countries, central bankers use interest rates as the brake and gas pedal of growth. During a recession, they reduce interest rates, making money cheaper for spending and investment, thereby accelerating growth. When inflation rises, they boost interest rates to slow growth and bring price increases under control. The system doesn’t always work well — as illustrated by the bubble-and-bust cycle in the United States in recent decades. But it is widely regarded as the most effective method for expanding wealth over the longterm.

The Chinese government takes a different approach. Instead of relying solely on interest rates, it regulates the volume of loans that banks issue. When the Chinese economy sputters, as it did in 2009, central planners instruct the country’s banks to increase lending. When inflation rises, regulators decrease loan quotas.

But now, Chinese consumers and businesses are hungry for more credit than the government will allow. As a result, bankers, entrepreneurs and even neighborhood loan sharks have taken matters in their own hands.

At the high finance end, Chinese banks have larded credit markets with “off-balance sheet loans.” These “invisible loans” reached nearly $350 billion by July 2010, according to the December Fitch report.

On the surface, this off balance sheet scheme is nifty financial engineering: bankers make loans and then sell them as wealth-management products — sort of like bonds or CDs (but with far more risk, as you’ll see below). This essentially lets underwriters lend money without calling them loans, enabling banks to circumvent the government’s loan quotas (as well as other safeguards that keep banks solvent).

These wealth-management products pay a higher interest rate than savings accounts do, so Chinese investors have been eagerly snatching them up. “Nearly every week text messages advertising new [wealth management products] are sent to retail investors, and Chinese corporations have become the fastest growing investor base,” Fitch wrote.

Ironically, the Communist country’s off balance sheet loans resemble a notorious financial innovation from Wall Street — the mortgage backed security. Nicknamed “toxic assets” by the media during the financial crisis, mortgage-backed securities deployed a similar scheme, moving mortgages off the banks’ balance sheets and into wealth management products.

But this is risky business. Removing loans from a financial institution’s books creates a moral hazard: bankers earn profits from issuing loans, but no longer have a direct stake in whether they get paid back. As a result, there’s little incentive for the banker to assure that the borrower is creditworthy. (Here’s a rough analogy: Imagine that I lend $100 to my uncle, who promises to pay me $110 next year, then I sell that promise to you for $105; in theory everyone wins, but if my uncle fails to pay you back, is it your problem or mine?)

Charlene Chu, senior director of Fitch’s Beijing office, told GlobalPost that while her firm doesn’t audit the quality of individual loans, “local government and property loans have been among the more popular to be moved off-balance-sheet, and there are widespread concerns about future asset quality of each.”

And it’s not only the banks that are engaging in risky financial alchemy. Unsatisfied with the paltry investment options allowed by the Chinese government, both wealthy and middle-class individuals are flocking to alternative (and risky) loan schemes.

These investments are even more difficult to track, but according to China Confidential, the research service, up to $150 billion “is under management by the almost unregulated ‘private’ funds industry — which is centered in Shanghai and typically involves ‘star’ managers investing funds for wealthy individuals.”

On a shadier note, China Confidential’s research found that underground lenders — loan sharks, in other words — issued as much as $600 billion in credit in 2010. These lenders borrow from Chinese citizens and lend at interest rates of 12 to 120 percent. Middle-class Chinese willingly participate, given that the alternative — savings accounts — pay interest at a rate lower than inflation (meaning that depositors basically pay the bank to hold their money).

The Chinese government has limited options for dealing with the runaway loan problem. In July, regulators attempted to halt off balance sheet lending, and directed banks to bring outstanding loans back onto their books by the end of 2011. But in the months that followed, the practice appears to have become even more prevalent.

Meanwhile, regulators have hinted at an official 2011 loan quota of about $1 trillion, halving the total credit issued in 2010. Abiding by such a quota, however, would be messy, if not impossible. A multitude of real estate and infrastructure projects across the country will need additional loans. A strict clampdown could result in a landscape laden with unfinished roads, buildings and bridges.

“An economy that will have received more than 11 trillion Renminbi [$1.65 trillion] in new credit for two consecutive years cannot get by with trillions less overnight … without seriously stunting growth,” Fitch’s Charlene Chu wrote. “We expect that hidden channels will continue to fill this gap.”

David Case directs GlobalPost Research [2].

[Kubes.SG]

I know far more about the Japanese bubble economy of the 1980's as I was based there at when it all collapsed, than I do about the Chinese bubble economy of the last 5 years.  That is certainly an interesting article, and it reinforces the evidence that interest rates (up or down) as blunt and crude as they are, are still the most effective means for regulating an economy when it moves out of the comfort zone.

What I read today about China, and this article by newinvestor is another, reinforces my view that China today has all the same issues and risks that Japan did at the peak of it's bubble just over 21 years ago.  The causes are largely the same:  free money, massive asset inflation, out of control banks, loose banking controls, and astounding levels of debt secured by bubble priced assets.  China (and singapore has many of the issues too) has set itself up for a mighty fall.

For those who don't understand the Japan bubble here is synopsis:

October 13, 1997

New book by UCSC economist examines Japan's "bubble economy"

Michael Hutchison

By Jennifer McNulty

When Japan's powerhouse "bubble economy" of the late 1980s burst on the last day of 1989, it signaled the end of phenomenal growth and more than two decades of rapid overseas business expansion. The remarkable combination had provoked discussion among economists, who have continued to watch the country's subsequent reforms nearly as closely as the policies that contributed to impressive growth.

One of those who has tracked the roller-coaster ride of Japan's modern economy is Michael M. Hutchison, a professor of economics at UCSC. Hutchison is coauthor of a new book, The Political Economy of Japanese Monetary Policy (Cambridge, MA: MIT Press, 1997), which provides a detailed analysis of what went right, what went wrong, and where Japan is headed now.

"During the 1980s, a lot of credit for Japan's success was aimed at their management techniques, their educational system, their trade policies--even the harmony of their traditional culture," said Hutchison. "What we've tried to do is look at their successes and failures within the context of Japan's financial and monetary systems."

The book covers the history of the modern Japanese economy from about 1975 to the present; monetary and exchange-rate policies; the banking crisis that began in 1990 and continues today; and Japan's political economy--the politics of business cycles, oversight of its central bank, and reforms adopted in the wake of the downturn.

"Basically, Japan went from an economy that was enjoying above peak level growth in the last half of the 1980s, with soaring real estate and stock prices and major overseas expansion of banking operations, to a 60 percent decline of asset prices within about two years," said Hutchison. "It's a decline that rivals the Great Depression, and they've been working through it ever since."

The book describes the impact of the "bandwagon effect" on the bubble economy. "We call it a bubble economy because it wasn't supported by the fundamentals," said Hutchison. "Investors were buying up stocks at inflated prices not because they expected a solid dividend return but because they expected further gains in the value," said Hutchison. "Real estate prices were so out of line that at one time the land beneath the Emperor's Palace in Tokyo was considered more valuable than all of California."

Although the collapse was anticipated by many economic observers, experts had been intrigued for years by another compelling aspect of the economy's performance: From 1975 to 1994, Japan enjoyed an inflation rate of only 2 percent--the lowest in the industrialized world. "We had to ask ourselves how Japan was able to deliver this," recalled Hutchison. "Clearly, you didn't need high inflation to have high growth. Japan had the best of both worlds."

Hutchison and his coauthors Thomas F. Cargill, a professor of economics at the University of Nevada at Reno, and Takatoshi Ito, professor of economics at the Institute of Economic Research at Hitotsubashi University, credit Japan's central bank with adopting conservative policies after the 1973 oil crisis sent inflation soaring to 20 percent. "It's not that Japan had a particularly independent central bank from a legal perspective," said Hutchison. "Rather, they had a very tough-minded bureaucracy that resisted party politics."

In the wake of the banking crisis, political pressure focused on the Ministry of Finance, which ironically sought to deflect charges of incompetence by offering up the central bank for reform. "There was no problem with the central bank," noted Hutchison. "But the Ministry of Finance granted the bank more independence at a time when most countries suffering from very high inflation were seeking to give their central banks more autonomy from the whims of politicians."

If anything, the Ministry of Finance itself suffered from a tendency to micromanage the terms of financial regulations while operating under a set of unwritten rules that favored personal relationships, said Hutchison.

Hutchison and his coauthors devote two chapters to Japanese exchange-rate policy, which is Hutchison's specialty. Although the value of the yen has fluctuated over the past 25 years, Japan has for the most part enjoyed long-term appreciation of its currency--another important factor that helped gird the country's economy, said Hutchison. "We give a lot of credit to the monetary policy side of things," he noted. "It has been quite well run."

By contrast, Japan's financial system has not fared so well, and Tokyo is scrambling to gain ground with the international financial powerhouses of London, New York, and Singapore. "Japan's system of limited foreign access, unwritten regulations, and discretionary decision making has not allowed it to keep up with the demands of the world economy. Even Japanese corporations go abroad for financing now," said Hutchison. "Japan is having to run as fast as it can to modernize and update its policies, and it remains to be seen whether it is flexible enough to adapt to modern realities."

Hutchison and his coauthors have already signed a contract with the MIT Press to publish a follow-up book that examines Japan's push to modernize its financial system.

[ummm...]

China today has all the same issues and risks that Japan did at the peak of it's bubble just over 21 years ago.

No, the US didn't owe Japan USD 1 trillion back in 1989.

[The numbers say...]

Nor is China holding US$1 Trillion in US debt today.  But both China and Japan are quite close right now.

In 1989, Japan also held a large amount of US debt.

China's similarities to Japan are quite real.

[newinvestor]

China today has all the same issues and risks that Japan did at the peak of it's bubble just over 21 years ago.

No, the US didn't owe Japan USD 1 trillion back in 1989.

Back in those days I recall the US being deeply in debt to Japan, and the Japanese had a very high personal savings rate that had to be put somewhere == US Treasuries.

Since then, Japan has been one of the largest Foreign Owners of U.S. Treasury Securities, barely second to China.
As of July 2010, The People's Republic of China holds 846.7 billion ( which is 20.8%) and Japan holds 821.0 billion, (which is 20.2%). This is from the US Treasury web site.

I'm not a pessimist, but yes, I can see the parallels.

And even in those days, there was always talk about something special about Japan which would allow it to defy conventional economics, just like today there is something special about China.

[Agent007]

China is different, they even speak a different language.

[wrong]

Nor is China holding US$1 Trillion in US debt today. 

Google it.

[Yahooooooo]

Don't believe everything you read on Google!

[Vulcanl]

About USD 1 trillion sounds right: 

http://www.treasury.gov/resource-center/data-chart-center/tic/Documents/mfh.txt

The below story refers to 'analysts estimates' of even more:

Central banker urges China to cut U.S. debt holdings: report

Sun Jan 9, 11:52 pm ET

BEIJING (Reuters) – China should further diversify its huge foreign exchange reserves away from U.S. government debt to reduce its risk exposure, a central bank official said in comments published on Monday.

"We should change the single-currency focus on buying U.S. Treasuries and adopt a more diversified structure for foreign exchange reserves to reduce risk," Xu Nuojin, deputy-director of the People's Bank of China in Guangzhou, was quoted as saying by the Securities Times.
China should channel more of its foreign exchange reserves into resources and equities, Xu said.

Analysts estimate that about two-thirds of the reserves, which hit a record $2.65 trillion at the end of September, are parked in dollar assets, although the currency composition is a state secret.

Xu also urged the government to relax capital controls to enable companies to hold more foreign exchange earnings, which he said would help slow the rapid build-up in official currency reserves.

A slower rise in reserves could take some heat off the central bank when it sets monetary policy, he said.

[nope]

Back in those days I recall the US being deeply in debt to Japan, and the Japanese had a very high personal savings rate that had to be put somewhere == US Treasuries.

Incorrect. The US was not deeply in debt to Japan in the late 80s, and the Japanese did not have a high personal savings rate. In fact, the whole crisis only occurred because of quite the reverse: the astronomical level of private debt in Japan.
 

[Vulcanl]

Kubes,

"...it reinforces the evidence that interest rates (up or down) as blunt and crude as they are, are still the most effective means for regulating an economy when it moves out of the comfort zone..."

Evidence?!?!?  What evidence???  If you truly consider yourself a 'free marketeer' (and you have so professed on more than once occasion) you would know that Economies are living, dynamic constructs that CANNOT be 'regulated' by anyone or anything!!!

If central banking were done away with we would have no more bubbles of any kind...free markets would do their work of regulating and continually bringing to the fore natural opportunities for investment and growth.

As it stands it is the central banks that cause these distortions that result in amplified effects!!!

You're NOT thinking as usual, old man...

[$Pripps]

Kubes,

"...it reinforces the evidence that interest rates (up or down) as blunt and crude as they are, are still the most effective means for regulating an economy when it moves out of the comfort zone..."

Evidence?!?!?  What evidence???  If you truly consider yourself a 'free marketeer' (and you have so professed on more than once occasion) you would know that Economies are living, dynamic constructs that CANNOT be 'regulated' by anyone or anything!!!

If central banking were done away with we would have no more bubbles of any kind...free markets would do their work of regulating and continually bringing to the fore natural opportunities for investment and growth.

As it stands it is the central banks that cause these distortions that result in amplified effects!!!

You're NOT thinking as usual, old man...

Here's a thought: why don't you do a google on "interest rates effect on the economy" - among the 41 million hits maybe there is one source you can acknowledge as a reliable?  Or you can pretend all those are wrong and you are right which makes perfectly sense after reading what you have posted so far..

[Vulcanl]

$Pripps,

I understand more about this than you ever will...of this you can rest assured.

Kubes is inferring that "....interest rates...[as a 'regulator' of economies]....are...most effective means..."  which is a ridiculous statement to make. It's kind of like saying that the most effective way to cure a hangover is to drink some more from the punchbowl...whereas obviously it would have been better not to drink so much to begin with!

You should stick to posting about the latest Apple products.  You're way out of your league here.

[Kubes.SG]

Kubes,

"...it reinforces the evidence that interest rates (up or down) as blunt and crude as they are, are still the most effective means for regulating an economy when it moves out of the comfort zone..."

Evidence?!?!?  What evidence???  If you truly consider yourself a 'free marketeer' (and you have so professed on more than once occasion) you would know that Economies are living, dynamic constructs that CANNOT be 'regulated' by anyone or anything!!!

If central banking were done away with we would have no more bubbles of any kind...free markets would do their work of regulating and continually bringing to the fore natural opportunities for investment and growth.

As it stands it is the central banks that cause these distortions that result in amplified effects!!!

You're NOT thinking as usual, old man...

Are you trying to provoke me?  You know I don't have any time for fools.

I am a capitalist and pragmatist.  I believe in basic economic principles.  I don't believe in a completely open market place - all markets needs basic regulations and controls to ensure that imbalances do not occur.  I believe this the controls benefit all to ensure optimal outcomes.  Unregulated markets always skew out of balance.

Interest rates are crude and broad, but they have major impact on economic activity.  With low interest rates you get high levels of speculation and mal-investment, that is captial does not flow to the most appropriate investments but to the quickest gains as the market distorts from hyper speculative activity (fueled by free money).  Greed is not good.  

What popped the bubble in Japan was a big jump in interest rates.  Then the Japanese politicians did everything possible to maximize the damage and prolong the pain.  All banks where zombies and only small one was allowed to crash.  The massive debts are still weighing the economy down as JP never tried to do the hard structure changes needed.

I again point you to the world's best managed mature economy.  Not entering it's 20th year on continual economic growth, powering through the AFC, GFC, TechCrash, you name, while poorly managed and highly distorted and speculative economies like Singapore have been through 4 or 5 recessions in that same time frame.

[Kubes.SG]

$Pripps,

I understand more about this than you ever will...of this you can rest assured.

Kubes is inferring that "....interest rates...[as a 'regulator' of economies]....are...most effective means..."  which is a ridiculous statement to make. It's kind of like saying that the most effective way to cure a hangover is to drink some more from the punchbowl...whereas obviously it would have been better not to drink so much to begin with!

You should stick to posting about the latest Apple products.  You're way out of your league here.

Stop tying to interpret what I mean.  You are getting it wrong.  

Increasing or decreasing interest rates are still the best method for regulators of modern economies to influence the level of activity in the economy.  Setting rules like Singapore and China are trying to do are messy and highly ineffective.  Yes, higher interest rates are broad weapon, but they help force capital back to productive investments and away from speculation.

Clearly this is not sinking if for you.  So I have found a simple explanation for you:


The economy can be influenced easily by interest rates. When interest rates are high, people do not want to take loans out from the bank because it is more difficult to pay the loans back, and the number of purchases of cars and homes goes down. The opposite is also true.

The effects of a lower interest rate on the economy are very beneficial for the consumer. When interest rates are low, people are more likely to take loans out of the bank in order to pay for things like houses and cars. When the market for those things gets strong, price decreases and more people can purchases these things. This also bodes well for investors, who perceive less risk in taking out a loan and investing it in something because they would have to pay less back to the bank.

When people do not have to spend as much money on bank payments, they have more disposable income to put toward things they want to purchase. Suddenly, a trip to the ice cream store is not so much of a budget crunch and a weekend at the spa seems more doable. These effects, although certainly not direct, are enough to stimulate the market when interest rates are low.

Low interest rates are not beneficial for lenders, who are seeing less of a return on their loan than in times when interest rates are high. This means that banks may find themselves having to lower the interest rates accrued on money deposited in the bank in order to maintain a steady profit. However, interest rates do not really have an effect on how much people save, because an increased amount of disposable income means that they are more likely to spend it than to save it.

When interest rates increase, though, foreign investment can increase because people outside of the country want a larger return for their investment and they are more likely to get it in a state of high interest rates. This causes more demand for the dollar, driving up its value in the international market. The opposite happens, though, when the interest rates are decreased.

Although much of it is contained within consumers' perception of the economy and their income, interest rates can drive up consumer spending, investment and the amount of loans people take out of the bank. Or they can increase foreign investment.


The whole effing GFC was basically caused by interest rates set far to low after the techcrash, thus allowing people who should never buy a house to do so, plus massive breakdown of the regulatory controls that determined who qualified for a loan.  With this two gifts, Wall St invented a whole bunch of instruments to sell these toxic debt to the world.  There you go, too low interest was a key cause.

I repeat.  Look at Australia.  The ARB has rapidly moved interest rates up and down over the last 20 years completely independently of the Govt, thus freeing spending/pain in tough times (reduce rates), and reeling in the spending/borrowing when times are good (by increasing rates).  Interest rates are a wonderful tool if use properly.

SG has totally screwed up because the entire country has loaded up on so much debt an increase of interest rates would be very painful.  But it is a step that needs to be made.