First, welcome to Michael Pettis. Michael is a professor at Peking University’s Guanghua School of Management, where he specializes in Chinese financial markets. He is also Senior Associate at the Carnegie Endowment for International Peace. Second, this is an excellent article that provides insight into the thoughts of the Chinese people. – Ilene
Courtesy of Michael Pettis at China Financial Markets
Three weeks ago China Daily published a pretty funny article about a recent survey on credibility that had taken place in China. According to the article,
At a time when shamelessness is pervasive, we are often at loss as to who can be trusted. The five most trustworthy groups, according to a survey by the Research Center of the Xiaokang Magazine, are farmers, religious workers, sex workers, soldiers and students.
A list like this is at the same time surprising and embarrassing. The sex business is illegal and thus underground in this country. The sex workers’ unexpected prominence on this list of honor, based on an online poll of more than 3,000 people, is indeed unusual.
It took the pollsters aback that people like scientists and teachers were ranked way below, and government functionaries, too, scored hardly better. Yet given the constant feed of scandals involving the country’s elite, this is not bad at all. At least they have not slid into the least credible category, which consists of real estate developers, secretaries, agents, entertainers and directors.
I am not sure what secretaries have done to get themselves such poor rankings (could they mean party secretaries?), and I am not sure what kind of directors they mean (movie directors? managing directors?) but not everyone found this survey funny. Last week a columnist in the People’s Daily had this to say about the same survey:
In recent years, China has already paid a high price for the prevailing credibility crisis. The annual losses caused by bad debts have reportedly amounted to about 180 billion yuan, and the direct economic losses induced by contract fraud each year is also up to 5.5 billion yuan. Besides, shoddy and fake products contribute to another great loss involving at least 200 billion yuan. Generally, credibility crisis would cost China as much as 600 billion yuan every year.
The shortage of credibility is not only seen in the market transactions, but in the officialdom as well. Corruption in any form is about to erode the faith of the general populace in authorities and officials at different levels.
Perhaps, the survey result can just give a restricted description on China’s credibility status, or people can take it with a grain of salt. But it did portray a picture of the spiritual outlook of today’s Chinese society, with money as the overriding motive. It is this that especially deserves attention.
Although I fully accept that sex workers are more credible than government officials, I am outraged that teachers are so much lower on the list than prostitutes. Since bankers have become so out-of-fashion recently, I have been vociferously denying my banker roots and assuring everyone that I am and always have been a professor, but now it seems that in order to get any respect I am going to have to buy tight jeans and a leather jacket and try to convince friends that I actually make my living turning tricks. At my age it won’t be easy, but probably a lot easier than convincing people that I am a farmer (unless it’s on a plate I can’t tell a potato from a chicken) or a priest.
Speaking of low credibility, last week the South China Morning Post reprinted a New York Times article on continued losses in the US banking system:
Banks in the United States are now losing money and going broke the old-fashioned way: They made loans that will never be repaid. As the number of banks closed by the US Federal Deposit Insurance Corp has grown rapidly this year, it has become clear the vast majority of them had nothing to do with strange financial products that seemed to dominate the news when the big banks were nearing collapse and being rescued by the government.
…Staying away from strange securities has not made things better. Jim Wigand, FDIC’s deputy director of resolutions and receiverships, says lenders that are failing now are in worse shape – in terms of the amount of losses relative to the size of the banks – than the ones that collapsed during the last big wave of failures from the savings and loan crisis.
The severity of the current string of bank failures shows many of the proposed remedies batted about since the crisis began would have done nothing to stem the closures. These banks did not go beyond their depth with derivatives or hide their bad assets in off-balance sheet vehicles. Nor did their traders make bad bets; they generally had no traders. They did not make loans they expected to sell quickly, so they had plenty of reason to care that the loans would be repaid.
What they did do is see loans go bad, in some cases with stunning rapidity, in volumes that they never thought possible. That so many loans are souring is a testament to how bad the recession – and the collapse in property prices – has been. But looking at some of the banks in detail shows they were also victims of their own apparent success. Year after year, these banks grew and took more risks. Losses were minimal. Cautious bankers appeared to be missing opportunities.
Besides the fact that this suggests that it is not just in China that prostitutes may be more respected than bankers, I found this article very interesting for two reasons. The first is because it suggests pretty clearly that green shoots notwithstanding, we are far from an end to the banking crisis in the US (and, I assume, elsewhere), and it is going to take a while longer before bank balance sheets are robust enough to expand. All of this will adversely impact both consumer spending and business investment for the foreseeable future.
The second reason I found this article interesting is that I think it supports an argument I have been making for a while, that the current financial crisis was not “caused” by derivatives or complex securitizations. It was caused, as nearly all financial crises in history have been caused, by banks being forced to accommodate excess liquidity and taking on too much risk – something they must do when monetary conditions are too loose for too long. Making opaque investments in derivatives and complex securitizations is, of course, one way to take on too much risk, but it in no way caused the excessive risk-taking.
When observers insist that it was the deregulation and fragmentation of the “Anglo-Saxon” financial model, and the ease with which Wall Street was able to innovate financially that caused the big losses, I can sympathize only with the observation that we paid an awful lot of money to some very smart people whose great contribution to society – a newer kind of exotic swap, let’s say – was not terribly valuable. But it wasn’t the system itself that caused the crisis. After all one of the main reasons for the prestige of the “Anglo-Saxon” model was that its greatest competitor, the very highly regulated, rigid, highly integrated and almost innovation-devoid counterpart, the Japanese banking system, collapsed so frightfully – if less spectacularly – after 1990, and now the article cited above suggests that a lot of banks even in the US also managed to collapse in very old-fashioned ways – something Hyman Minsky would have predicted would happen even without the help of dastardly derivatives.
This is one of the reasons why I take it almost as an article of faith that the massive expansion in Chinese credit will lead inevitably to a massive expansion in bad lending, and that the “great” economic data is actually worryingly weak given the amount of resources, especially banking resources, expended to produce those numbers. Too many regulators here who should know better (and too many foreign observers, too) are convinced that Chinese banks are safe from losses because Chinese banks were too slow to understand complex financial instruments and so took on very limited (and often ill-advised) exposure to these instruments, and because they continue to be sharply constrained in their abilities to do so. In fact the biggest losses are always caused by exposure to real estate or lending against insufficient future cashflows, whether these come in the form of old-fashioned loans or in the form of total-return swaps on sub-prime mortgage tranches.
Interestingly enough, it seems that recently there has been an increasing chorus of warnings within China about mounting risks in the banking system, and more generally about problems in the fiscal stimulus package. For much of the year the Chinese fiscal stimulus has been described – as I heard repeatedly during my testimony last February in Washington, to my surprise – as the “gold standard” of stimulus packages, but over the past two months the number of worriers seems to have expanded dramatically. The Financial Times in an article earlier this week put it this way:
Official readings of industrial production, fixed investment, power consumption and gross domestic product all show a strong revival, while equity and property prices have soared in recent months. There have even been signs of a recovery in exports, although these are still about one-quarter below the levels of a year ago.
But a growing number of economists and officials say the positive growth data hide worrying structural imbalances and the government’s response to the crisis may only have postponed an inevitable reckoning. With the world looking to China as a beacon to lead the way out of economic gloom, a second downturn would have a big impact on global confidence, not to mention commodity prices. “There is such a thing as good 5 per cent growth and bad 8 per cent growth,” according to one senior adviser to the government. “We worry that what we’re seeing falls more into the latter category.”
The concerns are the ones I have been discussing here for the past year – the fiscal stimulus is exacerbating the domestic imbalances, non-performing loans are certain to rise dramatically, and there is little evidence that consumption is going to grow organically quickly enough to absorb Chinese capacity. The article goes on to say:
“The main concern we have now is that a tremendous volume of loans was extended very rapidly to the corporate sector at a time when corporate profitability was declining,” says Charlene Chu at Fitch Ratings. “That would suggest there will be some significant asset quality problems down the road.”
While state-owned enterprises have been inundated with loans from the state banks, economists worry too that China’s vibrant private sector has been largely left to fend for itself. “The fiscal and monetary policy response to the crisis has mostly benefited the largest enterprises and biggest projects,” says Wang Yijiang, professor of economics and human resources management at the Cheung Kong Graduate School of Business in Beijing. “The small and medium-sized enterprise sector provides 75 per cent of the jobs to China’s urban workforce but now it is shrinking for the first time in 30 years of economic reforms.”
Not surprisingly, it was Chinese economists who were quicker to sense the problems than most foreign economists and observers, whose optimism has generally been more robust. For example the highly respected Yu Yonding, an economist with the Chinese Academy of Social Sciences and a former member of the PBoC’s monetary policy committee (who told me three months ago at a conference at Tsinghua University, during which I presented my now-standard argument that China’s development model was about to fail, that the problem with my analysis was that I am much too optimistic about China), had an OpEd piece in today’s Financial Times that repeats the familiar litany:
China has rebounded from the global slump with vigour. In the second quarter, its official figures showed year-on-year gross domestic product growth of 7.9 per cent. Those who doubt the quality of China’s macroeconomic statistics can check its physical statistics: in June, electricity production increased 5.2 per cent, reversing the falls of the previous eight months. It is almost certain that China’s GDP will grow more than 8 per cent this year.
But there are problems looming. More investment thanks to China’s rescue package threatens to worsen the already severe overcapacity, while the cash injection is already creating asset bubbles.
Dr. Yu warily suggests specific policy recommendations when he says that “China’s rebalancing is more the result of the global economic crisis than of policy initiative. China could do more to eliminate both internal and external price distortions to reduce its dependency on external markets.” Eliminating these price distortions involves, I suspect, revaluing the currency, liberalizing interest rates, and doing the other things that I and others have suggested would address the root imbalances between consumption and production, albeit at the expense of accelerating unemployment in the short term.
Premier Wen himself has been actively warning about trouble ahead. Earlier this week the South China Morning Post had this to say (although I wasn’t able to find any reference in the local press):
Premier Wen Jiabao warned the mainland faces new economic problems and said Beijing would stick to its stimulus plan because the recovery lacks a solid foundation, according to comments reported yesterday. Mr Wen cautioned against being “blindly optimistic” despite improvements in the economy, according to a statement on the State Council’s website.
“[The economy] still faces many new difficulties and problems,” Mr Wen was quoted as saying during a visit to southeastern China that ended yesterday. “There are still a lot of unstable and uncertain factors ahead and the economic situation ahead is still very grave, although both the world economy and the national economy are making positive changes now.” He cautioned that the effects of some government measures might fade while others would take time to show results, the cabinet statement said, without elaborating.
Meanwhile there is more and more talk about attempts by the PBoC and the CBRC to limit and control the banking expansion. The CBRC has apparently been tightening capital adequacy requirements and is reportedly going to disqualify subordinated debt from being counted as bank capital. Chinese banks have been encouraged to raise their capital ratios, and one of the ways they have done so is by selling subordinated debt – there was about $30 billion issued in the first half of 2009, versus about $10 billion in 2008. But much, if not all, of this subordinated debt was purchased by other banks, so it always made a lot of sense to eliminate bank subordinated debt from any notion of a capital cushion. In a banking crisis, just when banks need capital, this asset immediately becomes worthless.
Yesterday’s Financial Times had an interesting little piece on all this:
The banking regulator last month told lenders to raise reserves to 150 per cent of their non-performing loans by the end of this year, up from 134.8 per cent at the end of June. A communiqué last Friday canvassed views on deducting holdings of other lenders’ subordinated or hybrid debt from supplementary (non-core) capital. Then there are softer measures, such as reminding banks to ensure that loans for investment in fixed assets actually end up there. The central bank also has raised money-market rates to drain liquidity. The effects of all this can be seen in the M2 measure of money supply, which was up 28 per cent at the end of July, year on year, but which fell 3 basis points from the end of June.
This is how China tightens: imperceptibly, by degrees. As Goldman Sachs points out, China’s last tightening cycle began not when it raised rates in November 2004 but 18 months earlier when the central bank began to issue short-term bills to mop up excess cash. Listen to the rhetoric now, and you can almost hear the fluttering of doves. But look at the evidence, and it is obvious that hawks are gathering.