William Gamble's  Instablog

Last May I wrote an article for Seeking Alpha called “Really Bad Banks”. The article was about the Chinese Asset Management Corporations (AMCs). These are basically repositories for toxic assets from the 1999 to 2001 recession. Well, they are still there.

In theory or at least according to the Wall Street Journal these AMCs got rid of their toxic assets a long time ago at 20 cents on the dollar, which I find wildly optimistic. Bondholders of some recent melt downs have been lucky to receive 3 cents on the dollar. Whatever the number is makes little difference. The toxic assets were ‘sold’ to the AMCs by China’s four major banks in exchange for bonds valued at the full face value of the loans. These bonds are still on the books of the banks at face value even though their real value is probably a small fraction of face.

Well the bonds are coming due. Rather than solve the problem, the WSJ reported that they are just being rolled over. According to the WSJ the ministry of finance has made noises about helping provide support" in paying interest on the bonds, in essence a government guarantee, hardly surprising in this era of government guarantees.

That’s not the problem. The problem is that these AMC bonds are potentially a big hole in the bank’s balance sheets, half of the “net assets” and nothing has been done to fix it for the past ten years. I wrote first about these things in my book, Investing in China in Chapter 3. Although Investing was published in 2002, the predictions are still accurate.

No doubt the present $1.2 trillion stimulus package in the form of loans from the banks will create a new a new crop of toxic assets, which will undoubtedly still be on the bank books in another ten years. Along with many other issues, the inevitable result will be slower growth for China.

A proposal to use behavioral economics as a way out of  the Afghanistan problem using an American comparative advantage.

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As I have written before China is a relationship based system. The market is based on government pronouncements. The stimulus was caused by a wall of money from banks, which was misallocated, because it was assigned by the government through the banks to state owned businesses and local governments. Some went into the stock market and real estate markets. A lot was used to stockpile commodities. That is where Brazil comes in.
 
Brazil has had a higher percentage of exports of commodities to China and it has recently boosted its trade. Since we are far from high growth, the demand for commodities over the past few months has been driven by China. As China pulls back, so will the demand for Brazilian commodities.
 
Without the American consumer, the demand for consumption of Chinese goods will fall off and China will experience slower growth. Also look for massive dumping. And the complaints to the WTO are not coming from the US. The big filers are places like India and even Latin America.
 
I point out that all of my pronouncements have been correct. Look also for growing toxic assets within the Brazilian banking system. I have predicted this for months and the dominoes continue to fall. First Russia, then the Gulf, now Nigeria. The next will be China and Brazil. I can't confirm it. I do know they are there. It is typical of a state dominated financial sector. In Russia the state owned Sberbank has just been hit by a $180 mm embezzlement scheme. In China it was $780 million for I believe CCB.

During booms all banks make bad decisions. As Buffet says, you get to see who is naked when the tide goes out.  Brazil has been exceptionally lucky that the Chinese stimulus package kept commodities afloat while all other economies where collapsing. But as the Chinese economy deteriorates so will the economy of Brazil and with it bank loans.

 It has to do with information. Information has value. It is disclosed only for money or because of a legal disincentive. The conflict of interest between the state as enforcer of the legal disincentive and the owner of the bank will be decided in favor of the bank. So the state will cover it up as long as possible. There aren't any stress tests that I know of. Trust me. They are there.

The Chinese have put a $1.2 trillion loan band aid on the problem but it won't stop the hemorrhaging because American buyers are not going to pick up the demand and the Chinese cannot change their legal environment fast enough to increase their own demand from 35%. So the growth in the US will be slow but steady. While the economies of many EMs East Asia and commodities producers (ex India) will flounder.

Eventually the US market will recover as capital is reallocated to more efficient firms. Without an efficient legal system in EMs that cannot happen. The banks will never get rid of their toxic assets. Toxic assets a can only go if there is a way to collect collateral through foreclosure or bankruptcy. These do not exist in many EMs

As the pie shrinks, rent seekers have a larger incentive to use more stringent methods to take more. We are seeing this occur in China with Rio Tinto and Russia with Ikea, ArcelorMittal, and Telnor. The only thing that restricts rent seekers is the law. Eventually these issues will feed through to the larger economies as I have been predicting. Only India and Brazil that have relatively strong legal systems will be able to sustain higher growth rates although I believe that Brazil will be affected by China.