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Just a quick note to clarify a misconception one often hears regarding China’s infrastructure investments and the health of its banks.

One of the most common mistakes people make in analyzing infrastructure investments in China is that they fail to note how the income stream is actually supposed to work. Typically one would assume that banks lend only to projects that generate a decent return by themselves. Emphasis being that at the core of the banks’ decision lies the revenue stream of that single project and that even to outsiders the revenue stream is predictable as they assume some sort of linear progression.

In China, however, banks are for all practices and purposes agents of the state. That is why infrastructure investments are rated by their contribution to national growth as opposed to direct attributable yield. Banks are backstopped by the government which in turn finances its needs through a growing economy. If banks run into trouble they are re-capitalized or given the opportunity of benefiting from higher spreads.

Bureaucrats, inherently loving big infrastructure projects, make the conscious decision to build big as they rightly assume that infrastructure once built is difficult to expand. Is there a nation in the West that doesn’t struggle with an airport extension? Better have overcapacity now rather than deal with an increasing middle-class better educated on its rights later on.

People like to point out to empty cities such as Ordos but once again China’s specific way of doing things comes into play. Through our experiences and education we are prone to assume that cities grow in an organic fashion, yet state-led countries are different as sometimes jolts and spikes dominate. In top-down decision making environments there’s bound to be the odd mismatch, especially in a country as large as China. As of now the Chinese state prefers to bail-out the eventual bad investment here and there rather than spend that money on consumption or building a social safety net.

The element that directs finance is not yield but rather long-term viability from the perspective of the state.

China is not alone in East Asia for its approach in funneling investment through government intervention.

It stands out right now as Japan has run out of viable investments and thus made infrastructure spending look ridiculous and South Korea has de-emphasized the role of government in the banking sector. If you take a step back to see the big picture and have an honest look at the data this way of organizing an economy has delivered results. Many people unaccustomed to China are simply philosophically at odds with the way the financial system is organized and end up having their investment decisions clouded by that negative sentiment.

China is a state-led economy where companies are under capitalist-like pressure to deliver. Never be fooled by its political system.

Why is the way banks conduct business so important? Well, many people use ETFs to benefit from Chinese growth however personally I abstain from those unless the general macro-picture is very bright since banks account for a large chunk of their composition. Even though I just highlighted their role I can’t bring myself up to fully trust their accounts and so downside-risk remains too high for my liking.

What’s further is that foreign banks will struggle to achieve a sizeable market-share for a long time to come as the financial sector is central to the Chinese political economy. In fact it is at the heart of it.

Disclosure: No positions.

Source: Getting Clear on Chinese Infrastructure Investments