Taming the galloping dragon?

Most economists understand an expression like the title to refer to the battle to restrain inflation.  For China, the dragon is a national symbol and in recent times the political elite have not only been battling inflation but struggling to steer China Inc.'s runaway growth.  Prime Minister Wen Jiabo's announcement of the lowered growth target at the annual National People's Congress this week was well covered in the international media, which used the opportunity to look back at the last decade of China's astonishing success story and speculate as to where China (and its trading partners) are now headed.

Speculation like this is not new, but it is an issue which divides - most analysts seem happy to quickly take a stand as either a China bear or as more upbeat.  Jim Chanos, famous for shorting Enron, has been one of the most vocal and consistent in pointing out the peril should a collapse in the Chinese model of over-investment and top-down directed rapid growth occur, in 2010 speaking to students at Oxford University, followed by a more recent explanation of his "long corruption short china" trade when discussing recent property price falls in China on CNN.  Meanwhile with Jim Rogers and other outspoken individuals coming to life, the Wall Street Journal felt compelled to track the ongoing exchanges in its "Chanos China Smackdown Watch" series.

Most will have seen a picture or two of an empty Chinese mega shopping mall, or even London hedge fund manager Hugh Hendry's form of disaster tourism, which involved him standing in front of lots of tall empty skyscapers in a third tier city.  What is interesting is a dynamic behind-the-scenes that may be equally or more important - weakness in the Chinese banking system.

Hugh Hendry in front of a building

This was touched on in Walter and Howie's book, though they covered all of the Chinese financial system, the domestic banks were at the core of the story.  And there was certainly at least one paradox they identified - how could China's large pillar banks, recently internationalised and amongst the largest banks in the world, be so reliant on external fundraising?  Why did rights issues follow soon after their IPOs?

Chinese banks have numerous advantages in their domestic market due to the regulation and restrictions on savings and capital in China - as one piece in the Sydney Morning Herald put it (when referring to the low deposit rates on offer to savers due to government regulation):

No wonder that one senior Chinese bank executive was embarrassed to reveal his bank's profit, or rather, the money his firm had fleeced from depositors.

The large banks have played an even larger role in executing government macro policy, including accelerating lending after 2008 and, with the People's Bank of China's elevating the reserve requirement ratio to its primary tool for slowing inflation, becoming the conduit for transmission of government targets into the economy.

Yet despite (or in spite of) such conditions, Chinese banks are not as necessarily healthy as they seem.  Not only is it likely that the size of their non-preforming loans is understated and likely to rise, there are more fundamental and deeper problems which are likely to manifest themselves.

Charlene Chu is a Fitch analyst who has brought to attention some of these weaknesses.  In this interview with Bloomberg she named a number of issues for concern.  Many are familiar and outcomes remain to be seen.  Of most interest I thought was the reference to questions about the level of capitalisation of banks.  For most the ultimate answer would be that the central government of China has sufficient foreign reserves to act as a backstop in the event of (or preventing any) contagion.  Of course as we know from the European debt crisis, any doubt or uncertainty about a government backstop can disrupt any attempts to bolster bank balance sheets.

There are plenty of toxic loans in China's banking system from legacy debt portfolios accumulated in the eighties and nineties to local government excessive borrowing in the 2000's.  This article by Anthony Hilton in today's Evening Standard (covering a gloomy note by Lombard Street Resarch) gives some more detail and it does not look pretty.  In sum, China's leaders are going to struggle with an unpredicatble dragon for some time to come.