We are seeing some welcome news out of China. The plans made by the PBoC to liberalize bank deposit rates is certainly a step in the right direction to ending financial repression of the household sector in China, which would help re-balance growth towards the consumer. The bigger picture remains uncertain, as the problems in the banking sector is starting to make China look like pre-crisis Europe.
To explain, the eurozone crisis was a combined banking and sovereign crisis. Before crisis, banks raced to lend to peripheral countries because of the perception of that there was little or no credit risk. It's all one eurozone, right? They are all sovereigns in the eurozone and sovereigns don't default, right? What could possibly go wrong?
Banks gorged themselves with lower credit eurozone country debt, and, in particular, the bonds of their own countries. Yield spreads between peripheral country bonds and bunds narrowed to microscopic levels. When the crisis hit, national governments were handcuffed from bailing out their own banking system because their banks were stuffed full of their own governments' debt. So how do you bail out yourself?
It's all guaranteed, right?
As I read Kate Mackenzie's analysis of the Chinese banking system in FT Alphaville, I get an eerie sense of deja vu. China's banks are gorging themselves on SOE and local government debt because there is a sense that the central government wouldn't allow (fill in the blank) to default. A credit bubble formed and, as a result, the cost of growth was too much investment spending in infrastructure (see my recent post Who pays for China's excesses?). Sober Look also highlighted this chart from CS showing how China's recent infrastructure growth has been credit driven and how much of a credit bubble has formed:
Mackenzie quoted Anne Stevenson-Yang of J Capital Research writing about this exact problem:
In fact, Anne Stevenson-Yang of J Capital Research wrote in March that the early aspirations that the Chinese bad banks would facilitate more responsible lending has given way to a consolidation of the big banks’ financing of the powerful state-owned entities:
The AMCs were to assume debt from fundamentally viable companies and swap it for equity. This was part of the massive SOE restructuring plan of the time: the AMCs were expected to act like private equities—stern and dispassionate board directors motivated by profit. It was thought that this would help create SOEs that thought and acted like commercial companies. To the contrary, the result was an implicit guarantee to SOEs that they would not go bankrupt, which in turn supported the general disregard for debt-equity ratios and any calculation related to servicing debt.
The SOEs’ are widely acknowledged to be one of the biggest hurdles to China reforming its economic strategy, due to a combination of their poor performance, easy access to credit, and significant political power.
I don't know how this all ends up, nor do I know the timing, but this won't end well.
At worst, it ends with a banking crisis that spills over beyond China's borders and sparks a global financial panic. At best, bailing out SOEs and local government authorities amounts to financial repression of the household sector and impedes the government's stated policy of re-balancing growth to the consumer and household sectors of the economy, which would create long-term headwinds for China's growth path.
Disclaimer: Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest. None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.