06 March 2011

China: Are We Seeing First Signs of Turnaround?

The news of last Friday about China was that in February Chinese banks issued less than 600 billion yuan ($91.3billion) worth of new yuan loans compared to over 1 trillion yuan of bank loans in January. This has been explained by a series of tightening measures that People’s Bank of China (Chinese central bank) has undertaken in order to curb rampant growth of lending and cool inflation pressures. Measures include reserve requirement hikes (see the Figure below), raising interest rates and especially the implementation of the dynamically differentiated reserve requirement system which requires different banks to set aside different levels of deposits with the central bank as reserves according to the individual banks' capital adequacy ratio levels and risk-control requirements.

Recent measures proved to be more effective than many analysts expected. Furthermore, if  new lending declines by more than 40% with one single month, it has to have an effect to the bubbling economy (see also our earlier post “What Has Kept China’s Bubble from Popping”). As an example, consider what will happen with the China’s second-largest real estate developer Poly Real Estate if it would not be able to refinance its loans (financials can be found e.g. from Bloomberg BusinessWeek). 

The company has not enough liquid assets to satisfy current obligations. Over the past five years but probably much longer, cash from operations has been negative and apparently so. Thus, cash has come from financing activities, more precisely from debt issued. If new loans are not available any longer and old debts cannot be rolled over, customer demand declines and investors are more cautious, there is a high probability for a default or restructuring case. The other leveraged companies that depend on the availability of new debt, would share the same fate. This clearly would show up in banks’ loan losses and lead to further tightening in money supply.

Based on the latest available financial statements (Q3 2010), the “Big Four” banks in China (Bank of China, China Construction Bank, Industrial and Commercial Bank of China, and Agricultural Bank of China) look rather strong: high liquid reserves, deposits clearly exceeding loans, loss ratios that have come down during the last years. The only thing that might be questioned is equity that forms less than 6% of total assets. However, compared to many European banks, equity ratio above 5% still seems pretty ok.

This strength may easily be illusory. Defaulting loans combined with considerably lower new lending would hit the banks' revenue base. Increasing perceived risks would quickly lead to higher funding spreads and narrowed interest margins. Credit losses would jump considerably.  More than 70% of the loans are to corporate customers the defaults of which tend to be highly correlated (meaning that if one company defaults, several others are likely to default as well). Furthermore, collateral market values would decline and, taking into account the earlier hikes in property prices (see Figure 2 below), not little but maybe by 30% or even more. Of course, a lot depends on what will happen on the main export markets of China, notably US. Since US imports are very much dependant on Chinese money, China’s troubles would quickly be reflected back in lower export demand. Losses would hit capital base of the banks, further increasing perceived risks and banks’ funding costs. 

To summarise, weak central bank’s measures do not help to cool the overheating economy and strong measures easily lead to downward spiral. The recent news of sharply declined lending may be a signal of turnaround in China’s economy. The current structure of financial system and economy is fragile indeed.

1 comment:

  1. Interesting. I have a great deal of interest in China as a home for my money, but felt obliged to stand aside recently, worrying about all kinds of things external, AND internal as above: the tendency is for late action by central banks to be big action and so create a fragile state of affairs that can easily turn nasty as you say in the above commentary.

    There is a case here for looking for faster acting measures and faster input of data to central banks so as to enable sensitive timely action.

    Thirdly, speaking all the time as a systems control engineer, they need the right instrument to transmit their messages to the economy so that all sectors respond proportionately - if that was possible.

    Currently there is no such instrument, but I am hoping to change that with my new lending structures.

    Then finally, they need to know which target to attack. I am not at all convinced that the prices index or the exchange rate should feature here, at least not as such.

    I am thinking about what I would select, and at present I have not made up my mind. But for waht it is worth here is some free thinking that may look foolish and it may be wrong.

    But given that their main istrument is interest rates and money supply, I would attempt to ensure that loan demand in the economy was rising at as near an appropriate speed as possible to meet the sustainable rate of economic growth at a sustainable rate of inflation.

    This comes down to the managing (targeting) the rate of growth of average incomes; with this target in the sights, loan demand should increase at that same target rate - or be permitted to since you cannot force people to borrow. And I would probably leave it at that, because all other input factors are more likely to be temporary and self correcting: e,g, excessive wage demands, oil price spikes (not within control anyway so don't try). But if it lowered loan demand that may be a reason to respond - not by raising rates but by lowering rates. That is opposite to waht central banks tend to think as they are watching inflayion which I think is the wrong target.

    I would make an exception if a factor created a high economic impact that altered the sustainable rate of economic growth AND was not going to reverse of its own accord in a reasonable timescale. But then again, I would need to considerr whether interest rate policy was the instrument that should be used to address that. You cannot aim at more than one target with one instrument.

    Hence I would probably target average incomes/earnings growth based upon it being approximately the sum of my inflation target plus the targeted rate of economic growth which comes to about the same thing.

    If shortages (eg of oil) led to a hit on economic growth I would see inflation rising but I would expect that to work through after a year without action being needed. But the damage to economic growth would justify an easing of credit and lower rates of interest.

    What is governing my thoughts here? Again engineering principles - if you keep on responding to all kinds of temporary inputs you may get way off the centre of the road you wanted to stay on.

    It might be different if the controls you were using were fast acting and precise and did not cause the housing sector for example to respond differently (much faster) from other sectors. Then any errors could be corrected quickly. But with economies if you do not look after number one - which is sustained confidence, the whole machine can take a course of its own.

    And responding late is a case in point where an over-correction to compensate for late action threatens that very thing.