China: A Run on the Bank of East Asia

What was supposed to be largely a US financial crisis seems to be spreading even further.  This might come as both a surprise and an annoyance to those who believe that the cause of the crisis was specific mistakes made by US bankers and regulators, but much less of a surprise to those who assume that runaway monetary expansion always leads to very risky and vulnerable financial systems, and the list of countries that have tolerated or even exacerbated runaway monetary expansion is a very long list.

 

Here in China, in sympathy with the weirdness abroad, the stock market is still racing around erratically.  On Wednesday the market bounced up and down violently several times before ending the day with the SSE composite up 15 points, or 0.7%.  Today, prices surged 5.3% within two hours of opening, and then gave some of it back to close at 2297, up 3.6%. 

 

The market surged, according to Bloomberg, “after the country’s two exchanges eased restrictions on equity buying by controlling shareholders and on speculation government-run investors increased purchases,” although I think the bank share purchases have been, fortunately, quite small (an article in today’s Xinhua stated that the net purchases of shares by Central Huijin in the three big banks amounted to increases in ownership of well under 0.001%).  The Bloomberg article goes on to say:

 

Under new rules taking effect today, the period in which controlling shareholders are barred from raising their stakes in publicly traded companies has been cut to 10 days before earnings are released, from 30, according to statements from the exchanges.  China's state-owned companies should be “a role model” in promoting “stable” development of the nation's capital markets by buying back shares in publicly traded units, the State-owned Assets Supervision and Administration Commission said Sept. 18.

 

Aside from the fact that to be a “role model” these days is pretty narrowly defined (you must simply buy shares), my former students in the market tell me that there is also serious speculation that securities rules will be changed to allow shorting and margin investing.  Although I am not sure either of these measures is likely to add stability in what is a highly speculative market (on the contrary), to some extent these rumors are more of the same old stuff.  Basically what is driving the market is government intervention and government signaling. 

 

Given how chaotic and dangerous markets have been recently, this is probably as good a time as any for market intervention, and certainly Chinese policy-makers are not the only ones around the world who think so, but investors here have been so conditioned to think of the market’s performance as almost exclusively a function of government behavior that I am afraid that the impact of the latest round of activity in China will be far more ephemeral than it might be in other markets.  Once investors perceive that the government has run out of ammunition or new tricks to spur the market, prices will plunge.  Once the market stops surging, it will very quickly lose its legs as investors pile out waiting for the next bag of tricks, and we’ll soon be testing the lows again.

 

More interesting to me than the stock market were events in Hong Kong concerning the Bank of East Asia.  After several days of rumors and speculation, long lines of depositors are now lining up at the bank desperate to take their money out – and have been so since late last night.  Deposit withdrawals actually began on Tuesday, but only really picked up steam last night.  Bloomberg says this is Hong Kong’s first bank run since the Asian Crisis of 1997, but the South China Morning Post lists the last bank run as BCCI in 1991.

 

The chairman of the bank, David Li Kwok-po, is apparently furious at what he calls “groundless” rumors about solvency problems at his bank and he and Hong Kong regulators are loudly proclaiming that the bank is perfectly safe, but, whether they are telling the truth or not, this is the way bank runs work.  There is no strong incentive for depositors to trust the safety of the bank, beyond their giving up a few days of (low) interest, and every incentive for them to flee to safety.  Even if every one knows that the bank is safe, simple game theory suggests that once the process starts, until something happens to signal that the game is over it makes sense to withdraw deposits.  More ominously, two other local banks, DBS and Dah Sing, are also now subject to rumors.  By the way there is an interesting article on the subject in today’s South China Morning Post, which also has a brief history of Hong Kong bank runs.

 

Interestingly enough, according to today’s South China Morning Post, one of the factors in the bank run was the wide diffusion of mobile phone SMS and BBS postings warning that there was trouble in the bank.  There was also a seemingly unrelated news story in the same newspaper about the closing down for three months of China Business Post, “one of the oldest financial newspapers on the mainland,” for a “scathing” report in July on Agricultural Bank of China.  Apparently the newspaper received an unexpectedly harsh punishment for reporting a story about fraud at ABC, which was later denied by the bank.  Why such a harsh punishment?  Could it be that authorities are worried by negative articles about mainland bank practices?

 

Regular readers of my blog know that I am always interested in the phenomena of bank runs.  They almost always come as a shock to places and institutions where only a short while earlier most people would have considered them inconceivable.  But the more overextended a bank’s balance sheet is, the smaller the shock needed to cause a sudden contraction, and as Nassim Nicholas Taleb has pointed out several times – often a little grumpily – these are not events whose probability can be statistically modeled in a meaningful way.  Under current conditions, we can only say that unexpected events like bank runs should not be considered unlikely.  This obviously has implications for the Chinese banking system – which actually experienced bank runs not so long ago, earlier in this decade. 

 

And implications also for the country’s currency regime.  A lot of people have been asking me recently about China’s strategy for the RMB.  Should China continue forcing the RMB up, or is it time to change strategy?  Given the possibility of slower export sales, might we even see depreciation?

 

I have never believed that the purpose or RMB appreciation was directly to rebalance trade.  For several years China needed to revalue the yuan not to reduce the trade surplus but rather to regain control of its monetary policy.  If it was able to regain control, the trade surplus would automatically decline anyway because what was pumping exports was the surge in industrial production caused by the channeling of China’s money growth into the banking system – fueled at first, in a self-reinforcing feedback loop, largely by the impact of the trade surplus on reserve accumulation.

 

At first the main source of money inflow was the trade surplus.  While this continues to be large, in the last year it has been speculative inflows that have driven reserves up.  China’s currency regime needs sharply to reduce the latter and to bring the former to a more reasonable level. Until the now it seemed to me that the only way to do so was to engineer a maxi-revaluation.  But there are four things that can, in principle, reduce the need to revalue, although all of them, one way or another, create problems for the economy. 

 

1.     If global growth slows sharply, China’s trade surplus is likely to decline.  This will reduce the impact of the trade surplus on reserve accumulation and so slow money growth.  A reduction in the trade surplus might not be enough by itself to allow the PBoC to regain control of monetary policy, but if slowing export growth leads to slowing economic growth, which then also reduces capital inflows, it might be more than enough.

 

2.     If the prospects for asset appreciation (including currency appreciation) decline, speculative inflows will slow or even reverse, thus removing the biggest recent source of unstable growth in reserve accumulation.  This means that when investors expect lower returns from their Chinese investment, the incentive to bring money into the country to invest will, of course, decline.

 

3.     If the currency is forced to appreciate surreptitiously via a surge in inflation, China can eventually reduce net inflows once the currency is perceived to be overvalued and expectations of a Vietnam-style depreciation set in – but of course in that case China will have anyway achieved everything it was hoping to avoid.

 

4.     Most dangerously, if the perception of risk in the financial system (or anywhere else in the economy, for that matter) rises, investors will begin to exit, and the worse the perception of risk that faster the exit.  At some point it even becomes self-reinforcing, as fleeing investors force an uneven contraction of the money supply, this exacerbating risk.  Unfortunately it is exactly the uncontrolled growth of money in previous years that would create the conditions for a surge in the perception of risk, by causing serious overextension in the country’s formal and informal financial systems.  This was always, in my opinion, the strongest reason for a maxi-revaluation: get monetary policy under control before the banking system became too risky

 

5.     Of course the fifth option, which is the one I had always supported, is that China revalue the RMB substantially (and in one maxi-revaluation) to reduce or even reverse capital inflows and, by reducing the consequent monetary growth, eventually slow industrial production.  This was never going to be a painless option, but I expected that if China waited too long it was likely to see either #3, a surge in inflation, or #4, a breakdown in the financial system.  It may be too late to take that option – certainly under current conditions it would be very difficult.

 

It seems to me that we may be seeing all of these things happen at once.  It is too early to say, of course, but it is pretty easy to construct a plausible scenario where the US and Europe reduce their imports substantially (so reducing or even reversing China’s export growth), investors both expect lower returns in China (the pressure for currency appreciation declines) and see higher risk in the banking system.  Whether this is accompanied by inflation or not will depend on the actions of the PBoC and on how robust and stable the financial system is, but either outcome is pretty negative.

 

The outlook is worrying.  I guess I generally try to achieve a balance between expressing my deepest worries about the banking system and being excessively alarmist in public, and this has been a particularly difficult balancing act in recent weeks, but every week it seems the banking crisis steps into yet another market.  Where will it go next?

Comments

[johnthebear:]

Mr. Pettis, I have admired your courage and honesty in reporting from China for several months as the World-Wide financial crisis evolves.

I have invested in puts in FXI and in FXP using ProShares ETF.

I wonder if you have looked at FXP as an investment which is 2:1 bet against FXI? If you have analyzed this investment, could you share your thoughts as to how well this mechanism is working and likely to work in the future as financial strains become more obvious.

So far, the 2:1 ratio is working as advertised, but in view of the exchanges restrictions on shorting, I am wondering what might happen to this and other ProShares funds?

I also own shares in SRS which is the 2:1 inverse of IYR. I have looked at the prospectus which was not available on line when I first invested in both funds. It is complicated and I don't understand them. Any help you could share would be appreciated. Thanks, John

2008 Sep 25 03:14 PM

[Portable Alpha:]

It seems State Council has approved short selling. Honestly guys, I almost burst out laughing when I was reading the article.
www.bloomberg.com/apps...#

I'm not sure what's on policymakers' mind, but seems to me a Pandora's box is about to be opened, and those late 20 sth. fund mangers will really have fun big time.

I'm sincerely wondering whose masterpiece advice is this, which nonetheless reminds me of Blackstone position by that HK broker. Maybe I'm a bit pessimistic, and hopefully government officials are indeed thinking outside the box this time around.

2008 Sep 25 09:56 PM

[M. Pettis:]

John, I don't really follow either of those instruments so I don't have anything useful to say. Sorry.

Portable, I agree with you completely. Adding gasoline to speculative trading strategies in a market that is already completely dominated by speculation is not a good idea. Expect to see more, not less, volatility.

2008 Sep 27 05:03 AM

[James Lewis:]

The reason why the CCP have introduced margin trading and short selling is because there are trying to 'mature' their financial markets.

They are all very very angry that the Domestic Banks/Government/Insur... companies have taken such a hit investing in international markets. They know this has been borm out of the fact they have no markets themself to do so, so are forced to recycle all their inflows through other markets. They also hope to drive the next level of growth through developing their markets as they can see they have saturated their export growth and that domestic spending growth will be very hard to enginner because of the fear of the people in China.

So the CPP figure, we need to improve and mature our markets.
So we can avoid sending our money to other markets.
And make money ourselves in the process.
So what do you they do, introduce short selling/margin trading???!!!!
This is the worst thing they could ever have done, they dont seem to understand that their financial sector is not developed because they refuse to give a piece of the pie to the foreigners. Even cirumventing their WTO policies by endless delaying etc. These protectionist policies are very much getting in the way of reform/development.

They also dont seem to understand that there are no 'mature' market participants.
The fund managers/stock buyers are just pure gamblers. The corporations/state owned companies are also just gambling/soliciting their power/influence for their own ends in stock manipulation/pyramid stock scams. There is no such thing as capital allocation and 'long term investment' in the Chinese markets. But the authorities can not see that because of their unbelievable nationalistic/pro-chin... views.
They anaylse everything one dimensionally and as a result, you get policies like this.

Their protectionsit policies do nothing but protect their close business contacts and put the poor everyday Chinese people at risk. The Chinese should be able to invest in Mutual Funds/Pension Plans without the worry that the market is going to shoot up/down 5% most days of the week. The Chinese should be able to be confident that they can keep their money somewhere long term and get a decent return without having to worry that some high level corruption/fraud will take away their savings. This is also a reason why the Chinese like to get in and out quickly. They are afraid their money is going to be taken from them. And rightly so, having spent a number of years in China among the Chinese people. I can not tell you how unfair the social fabric is.

The chinese really get bad effects from the protectionist policies of China. Simple example, if Import taxes were in line with those of the west. Better quality foriegn food could be imported into China and made available to the Chinese people at a cheaper price than domestically made food. Already it is cheaper to buy 'proper' milk from New Zealand (Anchor) then the higher grade brands from China.
The Chinese could buy foriegn cars at the same price of danagerous domestically made cars.

The markets in China can only mature if they are opened up, if Hong Kong/English/Singapore... fund managers come and live in Shanghai/Shenzhen and run a great deal of the funds. If they come in and help to properly mature the markets/train the market participants.The markets in China can only mature if the industry is truly opened up.

The financial district in Shanghai is just lots of big buildings right now.
With very little added value to the financial services industry.
The short selling/margin policies will send the market soaring short/medium term. Its like giving the Chinese a tab to gamble with. But at some point the tide will turn again and I see us going even lower. This very well could cause a lot of problems. Property/Banks/Social Order... everything.

There is a very real possibility, that this new margin could send the markets up, stimulate fake growth and pull even more inflows in. And we are all know what that sets everything up for.

I am very confident that a very prosperous mirage is about to appear.
And that it will send everything up..but thats all it will be a mirage.
I

2008 Sep 28 01:40 AM

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2008 Oct 06 02:34 AM