Blog > International Investing > Blog article: Forecast 2008: Outlook for the Chinese economy
 | Email This Article Email This Article  | 

Forecast 2008: Outlook for the Chinese economy

Posted January 3, 2008

"We will be seeing the first cracks to appear in the system when the Chinese real estate bubble begins to deflate about three months after the conclusion of the Beijing Olympics. If you think subprime was bad, you ain’t seen nothing yet." — J. Christoph Amberger

by J. Christoph Amberger

This is the continuation of yesterday's "Forecast 2008: Outlook for the US economy, Part 1"

(Have a feeling you've read part of this already? Well, sure. I originally wrote it for Taipan. But it's still good!)

Baltimore — (TFN): Throughout 2007, every quiver in the global stock markets has been blamed on increasing default rates in U.S. mortgages. The low-income, high-risk segment of the mortgage market we now know by its sanitzed euphemism “subprime” accounts for just about 10% of the U.S. mortgage market.

(That means that less than 1% of total mortgages are in subprime foreclosure. Keep this in mind for perspective, if you will…)

Those numbers might go a long way to explain the rough water in the markets that so unceremoniously wrecked my beautiful forecast of a 2007 year-end rally.

We've seen what miscalculating risk scenarios did to the balance sheets of the world's most powerful financial institutions. Their reflexive (if in all probability short-lived) tightening of credit certainly isn’t helping to move any excess real estate inventory that has built up.

The Credit Crash of 2009 is Building Up NOW! 

If a few billion in shaky loans can trigger what the pundits now call a “global financial crisis,” I’d like to point out another bit of a crisis brewing that makes subprime look like the broadway version of Now I Pronounce You Chuck and Larry.

China Construction Bank, the Bank of China and the Industrial and Commercial Bank of China have launched mega-IPOs in the last couple of years. But after decades of rapid loan growth, they — along with other Chinese banks, state investment companies, credit co-operatives — are now sitting on record nonperforming loans (NPLs).

The Chinese NPL market is one of the largest in the world with a total outstanding principal balance of over a trillion dollars. That’s about 40% of China’s gross domestic product. Every now and then, the big credit rating agencies point out that China’s efforts to clean up the balance sheets of its big four banks have been slow. Worse, they have completely failed to eliminate financial risks for the lenders.

In 1999, China established four distressed debt companies to take loans off the books of the big four banks. Progress has been challenging, especially in the early years. In the past, Beijing has spent the equivalent of 25-30 per cent of GDP in previous bank bailouts.

Accounting firm Ernst & Young calls the main reason for why these bad loans were generated in the first place political. Much like Maryland, China is a one-party state. And that one party is still Mao's old Communist Party.

All in the Family

The Communist Party relies on the state-controlled banks to maintain an unreformed core of what at the core remains a command economy. And like anywhere else where one-party regimes have mixed business with running the country (Maryland!), waste, corruption and nepotism are running rampant. In the face of triumphant capitalism, the party uses perks and careers in government and state-owned enterprises to keep the party faithful in line.

That includes access to capital.

The party appoints about 80% of the chief executives in state-owned enterprises and 56% of all senior corporate executives, who are under pressure to hit fixed growth targets quickly no matter how. The World Bank estimates that about one-third of fixed investments made in the 1990s were wasted.

Politically directed lending accounted for 60% of loans in 2000-2001. And in a 2002 survey, over 80% of polled bank employees said corruption in their branches was either prevalent or took place quite often.

New loan growth has been running at 15%. A healthy supply of nonperforming loans continues to be generated due to the sheer growth in total loan volume. At least 2% of loans made since 2000 have been reported as nonperforming. The proportion was as high as 60% for older lending. And a substantial portion of the loans that went out were issued to keep bad loans floating.

China’s banks could soon face a fresh wave of nonperforming loans arising from the rapid expansion of lending in 2003 and the first half of 2004.

Structural Problem

China’s bad debt issue is a structural problem that Beijing seems ill-equipped to deal with. Japan, whose banks had built up a similar problem in the 1980s, was punished with more than a decade of economic stagnation. I believe we will be seeing the first cracks to appear in the system when the Chinese real estate bubble begins to deflate about three months after the conclusion of the Beijing Olympics.

If you think subprime was bad, you ain’t seen nothing yet!

So far, there is no indication that this is of concern to anyone — or at least of less concern than new U.S. government debt is to the dawn chorus of doomsday prophets that constitute the financial punditry. Both cases in a way illustrate how valid Benjamin Franklin's observation still is that "The sound of your hammer at five in the morning or nine at night heard by a creditor makes him easy six months longer."

In growing economies, even bad debt is good debt. Economic growth in China is coming in at over 11%. And since Wall Street and Europe started their subprime shake-and-bake in July, the Shanghai stock exchange quietly packed on another 1,000 points, doubling its worth over September 2006, before dropping back into the 5,000 range in early December.

Soaking up Liquidity

Apparently, China investors — and Chinese investors — are not buying into the assumption that low-income loan foreclosures in the in Springfield is anywhere close to putting a dent into the consumption habits of their largest and most important export market. By floating state-owned companies in Shanghai, Shenzhen, and now Hong Kong, Beijing has managed to soak up unheard of amounts of liquidity within the system. This partly supplements its endeavors to curb inflation (in addition to the three interest rate hikes so far this year.)

It also had the additional benefit of converting passive savings into active capital, reducing the need for further credit — and redistributing existing debt (including bad debt) from banks to shareholders. It's what's meant by the democratization of capital… and the spread of risk.

The Last Bull Run

Of course, this method of risk management is not without a hefty price on the national economy. In Shanghai alone, retail investors have pulled between $2 and $4 billion in savings out of savings each month, converting them into at-risk stock market capital. For the time being, there seems to be no impediment to a further expansion both of the Chinese economy and the Chinese stock markets — especially in view of the Beijing Olympics less than 8 months from now.

Much like Japan in 1964 and Seoul in 1988, Beijing considers this its coming out party as an economic and military superpower. China is spending around $40 billion on its Olympics — building stadiums, airports, expressways, rail links, and infrastructure. That is a smaller percentage of GDP that both Japan and South Korea devoted to their respective Olympics — at least as far as the direct costs are concerned.

While China may not be actively propping up economic growth in a targeted fashion until the Olympics are over, the direct cost reported may just be a small part of the actual bill, given the nature of the centralist and political management of Beijing's affairs. Beijing will make sure that its still centralist economy runs smoothly throughout the Olympics, providing a continued a boost to A shares and H shares throughout next year.

After record numbers of IPOS in the last two years, there will be a pre-Olympics mini-boom in state-controlled companies going public. If South Korean stocks in 1988 are any guide, this post-Olympic boost could push Shanghai up another 50% — on top of a potential doubling of the index between now and the lighting of the Olympic fire next year. Japan's GDP growth almost halved from 11.2% in 1964 to 5.7% in 1965.

Cooling down of economic growth maybe just what Beijing is after. But it also would have a dampening effect on new institutional and retail investment in the Chinese markets — making an A share crash quite more likely after the Olympics. What makes the prospects of an A-share crash so daunting is not necessarily the effect on the small investor. But state-owned companies are at the forefront of punting in the markets… more often than not with money borrowed from the big four Chinese banks.

Tomorrow: Global Fall-Out

****Make sure you sign up for our FREE TFN News Feed for breaking news, special reports and new financial videos. Click here to pick your favorite reader. If you prefer to have the feed delivered to your email, just click here. 


Related Articles


Posted by J. Christoph Amberger · Filed Under International Investing 

Comments

close Reblog this comment
Powered by Disqus · Learn more
blog comments powered by Disqus