The publication of a very interesting new book, Gordon Chang’s “The Coming Collapse of China” (which I shall review tomorrow) has combined interestingly with a sharp downturn in the Shanghai stock market.
Chang talks a lot about Chinese politics; but more interesting are the economics: such as why Chinese collapse is likely, when it might happen, and what could trigger it off.
The downturn in the stock market, first, is quite sharp, and unexpected. Shanghai A shares, restricted to domestic investors only, have dropped by 8 percent in the last week, and by 18 percent since the market high in June. B shares, which took off like a rocket earlier this year when domestic investors were permitted to buy them, have dropped by 20 percent in the past week and 40 percent since the June high. Of course, this is all relative; A shares are still up by 66 percent since the low of early 1999, while B shares are up an astounding 700 percent. But it begs the question: if the Chinese stock market took off like Nasdaq, albeit boosted by heavy buying by the Chinese state sector, is it, gasp, possible that it could drop like Nasdaq?
There are a number of features that suggest it is. The government has been selling off minority shares, with essentially no control rights, in state owned enterprises (SOE’s) to small investors, producing such monstrosities as a steel company Initial Public Offering (IPOs) at 27 times earnings, whose earnings themselves were not audited to international standards. Meanwhile state owned enterprises and the banks have been buying shares when necessary, and, together with Party-connected brokers, manipulating the market, thus causing both a sharp upward market trend and a consistent bias in returns against the unfortunate retail investor, whose money is simply cannon fodder for inside manipulation. On close examination, in short, the shenanigans in the Chinese domestic stock markets dwarf even the most acerbic view by critics of what went on in Wall Street in 1998-2000. At some stage, therefore, the bubble has to crack.
However, the most damning feature of the Chinese economy, as revealed by UPI in March, is not the stock market but the banking system. The Big 4 banks are all state owned, and have loan portfolios largely consisting of loans to SOE’s. When the Party needed SOE’s to be bailed out, there the banks were, ready to lend and with no concerns about their balance sheets. Hence the size of the Chinese bad debt problem, in terms of gross domestic product roughly three times that of Thailand, a country whose banking system commentators have largely written off as dead.
There are a number of estimates of the Chinese bad loans problem, but the most likely current figure seems to be around $500 billion of a GDP of $1.1 trillion, on top of the $170 billion already transferred from the Big 4 banks to asset management companies in exchange for government guaranteed debt.
Total retail deposits in China’s banking system currently total around $800 billion ($720 billion at the end of 1999.) This is presumably a fairly solid statistic, although I understand it includes some “gray market” corporate deposits.
Then at least one possible mechanism for collapse is blindingly clear. The Chinese state banks currently have the confidence of their depositors, but have lost already $670 billion of the $800 billion entrusted to them. At some point, probably fairly soon given a world economic downturn that will presumably increase the losses in the SOE’s, the state banks will have lost all their retail depositors’ money. At that point, quite simply, they will have no cash.
There have already been examples of sporadic “runs” on particularly illiquid regional branches of the Big 4 state banks; once banks start refusing to pay out cash to depositors demanding it, news of condition will spread with “Internet speed” whatever the Chinese government’s restrictions on the Internet (reflect, after all, that bank runs happened with surprising speed in the slow-communication U.S. economy of the nineteenth century.) The result will be systemic collapse, final and total.
Of course, $170 billion of the bad assets held by the banks have been replaced by government guaranteed bonds, but it seems very unlikely indeed that the Chinese authorities will be able to realize what is happening, get together tens of billions of dollars in cash from their foreign banking friends, and siphon the cash into the domestic banking market, all without waking even the well-doped suspicions of their supporters in the Economist and the Financial Times.
Once the actual state of the Chinese banking system and the Chinese economy in general becomes a matter of firm public knowledge outside China, confidence will collapse, just as it did in Russia — it must be remembered that in 1998 Russia’s progress in the international media from white hope of economic prosperity to defaulting Commie basket case took less than a month.
Of course, the “Chinese Emperor” has a number of defenses against any suggestions that he is less than perfectly attired. For one thing, foreign journalists who report adversely on Chinese progress tend to have their residency papers revoked. This doesn’t need to happen often; most foreign journalists are keen to further their career in reporting on this exciting market, and so take care to keep their residency papers in order by looking on the bright side.
Another favorite Imperial trick is to produce apparently plausible statistics that “prove” that China is the fastest growing country in the world. Naïve foreign journalists print this claim, and continue to do so even when the Emperor makes claims contrary to clear factual evidence, such as that, following Jiang Zemin’s 1998 exhortations, the SOE’s have all moved from huge losses into profit, or that, in the first half of 2001, Chinese economic growth continued absolutely undisturbed by the downturn in the world economy, at an annual rate of 8.0 percent. This latter claim, like all China’s GDP statistics, was produced within a few days of the end of the period concerned, thus suggesting that Chinese statistics are produced by a well designed computer model, spitting out statistics in seconds, rather than by a laborious process of actually measuring output, which would take months.
In any case, even if China’s 1991-2001 average GDP growth rate of 8 percent were accurate, it does not take account of the $670 billion of bad debts in the system, none of which are accounted for in the official statistics. Hence, even taking the official statistics as accurate in other respects, deflating output sufficiently to produce $670 billion of losses over 10 years reduces China’s growth rate from an average of 8 percent to an average of 5.9 percent, or 4.9 percent per capita — still impressive but by no means the “fastest growing economy in the world.”
An additional deflation can be arrived at by examining “foreign investment in China.” Nominally, this is $45 billion per annum; in practice, as I outlined in an article in June, around half the pool of $350 billion net investment into China represents “round-trip” investment by Chinese savers. Since the return on the remainder of the investment is close to zero, this represents another $175 billion of cost free foreign funds transfer to the Chinese economy. Subtract that from the statistics, and the growth rate becomes 4.3 percent per capita.
And what of the much vaunted 40 percent Chinese savings rate? With personal income representing around 60 percent of gross domestic product, if the Chinese had saved 40 percent of their income since 1991, and had received a net 5 percent dollar return, their total savings today would be $2.49 trillion, well over 200 percent of GDP. However, the domestic banking system is almost a monopoly; until very recently, there was no significant stock exchange, and foreign banks are not allowed to take deposits from domestic savers. Therefore, the pool of savings in 2001 must comprise total domestic bank deposits of $800 billion (including any “gray” corporate deposits), plus “roundtrip” foreign investment of $175 billion, plus a maximum of say $200 billion in gold and stock market investment, giving a total savings stock of $1.18 trillion, less than half the figure that it would be if the savings rate were 40 percent (it’s possible, too that there were some savings before 1991.)
On this analysis, the Chinese net savings rate is not 40 percent but 19 percent, which looks about right for a nation of diligent savers thwarted by an oppressive economic system.
In short, therefore, Chinese statistics, like Soviet statistics before 1991, are made up out of whole cloth – the Chinese Emperor, like the Soviet Czar, is naked. The Chinese banking system is tottering towards collapse, and the stock market is way overdue for a Nasdaq style correction. Whether the banks finally running out of money in 2002-2003, or whether (more likely) the stock market collapsing before then causes a crisis of confidence, a run on the banks, and a collapse of the system, is the only question.
Not whether, or even how, but only when.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.