Can China Weather a Downturn?

 |  Includes: CAF, FXI, PGJ
by: J. Christoph Amberger

As Iceland’s banking industry is melting down, the pundits have started to look expectantly at China to put some of their $1.6 trillion dollars into play, taking stakes in distressed Western banks.

After all, Chinese banks appear to have dodged the U.S. subprime mortgage crisis. Barron’s wrote last month:

Chinese lenders accumulated large amounts of that bad debt. But bankers have assured investors they are within manageable levels that won’t greatly affect their profit, fattened by a domestic economy that is growing at double-digit rates.

But China will not escape unscathed. In fact, we are now seeing signs of yet another credit crisis that could rock global markets.

Remember, since 2007, every quiver in the global stock markets has been blamed on increasing default rates in U.S. mortgages. Given $700 billion bailout plans and collapsing investment banks all over the world, consider this: The risky segment of the mortgage market we now know as “subprime” accounts for just about 10% of the U.S. mortgage market. That means that less than 1% of total mortgages are in subprime foreclosure.

But if a few billion in shaky loans can trigger a global financial crisis, how about another bit of a crisis brewing that makes subprime look like the broadway version of American Pie.

Here’s what’s going on with China: After decades of double-digit growth… an incredible stock market boom…. and an even bigger real estate and building boom… the big four, government-run banks are now sitting on record non-performing loans (NPLs).

That’s banker's talk for "bad loans". Not debt. Not deficits. But loans that will never, ever be repaid.

The Chinese NPL market is one of the largest in the world… The last more or less reliable data about the total of outstanding balances dates from 2007. Back then, it was over a trillion dollars. That’s about 40% of China’s gross domestic product! Almost half of what the entire Chinese economy — one billion hard-working people! — produce in a year. In the past, Beijing has spent the equivalent of 25%-30% of GDP in bank bailouts.

Accounting firm Ernst & Young calls the main reason for why these bad loans were generated in the first place "political". Remember, China is a corrupt one-party state. And that one party is still Mao’s old Communist Party.

The party appoints 80% of the chief executives in state-owned enterprises and 56% of all senior corporate executives. All are under pressure to hit fixed growth targets quickly, no matter how. Consider this:

  • Politically directed lending accounted for 60% of loans in 2000-2001.
  • And in a 2002 survey, over 80% of polled bank employees said corruption in their branches was either prevalent or took place quite often.
  • New loan growth had been running at 15% in 2007.
  • At least 2% of loans made since 2000 have been reported as nonperforming. The proportion was as high as 60% for older lending. And a substantial portion of the loans that went out were issued to keep bad loans floating.

There was a bank bailout in the late 1990s and early 2000s that, according to the World Bank, cost China about 55% of GDP.

Bad loans for the major commercial banks (the big five plus the 12 joint-stock banks) stood at 6.63% of total loans at the end of September 2007, and rose to 6.74% by the end of December. This may seem like a small increase. But remember that this occurred during optimal times:

The economy grew at well over 11% in the 4th quarter of 2007. China was flooded with new money. Inflation increased faster than interest rates (which causes debt payments to decline relative to revenues and asset values). And loans expanded rapidly — which should push the NPL ratio down.

But that was last year.

In 2008, inflation was soaring! Energy costs went through the roof — squeezing the tiny margins of export-oriented manufacturers to nothing. Thousands of factories were forced to close their doors for good all over the country. And all the money corporate officers borrowed to play the stock market?

It’s gone! Evaporated! Gone up in smoke as the Chinese stock indexes fell 70% from their 2007 highs. And Chinese real estate speculation?

Real estate makes up about 25% of China’s fixed asset investment, which is in turn a major driver of economic growth. Land sales account for about 30% of local government revenues — and senior officials’ bonuses depend on economic growth indicators.

The increase in house prices in China’s 70 biggest cities fell from an average of 11% in early 2008 to 5.3% in August, only 0.4% above the inflation rate.

So developers have started to cut prices. This already has sparked protests — including some ransacking of offices — in parts of China from owners who have recently bought flats at a higher price. Most Chinese home owners have had no experience of price cycles… and have never seen prices fall before!

Now tie up the loose ends: Chinese investors pulled billions from personal savings and lost 70% of that money in the stock market… factories are going bust… and now real estate prices are seizing up.

In 2009, that trillion dollars of NPLs will hit the fan. People keep assuring themselves that the difference between Chinese banks and other banks is that Chinese banks are state-owned, and that fact makes a banking crisis in China nearly impossible.

They’re wrong.

Governments have had to bail out state-owned banks with taxpayers’ money. The Chinese did just that ten years ago. But if a state-owned bank were to go under, the consequences could be disastrous for the whole economy.

And China, at this point, is in no position to weather a downturn.