An Inflection Point In China's Banking Problem
By George FriedmanThe month of May witnessed an interesting
phenomenon: a spate of reports on China's nonperforming-loan problem. What
is most intriguing is that these reports did not come from organizations
like Stratfor -- minor outfits that have been talking about this for a
couple of years. It came from real, solid, serious mainstream organizations
that were, and continue to be in some cases, quite positive about China on
the whole. What is important here is not that China has a serious problem
with bad loans in its banking system. That's old news. What is important is
that mainstream analysts in the West now are taking official notice of it.
The wide divergence between the Western perception of Chinese economic
health and the realities of China's economy is beginning to close. There
will be consequences to that.
The first report came from Ernst &
Young, which released a study saying that China had a substantial problem
with nonperforming loans (NPLs). We have to confess to not having seen that
report, because the accounting firm withdrew it a few days later. The
Chinese government blasted the report, using words like "ridiculous" and
"distorted." Ernst & Young, which has a substantial practice in China,
denied having retracted
the report because of pressure from the government. Whatever their reasons
for doing so, we wish we had been faster in asking for a copy.
No
matter, because May also brought studies on the same subject from
PricewaterhouseCoopers (PWC), McKinsey Global Institute, and Fitch. Each
said the same basic thing: that Chinese banks have enormous NPL numbers on
their books. The PWC report was issued by a group within the company that
specializes in making markets in NPLs. Their news was that the water in
China was fine and everyone should come in. McKinsey focused on
inefficiencies in the Chinese banking system that should be cleared up, so
that NPLs could decline and the Chinese gross domestic product could surge.
Fitch was the harshest of the three, but that firm also argued that the
Chinese had the tools in place to handle the problem. The bottom line was
that all three acknowledged that NPLs were a big issue for China, but they
took different approaches in trying to put the problem in perspective. In
other words, they gave a warning without yelling "Fire!" Some of the reports
were criticized by the Chinese, but none were blasted. Meanwhile, Moody's
Investors Service has told us that they will be releasing a report in a
couple of weeks. It will be interesting to see what their take
is.
Let's begin this analysis by looking at a couple of quotes from
these reports. McKinsey, for example, writes:
"Underlying these
reforms, however, is capital misallocation by the system. Nonperforming
loans are the most conspicuous outcome of this misallocation, but our
research shows that the much larger volume of loans to underperforming
ventures that don't go bad but yield only negligible returns are potentially
more costly to China's economy."
Fitch's report states:
"Summing all of these figures, we come up with total official
nonperforming loans of US$206 bn and other estimated problem loans of over
US$270 bn in the banking system. We would reiterate, however, that a
large portion of this latter figure is comprised of estimated Special
Mention loans or loans that currently are not classified as
nonperforming [emphasis Fitch's]. At the same time, there is an
additional US$197 bn in NPL carveouts still remaining on the balance sheets
of China's asset management companies, which no longer represent direct
losses for banks but are a future liability for the
government."
Fitch also states:
"Beyond this, estimating a
rate of flow of new nonperforming loans is not an easy exercise given
Chinese banks' extremely weak historical data and ongoing deficiencies in
accounting and disclosure. Few banks report data on NPL flows, and those
that do show recent flow rates in the extremely low single digits. We
believe these numbers understate the likely level of ultimate credit losses,
given what we know to be the slow evolution of a strong credit culture and
risk management practices and our suspicion that China's over-reliance on
investment-led growth comes at a cost to bank credit quality."
Fitch
is estimating China's bad-loan situation (our term, lumping all these
categories together) at $673 billion, but it warns that -- given Chinese
accounting and reporting, and the fact that what reporting exists is not
credible -- $673 billion is a low number. That's important. If $673 billion
was the final number, then measures that are put in place could limit the
ultimate losses to a level below that figure. If, however, the total number
of bad loans is substantially higher than $673 billion -- which is our view
of the situation -- then the system would be lucky to have to write off only
this amount.
There are numerous ways to measure the magnitude of the
problem, but one of the simplest is this. China is said to hold nearly $819
billion in foreign reserves. Fitch's conservative estimate of the bad loan
situation comes close to matching that number, and a more liberal
calculation would swallow those reserves up and then some. Put very simply,
the Chinese banking system is in deep trouble -- and with it, so is the
Chinese economy.
It has become an article of faith that China's
economy is booming. The economy certainly is growing rapidly. But growth and
size alone don't tell you how healthy an economic entity is. During the Great
Depression, the U.S. economy was enormous, but it was crippled. Japan's
economy was growing at a phenomenal rate in the 1980s, all the while heading
for its disaster. Size and growth are but two measures of an economy -- or of
a business. They do not tell you how well it is doing.
The basic
problem of the Chinese economy, as in many Asian nations, is that the banks
have not made loans with business considerations in mind. They made loans
for political reasons and to maintain social stability. In many cases, loans
were seen as being more like grants. As a result, they were invested in
enterprises that did not make enough money to repay (or even attempt to
repay) the loans. Frequently, rather than bankrupting the business or
writing off the loan, the banks lent more money to the business -- so that
it could repay old debts, and there was an appearance that the loans were
viable. Loans went into land speculation or to investments in areas that
were already overbuilt. (And this does not attempt to take into account
ancillary problems, such as corruption
and embezzlement, which also have been significant
issues for the Chinese government.)
In the first part of 2006,
there has been a huge surge in lending in China. With the economy already
growing at rates of more than 9 percent, it would seem structurally
impossible to grow it any faster. Shortages in skilled workers, management,
buildings -- all these limit the rate of growth. The truth is that a
substantial portion of the loans that went out were issued to keep bad loans
floating, like using one credit card to pay the monthly payment on another.
You can do that for a while, but you can't do it forever.
What keeps
the Chinese system alive is not domestic consumption, which is not rising in
tandem with overall growth. What keeps China afloat is exports -- exports in
ever greater numbers, and with ever-smaller profit margins. Surging exports
are critical to China, as they were to Japan before it. They generate the
cash that allows the financial system to continue operating.
This is
also the Achilles' heel of the Chinese economy, as Fitch points
out:
"Given the weaknesses already discussed, we believe Chinese
banks remain acutely vulnerable to an economic slowdown, although the
analysis above recognizes that much work has been done to tackle these
weaknesses and at a minimum suggests that Chinese banks and the government
are more equipped today than in the past to deal with problems that may
arise."
Here is the problem. The official policy of the Chinese
government is to cool off the economy. In fact, the Chinese are attempting
to cool growth only in certain sectors, where they perceive particularly
dangerous bubbles starting to form. For the most part, however, they are
doing everything they can to keep the economy hot, in order to try to manage
the financial problem. Now, Fitch argues in its report that the Chinese banks
are better equipped than in the past to deal with their problems. We agree
with that assessment; they were completely unprepared in the past and now
are abysmally prepared. You cannot prepare to deal with a loan situation as
bad as that in China. You simply keep cycling as fast as possible and hope
that something turns up.
In our view, this spate of reports on
China's financial situation marks a turning point.
One of the things
that has kept the Chinese economy booming was cheap exports. But another was
the perception in the West that, underneath it all, China was sound. This
perception induced foreign banks to invest in Chinese banks. There have, of
course, been studies detailing the Chinese debt problem for some time:
Standard & Poor's, for example, estimated the bad debt in 2002 at $600
million. That part isn't new.
However, when "irrational exuberance"
(to quote Alan Greenspan) is at its peak, it is hard to break through the
noise. Markets continue to rise, even as bad news comes out. Last week, for
example, we saw the Bank of China make its initial public offering and
shares soar, just as these financial reports were emerging. That doesn't
mean these reports are wrong or that the Chinese have things under control.
It simply means the market is ignoring news and rising on its own giddiness.
Nevertheless, a turning point has been reached that will be difficult
to ignore. Reports from Stratfor are, of course, one thing. Reports from a
single credit agency are another. But when a series of reports from highly
respected, mainstream analysts all come out within a few days of each other
-- with each, in their own way, telling the same basic story, it becomes
hard for the system to dismiss that. Western companies moving into China
have CEOs and CFOs who must exercise due diligence. There are now too many
reports out there to be simply ignored. All of them are caveated. None of
them write China off. But a critical mass is forming that will cut through
the froth in due course.
Obviously, this does not mean that China
will implode, disappear or anything like that. It will remain an enormous
economy and an important one. But this does mean that the dynamics of the
Chinese economy are shifting. The debt issue represents a deep structural
problem that China will either deal with -- as South Korea did -- or not, as
Japan did not. (Japan reaped more than a decade of economic stagnation as a
consequence. It is significant that China lacks the degree of insulation
that Japan built up; the economy has more external exposures and would not
weather a similar crisis as well.) The point is that, ultimately, the books
have to balance everywhere. That means that the huge structural imbalance of
China, which these debts represent, must be rectified. And that process, as
in all such matters, will be painful.
It is not clear how much pain
Chinese society can withstand before it fractures. This is clearly a concern
for Beijing as it tries, simultaneously, to reform the economy and to crack
down on dissent. The Chinese, like anyone in this fix, try to put the best
possible face on the situation. Which is why they exploded at Ernst & Young.
But even the government in Beijing couldn't shout down the ensuing tidal wave
of financial reports; instead, they grumbled and pointed to the passages that
said it could all be managed.
Perhaps it can. But if it can, it won't
be easy -- and we doubt that it is possible. We have been writing about this
problem for several years now, and people keep asking when the crisis will
come. Our answer is simple: If this isn't a crisis, what would a crisis look
like? The Chinese financial system is sinking under nonperforming and
underperforming loans. Mainstream Western analysts are all writing about the
problem and calling for reforms that the Chinese cannot possibly implement in
time to make a difference. At some point, the weight of evidence will shift
the behavior of the Western financial community, and that will be that.
In the meantime, let the exports flow -- for they surely will, and
in breathtaking quantities.
