Is China weeks away from 'Great Depression'?

Euphoria, Meltdown and China's Economy
Stratfor Weekly, April 30, 2004

Summary

New lending policies in China are triggering a fundamental rethinking of the stability of the Chinese economy. This time no amount of damage control can hide the fact that the myth of the Chinese economic miracle is finally -- and perhaps fatally -- breaking apart.

Analysis

Significant uncertainty erupted in Chinese banking circles this week as reports circulated globally that the China Banking Regulatory Commission had suspended all lending for three days. This would effectively create a lending moratorium for well over a week due to the upcoming May Day celebration. The story, which appeared in the Wall Street Journal and other media, was quickly denied. However, Western media, including Agence France-Presse, are citing specific examples of Chinese banking officials who claim to have seen the order. Officials at the China Merchants Bank said they received the order from the CBRC -- and that it was issued by the Chinese Cabinet.

The issuance of the order -- which obviously could not be kept secret -- indicates one of two things. One, the Chinese government, alarmed at what it sees happening in the banking system, decided the situation was out of control and sought to take control with a moratorium that would buy some time for planning. When the international reaction started to roll in, they became alarmed at a collapse of global confidence in China's economy and pulled back. This would indicate a degree of panic. A second explanation is that Beijing, concerned with the banking system, issued an order it had no intention of enforcing -- in order to fire a shot across the bow of the banking system and generate internal discipline.

Either explanation leads to the same conclusion, as Stratfor stated in its annual and quarterly forecasts: There are extremely serious problems with China's economy in general -- and with its banking system in particular. The only issue on the table is whether the behavior of China's authorities reveals deep concern or outright panic. That is an interesting question -- and not a trivial one -- but it does not cut to the heart of the problem, which is that China, contrary to popular perception or even its extremely high economic growth rate, is in serious trouble and is desperately searching for a soft landing -- a landing that might not be available.

To understand China's problems, it is necessary to look at the structure -- and failures -- of other Asian economies. We have already seen two major systemic crackups in Asia during this generation. Japan went from being an economic superpower that was predicted to dominate the global economy in the 21st century to an economic cripple during the early 1990s. East and Southeast Asia, excluding China, similarly passed from economic miracles to economic catastrophes in 1997. In both cases, the striking characteristic was the speed at which overblown Western expectations turned into disappointment. It is our view that China, which got started later than other Asian economies, is on course to be the third Asian meltdown in this generation. The euphoria about China until very recently -- and China's assiduous attempts to stoke expectations -- tracks with what happened in the rest of Asia.

The core problem in Asia -- a problem that the Chinese government is trying to address belatedly -- is that its banking systems do not allocate capital based on market forces. Loan decisions are made out of political and social considerations, and real interest rates vary depending on these relationships. Long-term business relationships in Asia receive favorable treatment from banks regardless of the actual business case to be made for a loan.

Of equal importance, these are debt rather than equity driven economies. The major source of financing does not come from sale of shares in businesses, but from direct loans. There are two reasons for this. The legal structure of Asian corporations gives limited rights and protections to shareholders, who do not collectively control corporate boards. Therefore, maximizing shareholder value is not a driving consideration. It also means that a core measure of economic performance -- the rate of return on capital -- is not a critical variable.

Cash flow is critical. The primary financial relationship of Asian -- and Chinese -- businesses is with banks. The primary interest of bankers, who have tremendous influence on boards, is the repayment of loans and interest. Cash flow is therefore critical to the system, while return on investment -- particularly in the long term -- is not a significant factor. Investment -- and a return on investment -- is more significant in China than in other Asian locations, but the general rule still holds.

The Way It Works, or Doesn't

In Asia, there are two interconnected processes that must take place. First, there has to be a forced savings system that channels money into the banking system at low consumer rates to generate cash for loans. This obviously limits domestic consumption; if you are saving for your retirement because of nonexistent or insufficient retirement plans, you are not in a position to buy a great deal. This leads to a second, linked process: export-oriented economies. If you must make bank payments, and your own market has constrained demand due to high savings rates, your only option is to sell overseas.

In forcing exports, the focus is on cash flow rather than profit margins. This means goods are sold near cost -- and in extreme cases below cost -- in order to cover debt service. From the importing country's point of view, this can have a devastating effect because domestic companies driven by return on capital cannot compete in the short run with Asian imports that are indifferent to profit margins. Entire industrial sectors are taken out. At the same time, economic growth in the exporting country -- measured simply in terms of production and sales -- surges. But underneath these apparently astounding economic achievements, the Asian economy is actually hollowing itself out.

The core problem is that, over time, the allocation of loans based on non-market consideration, means that the economy, lacking market disciplines, behaves in irrational ways. Most important, the disciplines of market economies -- from foreclosures to recessions -- don't happen. Essentially unhealthy businesses continue to grow due to the infusion of debt. The infusion of debt has a number of positive results. It maintains social stability, keeps the political system functioning and it allows banks to avoid non-performing loans. It also has a single devastating effect -- it creates an economy that is kept alive by pyramiding loans that undergird an increasingly dysfunctional system.

Non-performing loans are avoided in three ways. First, there is the continual restructuring of debt and infusion of more money, designed to keep bad loans off the books and maintain confidence in the banks and the banking system. Second, companies implement aggressive export programs to generate cash flow. Finally, programs are put into place to induce foreign investors to put money into joint ventures, whose boards are controlled by Asian companies. This prevents foreign investors from really looking at the books of the Asian parent companies, but allows the boards to make decisions that transfer money from the joint venture into the parent company.

In order for this latter process to work, the Asian countries create a sense of euphoria for foreign investors. Japan in 1990, East and Southeast Asia in 1995-1996 and China in 2003 all created nearly hysterical environments in which foreign investors felt they could not resist participating in various placements and industrial joint ventures. Western investment banks play a critical role in this process by overestimating Asian potential, while collecting fees on placements.

This hollows out the banks. In Japan and Asia, it was the large financial institutions that first felt their foundations collapsing under them. At a certain point, the cash flow requirements outstrip debt service and export demand, and foreign direct investment can no longer make up for them. Non-performing loans begin to accumulate. The banks wind up with more hungry mouths than they can feed, and they scramble to maintain the system.

The system erodes slowly but the perception of systemic failure comes suddenly -- making the management of the flow of financial information a critical issue. The banks, working with the government, hold things together until they can no longer do so. A crisis builds around the public realization that major financial institutions are failing, vulnerable to failure or can survive only through heroic measures. A period of sharp, intense crisis takes place, which does not solve any fundamental problems. A long period of malaise follows, as some recover and others fail.

China Tries to Cope

The Chinese government is trying to prevent the crisis from breaking out into the open, essentially by stopping the intensifying debt production process that banks are engaged in. Of course, if the banks stop making loans, the entire system can hit a brick wall. You can evade the wall if foreign direct investment increases, driven by confidence that the Chinese government is taking steps to control the situation. You can evade the wall if you can increase exports. But if exports are at the maximum -- simply because you can't produce more goods and foreign markets can't absorb them -- and global finance is thrown into a panic by suspending loans, then the entire system can crack.

The Chinese government knows it has a major crisis on its hands. Its loan moratorium was designed to buy a week or so to try to sort through this problem. Somehow, it fantasized that it could keep the moratorium quiet. When the Wall Street Journal announced it, the Chinese realized that a global crisis of confidence was in the offing, so they officially suspended the moratorium. Saying "never mind" is an interesting strategy, but essentially Beijing has let the cat out of the bag. The banking industry is out of control, and the government is not sure how to get it back under control without the very public airing of some very dirty laundry.

In reality, the enormity of the problem is dawning on everyone. This is not a technical problem of managing a normal business cycle. This is a banking system nearing meltdown for which the government would like to find a technical solution that would allow the game to go on. Beijing had hoped a $45 billion bailout ahead of a series of initial public offerings (IPOs) of shares in two of its leading commercial banks would help keep the system afloat. IPOs for banks whose policies are so troubling that the government forces them to suspend lending are not likely to be a wildly successful. The system is crumbling.

The problem is that, as with the rest of Asia before it, the game can't go on for China. On the other hand, the Chinese government can't possibly take the draconian steps that would be needed to begin the process of healing. There would be political chaos.

Therefore, the Chinese government has signaled what it would do with political chaos by blocking elections in Hong Kong. Therefore, we have seen a major outflow of money from China by individuals and institutions that know the jig is up. Therefore, China's leaders have been signaling for the past week that there is a major crisis. They are trying to manage their way through it. But even if they do, the best they can hope for is Japanese- style malaise -- and China's political and social systems are not Japan's. Malaise is not a viable option.

It is interesting to note that the Japanese and Asian meltdowns did not affect the rest of the world as one might predict. Certainly, investments there were devastated, and business plans based on 10 percent growth a year were shattered. But the United States in particular benefited from the meltdown, as panicky money fled its way. One could argue that the impetus for both the early 1990s surge and the late 1990s surge came from money fleeing Asia and moving into the United States.

The sky is not falling for the global economy. It might be falling for China. Without a convertible currency -- this is why Beijing will not float and trade the Yuan -- China has some tools to handle the problem that Thailand or Indonesia did not. In the end, the economic game is ending and the political one is beginning. As China -- slowly or quickly -- decays economically, the political consequences will be the most important. Even if China avoids complete meltdown, avoiding malaise will be much, much harder. Stratfor thought all this would wait until 2005. Right now, the Chinese do not look so lucky.


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