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Economist Brad Setser (Director of
Research, Roubini Global Economics)
has authored a paper The Chinese Conundrum: External financial strength,
Domestic financial weakness(link
with free registration required alt link)
describing the current state of the Chinese banking system. The paper focuses
on the extent of bad loans and the possibility that the system is headed
toward a crisis of some kind.
The Chinese government maintains
a fixed exchange rate between the dollar and the Chinese RMB as a matter of
(mercantilist) policy. Because this rate is below the market-clearing value,
they must intervene regularly in the foreign exchange market to prevent it
from rising, by purchasing dollars offered by Chinese exporters and selling
them RMB. When they are no longer able to borrow enough RMB from domestic
credit markets, they print the rest. This new money serves as a reserve asset
for the Chinese commercial banking system. The banking system is then able to
expand credit on top of this reserve. This is resulting in a massive credit
bubble within China.
An Austrian economist would look
at the situation and see the initiation of a Misesean bank credit cycle, that
must inevitably end in a bust. Setser, while not an Austrian (as far as we
know), comes to a similar conclusion:
This paper will argue that China’s external
strength will not allow China to avoid a new round of costly non-performing
loans, though the trigger that leads a new generation of bad loans in China will differ from the trigger of the Asian crisis. China simply is not vulnerable to a
sudden withdrawal of external credit. In China’s case, trouble is more
likely to emerge from a shock to the real economy than from a financial
shock. Chinese banks have financed too much capacity chasing too little
demand – excess capacity that will eventually give rise to a new
generation of bad loans. Investment growth is sure to slow at some point.
Moreover, China’s overall economy is increasingly exposed to a global
slowdown.
There is no realistic way
the government of China can avoid picking up the bill for a new generation of
bad loans from the post-2002 credit boom.
The mis-allocation of resrouces
in China is exacerbated by the quasi-state ownership of most
"commercial" banks. This means that they are even less subject to
market discipline than are private banks operating in a fractional reserve
banking system, as exists in most of the developed world. As one would
expect, the system is riddled with bad loans and there are no negative
consequences for the bankers or the bank shareholders.
Setser cites another researcher
to the effect that 70% of loans made in 1992 and 1993 "ultimately failed
to perform". Setser explains how "government has often shifted the
bad loans to Asset Management Companies (AMCs) rather than realize the likely
loss immediately."
Setser anticipates that, rather
than allow banks to fail, the government will continue to bail them out one
way or another:
Despite ongoing improvements, the regulatory capital of
the banking system still hinges largely on favorable accounting treatment of
bad – and potentially impaired -- loans. Some state enterprises can pay
interest on their outstanding balance, so their loans are not formally
non-performing. But they are unlikely to ever repay the principal on their
loans
Another distorting aspect of China's banking system is
that the interest rates on loans are controlled by regulation. As any
Austrian or Public-Choicer would expect, credit allocation has become
politicized:
The Chinese government has been reluctant to raise the
basic lending rate, in part because higher lending rates would jeopardize the
health of certain state enterprises....There is a real risk that available
credit is going to projects with strong political backing, not necessarily to
those projects that pose the least risk to the bank.
What do I conclude from this?
The sadest thing is that the
banking system has wasted the incredibly high savings rate of the Chinese
population. Instead of savings being used to fund econmicaly viable
investments, the savings are mostly wasted on projects that are either
politically connected or simply not rational for the existing, though quite
high, level of savings.
Setser writes that the Chinese
credit markets are bank-centric. That is, the banking system is the primary
conduit for allocating savings to investment. This conduit is fundamentally
broken in two respects: one, that the banks are political entities, not
economic firms, and as such face the problem of central planning: without private
ownership they have no way of rationally allocating resources or assessing
risk. I would expect the same outcome as in any centrally planned economy:
political favoritism and massive waste.
Mises' business cycle theory
identified bank credit expansion as the cause of resource misallocation. China appears headed toward a credit bust, which will show up as a surge in non-performing
loans in their banking system. The government can bail them out, again, as it
has done several times in the past. But where does it get the money to bail
them out? Setser explains the way that this process could reach an end game:
The banking system as a whole faces precisely the
opposite risk as the central bank: Over time, central bank bills will account
for a larger and large share of the banking system’s total assets and,
if PBoC bills continue to pay little more than the banks pay on their
deposits, the banks’ profitability will decline.
Capital markets are not the only
means of resource allocation. It may be the case, although I do not know,
that a substantial fraction of Chinese economic growth is funded by private
savings that never go through banks, or by retained earnings of private
firms. To the extent that economic growth in China is funded by bank credit,
Setser's piece calls into question the Chinese "economic miracle".
Impressive GDP figures may overstate the extent of China's actual growth
because GDP counts the outputs of firms who owe their existence to phony
credit.
Robert Blumen
Robert Blumen is an independent
software developer based in San Francisco, California
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