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Yesterday I was on China Radio International (CRI) talking about the latest figures and trends for the Chinese economy: the drop in real estate, record bank profits, weak trade and PMI data, and persistent inflation. The overarching question was whether the perceived slowdown in China’s economy is real, and how worried we should be about it. You can listen to the discussion by clicking here.

Regarding the record annual profits being reported by Chinese banks, I don’t have too much to add to what I wrote on that subject last year (in my blog post on “Chinese Banks’ Illusory Earnings”), except to say that it would be comic, if it weren’t so tragic. As I said on the air yesterday, banks have two costs of doing business: the cost of funds (which they pay to depositors) and the cost of bad debts that aren’t repaid. Since Chinese banks enjoy a regulated spread between their deposit and lending rates, the more they lend (and they’ve been lending a LOT these past few years) the more money they make. But the more generously they lend, the greater the risk they won’t be paid back — a risk that should be realistically tabulated and deducted from the earnings spread.

That isn’t happening. The notion that Chinese banks have 1% non-performing loan (NPL) ratios is patently ridiculous, and the claim that provisions for 2.5 times that amount are somehow “generous” (or remotely adequate) are equally absurd. I don’t believe it, and neither do investors in Chinese bank stocks, based on their valuations. Any company can report “profits” if it doesn’t recognize half its costs of doing business. Any company can boost “revenues” by granted easy credit terms to customers who can’t pay it back.

Regarding inflation, the Wall Street Journal published an excellent editorial today that expresses my thoughts as well as I could. You can read it here. They do an excellent job describing the stresses facing China’s banks, and reconciling the apparent contradictions between a slowing economy and inflationary concerns:

It might seem odd to worry about inflation, capital outflows and tight liquidity at the same time, but that’s a consequence of China’s distorted financial system. Because allocation of capital remains politicized, a significant portion of the credit stimulus has gone into wasteful projects; since that money is not creating real growth or productivity gains, it chases too few goods at higher prices.

Meanwhile, those who need cash—including bankers and small and medium-sized businesses—can’t get it. Liquidity injections might help bankers with short-term funding. But absent broader reform, that cash will only follow earlier credit down the inflationary rabbit hole.

Usually economists consider slowing growth and inflation as polar opposites –you can have one or the other, but not both at the same time. Over-rapid growth spurs inflation, but slowing growth reduces price pressure. However, if you print (or in China’s case, import) money and spend it on projects with a zero or negative return, you will get an initial GDP boost (as long as you keep spending), but eventually you will get stagnant growth AND inflation: stagflation. The Journal gets it. Does anyone in China?

Source: China's Slowdown: How Worried Should We Be?