My Blog

September 23, 2008

While Monday’s stock market, led by the banks, continued Friday’s big bounce back, rising 7.8% to add to Friday’s 9.5% surge, leaving us at a 2-week high (largely on buyback talk, I think), worries about the banking sector actually seemed to be deepening.  Today, perhaps in response, the stock market was a lot more confused, with the SSE Composite gaining or losing 50 points five times, before closing down 35 points at 2202, for a loss over the day of 1.6%.  Most other indices – many of which track market value much better than the widely followed SSE Composite – fell by a lot more.  The CSI 300 index was actually down 3.8%.

What’s going on with the banks?  A lot of recent attention has been focused on Chinese banks’ exposure to Lehman and other collapsing US credits.  The nominal numbers being reported are relatively small compared to the bank’s capital base and earnings expectations, but there are persistent rumors that the reported exposure understates the extent of the problem.  That would not be a surprise to many of us.  A Peking University professor who I was talking to yesterday said emphatically: “Do not trust any number the banks submit.”

I am not sure if I am as negative as he is, but coincidently today I had lunch with one of my graduate students who spent the summer working in the treasury department of a large city bank whose name, for obvious reasons, I cannot mention.  He told me that one of the discoveries that surprised him during his time there was the sheer amount of fake bond trades engineered to raise trading volume numbers.  A bank will sell a large volume of bonds today to another bank at some market-related price, with the agreement that the buyer will sell them right back tomorrow at the same price.

Although there has been little economic change as far as the transaction goes – the bonds were merely temporarily “parked” – both banks get to report higher trading volume, which is necessary for them to retain their dealer licenses with the PBoC.  How much of the total trading volume is fake, I asked him – 10%, 20%....50%?  I think much more, he said.  

I don’t know how widespread this is – he said the dealers in his bank claim it is very common – but it does suggest that the government bond and money markets are a lot less liquid than we might think.  This might not matter much for now, but it does suggest that, in a bad market, prices may be a lot more volatile than we would hope and liquidity tighter.

At any rate I have absolutely no idea if the rumors of understated exposure to bad US credits are true, but today Market News International, which tends to have very accurate inside sources in Beijing, had an article titled “Government Concerned Banks More Exposed to Wall St. than Disclosed”.  The article cited statements by unnamed sources who claim that the Ministry of Finance “has already held at least one meeting to discuss a proposal that would involve the sale of treasury bonds to raise funds for a cash injection.”

Although the article claims that nothing has yet been presented to the State Council, who would probably have to approve any such proposal before it could be enacted, it is interesting that in spite of all the soothing noises about healthy banks and limited exposure the government is so worried.  Perhaps they are only taking precautionary steps, with little expectation that they will ever need them.  If that is the case, needless to say, it certainly is a good thing.  Well-thought-out precautionary plans seem to have been in very short supply among both US and Chinese officials in recent years.

The most interesting news today, from my point of view, was the release of a report by Fitch ratings on the Chinese banking system.  The report, prepared by Fitch’s Charlene Chu, argues that Chinese banks are starting to show the first signs off stress and makes the point – obvious to most of the smart folk who read my blog – that what looks good during great credit conditions can easily look a lot less healthy in a less welcoming environment. 

The steadily declining NPL ratio of recent years, for example, has been caused largely by surging loans, but a surging loan market can hide serious credit problems that only emerge during a slowdown, and Fitch claims to see increasing evidence of borrower stress among smaller companies (although they are quick to point out that they are only seeing the beginnings of stress).  They also point out that overdue loans, after declining steadily for many years, reversed course this year to show a 31% jump, from December 2007 to June 2008.  Every single bank of the twelve they monitor except one (Huaxia) showed large increases.

Granted, overdue loans of RMB 187 billion may not be much compared to the overall loan portfolio, and is only 2% higher than the December 2006 figure, but in China we need to be far more focused on the trends indicated by the proxies than by the proxies themselves.  The point is that in the first half of the year, when the economic stress was much lower than it is today and probably even lower than it is likely to be next year, one measure of credit deterioration rose sharply.

Fitch also mentions one of the things I discussed in a blog entry three weeks ago – the repackaging of loans into wealth management products.  Fitch says it is difficult to track these transactions, but they believe that about RMB 50-100 billion was done in 2007, mostly in the second half, whereas as much as RMB 315 billion was done in the first half of this year.  This isn’t large in absolute terms – I am guessing equal to just over 2% of new loans extended – but it confirms my suspicions that off-balance sheet lending (by which I include lending in the informal banking sector) has surged in recent quarters.  They also refer to something I had heard of but knew little about – what they call “entrusted lending on behalf of third parties” – which has also grown substantially.  Aside from the fact that Fitch – like me – worries whether these are truly off-balance sheet when things turn ugly, it shows that there is an awful lot more leverage on both sides of corporate and household balance sheets than we think.

There is a lot more in the Fitch report, and it is certainly worth reading, partly because it is one of the first in what I expect will be a series of increasingly nervous reports by other firms on the banking system.  The report concludes with:

After years of stable, strong economic growth and a benign credit environment, Chinese banks appear to be approaching their first real test of resilience since starting to operate more fully on commercial terms.  How trying this test will prove to be, and how banks ultimately will fare, remains to be seen. While China’s largest banks have achieved a remarkable amount of progress in recent years, deeper, more difficult reforms of banks’ credit culture, risk management, and governance remain in the early stages.

As a result, Fitch continues to be quite cautious with regard to Chinese banks’ ratings, knowing that history has shown that even bad entities can look good during strong economic times. These reservations are underscored by concerns that potential future credit losses may be being under-estimated due to weaknesses in the data underlying banks’ expected loss models.

One piece of possibly good news for the banks as far as liquidity goes, but not good news for NPLs or the performance of the economy, was a PBoC household survey released today.  Chinese households, according to the result of the survey of 20,000 households in fifty cities, have lower inflation expectations than before, but they are also more nervous about the economy and plan to save more (i.e. consume less).  They also plan to invest less in real estate and stocks – only 13% of the respondents said they would like to buy a house in the next quarter, which struck me actually as a high number but is apparently the lowest quarterly number recorded since the series began in 1999.  I assume this increased savings means a faster growth in bank deposits.

Meanwhile a similar survey on corporations also by the PBoC was also released today, with evidence that corporations are increasingly worried about future growth.  According to an article in today’s China Daily:

Chinese entrepreneurs and bankers are concerned about a domestic economic slowdown more than before, according to a quarterly survey by the central bank in the third quarter…A survey of about 5,000 businesspeople show they have higher expectation of an economic slowdown, the People's Bank of China said in a statement on its website.

The macroeconomic expectation index, which gauges entrepreneurs' confidence in future economic growth, dropped sharply to 1.3 percent in the third quarter from 10.3 percent in the second quarter and 16.8 percent in the third quarter of last year. It was the lowest point since last year.

If corporations and households are both worrying about upcoming economic conditions, we may see both fixed asset investment and consumer demand slow.  Coming on the back of what seems to be declining global demand for exports, there is a real risk that slowing growth exceeds even the more pessimistic expectations.  

On a final note, I had been meaning to discuss this last week, but the indefatigable Logan Wright of Stone & McCarthy had a very interesting piece out on September 19, “Monetary Policy Signals in the Chinese Interbank market”.  Early in his report he says:

The Chinese interbank market is turning upside down. Previously, banks avoided purchases of central bank paper if they had a better alternative for the funds, including lending out the money. Now, sterilization paper is in demand, and banks appear increasingly cautious about lending out funds, particularly to smaller companies. This suggests that the central bank's recent cut in smaller banks' reserve requirements is not likely to boost lending growth significantly, but issuance of sterilization paper is likely to surge due to rising demand.   

I have never been convinced that the PBoC actions on credit – raising minimum reserves, for example, or imposing lending caps or changing interest rates – have had nearly as much impact on the overall credit market as many suppose, largely because of the tremendous leakage in the system, including some of the things that the Fitch report mentions.  The main impact of these PBoC credit measures, it seems to me, has been to cause equivalent but opposite shifts elsewhere in the financial system that partly or wholly negate the economic impact of the original measure.

So, for example, constraining loan growth at a time when corporates demanded more loans simply pushed loan formation outside the formal banking system – and it is pretty clear that this has happened quite a lot.  Even raising interest rates for commercial bank deposits and loans altered the balance of loan and deposit demand outside the banking system in ways that limited the net impact – higher bank deposit rates encouraged depositors in the riskier informal system to shift deposits from the higher-paying informal banks to the lower paying but safer commercial banks, so that at least part of the impact of higher rates on deposits and loans was dissipated.

That is why I am not nearly as convinced as most other analysts are that one way the policy-makers can respond to a monetary contraction is to reduce minimum reserves or relax lending constraints.  I don’t think these measures have been effective on the way up, and won’t be on the way down. 

Comments (9) for "Worrying about the banking s...

I am sure nobody has the illusion that the administrative measures can prevent the leakage. They are not meant to prevent that. As you said before, and I had said it several times, the high interest rates in informal banking sector, had the same economic impact of the original measures, curbing the demand for money. Regarding the domestic bond market and the liquidity in the bond market, as far as I knew, there are such a small number of bond products and market participants, also given the interest rates are highly regulated, I wonder what impacts of this market has on the real economy in China. People are more 'permisstic'-this is not some news. World demand is being destroyed. Everybody is going to take some heat. Domestic consumption cannot fill the gap yet. The only question is how hard the hit is going to be? Again, I think the current policies are carried out toward the right direction. But not sure that the new measures are strong enough to offset the negative effects. By fatbrick - 9/22/2008 9:37 PM

NY Times: "One of China’s biggest dairy producers received consumer complaints about its baby milk formula as early as December 2007 — much earlier than previously thought and nine months before the producer ordered a nationwide recall because of concerns that the formula had been adulterated with a toxic industrial chemical, state media said Tuesday." But, the price controls on milk were not imposed until January 2008? If true, then there may not be a cause and effect relation between price controls and the use of melamine in diluted milk. Bingo. By Brestmilk IsStillbest - 9/23/2008 3:30 AM

And, if, news of the milk fiasco was suppressed by the government, as many are now suggesting, to safeguard the hallowed olympics, this is amazing. Because this would mean that far more babies, tens of thousands, in fact, were exposed to the melamine tainted milk, than needed to be. The government officials involved should have known that passing a kidney stone is an agonizing experience. Even for a two year old. And enough to make a grown man cry. Truly amazing. But, the same type of cover-up was orchestrated by the government for the H5N1 avian flu and SARs epidemic, plus many more. Also, there is no hope to enforce any new pie in the sky regulations or laws the central government may make. Because, these will not be enforceable, just as the building codes are not so far enforceable for up to 95% of all buildings in China. In order to enforce these laws, there must be a democratic government at the grassroots level so that corrupt officials can be thrown out of office. There is probably no other way. By Breastmilk IsStillbest - 9/23/2008 4:01 AM

Unsubstantiated rumors on the Chinese Web: Some say that wealthy foreign finance sector and bank executives are now importing to Beijing and Shanghai Guernsey cows for their personal use to control the quality of milk and ice cream they enjoy. These Guernsey cows can be conveniently housed, fed and milked in the second bay of the execs' two car garage, alongside the Benz. If true, they really will be the fat cats that got the cream. By Fat Cat - 9/23/2008 12:12 PM

I think I am being outflanked. This just in from Reuters: SocGen warns China will suffer a deep slump "The collapse of emerging market economies will shake investors to the core. The great unwind has only just begun," said Albert Edwards, the bank's global strategist. "The big surprise in store is what could happen in China. The potential for a deep recession in the US is already on the radar screen, but people will be stunned if China's economy contracts, as I believe it will. Investors could be massively caught out," he said. "The consensus has a touching belief that emerging markets will prove resilient despite a deep downturn in developed economies. My view is that an outright contraction in global GDP is entirely possible next year. The emerging market boom is totally tied up with a decade of ballooning current account deficits in the US. Put that into reverse and you'll be surprised what pops out of the woodwork." Mr Edwards said the vast accumulation of foreign exchange reserves – led by China with $1.8 trillion – had provided the "rocket fuel" of liquidity for frontier markets. This virtuous circle has now turned vicious as America tightens its belt. Countries in Asia and Latin America are intervening to prop up their currencies, causing reserves to fall. "We could see monthly trade surpluses in the US within a year. The emerging market liquidity squeeze will intensify ferociously, and assets linked to the region will become toxic waste. That includes previously resilient banks such as HSBC, Standard Chartered and Banco Santander," he said. By Michael Pettis - 9/23/2008 12:38 PM

There really isn't too much to analyze about the milk thing. It is sad, but totally normal. 1. People take chances, all of us do; 2. Moral incentive is an unsolvable inherent problem with corporates. When economic goal is in line with moral guidelines, no problem; but when they are conflicting, corporates will always choose to take chances; they are called corporates because making money is THE real only goal (forget about the social responsibilies etc crap); 3. For this specific high-growth phase china is experiencing, economic/money is on top of everything (although it shouldn't be). It is expected we see many similar sad incidents taking place as a result of this phase-specific mentality. America's been through this already, when human lives are totally dispensable and 'cheaper' than a bucket of crud oil in the west. Simply, there is nothing you can do to prevent this from happening. The government can only take actions reactively, putting the bad guys in jail/firing government officials etc.. I am sure we are going to see other stuff like the tainted dumplings/milk or whatever continue to take place. Sad fact but have to live with it. p.s. Those importing cows are also the first ones who wore the stupid masks during the SARS period. Bunch of idiotic wimps. if they want to reduce the chance of being killed, they should quit driving cars or stop breathing beijing air first as those would have a higher chance. ha. By Megatone - 9/23/2008 12:51 PM

Megatone, I think the comment made about importing cows for milk was a joke. Even in a milk crisis it is not easy to import cows. By Michael Pettis - 9/23/2008 6:56 PM

Wow, I'm reminded of the American "Snake Oil" salesmen, and Carney Plant, I'll buy a bottle. By Victor Poison-Tete - 9/24/2008 12:31 AM

Well, I know the cow itself is a joke, but what i meant was that there are people of this type running around. Like I know people who would only buy italian tomatoes as they are claimed to 'taste really different' from the 'China polluted ones'. These guys are a joke. By Megatone - 9/24/2008 8:26 AM