24 April 2009

Duncan on China

“It would be difficult to discover any (peacetime) nation during the industrial age that had strayed further away from any kind of sustainable economic equilibrium than China has over the last 15 years…the economy has become dependent on double-digit loan growth to keep loss-making state-owned enterprises in business and China’s huge workforce employed. However, now that the country faces excess capacity and deflation at home, most new investments (undertaken to expand industrial capacity still further) can only be loss making if targeted at the domestic market. In such an environment, the majority of new loans that are extended within China are destined to become non-performing. If the banks continue to extend credit aggressively, the cost that the government will have to bear to bail out China’s depositors may quickly exceed fiscal resources.” 1

“When China’s trade surplus with the U.S. stops expanding, China could find itself burdened with excess industrial capacity, a bankrupt banking system, and insufficient fiscal resources to pull itself out of a deflation-induced liquidity trap similar to the one confronting Japan today. China’s imports from the rest of the world would then plunge dramatically, with a knock-on effect felt from South Korea to Brazil.” 2

“China has a bubble economy. Economic bubbles are caused by excessive credit creation. In China, the loan growth of the commercial banks has amounted to approximately 15% per annum for almost 15 years. To extend loans, banks must have deposits. Much of the deposits the Chinese banks have extended as loans were earned when Chinese businesses exported their goods to the United States. In 2001, China’s surplus with the US was equal to 7% of China’s GDP. China’s GDP growth that year was 8%. Without its trade surplus with the US, China’s economy would have grown at a much slower pace—if at all—both because the exporter’s profits would have been much worse and also because the banks would not have had enough deposits to allow them to expand lending so rapidly. There are a number of problems with this economic model. First, a very large percentage of the credit extended by the Chinese banks cannot be repaid: estimates of non-performing loans in the banking system range from 25% to 50% of all loans. Next, credit expansion in China has already been so excessive that the supply of goods exceeds the purchasing power of the public by a considerable margin. Consequently, prices are falling and China is experiencing deflation despite its rapid economic growth. Finally, China cannot depend on maintaining such large trade surpluses with the US for very many more years. The origins of China’s rapid growth—credit creation and trade surpluses—are both unhealthy and unsustainable.” 3

Richard Duncan’s analysis of China has been consistently bleak for some time. It has been a minority view, but his concerns about non-performing loans have had support from other sources:

“Standard & Poor’s warned yesterday that non-performing loan ratios in China have risen, and added that corporate defaults in 2008 may increase because of tighter credit controls and weakening demand from a slowing U.S. economy. NPLs for the major commercial banks (the big five plus the 12 joint-stock banks) stood at 6.63% of total loans at the end of September 2007, and rose to 6.74% by the end of December. This may seem like a small increase in the ratio, but remember that this increase occurred during what can only be described as optimal times — the economy grew at well over 11% in the 4th quarter, the country was flooded with new money, inflation increased faster than interest rates (which causes debt payments to decline relative to revenues and asset values), loans expanded rapidly (which should push the NPL ratio down), and equity issuance surged.

“We can only guess what will happen if Chinese borrowers are hit by a combination of rising interest payments, slowing external demand and credit constraints. There are already good reasons to suspect that the NPL ratios seriously underestimate the true extent of NPLs, and of course it is well known that most of the improvement in the NPL ratio during the last five years (the NPL ratio was around 20% in 2003) occurred because of the huge increase in loans outstanding — total loans outstanding grew by over 16% in 2007. The question is whether that increase in loans, made during what can only be described as a party atmosphere, doesn’t include a large amount of future bad loans.” 4

And more recent news provides new support for his view that loan growth is leading to excess capacity and deflation:

“China’s new loans skyrocketed in the first two months of this year — new credit in these two months alone amounted to over 70 percent of last year’s level…state-owned and state-controlled companies increased their investment by 35.6 percent in the first two months, and projects funded by the central government saw a 40.3 percent growth compared to last year…If banks continue to extend credit into channels that won’t help the real economy, and if companies stick to their over-capacity instead of downsizing production, it is almost certain we will see even lower prices due to excessive supply.” 5

Also, the combination of credit growth and over-capacity appears to be having unforeseen consequences:

“Chinese companies may be using record bank lending to invest in stocks, fuelling a rally that’s made the benchmark Shanghai Composite Index the world’s best performer this year” 6

Not unlike much of the rest of the world, China may already have entered the “deflation-induced liquidity trap” that Duncan warned about several years ago and its state-run banks may well be insolvent. And, if we accept his analysis, then we have to acknowledge that of all the bubbles in the world the Chinese economic bubble is likely to make the loudest pop when it bursts.

UPDATE May 4, 2009: More evidence of the growth in non-perfoming loans comes from yesterday’s post by Michael Pettis 7 in which he reports on anecdotal information coming out of China that is:

“certainly consistent with all the stories and rumors we hear about banks lending not because borrowers need money for specific (hopefully profitable) projects but rather because they want to show loan growth, and the safest way to do that is to convince large companies and projects with explicit or implicit government guarantees to borrow massive amounts of money…this is almost certainly a recipe for future growth in NPLs.”

1 Richard Duncan, The Dollar Crisis, Revised Edition, 2005, page 159

2 The Dollar Crisis, page 305

3 Interview with Christorpher Runckel, 2007

4 Michael Pettis, February 2008

5 Caijing, March, 2009

6 Bloomberg, February 2009

7 Michael Pettis, May 2009

d. sofer