Chinese Finances and Milk Formula

Chinese mothers and politicians are actually pretty similar.  Safety conscious Chinese parents causing baby formula shortages “from the Netherlands to New Zealand” worry that what they are buying isn’t what it is supposed to be.  Chinese politicians are worried about the same thing.  Beijing is terrified that the Chinese finances are a house of cards and unfortunately the evidence of this keeps mounting.

As credit crunched in the last week of June because the Peoples Bank of China declined to provide overnight lending knowing the perilous state of state bank finances, the banks scrambled to meet capital adequacy ratios.  Since the end of the second quarter, Chinese banks have seen a trillion reminbi of deposits leave while seeing an explosion of credit.  In the first of week of July alone, 700 billion reminbi of deposits left and loans grew by 170 billion.  As Forbes notes, this comes from moving off balance sheet items back on the balance sheets and more worryingly not recording loans as deposits.

Even the Chinese government and press is waking up to the idea that the numbers they are being given are less than realistic.  The Chinese deputy finance minister of China actually admitted “the total amount of borrowing by local governments was unknown but he also asserted it should be manageable.”  I am unsure how you don’t know how much debt you have but know that the risk is manageable, but I am sure those Chinese statisticians will come up with something.  It is too bad that it took Detroit going bankrupt to bring the risks home.  I would have thought the 2008 financial crisis would have brought the issue of excess leverage home, but what do I know.

In an amazing show of independence, Chinese papers are even questioning land sales data.  Different ministries and government agencies that provide land sales data have been caught publishing such widely divergent numbers as to warrant skepticism by the Communist Party mouthpiece.  The reason this matters is because to reduce debt and pump GDP, local governments are selling land, and a lot of it.  According to one report, the first tier cities in China have already sold more land in 2013 than all of 2012 with another report saying land sales were up more than 40%.  Furthermore, the land is being sold for record amounts with final sales prices to consumer in many cases expected to top more than $1,000 a square foot or twice the average price in San Francisco.  Not sure how a farmer moving to the big city can afford that type of apartment so even mass urbanization won’t solve that problem.

The reason land sales and debt statistics matter is because they are intricately linked.  By one estimate, local Chinese governments received 40% of their revenue from land sales.  An acceleration of land sales by such an enormous amount should be an enormous warning signal that local governments are under enormous financial strain.  Local governments are selling assets to meet debt obligations.  Politically motivated loans are being made to developers so they can buy land and build enormous apartment blocks at $1,000 a square foot even if existing occupancy rates hover around 50% in most big cities.  The government is telling you how bad their debt burden is.  I have heard anecdotes of local government projects with total revenues not approaching debt service costs.

I mean building over priced homes with nobody living in them could never come back and cause problems right?

The Words You Can’t Say in Singapore

American comic George Carlin in his classic monologue on the words you can’t say noted “we have thoughts but thoughts are fluid and then we assign a word to a thought and we’re stuck with that word for that thought so be careful with words.”  Words give us the ability to express ourselves and ideas.  They give concrete meaning the ephemeral ideas that previously had no substance.

What scares oppressive governments about words is not the words themselves but what they represent: ideas.  In the hit movie Inception, Leonardo DiCaprio noted that “an idea is like a virus, resilient, highly contagious.  The smallest seed of an idea can grow….once an idea has taken hold of the brain it is almost impossible to eradicate.”  Governments need to repress words, the concrete examples of the idea that your freedom to speak, think, and express ideas does not depend on the permission of politicians.

The politically motivated charges against Leslie Chew are abhorrent and an obvious attempt to crack down on the ideas of a Singapore populace that wants the freedom to think its own thoughts.  The great multicultural city of Singapore with its variety of languages, foods, and people want nothing more than a similarly bustling marketplace of ideas and opinions.  Innovative and dynamic cities and countries are marked not by fear and oppression but by openness and freedom.

Ideas spread because they cannot be stopped.  Governments try to control words as a blunt tool to stop the spread of ideas and instill a fear in the populace.  Fortunately, much like a virus, governments cannot control the spread of ideas.  People talk.  At coffee shops, at work, or on the subway.  People talk.  Only by instilling fear throughout society can government control the spread of ideas.  Still, people talk.

Governments fear that people will realize that most people are fine law abiding citizens.  Politicians fear being held to a high standard by the people they are supposed to serve.  Governments need people to live in fear to create a culture that encourages oppression.  This creates the perverse outcome where government action encourages the opposite reaction.  Governments need fear to promote restrictions on speech, invasions of privacy, and excessive force.

The Wall Street Journal and New York Times do not need to write about the embarrassment beholden to the of the Singaporean judiciary because everyone already knows it.  It is already an idea that has spread throughout Singapore and the rest of the world.  How many times have opposition politicians won cases against the government or PAP?

No one needs the New York Times to point out that the Lee family has ruled Singapore nearly uninterrupted since 1959 for the idea of a dynasty to spring forth.  The idea has already spread whether it becomes words or not.

Talk of nepotism had already spread far and wide before Bloomberg published a piece about Ho Ching being appointed the head of Temasek.  These articles simply put into words the ideas that many people beyond these publications.  Can the prime minister really exercise proper oversight of a major public asset manager when he falls asleep next to her every night?

Singaporean politicians and judges have brought disrepute to their legal and political system not the journalists.  Journalists only put into words ideas.  Rather than refuting the idea, the Singaporean politician and judiciary has chosen to trample the word.   Unfortunately for them, the idea lives on.

The most telling thing about the Leslie Chew case is the general unimportance of his actions.  When I write this, I mean absolutely no disrespect to Leslie Chew.  Rather, I am talking about perspective.  The Singaporean government judiciary will bring far more scorn, mockery, and publicity upon itself by pursuing this case than ignoring it.

It is also an amazingly cowardly act.  Leslie Chew a Singapore resident wrote some mocking political cartoons, something that would in most every country not ranked 149th globally in press freedoms, would be ignored.

If the Singaporean government wants to establish its credibility: sue me.  I will gladly come to publicly defend my case.  I have made charges that approximately $500 billion SGD are missing from public funds and while Singapore becomes one of the most publicly indebted countries in the world, the government sues a political cartoonist.  It is a cowardly act to sue a cartoonist while attempting to ignore the $500 billion idea.   It seems unlikely Prime Minister Lee and his lovely wife have the courage to file that lawsuit.  I have the courage to respond if they are willing to file.

The idea that politicians gain respect by words or oppression has died.  Unfortunately, the idea that politicians earn respect by their actions and behavior is spreading.

Note: Please go to change.org to sign your name to the petition urging the Singaporean government to stop all legal action against Leslie Chew.

Note: I have no connection to Leslie Chew.  I generally refrain from any comments outside my expertise on Singapore public finances, Temasek, and GIC.  However, given that freedom of speech is a universal value which is under assault the world over, including the United States, I felt compelled to write.  As usual, I make no endorsement of any politician, political party, or group.

How To Accomplish Nothing Without Really Trying

Analysts and news articles admiringly cover the Beijing response to the slowing economy as if doing anything is the right answer.  If doing anything is your baseline for a good response, then yes, any action will be positive.  However, there is very little skepticism about whether Beijing is doing the right thing.

Take this recent article from Retuers which says the following:

“In a nod to growth concerns, Beijing has unveiled a series of small steps in recent weeks that analysts say are geared to providing quick help to the economy.  Last week, Beijing said it will scrap tax for six million small businesses, speed up railway investment and offer more help to exporters.”

Wait a minute, aren’t those the same exact policies that helped cause the problems in the first place?  Infrastructure investment with the heavily indebted rail ministry and more export subsidies or capacity investment for business doesn’t exactly seem like a winning formula.  This is nothing more than more of the same that fails to address the fundamental problems.

This is happening in other sectors of the economy as well.  This Retuers article cited a 40% increase in the amount of land for sale by local governments.  Considering that local governments in China receive an enormous percentage of their revenue from land sales rather than tax revenue and revenue from investment, this seems more like a big red flag (no pun intended).  It seems like more than coincidence that right before concerns over debt and announcements by banks and central government they will audit local government debt, land sales grow by enormous amounts.

Nor is this fairytale thinking limited to journalists but grows like a brain eating parasite into the rosy predictions of investment banks.  The French investment bank Societe General released a research report on what would trigger and happen if there was a hard landing in China defined as growth beneath…..6% (feigned gasp and shock)!!  Let’s ignore the fact that Chinese GDP data is clearly and obviously just made up.  If we take harder, tougher to make up numbers like rail traffic and electricity consumption, also preferred by Party leadership for that very reason, GDP is already well below 6%.  Rail traffic was plummeting in the second half of 2012 and first half of 2013 while electricity consumption was flat and growing slightly in the first half of 2013.

If Beijing is trying to make people feel better then they might be accomplishing that task judged by SocGen and Reuters nonsense.  If they are trying to stave off the inevitable restructuring and reform, they are failing miserable.  Kind of reminds me of the band playing as the Titanic slipped into the North Atlantic.

This Time is Different with Chinese Characteristics

The biggest incentive for banks to push WMP is not the lack of regulation but rather the Peoples Bank of China (PBOC) capital requirements.  As I noted earlier this week, the PBOC is generally regarded as high quality economists and technocrats.  They understand the risks and took a series of steps over the past few years to try and reduce bank risks.  This included raising the reserve requirement, which not coincidentally served the dual purpose of tightening money.  However, after lending tripled in 2009 and has actually declined slightly since, Chinese banks are facing both a large number of bad loans they need to get off their books and increased capital requirements.  New loans do not triple in one year without creating a large number of bad loans.

 This is where WMP enter the picture.  Given increasing reserve ratios and an unofficially rising number of bad loans, Chinese banks were desperate to maintain credit growth if nothing else to roll over their bad loans, but still satisfy regulatory requirements and political pressure.  After the 2009 loan explosion new bank loans have remained relatively steady but shadow banking has exploded.  According to JP Morgan, shadow banking in China doubled from 2010 to 2012 from $3 trillion USD to $6 trillion USD.  In other words, right after traditional bank lending wen flat, shadow banking started exploding.  That means that shadow banking was relieving the pressure of making new loans from Chinese banks.

A WMP takes loans off the banks balance sheet and allows the official assets to make new loans rolling over the old lower quality loans solves the problem.  As long as it isn’t a straight trade of deposits for WMP, the banks are able to make new loans or roll over the old ones while moving problem loans off their balance sheet.  One report maintained that “issued urban investment bonds are actually designed to pay debts for last year’s projects under the name of a new, fake project.”  Though there is no reliable data on this yet, Chinese banks are probably mixing in a higher percentage of problem loans but not filling WMP with exclusively bad loans.

 Second, shadow banking in its original form grew because banks in China heavily favor state owned enterprises.  It should come as no surprise that state owned banks favor other state owned enterprises.  In other words, the truly private sector in China is starved for capital.  One paper notes that “private Chinese firms are credit constrained while State-owned firms and foreign-owned firms in China are not…geographical and sectoral presence of state firms aggravates financial constraints for private Chinese firms (“crowding out”).”  Another paper found that “the findings suggest that less opaque firms and non-state-owned firms benefit more from foreign bank entry.”  Yet another paper writes “political affiliation contributes not only to alleviating individual firms’ financing constraints.”   Another paper unsurprisingly finds that “having the state as a minority owner helps firms obtain bank loans and this suggests that political connections play a role in gaining access to bank finance.” Consequently, shadow banking originally began when entrepreneurs would either guarantee loans for other entrepreneurs or make loans.

Beijing takes the primacy of state banks financing state owned enterprises so seriously that it has handed out death penalties, later reduced to life in prison, to entrepreneurs like Wu Ying in the finance industry.  It is worth noting that she was originally arrested for “illegal fundraising” and reportedly considered pleading guilty to a lesser charge of “illegally collecting deposits from the public.”  As it took two years for the charge to be changed to fraud for which she was later convicted, the veracity of the fraud charges against her is under serious debate especially considering that both investors and clients testified on her behalf.  Even the official news agency Xinhua noted that “Wu has drawn sympathy from the public, who have criticized a financing system that has made it difficult for small entrepreneurs to get loans from banks. These companies subsequently turn to underground lenders to finance their businesses, creating more problems.”  Shadow banking grew out of a system where state owned banks funneled credit to other state owned enterprises who used the capital poorly.  It is doubtful even Matt Taibbi would argue to execute Jon Corzine or Angelo Mozillo.

The major state owned banks started getting into the shadow banking game, not coincidentally, around the time the PBOC started raising the reserve ratio and about 1 year after the 2009 lending binge.  By moving loans off their balance sheet into WMP’s, they could continue to lend even as industrial capacity declined and apartment occupancy declined, keep their balance sheets healthy, and meet capital requirements.   It was no coincidence that the SHIBOR debacle coincided so neatly with the end of the official second quarter June 30 when Chinese banks have to meet capital adequacy audits.  Between loan targets and capital adequacy ratios, Chinese banks were under intense liquidity pressures and moving a lot of loans off balance sheet into WMPs.  If the deadline of capital adequacy ratios sound familiar, it should.  Think back to the Lehman Brother’s bankruptcy when they got in trouble for Repo 105 where they would move a lot of debt off balance sheet just before the end of the quarter in time to look good for investors.  Chinese banks are facing the same conundrum trying to move loans into WMPs.

These are not the hallmarks of a sound and healthy banking system.  Since the end of June liquidity crunch, one major lender, China’s Merchant Bank, has already been given the go ahead for a secondary offering after years of waiting.  Another bank, and the only fully private bank in the top 10 in China, is hearing chatter of needing $11 billion USD in capital.  Given the number of secondary offerings that have been conducted with the Chinese government as the main purchaser in the past couple years, Chinese banks appear to be sitting on a much larger number of bad loans than they are officially declaring.  You simply don’t have such frequent secondary offerings and regular liquidity crunches if your bank is healthy.

There are a couple of final points.  First, WMPs is the US mortgage bank model of originating the loan and selling it on with Chinese characteristics.  As we all know, this had disastrous financial consequences.  Research found that banks retained safer loans but sold on riskier loans.  There have already been small scale defaults on WMP’s with varying degree of guarantees and responses by the listed banks and regulators.  In short, given what we know about the track record of origination and distribute lending as well as the explosion of credit in China over the past few years, this alone should give anyone enormous concern about banks selling parts of their loan portfolio in WMP’s.

Second, many Chinese prognosticators have fallen into the same mentality that US bulls did prior to the 2008 financial crisis relying on asset prices to support debt levels.  The head of the China Banking Regulatory Commission recently said:

“Some people have compared our local government debt to European debt, but there’s a big difference — our debts are accumulated for production not for consumption — most of them have assets as guarantees and the overall risk is controllable…”

As long as asset prices remain high, then it remains semi-sustainable.  However, this is classic “this time is different” thinking depending on asset prices to support high debt levels that are not supported by cash flows.  Given falling demand, industrial production, and continued high loan growth to support asset prices seems like a bet with the devil at best.

There are however, two aspects of this process that are overlooked and that is the private sector and consumers.  The private sector started this because they were starved for credit and the private sector responded, even under threat of the death penalty.  The state owned giants with their size and need to move loans off balance sheet, jumped in and have been very aggressive.  Even now of the ten largest banks in China, only one Minsheng is a completely private enterprise, lending more to private small and medium enterprises, and relies more on short term borrowing than most other banks.  Financial consumers in China are much more savy than they are given credit for even if they don’t read all the fine print of financial products like many institutional investors.

The final point is the investment options of Chinese consumers. The stock market has been a losing proposition for many years and viewed as rigged.  Real estate has gone up by more than 300% as Chinese consumers sought a safe savings vehicle.  However, with new regulations with more teeth making it harder to buy multiple apartments, consumers have sought more outlets for savings and investment which WMP’s have handled.  Given the state of the stock market, no real bond market, capital controls, and regulation on real estate, WMP’s even with the risk represents one of the best available products for Chinese investors.  Furthermore, as bank deposits have not guarantee or insurance, WMPs are not necessarily a bad option for the portfolio constrained.  One has to wonder though if they will get left holding the bag for Chinese banks.

On Princes, Generals, and Temasek

Leo Tolstory wrote in his epic masterpiece on Russian aristocracy War and Peace, while generals and princes believe they determine the course of history it is the soldier and unknown man that create the events we come to know as history.  The deterministic evolution of history resigns princes and generals to actors in their own play.

The announcement that Lim Boon Heng would replace S. Dhanabalan as the Chairman of Temasek Holdings is the changing of generals with nothing but the delusion of control over the course of history.  It is an announcement full of sound and fury signifying nothing.

From my personal conversations with people, I have actually heard generally complementary comments and anecdotes about Chairman Dhanabalan.  However, the control over Temasek is dominated by a small number of people and filling the Chairman’s seat requires above all the ability to know how and when to say yes.

The appointment of Lim Boon Heng ultimately comes as no surprise.  With no experience that would appear to suit him for the chairmanship of a major institutional investor other than being a PAP loyalist, he will fulfill the most important mandate of executing the policies faithfully as they are handed to him.  The position could have ultimately gone to any number of PAP men that know where power lies and what their role is within the larger power structure and at Temasek.

More problematic is that Temasek is beset by an insular culture.  It is noteworthy that  the only significant outsider in recent history at Temasek are Chip Goodyear and Gregory Curl.  Goodyear has quite literally vanished after a few months preparing to head Temasek.  Curl is the Temasek President focusing on its America’s business who helped bring Bank of America to the edge of bankruptcy with their ill fated acquisition of mortgage lender Countrywide and the investment bank Merrill Lynch.  In short, PAP sycophants and failed retired American bankers are the backgrounds of Temasek executives.

Given the enormous discrepancies concerning the claims of Temasek returns and Singapore public finances coupled with the staggering debt load, leadership cannot run the risk of having people who ask questions or want to change things.  Acceptance and compliance are what is required.

Despite the announcement flourish and the expectation for change, I doubt this will result in any significant impact to Temasek.  You do not rise to the top by questioning authority.

In the end, the history of Singapore will be made by the people not the princes and generals.  The people of Singapore control their fate and what they expect of their leadership.  It is the people of Singapore with the sound and the fury signifying the values they hold and the future they want that matter, not the whims of princes and generals.

This change in leadership will in time be viewed as sound and fury signifying nothing.

Chinese Manufacturing Falls to New Low

The Chinese Producer Manufacturing Index (PMI) published by HSBC has fallen to an 11 month low.  This just continues to fuel the absurdity of Beijing claiming that GDP is humming along at 7.5% growth.

In other news, President Xi Jinping has said the Chinese economy needs to deepen reforms, shortly after telling governments to speed up spending, then bans new government buildings.  What is the Chinese word for schizophrenc?

Considering the Chinese government has talked about the need to “rebalance” for years and the investment consumption ratio has only worsened, I am surprised anyone is taking Beijing leadership seriously.

What I Cannot Fathom About Chinese Banking Analysis

One of the things that amazes me about investment bank analysts is the inconsistency of their logic to justify their rosy assumptions.  The latest example is the popular narrative that is taking place about the reasons and impact for the People’s Bank of China liberalizing rules on lending rates.

The narrative taking hold that is peddled by Hong Kong investment bankers is that best elucidated by the Wall Street Journal article which argues the following:

“Prior to the latest move, Chinese banks could already lend at 30% below the benchmark rate, which stands at 6% for one-year loans, but few took advantage of that freedom. A banker at ICBC’s branch in the southern Chinese city of Guangzhou said the bank is unlikely to offer “a bigger discount” to its borrowers in the short term. “But some small lenders may grab this opportunity to vie with big state banks for good clients such as state-owned enterprises,” the banker said.”

This has got to be one of the most glaring examples of self delusion I have seen in the analysis of Chinese banks.  Let me explain why.  First, Chinese banks and the Chinese banking industry are nothing close to a normal market place.  Every bank of any consequence is owned by the Chinese Ministry of Finance by way of at least one or two holding companies.  It is almost better to say that there are not Chinese banks but rather a Chinese bank.  Not only are they all owned by the same entity, the prices they can charge were until a couple days ago dictated and their costs of goods are still dictated.   How is that a market place by any definition? Just because they are listed in Hong Kong does not make them competitors.

Second, if everyone agrees that lending decisions are politically motivated, why do we think that the cost of lending isn’t a politically motivated decision?  The common line in this news article as well as most others goes something like this: because most bank lending is not beneath the regulated rate, we don’t expect that to change.  If the decision to make that loan was politically motivated, why can’t the political motivation now be to change the price of that loan?

Third, I believe that there is currently a lot of pressure being applied to banks by the government and state owned enterprises to roll over or refinance existing debt for well connected companies at rates that will allow the debt ridden companies to survive to fight another day.  Unlike most analysts who believe this doesn’t mean much, I believe there will be a lot of pressure applied to lower the rates for select companies to help them out.  I don’t believe this will apply to most companies and definitely not private companies who have historically been starved for capital.  Expect to see a lot of roll over and refinancing of debt at reduced rates to politically connected and favored state owned enterprises.  Do not expect to see this impact the state of the Chinese economy.  Consider it a lifeline for the well connected.

It is coming……

Chinese Banking, Shadow Banking, and Finance Part I

Since the “discovery” of the shadow banking sector and hiccups in the Chinese economy the past few weeks, commentators have hurriedly been writing pieces to fill a void that make significant errors.  Conjuring up images of back alley deals and seedy loan sharks, there is an enormous amount of misinformation about the shadow banking sector.  For instance, the New York Times believes that the this is driven primarily by “…less regulated part consisting of high-yielding wealth management products…”.  The Atlantic claims shadow banking as $2 trillion USD in assets while the NYT says it is around $6 trillion USD. JP Morgan who has produced the most detailed study produces an estimate of around $6 trillion USD equal to 70% of Chinese GDP.  Beyond the obvious factual and analytical inconsistencies there are serious deficiencies about the Chinese economy, banking in general, and shadow banking.

  1. Shadow banking isn’t in the shadows.  Despite the well chosen and catchy name, shadow banking isn’t in the shadows.  First, the shadow banking industry is driven by the largest banks in China which are owned by the government through Central Huijin Investment a subsidiary of the China Investment Corporation (CIC) reporting to the State Council of the Peoples Republic of China.  The new Chinese minister of finance Lou Jiwei came from the CIC which essentially owned a controlling stake in every major bank in China.  Nine of the top 10 banks in China are state owned.  Major state owned banks in China control nearly 60% of deposits.  The smaller provincial state owned banks dominate the remainder of the market. These are not shadowy corporations  owned by gangsters but directly controlled by the government.  These are the largest and most dominant banking government sponsored groups in China and most definitely not in the shadows.  These activities are approved of by the government and not some mistake that grew without government knowledge.  This evolution in Chinese banking has been at the very least tacitly approved by the highest reaches of Chinese government.  Second, it is simply misinformed to call a banking sector with approximately $6 trillion USD under management a shadowy enterprise.  In an $8 trillion nominal economy, $6 trillion just isn’t in the shadows.  JP Morgan who has produced the most detailed, cited, and replicatable data on shadow banking in China finds that it is 36 trillion RMB and doubled from 2010 to 2012.  As news report after news report notes, shadow banking products are being sold by the largest banks and it is worth nearly 70% of Chinese GDP.  The only reason it is called shadow banking is because it sounds much cooler with a catchy semi-nefarious sounding nick name.
  2. Chinese shadow banking is and isn’t any riskier than normal banking, but not for the reasons you think.  There is this idea that shadow banking merely by its nefarious name must absolutely be riskier.  Yes but also decidedly no.  First, there is currently no such thing as deposit insurance in China.  There is no formal protection or guarantee of bank deposits in China.  There is the belief or expectation that the government will bailout banks that go bust but that is very different than anything like a legal guarantee or deposit insurance.  Wealth management products (WMP) sold by the same banks have the same implied guarantee.  Consequently, wealth management products for depositors are little different guarantee wise than straight deposit savings.  In fact to date, WMP quasi-defaults have all been back stopped in some manner.  The distinction between WMP’s and deposits is legally and realistically minimal.  Beijing is concerned with the political implications or causing a bank run not the legal differences of guarantees on WMP’s versus bank deposits.

 

Second, WMP’s sold by banks are generally drawn from their book of loans because there is not a bustling secondary debt market and essentially no securitized or CDO market.  The corporate bond market is woefully underdeveloped reserved nearly exclusively for the major state owned giants that are viewed as having a state guarantee.  To put the size of the corporate bond market into perspective, despite having an economy that is seven times larger than South Korea, the Chinese bond market is only 24% larger.  Viewed from another perspective, the Chinese corporate bond market as a percentage of GDP is one of the smallest in the region larger than only Vietnam, the Philippines, and Indonesia.  China only exceeds them because their corporate bond market represents only .7%, 4.9%, and 2.3% of GDP respectively.  This means that banks in China are selling WMPs that comes primarily from their own loan portfolio.  Though banks may work with quasi-arms length trust companies to sell WMP’s, there is not what we think of as a bustling secondary market with any credit analysis of the underlying asset.  There is not the widespread ability to bundle or securitize loans and pass them on in the way most are familiar with respect to the sub-prime crisis in the United States.

Third, and this is where the risk enters, depositing funds with a bank gives risk diversification to the depositor across all their loans while a WMP holds a much smaller and self(bank) selected pool of loans.  In other words, depositing funds with a bank bets that the Chinese government won’t let a bank go bust while buying a WMP bets the government probably won’t be willing to let a smaller pool of wealthy Chinese lose money if a WMP goes bust.  This essentially turns Chinese banks into a slight variation of the originate to distribute model but without any formal risk management or securitization, though US ratings agencies and investment banks didn’t seem to interested in guarding against credit risk.  Extensive research on the US crisis shows that banks using the originate-to-distribute model “originated excessively poor quality” loans and “did not expend resources in screening their borrowers (PDF).”  One estimate found that the loss was quite significant with loans sold in the secondary market “suffer(ing) value destruction of about 15% (PDF)”.  It goes without saying that Chinese banks probably aren’t moving their highest quality loans into off balance sheet WMP, though there is no systematic evidence on this as this data is quite literally a state secret.

There is one additional uniquely Chinese characteristic to WMP as compared to the sub-prime crisis.  In the United States, securitized loans were bundled and sold on to institutions that should have known how to value assets and risk.  In China, WMP’s are sold directly to consumers by banks and other financial institutions like trust companies.  The consumers attribute the same riskiness to the WMP as they do to bank deposits with that bank, even though that is not financially accurate.  This makes any political fall out that much more explosive.  In other words, it is consumers and not institutions bearing the risk of dubious credit quality loans in the Chinese bubble.

Note: This is the first part in a series on Chinese banking, shadow banking, and finance.

The Reason to Be Skeptical of Chinese Interest Rate Liberalization

The People’s Bank of China (PBOC) announced last week that it has decided to liberalize interest rates banks can charge to borrowing customers.  Previously this rate was regulated by the PBOC such that the banks were guaranteed at worst a nearly 1% spread between the highest savings rate and the lowest lending rate.  Now banks can lend at pretty much whatever they want to charge borrowing customers.  Sounds like liberalization and a freeing of the market….right?

My first thought was that this sounded like an implicit bailout of heavily indebted political connected firms and a recognition of the pending financial crisis.  Call me skeptical of any “liberalization” reform by Beijing, but following right on the heels of the SHIBOR debacle and the recognition of the enormous debt burden, this just seemed too convenient.

Apparently, I am not the only one.  Reuters just published this article citing skeptics that this move seems designed to shield heavily indebted state owned enterprises.  Here is maybe the key point of the article:

“In the short term, though, international bankers and investors active in China say the timing of the reform – coming roughly a month after the PBOC cracked down on lending in the shadow banking sector – may be less about banks issuing new loans than about keeping old loans from going into default.”

China and the PBOC know that their debt burden public and private sectors is simply about to crush China.  This worries them enormously because this generate of Chinese have only ever known 10% growth.  A financial crisis in China would bring enormous political ramifications that I don’t think even Chinese planners dare contemplate.

It’s coming…….

Update:  The Wall Street Journal writes: “The big winners from the existing system are state-owned enterprises and local governments that get to borrow at bargain basement rates. But for the economy as a whole the consequence of that is wasteful investment – sparking overcapacity in industry, bridges to nowhere and ghost towns of unsold property.”

I am wondering why this isn’t a bigger story as lending in China is completely politically motivated.  The PBOC “liberalized” to further politicize lending.