In his latest Email review, Michael Pettis at China Financial Markets discusses financial reform (actually the lack thereof in China), as well as an observation on China's Growth.
Pettis writes ....
Three months ago during their 2010 Q4 conference, the PBoC said that they believed that the global economic recovery would continue in 2011, although they acknowledged a great deal of uncertainty. The PBoC also said that stabilizing the price level was their top priority, and the central bank planned to control the “main gate” of liquidity inflows and to bring credit growth to “normal” levels.Duration Mismatch Everywhere
Chen Long at SWS notified me yesterday of a change in tone. In their 2011 Q1 conference earlier this week the PBoC said that the fundamental basis of the global recovery is not very solid. The central bank still acknowledges that stabilizing price levels is an important task, but they only refer to “managing liquidity efficiently”.
What does this imply? I suspect it means that policymakers are becoming a little more concerned with slowing growth and a little less concerned about domestic overheating. As I argued in the past few newsletters, growth may be slowing more quickly than Beijing would like, and combined with the very volatile external environment, I suspect they are going to be cautious about too much more tightening. We will see how many more interest rate hikes and reserve requirement hikes we are likely to get in the next quarter.
Whether or not we have reached the point in China in which investment is misallocated and debt levels rising is clearly a matter for heated debate – I think we have already passed that point – but clearly we are tending in that direction.
In the last ten years the combination of socialized credit risk, very low interest rates, state-directed lending and tremendous pressure on the part of SOEs and local and municipal governments to generate employment and growth in the short term has increased the probability that the Chinese financial system may be misallocating capital on a dangerous scale.
Aside from the many studies I’ve cited showing that profitability in many of China’s largest companies is substantially less than the value of the financing and other subsidies, and anecdotal evidence of unnecessary real estate and infrastructure projects, just imagine what would happen to banking deposits and stock prices if the government credibly removed all guarantees on loans extended by the banks, and furthermore removed interest rate controls. I suspect most investors and depositors would assume, correctly in my opinion, a surge in non-performing loans that would wipe out the banks’ capital base, and so would sell their stocks and withdraw their deposits.
The fact that this is unlikely to happen is irrelevant. It just means that the losses are hidden and transferred to the state, and via the state, to households. If that is the case, then since the banking system can no longer easily identify economically viable projects and is in fact wasting money, the usefulness of the bank-as-fiscal-agent model is much reduced. We need now to have banks in China that can correctly identify economically useful projects in which to invest and limit their credit growth to those projects.
This is, I think, pretty clearly the attitude of financial regulators at the PBoC and the CBRC. They are concerned about the pace of credit growth, which would not be a problem at all if credit were going to economically viable projects. After all, I would guess that the only significant systemic risks that banks take on are credit risk and maturity mismatch, and Chinese banks don’t have to worry about the latter (no bank runs).
As I see it financial reform in China really means four things, none of which have been seriously implemented:
1. Interest rates must be liberalized so that the true cost of capital is reflected in evaluating the worth of a project. All central banks intervene in interest rates, if only to smooth out seasonal and temporary volatility, but PBoC artificially sets the rates for all maturities at least 400-800 basis points too low. By keeping the cost of capital so low, it disguises the true cost to China of capital and permits investment in projects whose returns are simply not justified.
2. Corporate governance must be reformed, and this means in part a significant reduction in the number of projects whose risks are socialized. Borrowers and banks must act on economic rather than non-economic issues, and as long as risk is socialized – implicitly or explicitly – there is no need to worry about the riskiness of repayment prospects. Remember how a much milder socialization of credit risk, the so-called “Greenspan put”, distorted lending and investment decisions in the US.
3. The regulatory framework must be stabilized and government intervention should become much more predictable, at least on economic grounds. Investors should be in the business of predicting what economical value will be created, not what steps the government will take next.
4. Information quality must be sharply improved – macroeconomic information as well as financial statements. It is pointless to ask investors to make decisions about the future if they have poor or systematically biased information with which to work.
To take the last point first, I would argue that the National Bureau of Statistics and the People’s Bank of China have done great jobs in improving the quality of macroeconomic and financial sector data, but there still is a long way to go, especially in the quality of financial statements. In that sense, there has been some real reform of the banking and financial systems in the past decade.
On the other three matters, however, I would argue that there has been very little change at all, expect maybe some backward movement in corporate governance in the past three years. There is from time to time some talk about eventually liberalizing interest rates, but interest rates are as controlled as they have ever been (in fact real rates have declined in the past several months to seriously negative rates) and I don’t think anyone expects anything to happen soon on that front.
Banks compete heavily for deposits, but they cannot compete on price, and any attempt to get around the system – for example when banks offer gifts to attract deposits – is prohibited. Many would argue that the PBoC cannot liberalize interest rates now because if they did, and rates soared as they would be expected to do, we would see a surge in bankruptcies. This is true of course, but it is equally true that the longer we wait, the more difficult it becomes for exactly that reason.
Pettis describes problems at every central bank not just China. I note with interest his discussion regarding duration (maturity) mismatch that I discussed at length twice recently:
- Central Bank Authorized Fraud; Fractional Reserve Lending Problems Go Far Beyond "Duration Mismatch"
- The Next Borrow-Short Lend-Long Guaranteed to Blow Up Bank Lending Scheme; Citigroup, Chase, Bank of America CD Ripoff
Question of Stability
Pettis comments "The current Chinese financial system, even more than Japan, is clearly one in which the purpose of the financial system is to act as the state’s fiscal agent and in which banking stability is guaranteed by the state. It is also clearly one in which capital misallocation can become a huge problem."
Certainly misallocation of capital was a huge problem in the Anglo-Saxon model as well. We saw it spades during the DotCom and Housing busts, something Pettis admits. We also saw it in Greece, Spain, Ireland, Iceland, Portugal, the Baltic states, the UK, etc.
We too socialized the losses at taxpayer expense for the benefit of the wealthy. Places like Ireland, Spain and Portugal were especially hard hit. Taxpayers will continue paying a price for another decade.
Also note that the "stability" provided by the FDIC in which there were almost no bank failures for decades, came at the expense of thousands of bank failures at once. Was this a good tradeoff? I think not.
Allocation of Capital Over the Long Term
Pettis argues that in spite of the housing blowup the Anglo-Saxon banking model has done "a pretty good job in allocating capital productively over the long term".
Under the Greenspan and Bernanke Fed we have seen serial bubble after serial bubble with increasing amplitude of booms and busts. Moreover, I would question whether we have given sufficient time to say just how poorly the system has performed.
Many mistakes have been massed over as households shifted from one wage earner to two and as the baby boomer cycle progressed. We are now at a state where those boomers are starting to retire and the system is not prepared for the transition.
I do not think the credit bust has fully played out. Moreover, I strongly suspect the US will suffer another lost decade.
Therefore, I suggest the "long-term" to which Pettis refers has not yet happened and the decades since Nixon closed the gold window provide an insufficient window to judge.
Nonetheless, I would agree with Pettis that the perverted fractional reserve fiat-credit model we are in will likely be better over the long haul than any command economy. However, that does not mean the model is any good.
China's Starting Point For Growth
One advantage of starting with little infrastructure as China did decades ago, is that there is a huge supply of economically viable projects. China was able to grow without fueling inflation because the growth was backed by a solid expansion in productive assets.
That is no longer the case today as evidenced by vacant apartment, vacant malls, and even vacant cities. As a result, inflation has soared. China is clearly overheating.
Pettis noted his belief "that policymakers are becoming a little more concerned with slowing growth and a little less concerned about domestic overheating."
I am not in a position to disagree with Pettis on that belief. However, regardless of whether Chinese officials are "a little less concerned about domestic overheating" several facts remain
- Inflation is still huge problems in China whether there is lessened concern or not
- Chinese interest rates are too low
- Price for the malinvestment and unwarranted infrastructure building is yet to be paid
- China's growth is still unsustainable
- Peak oil is a limiting constraint
- China has the world's biggest property bubble and it will bust
For more on China's property bubble please see
World's Biggest Property Bubble: China's Ghost Cities Revisited; 64 Million Vacant Properties
Speculation, Investment Scandals, Fraud, and China's Hard Landing; Miracle of Chinese High-Speed Rail will be Reduced to Dust; Peak Oil Doomsday Clock
China and commodity bulls keep repeating the China growth story. It's important to consider the other side as presented above.
Mike "Mish" Shedlock
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