China Stimulus Package: Part I, Bank Loans

The Chinese stimulus package, called the ‘gold standard’ by some economists, was announced November 2008. After it was announced the Chinese Shanghai A stock market began to rise. It has kept rising for the past seven months. Although still over 50% off its 2007 highs, it has still gained 60% from its early November lows. In the process it seems to have taken the rest of the emerging market stock indices with it. The Chinese stock market is the laggard. The Indian market has increased 85%. The Brazilian market has increased 100%, while the Russian market has increased an astonishing 140%. This seems to a validate the long held theory of decoupling; the idea that the emerging markets are no longer tied to the problems of developed markets. They can and will grow independently leaving the developed markets far behind. It won’t happen.

Much of the theory of decoupling rests with the idea that China, like the United States in the past, will be the engine of growth that will help take the world especially the emerging markets out of recession. One aspect of this argument is that as the Chinese economy grows it will increase the demand for commodities especially oil from Russia, minerals from Australia and food from Brazil. So as many parts of the world remain mired in a severe recession, the commodities markets, especially oil, have surged. The surge in prices for industrial commodities like copper and lead seem to be proof that the Chinese industrial miracle is up and running again at its usual break neck pace.

Of course the source of all of this optimism goes back to the Chinese stimulus package. Last November the Chinese government announced a 4 trillion Rmb ($586 billion) stimulus package which was supposed to be made up of a combination of investment on infrastructure and social welfare to be spent over the next two years. The total amount could reach up to an equivalent to 15 per cent of GDP. This massive package of spending has been cited and recited as the basis of renewed growth in China and everywhere else. It was never quite as good as it seemed.

First, the package was not wholly financed by the central government. Only a small part of the package came from Beijing. The amount pledged was only 1.2 trillion Rmb about 30% of the total. The rest was supposed to come from local governments and lending by state owned banks. Besides its composition, another problem with the package was that it did not consist of new money. The actual extra investment of new money might have been less than a third of the announced stimulus package because much of the investment including earthquake relief had already been announced.

Seven months later, the composition of the stimulus package is much different than what was actually announced. The central government did indeed pay out its share of the package. The banks share made up of lending went into overdrive and the local governments only put up about half. The stimulus package was supposed to be divided between investment to help companies and social welfare to help stimulate demand. Only one part of this was realized.

Stimulus Package: Loans from State Banks

Almost all of the banks in China are owned by the state. The four largest are China Construction Bank, Bank of China, Industrial and Commercial Bank of China and Agricultural Bank of China. Five years ago after the recession of 1999 to 2002 the state owned banks were saddled with bad loans estimated to be about $430 billion or as much as 42% of all loans. In short, they were all insolvent. As part of the preparation for IPOs in 2005, the first three of the banks were recapitalized and the non performing loans (NPLs) were taken off their books. Many of the bad loans, about $205 billion, were ‘purchased’ at face value by specially created vehicles called Asset Management Companies or AMCs in exchange for bonds. This created a number of issues that are still with the banks. The bad loans were not worth their face value, no NPL is. The AMCs were supposed to dispose of the loans through collateral sales, work outs or bankruptcies, but did not. The bonds that were exchanged for the NPLs were supposed to pay interest and be redeemed in 2010, so whatever they are worth, they are still on the bank’s books.

During the boom years that followed the bailout in 2003, Chinese banks, like almost every other bank in the world, no doubt made some bad lending decisions. Like the US, China had two asset bubbles, one in its stock market and the other in real estate. Both have declined precipitously.

Apparently the Chinese banks were much better managed than their western counter parts, because they are supposed to be very profitable and very solvent. In fact, they were so liquid that when the government called up them to lend to help stimulate the economy, lend they did. In the first quarter of 2009 the banks showered money onto the economy. They lent out more than headline amount for the stimulus package. The government had planned that the banks would lend 5 trillion Rmb for the entire year. The banks lent out 4.5 trillion Rmb in the first quarter alone, nearly three times the credit level reported during the same period last year. Even if new loans for the remainder of the year are reduced to 500 billion Rmb a month for the rest of the year, the total would be more than 9 trillion Rmb which would exceed all the loans issued over the previous two years combined

In the US and in other countries there is enormous concern as to the destination of stimulus funds. The object is to distribute funds to consumers to get them to spend and to make investments in infrastructure to make the economy more productive. The concern is that the money will be wasted on useless projects or even worse, simply stolen through corruption. Even in the US it is estimated that 5% of the money will be wasted.

In China the concerns are the same. With three quarters of a trillion dollars being loaned out in a very short period of time, the concerns are very real. Ideally, banks are supposed to act as intermediaries. A normal banker acts as a portfolio manager for her depositors. She picks what she considers to be the safest investments, the safest loans, and invests the depositor’s money. In most cases, the bankers try to pick the most efficient and safest enterprises. In China the reverse happens.

Unlike private companies, state owned companies everywhere are run for political motives and not necessarily for profit. So it is in China. Large state firms witnessed a 25% decline in profitability at the end of 2008 from the end of 2007. Still most of the money that was lent by the state owned banks went primarily to state owned enterprises (SOEs). In April alone these institutions received three quarters of the 591.8 billion Rmb ($86.8 billion) of the money lent by the banks. In law and economics there are five reasons why managers try to make money for their firms and not for themselves, but none of these limits applies to SOEs.

With all of the money going to the SOEs, little is left for the 40 million small and medium sized firms. These firms, largely family owned, are the engine of employment in China, employing about 75% of China’s workers and producing 68% of its industrial output. Many of these firms are employed in the efficient export industries. The failure to get any of the stimulus money is a particular problem in China, especially since the latest figure show that exports in May fell 26.4% from a year earlier, accelerating from April's 22.6% decline. The impact on China’s employment, productivity and private sector will be severe.

For private companies getting money from state owned banks even in good times was never easy. Most were able to obtain credit through trade finance. The number of suppliers that are extending credit to their domestic customers has increased dramatically, from 70% a year ago to over 90% today. With money tight, the number of defaults of domestic customers and the cost of insuring them is rising. It has risen by 30 per cent since the financial crisis. This is a new problem for many firms. In the past payment wasn’t a problem. Sales were always increasing. The use of more sophisticated financing techniques like secured inventory or receivable financings were not necessary and were not used because the legal infrastructure was not in place.

After numerous reports all spring from different sources, (Financial Times, Wall Street Journal, South China Morning Post), it appears that the state owned banks have in fact been lending to Chinese SMEs all along. The official Shanghai Securities News reported on Monday June 8^th that China’s biggest state owned banks had made very sizable loans to SMEs. Industrial and Commercial Bank of China had in fact extended 325.4 billion Rmb of new loans to SMEs during the first five months of this year, or 61 percent of the total. Agricultural Bank of China had increased its lending to SMEs lending by 240 billion Rmb this year, half of total new loans. The Bank of China's new lending to SMEs jumped 44 percent during the January-May period from a year ago and China Construction Bank's SME lending totaled more than 500 billion Rmb or 18 percent of the total.. The newspaper cited statements made by high officials or presidents of the banks.

While it is possible that the bank’s presidents are correct, the timing of the pronouncements after so many other statements looks odd. Without independent verification it is difficult to determine the veracity of such statements. With increasing stories and criticism, it is likely that these recent statements deserve a bit of doubt. Of course it is probably easier to determine the real age of a Chinese gymnast than the composition of the bank loans over the past few months.

The probability is that the prior statements have been correct and that the most efficient parts of the economy are continuing to go hungry. If the state owned enterprises are flush with new loans, they could be making a bad problem worse. "China is now already plagued by overcapacity in some industries. To add more investment now, just to get some companies going, might threaten the industrial base years from now," said Joerg Wuttke, president of the European Union Chamber of Commerce in China. "Authorities here seem to underestimate the severity of overcapacity," he said, in part because they are so focused on getting economic growth moving in the short term.

With the potential for social unrest especially in the cities growing as a result of unemployment, shuttering unneeded factories is difficult. The 2007 bankruptcy code was a needed reform, but it is rarely used. Bankrupt firms rarely go through a formal procedure. Often workers find the gates closed and locked, while management and any liquid assets are nowhere to be found. Local governments get stuck with demands from angry workers for unpaid wages.

The result is that state owned firms are absorbing commodities to produce unneeded capacity and over investment. While this takes care of the supply side it does nothing for the demand. A good example is the Chinese steel industry. While most of the world is experiencing a contraction in the demand for steel resulting in the shuttering of factories to dramatically cut supplies, the Chinese steel industry is producing a record output. The nation's steel production is up some 25% from the bottom in October and at the current operating rate, production for the full year will come in at 528 million metric tons, which is a new all-time high and up some 6% from 2008's record high.

The record production is not met with record consumption. The demand for steel in China is expected to fall for the first time since 1995, according to the World Steel Association, which estimates that China will witness a decline of 5% in apparent steel use in 2009. Eventually even the state owned industries cannot keep producing unsold product. When the level of inventory becomes untenable, so will the demand for commodities from the rest of the world.

Even if we assume that the presidents of the state owned banks are correct, and they did loan large amounts of money to the SMEs, the question as to the demand for the SMEs goods is just as important as the demand for products of state owned firms. Many of these smaller and medium sized businesses were part of the export machine selling all sorts of goods to overleveraged American consumers. These consumers are in the process of deleveraging and actually saving. So they will probably not be buying much of what the SMEs produce any time soon.

State owned enterprises may be inefficient, but at least the loans are being used. The amounts of the loans were so great that in any system, especially one like China’s that is plagued with corruption, a certain amount of the money is bound to go astray. Last year the auditor of the four main electricity companies and 41 other giant state-owned firms found cases of "false fiscal reports, mismanagement that led to loss of state assets" and problems related to "grain reserve safety, overseas investment risks and national energy safety". Li Chengyan, head of Peking University's Anticorruption Research Institute, estimated that there may be as many as 10,000 corrupt Chinese officials who have fled the country over the past decade, taking as much as $100 billion of public funds with them. There is evidence that some of the money from the loans has been diverted is that sales of luxury cars in Shanghai reached an all time high in March. Meanwhile the gambling tables in Macau, which were in trouble three months ago, are now full and the stock of the gaming companies has risen 700%.

Between the corruption and overcapacity, many officials in Beijing are beginning to worry about the reappearance of massive bad loans. The China Banking Regulatory Commission in April became concerned that much of the lending was going to inappropriate investments like the stock market or for real estate speculation. So they circulated new rules to try to fix the problem. It may be a while before the rules are even adopted. The bank regulator is concerned, but still believes that the risks are controllable and all that was needed was a directive to encourage banks to be more vigilant.

Comments

[Wizler:]

Bad loans still on the balance sheet, clever investment vehicles to free liquidity, government owned banks controlling capital....sounds familiar

Jun 15 10:29 AM

[William Gamble:]

Agreed. The difference is that in many countries there are independent agencies, newspapers, etc that have an incentive and sometimes legal duties to report the bad loans. In other countries these things do not exist, so it is difficult to determine the size of the problem

Jun 15 10:58 AM