from Follow the Money

Interesting recent work on China

May 31, 2006

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Chinese stock markets have not been as frothy as the Chinese economy – though the Chinese market is doing better in 2006 than it has for a long time.  But what doesn’t go up as fast also doesn’t necessarily go down as fast. India, Turkey, Brazil, Russia and other emerging economies with (formerly) frothy stock markets have pushed China off the front pages of the financial press.

The US decision not to brand China a manipulator helped too.  Though I would note that China has yet to reciprocate by allowing the RMB to appreciate a bit.    China presumably wants to wait til markets are a bit calmer.   It always finds a reason to wait.

But there has been a lot of good work on China recently -- work that is worth just a bit of attention.

John Makin has nicely pointed out that the combination of rapid reserve and rapid deposit growth and strict lending controls have led to an absolutely enormous build up of liquidity inside the Chinese banking system.

He doesn’t think that is a stable situation.   I tend to agree.

The World Bank’s Beijing office continues to do a great job of providing real time analysis of China’s economy.   The latest quarterly dissects the surge in bank lending, investment and exports in the first quarter.  It notes that Chinese investment continues to be biased toward the tradables sector …


The IMF hasn’t entirely conceded China to the World Bank.   I liked the section’s of the IMF’s regional economic outlook that looked at the impact of the electronics cycle on Asia.   And the data showing the surge in China’s non-oil current account surplus, which the IMF estimates will reach 14% of China’s GDP in 2006.  That is bigger than the US export sector.  So much for the argument that the value-added in China’s export sector is tiny.  

Eswar Prasad and Marvin Goodfriend’s paper lays outs why it is in China’s own interest to stop directing its monetary policy at stabilizing the exchange rate.    Targeting the exchange rate – particularly an undervalued exchange rate – ends up introducing other distortions into China’s economy.  They argue that the PBoC should anchor their policy around the goal of maintaining a low rate of inflation.  That falls short of formal inflation targeting, but it also implies no longer targeting the exchange rate.

I see echoes of Prasad's work around the world.   Eswar – more than others – has argued that China’s current peg requires administrative controls on bank lending, and thus retards China’s efforts to develop a more market oriented banking system.   He consequently is not all that impressed with all the “market” reforms that Chinese officials trumpet.   I think Eswar is right – and so apparently does the OECD.   Their latest economic outlook included a section on China (and the other BRICs). It noted:

“Rapid monetary growth coupled with lower growth in loans [Setser note: in 2005, not q1 2006] has led to abundant liquidity in the inter-bank market and has pushed down short-term interest rates to below the inflation rate, helping to reduce the pressure on the exchange rate but moving the authorities yet further from their goal of using market instruments to stabilize the economy.”

Chinese monetary policy in the second half of 2005 looks to have spurred investment and pushed Chinese growth up – hardly a counter-cyclical policy.

Jaime Marquez and John W Schindler of the Federal Reserve staff have looked at how China’s trade responds to changes in the exchange rate.   And – contrary to lots of “pop economics” commentary that says that the exchange rate doesn’t matter, they found that depreciation significantly increases China’s share of global exports.  It has a small and ambiguous impact on imports.   That makes sense: Chine imports in part because it exports.

Their conclusion shouldn’t be a total surprise.   It you look at the data on p.1 of the Bank of Finland’s quarterly report on China (hat tip New Economist), Chinese industrial production growth clearly accelerated in 2002 before reaching 17% in 2003 – a level that has been sustained since.  That is almost two times the growth rate from 1998 through 2001.  The acceleration in industrial production growth coincides with China joining the WTO.  But it also coincides with the depreciation of the RMB against the euro (see the data on p. 3 of the Bank of Finland report).   I don’t think it is an accident that export growth, investment in the tradables sector and particularly exports to Europe all took off when the RMB started to fall against the euro.

Incidentally, the expansion of Chinese exports embedded in the OECD’s forecast is nothing short of spectacular.  Goods and services exports – roughly $840b in 2005 – will hit $1275 in 2007.  They were only $485b in 2003.  The Bank of Finland data shows that China exported almost as much in the first quarter of 2006 as it did in all of 2000. 

I still think that a sharp slowdown in Chinese export growth is inevitable, and it is one of those things that is not “priced in” in any meaningful way.  Even Garber, Dooley and Folkerts-Landau’s latest work on Bretton Woods two assumes that the US trade deficit cannot expand indefinitely, which implies some deceleration in Chinese export growth.

There also has been a slew of recent work on China’s banking system – and not just from a major accounting firm.     I found Guonan Ma’s assessment of China’s efforts to move NPLs off the books of the banks to be particularly valuable.

Ma convinced me that China really has done a lot to try move old bad loans off the books of the three state banks that are being listed on the stock market …   In 2005, China really did do a lot to take bad loans off the books of ICBC.

Basically, three of the four state commercial banks (CCB, BoC and ICBC – ABC is different) are now in a lot better shape than they were two years ago.    Their bad loans have been bought by the PBoC and then sold to the asset management companies.   That improves the balance sheet of the SCBs – but damages the balance sheet of the central bank.  And adds to the hole in the AMCs balance sheet.   China traded bad banks for bad AMCs.    And at some point, those AMCs will need to be bailed out.

But that still helps the banks – AMC bonds can be discounted in a pinch by the PBoC in a way that bad loans cannot be.

That doesn’t mean that the SCBs are in as good a shape as many think.  Getting rid of bad loans from the 1990s helps, but only if the huge number of loans made during the post-2002 lending boom don’t start to go bad …

Richard Podpeira of the IMF asked whether these reforms have led the state banks to change their lending behavior.   His basic answer is not much.  And, like Ma, he provides a useful review of efforts to move bad loans off the state banks books.

Finally, an updated version of my paper on the “Chinese conundrum: external strength; domestic weakness” has also been published in CESIfo’s Economic Journal – and they generously have made an electronic version available for the world.

This article combines my by now familiar analysis of China’s balance of payments and with my attempt to assess the health of China’s banking system.  My work on China’s banks is largely derivative.  I relied on Ma, on the data from the Chinese government and on some of Jonathan Anderson’s work to estimate how many bad loans have been moved off the books of the Chinese banking system.

My analysis though differs from the standard analysis in one significant way.  Rather than focusing on the reported level of NPLs in the Chinese banking system – data that is somewhat suspect – I focused on the amount of bad loans that have been moved off the banks’ books.   In other words, I looked at the change in the banks NPLs, not the reported absolute level.

My framework lets you pick any number you want for the number of NPLs that the Chinese banks had on their books before the most recent lending boom started.   Personally, I used a higher number than the Chinese authorities.   That may be right.  Or may be wrong.  I have suspicions, but I don’t know.   

But even using a far higher number for “legacy” bad loans than reported by the Chinese authorities, I still found that there has been significant improvements in the balance sheets of the banks.   The banks aren’t as good as the government says, but they are a lot better than they were a few years ago.  

The core question is the one poised by David Dollar, among others.

“What I'm worried about is that there has been a big increase in credit and so the denominator in that ratio is expanding very rapidly," said Dollar.

"Usually when you make a loan it doesn't go bad in a month or two ... so when credit is expanding rapidly you may get a somewhat deceptively low figure for NPLs."

Since most new loans haven’t gone bad (loans don’t go bad so long as the boom lasts), the current stock of NPLs largely dates from the 1990s.   However, the future health of the banks will be determined less and less by the bad loans they made in the 1990s – those have largely been moved to the AMCs – and rather by the quality of their new loans. 

The huge surge in bank lending over the past four years in China, combined with the shift of old bad loans to the AMCs, has effectively remade the banks’ balance sheet.  It is a gamble for resurrection on an enormous scale.  If all the banks new loans perform, the banks will be ok.   The AMCs will still need to be bailed out, but that has been obvious for a long time.

And if they don’t, well, China’s government will have to write another check.

Both to the big four state commercial banks.  And, I suspect, to the fast growing joint stock commercial banks.   I am betting that China will end up writing another check.  The acceleration in Chinese investment growth from under 40% of Chinese GDP back in say 2001 to nearly 50% of GDP now doesn’t seem sustainable to me.   When the boom turns to bust, watch out.

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