China misunderstood

I have really no claims to know anything about China, but the quality of the comments in the English-speaking financial press and blogosphere is so low that some obvious fallacies seem to defy the most basic common sense. Maybe it’s because there’s nobody who understands both macroeconomics and Chinese politics and speaks English.

It seems people are seeing a banking and/or housing market crisis coming, Western-style. The problem is that  the idea that analysing China like if it was Canada or any other run of the mill modern Western country seems comprehensively flawed, there are too many differences. It might have a crisis but if so it is unlikely to be like a Western one given the institutional and cultural differences.

Exchange controls

There are exchange controls, the CNY is not freely floating, so there cannot be a “run” on the country via the exchange rate like there can be in Western countries in case of loss of confidence. Interest rates are thus less linked to the world environment which gives more leeway for intervention.

Rule of law or lack thereof

In the West, resolving a bank or major financial institution is a major hassle because it’s a complex web of contracts that are each subject to negotiation and litigation. It takes decades to resolve even a medium sized entity: the BCCI liquidation took 20+ years, Lehman is 5 years in and far from over. That’s why a comprehensive reshuffle of the financial sector would have been impossible without suspending regular laws and thus why AIG had to be saved and the system couldn’t bear more than one big systemic institution failing and the cost of that one failure was tremendous.

In China the rule of law seems more flexible, and they could probably resolve banks by decree in weeks by simply centrally reshuffling the liabilities of everybody as they see fit, just deciding by fiat who the winner and losers are — after all financial contracts are just promises people make to each other and they can be cancelled by the clearing house for contracts that the state is, it’s just that in the West a mass clearing out of contracts is politically unacceptable.

Public sector banking

Most of the Chinese banks are public entities which are functionally more like branches of the Central Bank or central government than they are independent institutions. So if one particular “branch” goes notionally bankrupt they can be reshuffled as the king pleases, as internal liabilities of the government. The central bank can take any systemic failed assets on its own infinite balance sheet (or simply equivalently have bad debts cancelled by decree).

In a system when one coordinated entity controls (or can control) every lever — mortgage rates and conditions, savings account rates,  for individuals and corporates — the leeway for fixing things is much greater than in the West where individual entities can push in contrary directions because they behave primarily for (1) self-preservation, (2) profit without concern for systemic impact (or at least always behind the primary objectives). Interestingly when Western governments nationalised some financial institutions, like AIG in the US, RBS and Lloyds in the UK, they were still tasked to behave as if they were private entities: self-preservation and a return to the taxpayer as shareholder were or are the primary objectives of their government-appointed executives. Arguably the Chinese government could synthetically run its subsidiary banks that way, but it may not be in the culture.

“Oh la la, the overnight rate is at 7%!”

Some basic maths here: an annualised rate of 7% means that to borrow 1000000 units, you pay around 200 instead of about 20 if it was 0.5%. Peanuts either way. Of course if it lasted a year it would become expensive, but switching into panic mode after a few days seems silly — and even long term high overnight rate would be fixable by forcible public intervention as explained above.

Flat hoarding in a thrifty culture

Allegedly some people in China are buying flats like gold bugs do gold bars, hoarding them without living in them or renting them out — only for their speculative or wealth storage value. While this certainly can be a sign of a bubble, it’s also a sign of solvency: people who have so much spare cash they can afford to pay for idle assets have some leeway in case of trouble: they can rent the bloody flats out. It’s unlikely a property market crash would take rents to zero.

This is pretty much unlike the US were the marginal real estate investor at the peak was very cash flow constrained, with very little leeway to cope with an income shrinkage (being out of a job or having to take a lower paid job for individuals, vacancies or lower rents for property investors). In general China seems to have a strong saving culture, where at least household balance sheets are in much better shape than the West.

Another factor that accentuates a crash, beyond insolvency of leveraged investors, is that some solvent people will exit the asset class that is going down, accelerating the fall for a while. I would suspect the wealth storage function of real estate to be robust, or reinforced by a property/financial criris (like in Spain).

1 comment
  1. I do agree with the sentiment CIG. I’m really not sure what people think is happening in China.

    I like your point about the banking sector not being independent of the centre. It’s spot on. Banks must lend responsibly. This is the risk in China – they lend irresponsibly. But at the same time, banks must lend. This is the western problem. In the wake of 2008 individuals working in their best interests, on both sides of the banking equation, bank and client, have not lent.

    Not sure about the property point though. I agree the demand is cash based. There is an enormous predilection to save in China. The problem is that there is no rental market for many homes. A lot of Chinese don’t want to live in a home someone else has, so there’s only a small secondary market for homes. You buy an empty apartment in China on the basis the apartment becomes valuable in the future as urban sprawl occurs.

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