Economist Brad Setser (Director of Research, Roubini Global Economics) has authored a paper The Chinese Conundrum: External financial strength, Domestic financial weakness(link with free registration required alt link) describing the current state of the Chinese banking system. The paper focuses on the extent of bad loans and the possibility that the system is headed toward a crisis of some kind.
The Chinese government maintains a fixed exchange rate between the dollar and the Chinese RMB as a matter of (mercantilist) policy. Because this rate is below the market-clearing value, they must intervene regularly in the foreign exchange market to prevent it from rising, by purchasing dollars offered by Chinese exporters and selling them RMB. When they are no longer able to borrow enough RMB from domestic credit markets, they print the rest. This new money serves as a reserve asset for the Chinese commercial banking system. The banking system is then able to expand credit on top of this reserve. This is resulting in a massive credit bubble within China. An Austrian economist would look at the situation and see the initiation of a Misesean bank credit cycle, that must inevitably end in a bust. Setser, while not an Austrian (as far as we know), comes to a similar conclusion:
- This paper will argue that China’s external strength will not allow China to avoid a new round of costly non-performing loans, though the trigger that leads a new generation of bad loans in China will differ from the trigger of the Asian crisis. China simply is not vulnerable to a sudden withdrawal of external credit. In China’s case, trouble is more likely to emerge from a shock to the real economy than from a financial shock. Chinese banks have financed too much capacity chasing too little demand â€“ excess capacity that will eventually give rise to a new generation of bad loans. Investment growth is sure to slow at some point. Moreover, China’s overall economy is increasingly exposed to a global slowdown.
There is no realistic way the government of China can avoid picking up the bill for a new generation of bad loans from the post-2002 credit boom.
The mis-allocation of resrouces in China is exacerbated by the quasi-state ownership of most “commercial” banks. This means that they are even less subject to market discipline than are private banks operating in a fractional reserve banking system, as exists in most of the developed world. As one would expect, the system is riddled with bad loans and there are no negative consequences for the bankers or the bank shareholders.
Setser cites another researcher to the effect that 70% of loans made in 1992 and 1993 “ultimately failed to perform”. Setser explains how “government has often shifted the bad loans to Asset Management Companies (AMCs) rather than realize the likely loss immediately.”
Setser anticipates that, rather than allow banks to fail, the government will continue to bail them out one way or another:
- Despite ongoing improvements, the regulatory capital of the banking system still hinges largely on favorable accounting treatment of bad â€“ and potentially impaired — loans. Some state enterprises can pay interest on their outstanding balance, so their loans are not formally non-performing. But they are unlikely to ever repay the principal on their loans
- The Chinese government has been reluctant to raise the basic lending rate, in part because higher lending rates would jeopardize the health of certain state enterprises….There is a real risk that available credit is going to projects with strong political backing, not necessarily to those projects that pose the least risk to the bank.
The sadest thing is that the banking system has wasted the incredibly high savings rate of the Chinese population. Instead of savings being used to fund econmicaly viable investments, the savings are mostly wasted on projects that are either politically connected or simply not rational for the existing, though quite high, level of savings.
Setser writes that the Chinese credit markets are bank-centric. That is, the banking system is the primary conduit for allocating savings to investment. This conduit is fundamentally broken in two respects: one, that the banks are political entities, not economic firms, and as such face the problem of central planning: without private ownership they have no way of rationally allocating resources or assessing risk. I would expect the same outcome as in any centrally planned economy: political favoritism and massive waste.
Mises’ business cycle theory identified bank credit expansion as the cause of resource misallocation. China appears headed toward a credit bust, which will show up as a surge in non-performing loans in their banking system. The government can bail them out, again, as it has done several times in the past. But where does it get the money to bail them out? Setser explains the way that this process could reach an end game:
- The banking system as a whole faces precisely the opposite risk as the central bank: Over time, central bank bills will account for a larger and large share of the banking system’s total assets and, if PBoC bills continue to pay little more than the banks pay on their deposits, the banks’ profitability will decline.
Capital markets are not the only means of resource allocation. It may be the case, although I do not know, that a substantial fraction of Chinese economic growth is funded by private savings that never go through banks, or by retained earnings of private firms. To the extent that economic growth in China is funded by bank credit, Setser’s piece calls into question the Chinese “economic miracle”. Impressive GDP figures may overstate the extent of China’s actual growth because GDP counts the outputs of firms who owe their existence to phony credit.