Wednesday, July 27, 2005

The China Chimera

I haven't posted for a while, sorry. Partly due to family commitments, partly because I've been working on this, and partly cos I felt a bit slack. Anyway, I want to commend a book that should be read by anyone concerned with the future prosperity of Australia. It's called The Coming Collapse of China, by Gordon G. Chang. The book itself is full of long-winded anecdotes and is quite repetitive, however it states two critical facts about the Chinese economy that, whilst widely available, seem to make no difference to the almost universally exuberant assessments of China's meteoric rise. This, I believe, is thoroughly irrational. And, in terms of economics, irrational exuberance is known as a bubble. We are experiencing a China bubble. And when it bursts, shockwaves will be felt throughout the world - not least in Australia, and especially in resource-rich Western Australia.

The first fact is the deep insolvency of China's banks. China's domestic banking market is dominated by four publicly owned banks, that hold 67% of China's deposits. That's a lot of dough, because the Chinese people are great savers, squirrelling away around 40% of their income into the banks. Since Chinese stocks - Chinese are not allowed to own foreign assets - are so shambolic, most of that money ends up in bank accounts. Bank accounts. Boring, unproductive, but safe - right? Wrong. The big four Chinese banks are drowning in bad loans. The Chinese government, far from the most reliable source of information, admits that 25% of loans on the books of the Big Four are NPLs (non-performing loans). Most everyone else reckons the true figure is at least 50%, and possibly up to 70%. In Chang's book, he recounts the results of an analysis carried out by Deutsche Bank. According to Johannes Schoeter, manager of Deutsche’s China branch,
The more I knew, the more pessimistic I became.
To give you some idea about the level of NPLs a healthy bank carries, the National Australia Bank states that 0.46% of the outstanding loans on its books are non-performing. A bank sources much of the capital it loans out from deposits it holds. With such an enormous amount of NPLs, the Chinese banks can't possibly honour all the deposits they currently control, even when the performing loans the banks hold are repaid. Too much money has been lost through defaults on existing loans. If the banks are not recapitalised by the government to the tune of anywhere between (no one really knows for sure, but the figure's enormous) 500 billion and a trillion USD, sooner or later they are doomed. They cannot defy gravity forever.

How did the banks get this way? It's down to the second fact - huge chunks of the state-owned industrial sector are made up of bankrupt zombie companies that the government won't allow to collapse. The companies that make up the state owned industrial sector - the State Owned Enterprises or SOEs are a huge collection of, on the whole, wildly inefficient firms that have utterly failed to develop the market instincts that Deng Xiaoping hoped to instil in them when he corporatised them in the early 80s and pulled them off the government boob. An understanding of incentives in the context of risk was sadly lost on a generation of millions of Chinese managers, used to the realities of a largely corrupt socialist system. After two and a half decades of (at best) mismanagement, and (at worst) extreme kleptocracy, many SOEs are in appalling shape. Ancient plant machinery, bloated workforces, unwanted products, enormous inventories and highly opaque balance sheets are the modus operandi of the typical SOE. According to Chang, in 1999, official Chinese statistics - which tend to be optimistic - showed that
SOEs produced around 28% of China’s output with about 53% of its industrial fixed assets and 41% of the urban workforce.
And there's the rub. Not only do SOEs employ a huge fraction of the Chinese workforce, they also carry the crippling legacy of the so-called Iron Rice Bowl - millions upon millions of elderly Chinese who worked for the SOEs during the Maoist era and accepted low wages in return for guaranteed employment and welfare from cradle to grave. If the doomed SOEs were allowed to fail, perhaps hundreds of millions of people would be gravely affected.

The government can't let this happen. Zhongnanhai has identified that unemployment is the number one threat to social stability. Already, the unemployed are restive. Allowing the sick SOEs to collapse, as they surely would if they were cut adrift, will throw many tens of millions out of work and tens of millions more out onto the streets all across China. Such a situation could spiral out of control very quickly. It's hardly being hysterical to say that this scenario could be the harbinger to revolution and the overthrow of the Communists.

This is where the banks come in. Since the government won't let the SOEs fail, the government-owned banks, stuffed with the cash of private citizens, are coerced into "lending" money to the SOEs to keep them afloat. Somewhere between 50% and 80% of all loans are made out to them. Most will never be repaid, because they were not taken out for investment purposes. They were taken out to keep the SOE in question from collapsing due to lack of funds. Hence, the banks have run up enormous portfolios of loans that will never be repaid. And hence the banks' quagmire.

So what can the sages in Beijing do about this seemingly intractable situation? Neither the government-owned banks or the sickly SOEs can fail without catastrophic, and probably revolutionary consequences for the communists. The root solution lies with the SOEs, in my opinion. The banks can be recapitalised by the Central government - at phenomenally vast expense, I might add - but it's possible. However, the problem with the SOEs will still be there. Perhaps the banks will be turned to for a new bout of throwing good money after bad? The SOEs suffer from an endemic culture which traces its legacy back to the Maoist days when they were ran as arms of a giant bureaucracy - the state planned everything, paid the bills, took the revenue and the produce. Losses didn't matter. Inefficiency didn't matter. If these things ever did matter due to some propaganda drive taking place, the results were falsified. Which is pretty much how many SOE managers run their companies these days. If left to their own devices, these SOEs would shut down, however Beijing won't let that happen. So there needs to be a culture change. A completely new method of management must be introduced and enforced.

Very much easier said than done, and I personally don't think it can be implemented in time. The banking system is extremely frail, and the people know it. News of a bank wobble or run, accurate or not, could presage the real thing and travel across the country at the click of a mouse. When one bank goes, they all go. Expect soldiers guarding banks and ATMs. Expect chaos. And then, if the banking system collapses, the dodgy SOEs will be breathing their last. Another hundred million take to the streets across the nation as "Socialism with Chinese characteristics" unravels. How will Beijing react? Another springtime 1989 is a distinct possibility. Trouble is, as Chang says,
A Tiananmen Square solution just will not work these days. Although most Chinese might have a hard time identifying with the democracy activists of 1989, there will be no lack of sympathy for other ordinary citizens.
That is, millions upon millions of ordinary citizens who have lost their job and/or their savings.

I am worried about Australia's economic engagement with China. Our government seems hell bent on driving Australian companies into China. Why, just take a look at this publication by the Department of Foreign Affairs and Trade. It provides an economic overview of China and outlines the opportunities and threats for an Australian business considering starting an operation in China. It also details the bilateral trade relationship between the two countries. This document is the government-sponsored guide to investing in China. It contains the best advice from the Australian government. It emphasises the optimistic view surrounding China, the land of opportunity. It discusses the reforms of the government; “SOE reforms deepening” (pg. 33) is a chapter and “Financial Sector Reform Proceeding” (pp.33-34) is another. It cites the phoney figures released by the Central government regarding the level of bad loans the banks are carrying on their books - 25% of total outstanding loans, (pg. 33) when 50% is thought by most independent experts to be much closer to the mark. The report describes the problems of the banks and the SOEs as “serious challenges” (pg. 43), however the language is couched in terms of ‘these reforms have further to run’ – in other words, the problems are being solved. Merely looking at the contents page (pp. xi-xiv) of this report is instructive; the “serious challenges” (pg. xxi) fill just four pages of a two hundred and seventeen page report.

The Australian Government’s foreign policy stance towards China indicates, with the Free Trade Agreement negotiations and its bullish analyses, that it underestimates the problems lying at the heart of China’s banks and the State Owned Enterprises. The Government in Canberra should be counselling caution to Australian businesses looking to invest in China – its main aim should be trying to scale back the unrealistic optimism surrounding foreign entry into the Chinese market. China has a great deal of potential; however its paradoxical hybrid of communism and the free market have created unsustainable outcomes. It is highly unlikely the Communist Party will be able to solve the aforementioned problems – too much damage has been done to be able to restore these pillars of the economy back to health. Some kind of failure seems inevitable. When the dust has settled (and this may take many years), business engagement in the huge Chinese market makes sense, although it is now continuing unabated – foreign direct investment is currently driving China’s stellar economic growth. Foreign investors are excessively confident, and their confidence shows no sign of slowing. The foreign investors courting China and the governments urging them on are showing this in abundance. However, all booms end. From their failure to recognise the seriousness of the problems within the People’s Republic and the intractability of these problems, countries like Australia stand to import a great deal of the economic misery that China will be exporting to the rest of the once-eager world when the collapse occurs.


Anonymous Steve Edwards said...

I wonder what PF Journey, the Webdiary China expert, will do when China folds.

The obvious thing to do is to jump on the "India bandwagon". But where is the bandwagon? India does not really pretend to be socialist anymore, and is much less sexy than the Communists. In any case, India has no quarrel with the US et al, so it is simply ignored.

Anyhow - these days I'm blogging infrequently over at

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