Prudent Capitalism - China Style

Source: Stockcharts.com

China is behaving in truly Keynesian fashion by cleaning up bad debts on bank balance sheets and demanding prudence and risk management during boom times while forcing banks to expand their balance sheets aggressively during more challenging times in order to move funds into the economy.

Though the author of the article below takes the view that China’s actions within the banking system are inappropriate, I would assert that it is exactly this mechanism for moving funds into the economy that European and North American economies are lacking.

It is also why China is likely to lead us out of this global slump. Chinese shares have been demonstrating consistent relative strength since mid-October. Shares in Shanghai and equivalent H-Shares in Hong Kong are making higher highs and higher lows, and they are holding above both short- and longer-term moving averages.

 Source: Stockcharts.com

Singapore, Hong Kong and Taiwan appear poised to break out to the upside on the back of the strength in Chinese shares. Brazil and South Africa also look strong and, with both the reais and the rand looking to join the Euro in a surge against the dollar, you may receive a double whammy on the ETFs.

Please see the following story from Dow Jones News.

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Chinese Banks' Great Leap Backward

Around the world, the banks we see today are very different from their former selves of just a few months ago. The transformation has been most pronounced in the U.S. and Europe, where a combination of mergers and government involvement have reshaped the financial sector. But change is afoot elsewhere as well, and it isn't always positive. In particular, Chinese banks are currently under enormous pressure to change their business practices in ways that represent a serious step backward.


A year ago, many of us were ready to be impressed with China's banking system. To be sure, banks were still mainly state-owned, and the Chinese Communist Party continued to be omnipresent. However, the average bank managers were extremely risk conscious, and regulators from the China Banking Regulatory Commission (CBRC) swooped down on bank branches conducting surprise inspections every so often. Bankers were extremely hesitant to make uncollateralized loans to any firm except for the largest corporations.

This was an enormous change from just 10 years ago, when bankers doled out large sums at the slightest urging of the local governments and when banks were considered the "second treasury" by central policy makers. At that time, the nonperforming loan ratio was estimated to be nearly half of all loans outstanding. By January 2008, the official NPL ratio was less than 6%. This transformation wasn't cheap or easy -- it required hundreds of billions of dollars from the government to buy bad loans off bank balance sheets and recapitalize the institutions, and also the participation of Western "strategic partners" brought in to lend their expertise in best practices.

However, risk-prevention institutions built up over the past decade are now under enormous pressure to forgo prudence in the interest of maintaining economic growth. There have been two triggers for this. First, the global recession caused a plunge in demand for Chinese goods -- in November, Chinese exports fell for the first time in nearly a decade. At the same time, the property market continues to shrink in many major Chinese cities.

Anticipating a declining economy, in November the central government announced a four trillion yuan ($586 billion) stimulus package to be carried out in the next two years. At the same time, the National Development and Reform Commission was ordered to approve fixed asset investment worth 100 billion yuan before the end of the year. As of mid-December, much of the money has been doled out. This forceful injection of funds into the economy will be the dominant method of generating growth in the next two years.
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Banks are trapped in the middle, because they will finance much of the stimulus package. Of the four trillion yuan stimulus, only about a quarter will be financed by the government's central budget. At a time when local governments are strapped for cash due to falling land prices (land sales are a common form of municipal cash-raising), banks are expected to finance much of the remaining three trillion yuan in the package. This isn't a matter of choice. Most banks must follow the government's lead because senior bankers are appointed by the Party.

It gets worse. Local governments have announced a further 20 trillion yuan in investment to "supplement" the central package. Assuming both Beijing and the local governments stick to these spending targets, banks will be under enormous pressure to finance trillions in state-sponsored projects in the next two years. With so much money to push out the door, risk management will almost inevitably take a back seat. Banks that had made enormous strides toward global best practices were compelled by central pressure to greatly boost credit in the last two months of this year.
Prudence is not completely out the window yet because of continuation of CBRC monitoring, but risk management is increasingly a second priority. The CBRC has sent subtle signals to banks to not worry about profit too much and to exclude more risky loans to small- and medium enterprises from their main balance sheets.

Partly as a result, banks are increasingly compromising between risk prevention and political pressure by boosting lending through bill financing instead of writing outright loans. In theory this limits risks because bill financing tends to be short-term and can be easily transferred to another bank. Of the 477 billion yuan of new loans made in November, half were in bill financing. The rise of bill financing may increase systemic risks in the future because banks tend to be less careful when they discount these bills due to their transferability. Loans, on the other hand, are stuck on banks' balance sheets.

Meanwhile, if the economy worsens in the first quarter the government may be tempted to abandon prudent regulation altogether. Beijing could order the CBRC to disregard risk targets or even abolish the CBRC. This would plunge China back into the old days when the only risks that bankers faced were political ones.

Without a global financial crisis, the global financial community might have criticized such a giant step back toward the planned economy. The criticism might have at least triggered some debate in China. However, with the rest of the world suffering a severe credit crunch that has seen free-market governments bailing out their own financial institutions, there are few people left who can credibly criticize China's actions.
Western central banks have conducted operations that once were monopolized by the Chinese central bank and drew scoffs and snorts from the global banking community. For example, the People's Bank of China, the central bank, used to conduct "relending" operations to inject funds into distressed banks to pay creditors or to write off distressed assets. Now, the Federal Reserve is doing the same by buying or accepting as collateral questionable assets from banks.

In any event, everyone is too preoccupied with their own losses to comment on Chinese policies. Which is a problem, not least for China itself. With enormous political pressure from the central government to pump money into the economy and silence from the rest of the world, much of the work in the past decade is being undone.