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Saturday, 3 March 2012

China's Financial Architecture

So what do we know about China's financial system?
A good place to start is with a recent work by Walter and Howie called "Red Capitalism". I came across the volume by the two veteran China bankers in Hong Kong over a year ago.
It's a bit of a technical read, but the pair give a thorough analysis of the Chinese financial system and fill in with a lot of the history (you can buy it here).  It was well reviewed and one by John Plender in the Financial Times really gets to the crux of the matter:

There are, in effect, two Chinese economies. One is dominated by foreign-owned and family-run private companies that generate phenomenal growth mainly in Guangdong and the Yangtze River Delta......Then there is the slower-growth economy dominated by state-owned enterprise, which still provides some social security for its workers. This is a bank-based model.....
While the state-owned system has many of the trappings of western financial models such as stock exchanges, bond markets, interbank markets and so forth, Walter and Howie argue that this is just camouflage.....
Such "trappings" are problematic because as Walter and Howie show (in figures if not in explanation),   China's modern institutions are intertwined with each other in shared political and bureaucratic expediencies.  Inefficiencies, perverse incentives and corruption abound. A good example is the rise of the asset management companies (or AMCs) which were formed to absorb and run off liabilities from the bank insolvencies of the 1990's.  Not much debt has been written off and today they actually compete as active players in the financial markets, contributing to increases in debt.

Throughout the financial system historical debts have not been run off and new ones have been accumulated on a massive scale.  The book covers Premier Zhu Rhonji's partially successful efforts to clean up some of the excess in the 2000's which allowed the largest Chinese banks to restructure their operations and list their shares on international stock markets.  By 2008 however these efforts had been abandoned and banks were lending rapidly to stimulate the economy (on government orders) in response to the global crisis.

A video of Carl Walter and Victor Shih leading a discussion forum on this is here.  Victor Shih is particularly expert on the functioning of government departments in China and touches on the problematic procedures which occurred with some of the post-crisis lending approvals.

So what does all this mean?

Well it probably means there will be a meltdown of some sort in China.

In the short term, China has a large debt overhang with private sector and governmental loans defaulting at just the time when the economy is slowing in response to global pressures.  Chinese statistics as to non-performing loans, manufacturing and the state of the economy are questioned by many.

An asset price bubble (in particular in the property sector) is currently deflating and some commentators are raising concerns about capital flight and decline in bank deposits (with liberalisation of the restrictions on trade in the Chinese currency and reductions in the bank reserve ratio by the Central government).

In the long term, the World Bank issued a report last week saying that without changes to its state sector, China would face a bleak long term future, with innovation stifled and the country falling into the "middle income trap", when growth stalls. A Financial Times article with the details is here.

For China, low growth means unrest.  The rule of thumb is that social stability has previously maintained if GDP growth is 8% or higher (which it has been for a decade).  Patrick Chovanovec makes the point that any growth is hard for China to maintain now after 3 explosive years in this interview with Noel Roubini.

Could there be political as well as economic instability in the near future? While there has been no arab-spring style revolution in China yet such an outcome is at the forefront of the Chinese leadership's concerns.  More on this later.

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