My Blog

January 9, 2008

WED 9 JAN

Chinese money growth and disguised loan sales By Michael Pettis

On their first day of trading in the Shanghai market today, gold futures traded up 10% in very active trading, in spite of the Shanghai’s Futures Exchange’s attempts to keep speculative activity down.  Gold prices in the futures markets in China are now much higher than they are worldwide, and although I have seen several attempts by various traders and experts to try to explain the difference, ranging from higher borrowing costs in China causing higher forward prices to the inability to deliver gold, it seems to me that there may be a simpler explanation.

 

One of the issues I keep revisiting in this blog is the various ways in which excessive money creation is likely to show up in China, especially as the regulators try to cap loan growth and depress property speculation, and perhaps all we are seeing is some of this excess money flowing into gold futures.  The difficulty of arbitrage means that gold prices in China can depart significantly from gold price internationally (just as Shanghai-based A-shares and Hong-Kong-based H-shares of the same company can trade at widely different prices), and we may be seeing the beginning of a rush into gold futures.  If gold prices continue their upward surge, perhaps the authorities will try to dampen the surge by making it easier to deliver gold from abroad.  This might make the PBoC’s sterilization job easier since gold imports would count towards reducing the trade deficit, although gold holdings may be a substitute for other types of savings and so free up money elsewhere in the system.

 

On a separate but related note, today I got this email from one of my former students who trades the local markets for a foreign investment bank:

 

From DEC 2007, a lot of local banks are looking for buyers for their existing loans, so they reduce their loan/deposit ratio to get around PBoC’s ratio and loan growth limit, most buyers are foreign banks.  CBRC just issued a notice asking all the banks in (both local and foreign banks) to stop buying loans.

 

After several back and forth emails for clarification, I think I understand what my student is telling me.  Chinese banks are selling loans to foreign banks (who are well within their regulatory loan limits because, I think, of their difficulty in getting RMB funding) with an agreement to repurchase them at some point in the future.  The main purpose of this is to get the loans off their books so that they can continue making new loans while not violating reserve ratios, loan caps, and so on.  Although the loans may no longer be on their books, the risk, of course, is since the repurchase agreements specify a date and price.

 

In an earlier posting I speculated that we might see an upsurge in loan securitizations in 2008 as banks try to get around the new lending caps by selling old loans to investors, who have plenty of cash.  Yields on the bond markets are lower than the interest rate on loans, so there are many ways for banks to do this while profiting, and loan caps can force bankers to do what they normally hate doing – removing revenue bearing loans from their portfolios.  I remember when I was a young banker in the early days of loan sales it was difficult for banks hoping to liquefy their loan books to convince loan officers to sell their loans, since the profit on the loan sale was never as high as the original interest income (even though it was much higher quality), and the size of total income measured the importance of the loan officer.  I suspect that there may be an equal reluctance on the part of Chinese bankers to sell their revenue-bearing assets, but lending caps may force Chinese bankers around this problem.

 

I still think we may see loan securitizations happen, but it seems that banks have discovered an easier – and much more dangerous – way of getting loans off their books.  I have no idea of how widespread this is, but one doesn’t need to have passed through the sup-prime crisis to know that off-balance sheet exposures can hide an awful lot of trouble.  If the system were to hit a speed bump or be forced into a contraction, banks that seemed to be within their loan limits would suddenly find themselves being forced to take on loans that had been recorded as sold, and so they might also be forced into selling these loans at knock-down prices in order to stay within their limits.  Of course this would happen at exactly the time when banks needed to shore up capital.

 

As I said, I don’t know how widespread this is but the fact that the CSRC has issued a notice asking banks to stop buying loans suggests that it is at least a noticeable problem.  I think we should expect lots of other “creative” ways in which banks will deal with lending caps.  After all, if deposits grow faster than the cap on new loans, the banks will have to do something with that money.

 

I would appreciate if any readers who follow the lending market closely can provide additional info or clarification on these kinds of loan sales, either privately to my email address or in the “Comments” section.

 

One last thing, a survey of economists suggest that December’s trade surplus is 16% higher than last year’s.  They predict that exports were up 23% year on year while imports climbed 25.5%.  We should be getting the actual numbers any day now.