One of the big risks to the outlook for the Chinese economy is banks’ exposure to local government investment entities.  I posted on this subject a little while back, especially on the results of a China Banking Regulatory Commission’s (CBRC) study which showed that of the CNY7.7trln in loans to local government investment entities, CNY1.7trln has little hope of repayment.

The CBRC has now gone a step further and produced more detailed classifications of that CNY1.7trln in irregular loans.  A recent article in Caixin divulges the details.  I think it makes interesting reading for the insight it provides into the murky world of local lending.  This is my translation of all the different ways local lending can go off track:

‘There are eight classifications of irregular loans, as follows:

1. The loan is not in accordance with company law

2. The project has no stable source of revenue that could generate funds for repayment of the loan

3. There is no mortgage or guarantee underpinning the loan

4. The project is out of line with national economic and property sector policies

5. Environmental protection or land use approval documents for the project are irregular

6. Funds from the loan have been illegally channelled into the property or equity markets

7. Capital for the project is not in line with national regulations

8. The borrower made use of fradulent information to obtain the loans’

CNY1.7trln in loans to local government investment entities that provide fraudulent information, misappropriate funds for a punt on the equity markets, or plan to invest in more dirty and redundant industrial capacity. 

I think this classification speaks loudly for the kind of sharp practice that is accepted behaviour at a local level in many parts of China. 

It also speaks loudly for the difficulties faced by the central government in delivering its objectives at a local level - when local government, banks, and industry are colluding to pull in the opposite direction.

You can see the Caixin article, in Chinese, here.

Banking, Regional

Last year, CNY9.5trln in new loans propelled the Chinese economy through the global financial crisis, its growth trajectory bent but unbroken.  This year, it is time to count the cost, and with inflation in abeyance, concern has focussed on risks associated with the massive quantities of loans issued to local government investment vehicles.

The China Banking Regulatory Commission has recently concluded a review of the extent and quality of loans to these murky institutions.  The headline figure of CNY7.66trln in loans, with CNY1.7trln (23%) at danger of default has been widely reported. 

At first sight, CNY1.7trln in potential bad loans is nothing much to worry about.  With total loans in the Chinese banking system currently adding up to more than CNY50trln, even if all those loans do go bad it would still add just over 3% to the total for non-performing loans. 

That, however, is not the end of the story.  An article in the latest edition of Caixin has a few more details, revealing that CN2trln of the total are regarded as sound, with the local government investment platform well placed to repay both capital and interest.  But CNY4trln of the loans will only be able to be repayed if the borrower receives additional credit.  If some of those loans go bad too, that would add a few more percent onto the non-performing loans total.

Even with this extra wrinkle, it looks to me like annoyance rather than apocalypse.  I’m sure that the Chinese government would regard even 10% non performing loans on the banks’ balance sheets as a price worth paying for pulling the economy back from the brink of the financial crisis.  It is certainly a considerably smaller number than in the early 2000s, and even then the government was able to clean up the mess without too much difficulty. 

You can see the Caixin article here.

Banking, Financial Crisis, Regional

Following on from my earlier post on Currency Wars 2, this is my translation of the next few pages of the introduction, where Song Hongbing introduces the 18 international banking families he believes are pulling the strings of global finance, and directing the course of world history:

‘The Rothschilds - the ‘godfathers’ of international finance, whose influence spans 200 years

The trusted advisor of Germany’s Iron Chancellor Bismark - Bleichroder

From Cologne in Germany the Oppenheim family

From Hamburg in Germany the Warburg family

Originally from Bavaria in Germany but finding success on Wall Street, the Selingman family

Originally from Frankfurt, but making it big in the USA, the Schiff family

The Schroder family, originally from Hamburg but finding success in London and New York

The Speyer family, originally from Frankfurt

The Mendelsohns from Berlin

The Baring family from England, who were associated with the Rothschilds in the 19th Century

The Hope family from Amsterdam

Advisors to the French royal family, the Fould family

The Mallet and Pereire families, also from France

From Switzerland, the Mirabauds

Finally, the Rockefeller and Morgan families from the USA.

The international banking families are the most powerful group on the international scene.  Their thinking, to a great extent, determines the fate of mankind.  Wherever they go, that place prospers, wherever they leave, that place declines and falls.

With a motion of their hand, they can instigate a period of great creativity and productivity.  With another motion they can seize the resulting riches for themselves.

For the last 200 years, these families have strutted on the world stage, their position unassailable, their influence on the course of Western history impossible to underestimate.  As times change, the star of some families has plummeted from the sky, but the majority retain their power and influence today.

The world is always changing, but the essentials of human nature do not change.  For thousands of years, the thought of wealth has aroused in man feelings of greed and horror, the thought of power feelings of desire and resentment.  Whether it’s the games of political chess that have characterised thousands of years of Chinese history, or the financial machinations of Western history, the same mark of human nature is evident. 

China is no stranger to the history of mans grasping after power, but regarding mans grasping after wealth, we still have a lot to learn.  Let’s start the learning process by examining the lives of the world’s most powerful banking families.’

You can see why the Currency Wars books are so popular.  They combine a romantic insight into an interesting period of Western history, with a plausible explanation of the way the world economy works, and wrap the whole thing up as a lesson for Chinese people on how they can avoid being cheated by the evil global financiers.  Song Hongbing satisifies curiosity about Western history and the global financial system, at the same time as playing to the nationalist peanut gallery.

Banking, Culture, International Relations, US-China Relations

Song Hongbing, the author of Currency Wars, is not a man to rest on his laurels.  With one best seller under their belts, many authors would have taken a well earned rest.  But Song has been hitting the library, and, as a result, his new book has already hit the shelves.  Imaginatively entitled ‘Currency Wars 2′ the book develops Song’s theory that the Western world is run by a shadowy cabal of banking families, led by the Rothschilds.  This is my translation of the opening pages:

‘Who are the international banking families?

Take the Rothschild family as representative of the 17 main international banking families.  Beginning in Holland, England, France and Germany, they slowly spread their influence to Austria, Italy and the USA, finally ending in our own time with a financial network that spans the Western world.  In the 19th Century, as Europe reeled from the shocks of a capitalist revolution in France and an industrial revolution that swept across the entire continent, the balance between the great powers was disturbed, leading to the outbreak of war.  The international banking families shrewdly seized this historical opportunity, using the financial system to provide capital to expanding industry and to warring nations.  At the same time as these families amassed great wealth, they revealed their enormous influence in world affairs.

The power of wealth is expressed in the corruption of power, in the thirst for power, and in the desire for influence.  In the market for capital, the international banking families gradually exerted control over the channels through which capital and credit flows, till the entire game was played according to their rules.  From the monopoly rights given to the Bank of France by Napoleon to the financing of the Louisiana purchase.  From the hyper inflation of the 1920s to the rise of Hitler.  From the emergence of the US dollar as the global reserve currency to the financial crisis of 2008.  In all of these events, indistinctly, in the background, is visible the shadowy outlines of these international banking families, and their control of the channels of capital and credit.

The international banking families have humble origins, working through connections with people in positions of power they gradually established their economic strength, grasping control of the channels of distribution of capital, exerting control over commerce and industry, and from there beginning to influence government policy to favour their interests.  They use enticements that are difficult to turn down to influence everything from the direction of economic policy, to the appointments and promotions of military officers, from shaping the agenda for public policy, to controlling what information is available to the public.  Over 200 years of experience, the international banking families have matured.  In the past they wielded influence, now they exert control.  They are the power behind the scenes in Western society, riding roughshod over laws, governments, and rights, completing the metamorphosis from the possession of wealth to the wielding of power.’

I translated a part of the first Currency Wars in an earlier post (Currency Wars Translated), and it doesn’t seem that Song has moved very far from his original thesis.

I’ll try and come back and translate a little more of the first chapter in the future.

Banking, Culture, International Relations

How serious a problem is China’s property bubble?  King of the China bears Andy Xie thinks its pretty serious, and on Friday I had the chance to hear him presenting his views.  The main points from the presentation are:

‘The Chinese response to the financial crisis has followed that of the US.  But where in the US a financial meltdown required near zero interest rates to keep the banking system solvent, in China there was no problem with the stability of the financial system.  Very low interest rates were inappropriate for the Chinese economy.  With the Chinese banks motivated to lend to appease their shareholders in Hong Kong, and the property sector motivated to borrow by very cheap rates, a year and a half of very relaxed monetary policy have made the Chinese property sector bubble bigger.

Property in China is a government business.  Many property sector developers are owned by local government.  For those that are not, the cost of land and taxes are so high that they are effectively just middle men for the government.  Property is the most important source of government revenue

The government is caught in a vicious cycle.  Property prices rise, which means that property developers demand more land to build on.  To meet that demand for land, local government has to clear residents away from more and more areas.  Residents see that to buy a new home, they will need large amounts of money.  They demand huge amounts of compensation - Xie mentioned a household in Shanghai that received CNY1mln compensation for being forced to leave a 10 metre square apartment.  The government is now massively in debt as a result of the high cost of compensation, and so needs to sell the land on at high prices to recoup its costs.  Property developers buy the land at high prices, and so can only turn a profit by selling high end property at high prices, and the cycle continues.

Land is now so expensive that only state owned enterprises, that face no real budget constraint, are willing to buy.  With state owned enterprises the only buyer, the property sector is just a series of transfers between different parts of the government.  State owned banks lend money to state owned enterprises who use it to buy land from the state. 

Local governments are waiting for private sector property developers to buy land.  Their attitude is that private property developers only exist with their approval, so their money is really government money, and can be extracted at will.  Private property developers might look big and powerful, but according to Xie they are being squeezed by the government, with profit margins of 50% a few years ago, 25% today, and non-existent if developers are forced to buy land at today’s high prices.

This state of affairs can’t continue for much longer.  In Hong Kong, property is expensive but other taxes are low.  In China, property is expensive and other taxes are high.  The middle class - grauates of the 1990s who are now earning CNY10-15K/month - are getting squeezed.  This is the most able and vocal of China’s social groups.  Xie pointed out that journalists are also in this group, which is why there is so much negative press attention on the housing issue.

Inflation will be the pin that pricks the bubble.  Xie believes that China is entering an age of high inflation.  Xie pointed out that in the 1950’s, Chaiman Mao encouraged families to have multiple children to boost the Chinese population.  ’Hero mothers’ that had 10 children could even meet Mao.  In the 1970s, the children of the resulting baby boom hit their teenage years.  The result was the cultural revolution.  In the 1990s, they entered the labour market and excess labour supply kept wages (and inflation) low.  Now they are leaving the labour market, wages will start to rise and with them inflation. When inflation returns, the Chinese government will be forced to raise interest rates.  When borrowing becomes more expensive, house prices at today’s high levels will not be sustainable, and there will be a sharp correction.  Xie’s intuition is that this will come in 2012.’

Interesting stuff.  I had not heard the argument about compensation for relocation before, and don’t think it is as important as an explanation for high land prices as local government’s need to close the gap in their finances.  But in general, a compelling account of the drivers and motivations of the key players in the most important sector of the Chinese economy.  Also fascinating argument about the role of demographics and Mao’s ‘hero mothers’ in China’s recent social and economic history.

Banking, Financial Crisis, Fiscal Policy, History, Labour markets, Monetary Policy, Property, Social Policy

Local government debt is back in the headlines.  Today, I attended a presentation by Prof Victor Shih, who has just finished some fairly extensive research on the debt taken on by local government investment entities.

The starting point for Prof Shih’s argument is that last year’s massive economic stimulus was massively underfunded by the central government.  Local governments were left with colossal spending obligations but no obvious way to pay for them.  The solution for many local governments was to set up local government investment entities to borrow the money on their behalf.

The process is quite simple.  Local governments set up a financial company and give it some land.  Using the land as collateral, the financial company, which is wholly owned by the local government, borrows money form the banks.  That money is used to fund local government’s investment projects.

Prof Shih’s calculations suggest that money owed by these finance vehicles now adds up to around CNY11trln - or about 1/3 of Chinese GDP.

This money will now have to be paid back.  If, as seems likely, the revenue stream from the projects in which it has been invested are not sufficient, some other way will have to be found.  Land sales, higher taxes, or reliance on a bail out from the central government are the most likely options.

The government might have kept the majority of economic stimulus spending off balance sheet, but the bill will still have to paid.

Chinese economists are also alive to the problem of local government debt.  These are the main points from a recent blog post by Guo Tianyong:

‘Many of the projects funded through local investment vehicles are not commercially viable.  A visit to local areas revealed projects that will not generate revenue for 5 or even 10 years.

That will mean that responsibility for repayment falls back at the door of local government, which has acted as guarantor of the loans.

If the real estate market wobbles and land prices fall, the repayment ability of local government will also come into question.

Properly understood, local government finance risk and bank credit risk are now two sides of the same coin.

A more sensible approach for the future would be for local government to invite bids from the private sector to build local infrastructure.  If projects are commercially viable, there should be no problem.  If the project fails, the private sector is left with the debt, and its no burden for the government.’

You can see Guo Tianyong’s blog post here.  Prof Shih’s research has been getting a lot of play and you can see a summary of it here.

Banking, Financial Crisis, Fiscal Policy, Infrastructure, Property, Regional

Guo Tianyong is a professor of finance at the Central University of Finance and Economics and an expert on China’s banking industry.  He also used to work for the People’s Bank of China’s Yantai branch.  This is my translation of the main points from his recent blog post on the question of capital adequacy ratios (CARs) at China’s banks:

‘Very high levels of lending by China’s banks in 2009 was an essential part of the stimulus, but they also meant that CARs have taken a hit.  Continue lending at elevated levels in the first few months of this year has made the problem more severe.

To ensure the stability of the banking system, the banking regulators require that small banks maintain a CAR of 10% and large banks a ratio of 11%.  The regulator also moved to control the purchases of banks’ subordinated debt by other banks.  This raised the cost of capital for banks and made it harder for them to meet their CAR.

The CAR puts pressure on banks’ ability to make new loans.  With banks’ business model built around profits from lending, and bank loans the main source of finance for most businesses, this is a serious issue.  There are various routes banks can take to control their CAR.  They can use their own profits, sell shares, bring in new strategic investors, or issue subordinated debt to increase the numerator of the ratio.  They can also take steps to reduce their loans - for example securitising loans - which would reduce the denominator.

First, let’s consider ways to increase capital - or raise the numerator of the CAR.  Issuing shares is often a preferred method of raising capital, but the cost of capital raised in this way is rather high.  Issuing debt has also been a preferred method, but the clamp down on the issuance of subordinated debt has raised the cost.  With high costs to selling shares or issuing bods, bringing in strategic investors seems like an attractive option.  Bringing in strategic investors keeps the cost of capital down, strategic investors can bring in new ideas and expertise, and with the government’s controlling share in many banks still close to 70%, there is considerable scope to bring in new investors without even coming close to losing majority control.

Second, banks can improve the management of their loan books - reducing the denominator of the CAR.  Loan transfers and securitisation are important routes to managing the CAR.  But because currently only other banks participate in the market for loan transfers, and because of lack of transparency in transactions, the credit risk in loan transfers can only shift within the banking system.  Securitisation of loans has greater potential to help banks optimise their loan books, meet their CAR, and bring greater stability to the banking system.

In the final analysis, however, neither raising more capital nor optimising loan structure gets at the heart of the problem.  Chinese banks’ profit model is based on issuing ever increasing quantities of loans. Inevitably this leads to an erosion of the capital base.  Issuing more loans and then raising more capital to bring the CAR back to the required level is not a sustainable business model.  China’s banks need to move toward a business model that does not rely on ‘eating capital’.

Banks need to develop intermediary services as a source of revenue.  Foreign banks get 40% of their revenue from intermediary services, for domestic banks that number is just 15-20%.  Individual banks need to develop and compete on the basis of their own unique competences, competences that meet needs in the market.  Finally, banks should develop a model of capital replenishment that is counter-cyclical, using profits from the good times to build up their capital base so that they have a buffer for the bad times.’

You can see the blog posting here.

Banking, Monetary Policy

Currency Wars is a very popular book in China.  It’s author, Song Hongbing, has tapped into a rich vein of nationalism and suspicion about the West, especially the role of US investment banks.

His argument, which is entirely specious, is that  a cabal of investment bankers have dictated the course of world history since the Napoleonic wars, are the gatekeepers to the US presidency, and - should they be allowed into the Chinese economy - would bring the current benign social order crashing down to serve their own evil interests.

I discussed this book with a Chinese friend who works in the financial sector and he said that its popularity was an interesting social phenomenon.  But the author was so obviously a crazy conspiracy theorist that his work had no influence at all in policy or finance circles.

Finance graduates might be able to see through the smoke and mirrors, but the book had a major influence on public opinion, and a follow up - imaginatively entitled ‘Currency Wars II’ - has just hit the book stores.

This is my translation of the main points from a chapter in the first Currency Wars, focusing on the potential evils of allowing foreign investment banks into the Chinese economy, and the benefits of returning to gold as the basis of the international financial system:

‘Control of money supply is key to control of the economy.  You might think that foreign banks have no way of influencing the money supply in China, that the People’s Bank of China controls the supply of money.  In fact, by issuing loans, banks influence the money supply.    Let foreign banks into China, and they would deliberately manipulate the money supply, using excess supply to cause inflation, and restricting supply to cause deflation, crippling the economy, as they have done to destabilize foreign countries throughout history.

The US is already using its influence to disrupt China’s money supply.  By manipulating its trade deficit with China, the US can increase the money supply in China, and that can lead to bubbles in the property sector and equity markets.  China’s Central Bank can only control the problem by selling bonds to soak up the additions to the money supply, but this increases the national debt.

These are the currency wars, and as long as the US dollar is the main international currency, China has no way to fight back.  Only when gold again becomes the basis of the international currency system can we have an independent, fair, and harmonious financial system.’

Of course, there is a kernel of truth in all this.  Hedge funds, many of them US hedge funds, were instrumental in destabilising Asian economies in the Asian Financial Crisis.  China’s trade surplus, combined with the fixed exchange rate, does cause problems for the People’s Bank of China.  The role of the US dollar in the international financial system is beneficial to the US and harmful to its creditors.

But the way all of these facts is put together is completely wrong.  It’s not foreign banks who are creating a problem in China’s money supply, it is domestic banks.  It’s not the US that is forcing China to run a trade surplus with a fixed exchange rate - it’s a deliberate part of China’s development policy.  And a US dollar based international financial system might have its flaws, but the world moved away from the gold standard for a reason - because it tied money supply to the availability of a scarce commodity - and a return is not on anyone apart from Song Hongbing’s agenda.

Banking, Exchange rate, International Relations, Monetary Policy, Trade, US-China Relations

I attended a financial sector conference in Beijing last week.  One of the more interesting speeches was from People’s Bank of China assistant governor Guo Qingping.  Aside from the usual reassurances that the government would not move away from its ‘appropriately relaxed’ monetary policy, he also offered some reflections on the monetary policy transmission mechanism.

In Guo’s view, the tendency of the banking sector to lend to large state owned enterprises at the expense of loans to small firms not only damages economic efficiency, it also damages the effectiveness of monetary policy.

The reaons he gave, as far as I understood it, is that if small and private firms are not reliant on banks for credit, they are not affected by changes in monetary policy, or at least are affected only indirectly as it impacts their cost of borrowing from other sources.  That means a large section of the economy is unresponsive to the interest rate as set by the PBOC.

He might have added that as many state owned enterprises are quite profitable and have large amounts of retained earnings, they are not completely reliant on banks for credit either - so monetary policy loses its effectiveness even to control the development of the state sector.

The implication of Guo’s speech is that the banking regulators are going to be pushing for banks to broaden their activities, lending more to private sector and small and medium sized enterprises.

But little of this has been evident in the lending so far this year - which has been heavily biased toward the state owned sector.  And with projects now underway at state owned firms that will require top up funding if the borrower is not to default on its debt, the availability of funds for lending to the private sector may be limited for the forseeable future.

Banking, Monetary Policy

One thing that is clear from the events of the last year is that banking is a risky business.  If lots of people who have borrowed from a bank default on their loan at the same time, the banks themselves can go bankrupt.  When banks go bankrupt, everyone is in trouble.

To try and make sure this doesn’t happen, regulators around the world require banks to hold capital equal to a certain amount of their assets.  Typically, that ratio is 8%.  So if China’s banks make CNY100 in loans they would be required to have at least CNY8 in capital.

The next question is what counts as capital?  In China, till now, one type of capital that banks relied on is debt they have sold to other banks.  Bank 1 sells debt to Bank 2 and Bank 2 sells debt to Bank 1.  Both banks can claim their capital base has increased (and can therefore make more loans).  The problem is that, in fact, the total capital in the banking system has not changed, all that has happened is that the banks have shuffled it round a bit.

Clearly this practice is not a healthy one for the stability of the banking sector.  The China Banking Regulatory Commission (CBRC) has a long standing objective of clamping down on it.  But in the face of the economic slowdown, with bank lending playing a key role in the stimulus, the State Council had little time for any regulatory changes that might dent the banks’ lending ability.

Now, with the worst of the crisis apparently over, the CBRC has been emboldened to come forward with a regulation to deal with the problem.  Caijing has managed to get hold of a copy of the regulation.  This is the main points from their recent article on the subject:

‘After a long period of uncertainty, the dust has settled on the question of how to deal with banks’ cross holdings of subordinate debt.  The CBRC has decided to follow a method of ’separating the old and the new’.

Any subordinate bank debt issued after 1st July 2009 cannot be included in the purchasing banks’ calculation of their capital base.

The fact that the CBRC is not requiring the banks to completely eliminate their cross holdings of subordinated debt will remove some of the pressure on the banks’ capital adequacy ratio.

One bank insider said that ‘the fact that new holdings of subordinated debt cannot be included in banks’ calculation of capital will have a large effect on the market, banks will now have little incentive to buy subordinated debt, and this will have an impact on the structure of their capital base.’

A source close to the CBRC said that sorting out the cross holdings of debt, and reducing banks’ reliance on that method to replenish their capital is a long standing objective of the CBRC and has not changed.

The regulation, issued on 25th August, adopted the ’separate old from new method’ not the ‘grace period’ approach. The grace period method was favoured by the banks and would have given them a certain period of time to reduce their relaiance on subordinated debt.

During the consultation period on the regulation, the banking industry said that excluding all cross holdings of subordinate debt from the capital base would reduce their capital adequacy ratios by 1%.

In the first 8 months of 2009, banks issued CNY231.65bn in subordinated debt, three times the CNY72.4bn issued in all of 2008.  According to notices from listed banks, there were plans to issue a further CNY238bn.

According to the source close to the CBRC, the regulator took account of the banks’ concerns, recognising that requiring the banks to eliminate all their cross holdings of subordinated debt would lead to operational problems.

A further requirement of the regulation is that issuance of subordinate debt cannot exceed 25% of a bank’s core capital.

The regulation also imposes a more stringent planning requirement, requiring bank directors to discuss and approve a plan for their capital base which must then be reported to and approved by the CBRC.’

China’s banks are clearly in much better shape than their peers in the US and EU.  But the lending spree so far this year will certainly be a strain on the adequacy of their capital base.  With the door to an easy replenishment through the issuance of subordinated debt now closed, the banks will have to think of other methods to meet the regulatory capital adequacy requirements.

Here’s the original Caijing article.

Banking, Financial Crisis