There is an interesting article in yesterday’s Xinhua headlined “Capital shortages top risk for China's SOEs.”This seems at first counterintuitive given China’s rapid reserve accumulation, but the explanation may be in the article itself. According to the article:
Lack of capital was the biggest risk facing China's centrally-administrated State-owned enterprises (SOEs), according to a risk assessment report released by the State-owned Assets Supervision and Administration Commission of the State Council (SASAC) on Monday.
A lack of capital worried most SOEs, especially those in electricity, petroleum, steel, investment, energy and real estate, said an expert participating in the evaluation of the report. The expert, who declined to be named, attributed the shortage of funds to the tightening of credit, materials price hikes and reckless expansion.
The rapid expansion of some SOEs was believed to have resulted in the capital scarcity as the continuous tightening of monetary policies and bank loans failed to slow acquisitions and mergers. SASAC director Li Rongrong warned against the "strong expansion impulse", saying investment beyond main business lines and capacities as well as investments with very low returns must be prohibited.
The SOEs, which traditionally get almost all of their funding from the large commercial banks, are being affected by the lending caps, although I suspect that these caps are likely to be relaxed in the upcoming months. It is interesting to me that one of the reasons cited for the capital shortages is “reckless expansion.”
The capital allocation mechanism in China is weak, and one normal consequence of excessively cheap money tends to be overinvestment and excessively rapid expansion.It seems that SOE expansion may have reached the point where the debt servicing costs exceed the returns on investment to an extent that it is putting a burden on SOE capital needs.
This is particularly likely to be the case if we start seeing a build-up in inventories. So far we have only seen this in the real estate sector and the automobile industry, as far as I know, but I suspect we will see references to inventory build-up more often in the coming quarters. The need for capital under current conditions also raises questions about how Chinese companies will deal with capital requirements if we ever were really to have "tight" monetary conditions.
Meanwhile Jake van der Kamp has an article (”Policymakers grappling with inflation monster”) in today’s SCMP with which I am in broad agreement.One of the interesting points he makes is in an attached graph that shows CPI inflation from 1983 to the present. The article and the graph, which I can’t insert here, indicate at least two things that I find interesting. They demonstrate the fallacy of the way-too-common argument that for all the naysayers China has been able to run very smoothly without serious economic problems or crises for the last thirty years, so it is unreasonable to expect anything to go wrong now.
In fact, there have been several periods that are only not called crises by Westerners because the links between the Chinese economy and the rest of the world were too small for the rest of the world to be affected.The graph also shows how quickly inflation can surge – from very low levels to well above 20% in two or three years.
Meanwhile the stock market seems to be ignoring the government’s recent injunction against bad news. It dropped 1.8% yesterday and drifted down another 0.5% today, to close at 2837.
On a very separate note, and for those interested in some of the smaller corners of China’s financial system, I have probably said it more than enough times before, but I am really fortunate in having so many incredibly smart former students from Peking University and Tsinghua University in the world of Chinese finance.They have been able to keep a close eye on the nuts and bolts of finance and come up with very useful information.One of my smartest kids, now a rising star at a major private equity group, sent me the following (slightly edited) email late last week:
As we have invested a substantial amount of capital in a financial leasing company in China, I’ve gotten to know this industry well and would like to share with you some observations. Basically, financial leasing companies here provide 2-3 year asset-backed financing for equipment purchases, with ticket sizes anywhere from RMB 1 million to RMB 50 million. The company in which we’ve invested focuses on the RMB 1-2 million segments, with the underlying assets being construction equipments, printing equipments, etc. Our customers are SMEs which are either too small to obtain bank financing, or have exhausted their real estate as collateral.
Obviously those are also the companies most vulnerable in period of a downturn. It is interesting to see that our financial leasing company has sort of become an informal bank, charging its customers an interest rate of around 25%, and funding itself at 7-8%. The credit default cost will definitely be higher than normal, although we don’t have a clear view as to how high it can go. Hopefully, after deducting the credit default cost we can still make decent returns.
There are at least three things to note there.First, the business is very risky but can be very profitable.A credit spread of 17-18% can tolerate a lot of defaults.It is also growing very quickly, albeit from a small base, at a rate exceeding 30% a year.
Second, I am not sure about, but am very interested in, linkages between these kinds of activities and the rest of the financial system.I assume that the leasing companies get at least part of their funding from banks, and my student confirms that they do (in fact banks are aggressively entering the market), but since the SMEs turn to the leasing companies precisely because lending caps at the banks have cut them off from bank financing, I would guess that much of their funding is direct and not intermediated by the banks.Still, as they mortgage their assets to raise financing from leasing companies, they are effectively putting the commercial banks in a junior position in case of payment difficulties.This means that defaults in the SMEs will have a bigger-than-expected impact on losses in the commercial banks.
The third thing worth mentioning is that neither minimum reserve requirements nor interest rate controls – two of the main tools used by the PBoC to manage monetary conditions in China – are likely to have any direct impact on the loan activity of the leasing companies (or indeed any of the other informal banks).As they increasingly take up the slack forced by the lending caps and minimum reserve requirement hikes, they further marginalize the PBoC.
Well, my view is that 25% lending rate here used by financial leasing company/informal banks is pretty high. I believe that it is safe to say that this 25% is the market rate. Thus, you have a capped formal lending market with negative real interest rate and a free (almost) informal lending market with positive real interest rate. I am waiting to see what PBoC is going to do next after the recentl top meeting.
By fatbrick - 7/29/2008 9:27 PM
zinc and copper smelting are definitely in overcapacity. News of apparel and shoe factories closing due to drop in export growth and increased cost - though I have no information as to the extent of the overcapacity. The big one to watch for is steel - the mother of all industries in a booming manufacturing economy. Production growth rate this year is 5% after many years of 20% growth. My guess is that it will go negative in '09 as overcapacity in real estate and manufacturing facilities flows back into lower steel orders.
on the lending side 25% rates are crazy - more evidence of a boom - bust structure in place. There is no way those companies are going to survive in a slowdown in groeth much a less a recession. Obviously, there are still many in China drunk on the wine flowing out of the boom - hangover in '09.
By SuperDiesel - 7/29/2008 10:23 PM
I agree Fatbrick. We have a two-tiered system with an unclear link between them. It will be interesting to see how they develop jointly.
It's not just 25%, SuperDiesel, it is also that most loans are for very short terms. That creates a real refinancing problem for companies in the event of a liquidity squeeze.
By Michael Pettis - 7/30/2008 6:11 PM
"saying investment beyond main business lines and capacities as well as investments with very low returns must be prohibited."
So, two government commands: Do not diversify your product line, and do not invest in low return ventures. I thought the long centuries of intellectual stagnation of Confucianism was undone in the Revolution of 1905. How are these two commands not evocative of the world-view of "stability," the very opposite of risk-taking?
weren't we arguing about this situation in your post about loose monetary policy?
with all that reserve buildup, the loose monetary policy and yet tightening credit resulting in the lack of financing options for private enterprises, even in the "private loans " sector, could this is be the opportunity for the long-awaited cleanup of invalid industries and enterprises?
Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business. He is a member of the board of directors of ABC-CA Fund Management Co., a Sino-French joint venture based in Shanghai.
Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups. He has also worked as a partner in a merchant banking boutique that specialized in securitizing Latin American assets and at Credit Suisse First Boston, where he headed the emerging markets trading team. Besides trading and capital markets, Pettis has been involved in sovereign advisory work, including for the Mexican government on the privatization of its banking system, the Republic of Macedonia on the restructuring of its international bank debt, and the South Korean Ministry of Finance on the restructuring of the country’s commercial bank debt.
Pettis is a member of the Institute of Latin American Studies Advisory Board at Columbia University as well as the Dean’s Advisory Board at the School of Public and International Affairs. He is the author of several books, including The Volatility Machine: Emerging Economies and the Threat of Financial Collapse (Oxford University Press, 2001). He received an MBA in Finance in 1984 and an MIA in Development Economics in 1981, both from Columbia University.
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January, 2008