Sinophrenia #2: Financial System Woes

This blog is a take on the problems in China’s financial system, as described in Thomas Orlik’s China: the Bubble that Never Pops.

 

Those risks/problems today can be traced back to the (Western) financial crisis of 2008. As the West fell into a recession, demand for Chinese imports fell. China responded with a massive stimulus package (4 trillion yuan, approx. $400 billion) to keep its economy running. The central government only came up a quarter of that amount, though. The provinces (states) were told to come up with the rest. How could the provinces come up with such a huge amount?

 

For historical reasons, most land in China is owned by the government. Ergo, the provinces decided to sell some of their land to raise the money. Other perks were thrown to industrialists so that they’d buy the land. In turn, real estate companies started buying land close to these planned sites of industrial expansion. So far it looks good, right? Those new industries and construction activities would add to economic growth. But then…

 

The governments wanted economic growth to pick up, so there was pressure on the banks to lend, er, easily. That led to indiscriminate lending with barely any care about the feasibility of repayment. The central government saw the risk and framed regulations to limit the risk banks could take on. But…

 

Banks, Chinese or Western, break laws and regulations. China’s banks created new dummy entities (“shadow banks”) – the bank would give a loan to the borrower, then transfer that loan as a bond to this shadow bank. Bingo! The bank no longer had the loan in its books, and was meeting the regulations. But of course, the loan was just hidden in the shadow banks. And then…

 

China’s growing middle class was always looking for opportunities to invest their wealth. The shadow banks started offering those high-risk bonds to them as an investment option! Suddenly, the risk of all these loans was spreading from the banks to the middle class as well. The government woke up. While they knew the banks were lying, how could they find out all the shadow banks, which by definition, were illegal and thus hidden? Center-province politics made any such discovery process very complicated. But without that knowledge, how could the government know the true state of the financial system? Or steps to take?

 

Even more problematically, the blissfully unaware middle class found those risky bonds attractive – after all, they offered higher interest than bank deposits. In turn, as more and more savings moved to buy these bonds, the banks found their deposits slowing and/or reducing. Which put pressure on the banks to slow down lending (which would then slow down economic growth) or to raise deposit rates (which would increase the risks to the banks themselves).

 

China’s government, therefore, is in a fix. Squeeze too hard, and lending might freeze, and financial panic would hurt economic growth. But do nothing, and the problems may grow so big that when they finally come out, it would be too late to fix them.

 

This then is the first problem China faces today:

“The economy has too much debt, taken on too quickly, and allocated by a deeply flawed financial system. Bad loans, unrecognized in the official data, are already high enough to pose a threat to stability.”

In China’s case, “stability” here doesn’t just refer to financial stability. After all, financial problems can quickly turn into social unrest, which could become a danger to the political system itself…