from Follow the Money

The Chinese conundrum: External (financial) strength, domestic (financial) weakness

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I disagree with Michael Mandel on the US current account deficit - I think it is a concern, he doesn't.  We also disagree on the US fiscal deficit.   He doesn't think it is a big problem; I disagree.  If US households don't save, the US government cannot run a fiscal deficit without adding to the overall national savings shortage, and a worrying large current account deficit.

But we agree that the rapid expansion of credit inside China over the past few years poses a serious risk to the long-term health of its financial system. I just finished a paper that looks at China's financial vulnerabilities and tries to relate them to macroeconomic developments inside China over the past few years - soaring savings, soaring investment, soaring bank lending, soaring foreign currency reserves, soaring exports and the like.  

That paper, alas, is behind the RGE firewall: I have to make a living.

But the basic argument is fairly straightforward:

Most severe banking crisis in emerging economies - at least recently - have coincided with a currency crisis.    Many such crises, particularly in Asia, had their roots in an expansion of bank credit which drove up domestic demand, often generated a real estate boom and usually generated significant current account deficits.   In some cases, those deficits were financed by short-term debts denominated in foreign currency.   When external creditors - or domestic residents -- lost confidence in the country, its currency collapsed.    The falling currency increased the real value of foreign currency denominated debts.   Firms with weaker balance sheets could no longer get access to credit - if they could pay at all.   Banks faced bankruptcy as a result of rising non-performing loans (NPLs) without a costly government bailout.  The crisis countries typically raised domestic interest rates to defend the currency, further adding to the distress of the financial system.    

China clearly does not fit the stylized facts that emerged out of the "Asian crisis" perfectly.  Broadly speaking, China shares most of the domestic vulnerabilities of the Asian crisis countries on the eve of their crises, but not their external vulnerabilities. 

Like the Asian tigers before their crisis, it has had an investment boom, including a real estate boom (at least in some cities).  Like Asia, that investment boom has financed in large part by a boom in bank credit.  Nor do Chinese banks just finance moribund state firms; they increasingly finance real estate development, residential mortgages and many dynamic, export-oriented (though often still partially state-owned) firms as well. 

[Note: Commentator DOR argues that there aren't many, if any, dynamic, export oriented state firms. In an ideal world I would amend my initial sentence to read "they increaingly finance real estate development, residential mortgages, export-oriented firms and other dynamic, though often still partially stated owned. firms."]

Yet unlike the Asian tigers, rapid credit growth has not generated domestic inflation, led the real exchange rate to appreciate or generated a current account deficit. 

One Chinese conundrum is that savings has grown even faster than investment, so China's current account surplus has surged in the face of an investment boom.   That is somewhat unusual.   The .com investment boom in the US led the US current account deficit to widen.  The .home residential estate boom more recently has led the US current account deficit to widen further.  The investment and office construction boom in the Asian Tigers in the mid-1990s led to significant current account deficits there too.

Good, you might say.  China lacks the external vulnerabilities - current account deficits, rising short-term external debt, and the like - that led to great Asian crash.    Fair enough. 

But by not running a current account deficit during the peak of its investment boom, China also may have lost a key source of support should its investment boom crack - namely the ability to export its way out of a crash.    The Asian tigers went from current account deficit to surplus (and the US went from a small deficit to large deficit) during the 97-98 crisis.  I am not sure China will be able to go from a large current account surplus in good times to an even larger surplus in bad times. China's current account surplus has surged from 2% of China's GDP to 8% of its GDP during its "boom" phase - OK perhaps 6% of GDP now that China's GDP is being revised up.  If China's investment boom crashes a la the Asian tigers, that surplus might rise to 12% of GDP or so. 

Nor am I convinced that the US can play its classic role as the world's importer of last resort should Chinese investment slump, slowing the Chinese economy - and the economies of all the countries that have grown by supplying China with the inputs needed for an investment boom.

I can put the argument in slightly different terms.  China's currency declined in real terms during its boom, in large part because of the central bank's intervention.  Yet currencies usually appreciate, not depreciate, during an investment boom.   So the real depreciation of the RMB between 2002 and 2004 (the RMB appreciated along with the dollar in 2005) was unusual.  And as a result, China may find itself facing continued pressure for RMB appreciation even as its economy slows.  Market pressure from the large surplus of dollars generated by China's large current account surplus and continued FDI inflows.  And political pressures too.  30% y/y export growth has played a significant role in China's boom; China cannot count on 30% y/y export growth to help tide it through a prospective bust. 

Rather than exporting its way out of (future trouble), China will need to consume its way out of future trouble.   That is why I am quite fond of Olivier Blanchard and Francesco Giavazzi's latest paper on China.   It provides a roadmap for reorienting China's economy.

One thing though should be clear: the trigger for financial crisis in China will differ from the trigger for the last Asian financial crisis.  China simply is not vulnerable to sudden pullback of international bank credit.   China's reserves exceed China's short-term debts by factor of six to seven and its total external debt by a factor of almost three.  

The core question, of course, is whether China's external strength will protect it from a domestic banking crisis.  My answer is no.  

Crisis though is an imprecise term.   Bank crises can happen if bank depositors - or a bank's short-term external creditors - pull their funds out of the bank.   Or they can happen if a large share of the banks' loans go bad, leading to large losses for the banks equity investors and even its depositors (if the government does not step in).  The two types of crises are of course often related - depositors are more likely to run if they worry that the banks are bad, and if the banks have to raise their deposit rates to attract depositors, that can cut into bank profitability and eventually deplete the bank's equity capital.   

But the link is not perfect.   So long as a bank is backed by a credible government guarantee, for example, depositors may be happy to keep their funds in a rotten bank.  China's banks, for example, still carry tons of bad loans from their lending to state owned enterprises in the 1990s.  But those bad loans have not stood in the way of a vast increase in the bank's deposit base - or a lending surge. 

Chinese banks also have extended credit in RMB, not dollars.  Consequently they not as exposed to a large currency move as the banks in the Asian tigers were.  That limits the banks' "balance sheet risks" from a hidden currency mismatch. And it is hard to see how the RMB would depreciate significantly in any case.

But lending booms - even lending booms in local currency -- often are followed by a surge in bad loans.  In China, the trigger for a surge in bad loans will most likely to come from the real economy.  And the longer China continues on its current path of export and investment led growth, the bigger the risks of a sharp slowdown (at least in my view). 

The risk:  if that slowdown in investment/ exports is not offset by a surge in consumption, China's growth could slow sharply.    That in turn would lead to a surge in bad loans, and a surge in bad loans might make the banks more reluctant to lend - and make depositors more reluctant to keep piling their savings into the banking system.   Both developments in turn would lead to slump in new lending - aggravating the cyclical slowdown.   Boom would turn to bust.  I am certainly not the only one to worry about such a scenario:  Nick Lardy expressed similar concerns long before I started thinking about China.  More recently, Stephen Green discussed the risk (See his writings for Standard Chartered; his Stanford paper focuses on other issues) though he  believes the risks can be managed with appropriate policies.

In my view, too much of the analysis of the Chinese banking system still focuses on the state banks lending to money-loosing state owned enterprises, and worries that this lending will cause the system to trouble.   That certainly was the story of the last Chinese banking system.  But China has changed.   Lots of state-owned enterprises were closed.  Many of those that remain are profitable businesses.  

I don't want to minimize the remaining problems with China's state-owned enterprises - there are certainly problems there.  The banks still have plenty of dud loans from past lending to dud state-owned firms on their books. But I am also pretty sure that lending to state-owned enterprises is not the only way to get into trouble.  The banks in the Asian tigers did not get into trouble lending to money losing state enterprises, but rather by financing over-investment, whether over-investment in the local real estate sector by local entrepreneurs, or over-investment by large private firms such as the Korean chaebol.  So called joint stock banks (which are often partially owned by the local government) have expanded their lending at a far faster pace than the big four  ...   and China's export sector is starting to look rather over-built, though banks perhaps are a smaller source of financing for the export sector than for the economy as a whole.

My fear: the new, more commercial, rapidly growing Chinese financial system might avoid the mistakes of Chinese banks in the 1990s, but repeat some of the other the mistakes of other Asian banking systems.   Those mistakes won't be financed by borrowing in foreign currency from the international banking system.  But they will still be mistakes.

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