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China: Slow Rot Or Sudden Crash?

The Chinese economy, like the economies of the rest of the BRICs, is slowing. Despite some neutral official numbers other numbers like industrial production and electricity consumption indicate that China's growth rate may have fallen below the target of 7.5%. In May Real estate values have fallen in a record 54 of 70 cities. One of the worst hit is the entrepreneurial Mecca, Wenzhou southeastern coastal Zhejiang province. There price tumbled by 14%. Large cities like Shanghai and Beijing also recorded smaller, but significant losses of 1.6%. In the first five months of 2012, real estate sales volume slowed by 9% compared to a year earlier. The central bank cut interest rates for the first time since late 2008, suggesting a weaker economy than forecast.

With all this bad news, China is still growing at a rate that any other country would envy. Business cycles have been part of every market in history. Have the Chinese found a way to prevent them?

Some people certainly think so. The famous Goldman Sach's economist, Jim O'Neill, the creator of the term 'BRIC', still sees China as a "beacon of light". O'Neill no longer believes that indicators like electricity consumption and industrial production, which have been so accurate in the past, still reflect the true level of China's economic activity. Instead he has switched to indicators of consumption, including monthly retail sales, which seem to support his forecast that China's economy is in for a "softer" landing. This thesis is quite common among economists and analysts. Any other thesis has probably not been priced in to global equity markets. A different reality could be quite a shock.

Other economists also do not see a 'hard landing' but for other reasons. The excellent economist Andy Xie points out that economic collapses occur only when creditors fear for their loans and try to collect from defaulting debtors. There is a major difference in different economies depending on their legal infrastructures. In places like the US, when a debt is not paid, the courts will happily enforce the contract. The creditor can satisfy the debt in cash, collect the collateral, foreclose on the real estate or force the debtor into bankruptcy. In other places like Japan, debts are not collected. The difference is between a sharp crash and protracted slowdown.

Although a crash or hard landing may sound worse than a slowdown or a soft landing, in fact the soft landing is worse. Unless creditors can clear the loans and reallocate capital to more efficient enterprises, the economy cannot restart. The country's economy becomes littered with zombie banks and mispriced assets. Growth comes to a halt, since the market is not allowed to function. The stagnation can last for over a decade.

This is what is occurring in China. Their 2008 bankruptcy law is unused. Defaulting debtors usually just leave town. Foreclosures are rare. Banks don't force developers to repay loans on time, so weak developers see no need to liquidate inventories at lower prices. So prices do not crash, but sales do.

Most of the loans did not go to developers or private businesses. Instead they went to local governments and SOEs. With slowing real estate sales, the main source of income for local governments is drying up. Rather than trying to collect from another branch of government, the state owned banks simply roll the loans over.

A perfect example of this problem has to do with the Asset Management Companies or AMCs. The AMCs were originally set up in China after the late 1990's meltdown in emerging markets. They were based on the very successful model of the bad bank used in the US and Sweden. In both countries the government recapitalized the insolvent banks. The shareholders were wiped out. The dud loans on the banks' books were transferred to bad banks. In the US, the bad bank was called the Resolution Trust Company and in Sweden it was called Securum. Both companies were given the task of administering the assets in preparation for sale at the highest possible price. The object of a bad bank was to eventually liquidate itself. Both were very successful. The Resolution Trust Company reduced the projected cost to the taxpayer of $300 billion to 'only' $90 billion in five years. Securum cleaned up Sweden's mess in the same amount of time and limited the cost to 2% of GDP.

In China they really didn't quite get the concept. In 1999 like most of the rest of world, the Chinese economy suffered a major recession. The Chinese banks are almost entirely state owned. The four largest include Bank of China, China Construction Bank, Industrial and Commercial Bank, and Agricultural Bank of China. After the recession these state owned banks were saddled with bad loans estimated to be about $430 billion or as much as 42% of all loans. To do something about it, the Chinese decided to emulate the US's RTC and Sweden's Securum. They set up four bad banks. These banks were called asset management companies (NYSE:AMC). There are four, each one corresponding to one of the big four state owned banks. Bank of China's AMC is called Dongfang. China Construction has Cinda. Industrial and Commercial Bank had Hurong. The Agriculture Bank of China has Great Wall.

The bad loans were transferred to the AMCs in 1999 and 2000 just like what occurred in the US and Sweden. However there was a distinct difference. In the US and Sweden, there was no consideration for the transfer. The RTC just guaranteed the deposits of the defunct S&Ls, nothing more. In China the AMC's 'bought' about $205 billion in bad loans at face value in 2002. Of course no bad loans are worth face value. In return for the bad debts, China's banks received 10 year bonds paying a taxable 2.25 per cent per annum.

The first transfers to the AMC did not stop the bleeding. So in 2003, the banks transferred another $120 billion to the AMCs in exchange for more bonds. This time at least the bonds were at a discount to face value. Still the AMCs were saddled with an annual interest bill of $3.6 billion.

When they were first set up, the AMCs were supposed to act like the other bad banks. They were supposed to try and get rid of the bad loans and close down. Collateral was to be found and auctioned off. Businesses were to be taken over and reorganized. Firms too far gone were to be put into bankruptcy. This never happened. Without a firm legal infrastructure, good public registries for interests in tangible personal property, intangible personal property and real estate, adequate documentation of the loans, it was difficult to determine who owned what, who owed what, where the collateral was and how to get it.

By 2005, the AMC's stopped trying to sell their bad assets to the outside world and just traded them between themselves. In one auction, the largest bidder for distressed assets of Cinda was its rival Great Wall. Rather than winding down as their assets were liquidated like the RTC and Securum, the AMCs made moves to become permanent. They now decided to become permanent profit-oriented financial institutions able to compete with investment banks in a wide range of services, but the bad debts remained.

Of course through all of this the AMC's bonds still remain on the bank's books. The AMC's state that they are profitable but their figures are never published. According to one expert, "These AMCs must by now be massively insolvent because all the better assets have been sold and they have used the proceeds to pay the interest on the bonds they issued." According to the Financial Times, "China's own state auditor said it was concerned that the AMCs were no longer able to pay the interest, let alone the principal, on the bonds they had issued to the banks." When the bonds came due in 2009, rather than trying to collect, the Chinese government just extended the maturity and rolled the debt over.

In 2009 to avoid a recession the Chinese government ordered its banks to open the flood gates. Lending for 2009, 2010 and 2011 more than doubled and one year tripled the amount lent in 2008. No doubt the level of nonperforming loans is enormous. The inefficiency of this lending is a massive drag on the system. It will slow the Chinese economy for years, but if no one bothers to collect these loans, will the Chinese economy crash?

Professor Michael Pettis has pointed out these problems for years. He understands the sclerosis inherent in the system, but believes that Beijing will prevent a slowdown by forcing banks to lend more to local governments for infrastructure projects. While this might be sufficient to stimulate the economy for a few months, eventually the loans for these projects or the bonds issued to finance them will end up in default as well.

Despite the predictions of these experts, there is a very strong reason to believe that China will not be able to engineer a soft landing. As central banks in the US and Europe are discovering there are limits to the ability of government to manipulate a market. Until quite recently the Chinese government held a tight grip on the banking system. Its control over the deposit and lending rate acted as a support to clean up the bad loans. But things change. Now there is a huge shadow banking system. This system is not only unregulated, its size and extent are unknown. It is estimated to be at least half the size of the regular banking system.

The concrete business is an excellent example. Families will buy a concrete mixer with vendor financing. But because of poor or unavailable records, the owners will double up on their debt by using the equipment as collateral for new loans. Then the mixing companies sell their ready mixed concrete on credit to developers. This overleveraged pyramid could collapse like a house of cards.

Recently the Chinese have tried financial reform to legalize the system and regulate it. But these reforms could make the problem worse. If government allows competition to the state system the guaranteed profits of its banking monopoly will disappear. State banks have to offer higher rates to attract depositors away from private competitors. This is occurring while the demand for loans has fallen, because of restrictions on real estate development and local government borrowing.

The real issue in China is that no one knows the extent of the problem. Europe has gone through about four stress tests to determine the size of their banking issues. Yet the uncertainty always ends up destabilizing the markets. In China information is tightly controlled. There is no independent free press constantly investigating or asking questions. The government controls most of the financial system and does not have to report to anyone. The size and extent of the shadow banking system and the underground economy can only be guessed at. In most emerging markets it is over 50% of the regular economy.

All governments try to manipulate the market. In the US the central bank, the Federal Reserve, had embarked on a series of 'stimulus' programs. These do have an effect at least in the short run, but there are also unintended consequences. By keeping interest rates low, they favor borrowers and more risk, but at the expense of savers and pension funds. The liquidity in one country doesn't stay there in a globalized world. The perverse effects may have different impacts in different countries which may come back to haunt the experts behind the policy.

The Chinese have the most manipulated economy anywhere. The distortions are massive. It is hard to predict when and in what form they will eventually make themselves known, but when they do, the landing will be very hard indeed.