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China Loan Cascade Seen Worrisome

May 22, 2009

This year, China's banks have opened the floodgates of credit: between January and the end of April, $757 billion worth of new loans were dished out, equivalent to 17% of the GDP in 2008. As such, China's banks are enjoying a rate of growth that their Western peers would kill for. The increase in lending is the government's doing, since it has given banks the task of financing the infrastructure spending that forms a large part of China's stimulus package.
Looking to the medium- to long-term, however, analysts are beginning to air concerns about what effect such a rapid increase in lending could have on the quality of the banks' loan portfolios. A report released yesterday by Fitch Ratings highlights issues with the banking sector's $4.2 trillion corporate loan portfolio.

The worry arises from the fact that China's banks are increasing their corporate exposure at a time when corporate profits are declining. "Ordinarily, falling corporate earnings are met with tightened lending, but in China precisely the reverse is happening," said the report. This illustrates that "despite years of reform Chinese banks still retain an important policy function in upholding local enterprises". ... In the process of increasing the number of loans, it is more likely that money will be lent to commercially unviable projects. However, the banks don't see this as a problem, since there is an implicit assumption that any coming losses will be paid for by the government. - FinanceAsia

Dominant Social Theme: Calm down folks, nothing to fear here ... just watch how well we handle these things!

Free-Market Analysis: It's funny to read that Fitch is expressing concern. It is about 20 years too late. China has been experiencing growth in the area of 10 percent per year (versus two or three percent in the West during the best times) and this sort of expansion just hints at the bubble that may have blanketed China and positioned it for an explosive monetary deflation. If and when China deflates, the world will cringe.

In the West, as we have pointed out before, the banking industry looks like a real business (though, it's not) - and Fitch is trying to apply that paradigm to China. Western regulatory necessity demands that there be independent assessors of capital exposure. And Fitch would like nothing better than to treat Eastern banks like Western ones. You see, the principals of Fitch have grown wealth by providing their "credit" assessment services, even though it means little in the central banking era. None of the ratings agencies, for instance, anticipated the economic crisis or predicted that the entire top rung of Western commercial banks would face ruin in late 2008. In fact, so long as governmental and quasi-governmental agencies have the legal brief to print as much money as they wish, putative controls and regulatory elaborations mean little or nothing. During a boom, the regulatory structures, public and private, are fairly well ignored. During a bust it doesn't matter much.

Once Western banks were serious institutions. Chinese banks have NEVER been entirely real businesses in our estimation - and no one is really trying to run them as such. That's not to say the Chinese don't understand paper-money banking. That great country ruined itself at least eight times with paper money over thousands of years, finally outlawing fiat money in the 1800s, apparently. (That didn't last long.) In any event, we don't think, over the past 20 years, the Chinese leadership has had the time or the inclination to dress up its banking industry. We figure that throughout the country the Chinese metaphorically built big granite buildings around very large printing presses and then let ‘er rip.

Yes, the Chinese leadership has stimulated the heck out of China. Generations of poverty have been eradicated in a decade for hundreds of millions of blue-collar and white-collar workers. There is a hardcore population of about 400 million impoverished farmers and workers that China has not yet been able to lift into the middle class, but 600-800 million Chinese are a lot better off than many previous generations.

One can look on this as a tremendous achievement on a number of levels. But no matter what one thinks, the only way you raise hundreds of millions out of poverty in a generation is by printing enough money to virtually drown a country, even one the size of China. All that money allowed China to build thousands of gigantic malls, factories, office buildings and suburbs. And to employ hundreds of millions.

The torrents of paper money, for the longest time, were sopped up by overseas demand for Chinese products - and China also bought trillions of dollar-debt from the West, which used up more money. Meanwhile, hundreds of millions of Chinese workers built every kind of gewgaw and gadget for Western consumption and the West, stimulated by the same monetary magic, bought what China provided. But now the West is not buying. And the Chinese leaders have turned the water cannon of monetary stimulation on the interior of the country. If the West will not buy, then Chinese will buy.

Conclusion: It is doubtful, however, that the Chinese leadership can substitute internal demand for external demand. And even if the leadership can, they will face, probably sooner rather than later, a population that - having achieved material success - now wants a political system that fulfills more than material needs. If an Asian bust finally occurs, especially a deep one, Western difficulties shall be much deepened as well. Maybe that's why China has turned into such a large net purchaser of gold. Memories of eons of paper-money problems linger still.
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