Can China Weather a Downturn?

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.

Comments

[User 273466:]

Good insight in to the Chinese banking system. For years, the Chinese government is paying the bill for the ever growing bad loans which are not based on sound business principles, but on political interests of the provincial officials. To a large extent, the banks are used by government officials to their personal benefits. A substantial part of the bad loans end up in the pockets of corrupt government officials and businessmen. A hidden partnership has long existed between two groups to siphon taxpayers' money from state-owned banks to fatten their own purses. The Chinese government simply has no idea on how to solve this problem. For years, they are delaying or covering up this issue by pumping more money into this bottomless dark hole using taxpayers' money from the booming economy. Nobody knows when this bomb will explode.

2008 Oct 12 08:33 AM

[investor88:]

Useful article.

To those who follow the herd "China's un-ending double digit growth is panacea for distressed world", this article would be a wake up call. If the Chinese share index falls 70%, it is a harbinger of something amiss and we need to examine deeper. China may be in a bubble, however there is no way to be certain except to watch developments carefully going forward. This article provides some clues as to where the vulnerable points are in the Chinese economy.

2008 Oct 12 10:25 AM

[Feng:]

The Chinese banks don't have as high leverage as their Western peers have. In fact, they were not even close. In China buying a house/apt requires 30% downpay.

This articles reminded me of the old rhetoric from the Western officials who have been lecturing the Chinese bankers/officials for its banking system's lack of openness and NPL over the years. And it's very funny to hear that again.

China for sure will be impacted by the global slowdown. But China will continue to grow at >7% and I don't see a financial crisis in China's banking system in the short term.

2008 Oct 12 02:28 PM

[Urbane Gori...:]

This from a Wall Street Journal article:

Chinese steel cut worries Aussie mining companies
Matthew Stevens | October 14, 2008


----------------------...
Mind you, there was comment even then that China was merely indulging in a little bit of price negotiation theatre. Revelations by Fortescue yesterday that some of its September revenues has been recorded as debt in its quarterly cash statement will reinforce worries creeping through the mining sector.

Fortescue's issue is that "cash has not yet been received from confirmed bank letters of credit". And that would seem to indicate some of its customers are having trouble getting their hands on the US dollars necessary to support their credit lines.

If that is the case, Fortescue's customers are not alone. Around the globe, the deep freeze in capital markets is constraining the normal processes of business, be it securing currency swaps, raising commercial paper funding or securing interbank lending.

The thing is though we thought China might well be immune from these problems. It is not.

2008 Oct 13 10:30 PM

[Kahou:]

There are so many holes in your assumptions. First of all, Chinese pulled billions out of savings and lost 70% in the stock market...well, if someone lost 70%, someone gained 70%. The stock market is only back to the level it was 2 years ago!

As for NPLs, at least in residential mortgages, anyone who knows anything about Chinese consumers is that many still pay with all cash! The average LTV for a mortgage at origination is only around 40%. The max is 70%. House prices would have to fall 30% for people to even to start to consider defaulting on their loans. And as you pointed out, house prices are still UP 5% from a year ago on average!

"Ppl keep assuring themselves that a banking crisis is impossible"...Well these people are right! I don't see how your point that the Chinese government did indeed bail out its banks 10 years ago is an argument against that. If a country like America with its trillions of national debt can bail out its banks, why can't China, with trillions of f/x reserves and billions of current account surplus bail out its banks?

Furthermore, no matter how much the government spends as % of GDP to bail out banks, I think most who actually knows what they're talking about would agree that China is a far stronger country financially than any Western country.

Just look to history, even during the last financial crisis in 1997 which originated in Asia and brought Asian countries to their knees, China was able to shrugg it off. In the 10 years since, China is still growing 10% on average and millions are being lifted out of poverty each year. Today, the crisis is in Western banks and Western countries. Yet, China is many times stronger than it was 10 years ago. So I think you should worry about the US begging on their knees for Chinese assistance before you start talking about China not being in position to weather a downturn. FYI, China has enough cash to buy a large chunk of America, if America was for sale.

2008 Oct 18 05:52 AM