There’s no economic bubble out there that’s about to go ‘pop’,” wrote dapper pundit Larry Kudlow. The American business news anchor was expressing his agreement with the editors of the Chicago Tribune that America was “enjoying a Goldilocks economy, not too hot and not too cold.”
That was October 2006. But Kudlow’s bullishness was about to prove somewhat off the mark. Only a few months later the US housing bubble would finally pop and banks would begin to write off a series of colossal losses. Goldilocks was rushed to the emergency ward to have her stomach pumped clear of the CDOs and other toxic porridge that had created America’s worst financial crisis since 1929.
It’s a cautionary tale on the dangers of forecasting. Not that it has stopped Larry from holding forth (each weeknight on CNBC, in case you’re interested).
The theme of the ‘Goldilocks economy’ is also getting a revisiting, although this time, the discussion is about China.
After all, the Chinese economy grew by 8.7% last year and did so with almost negligible inflation.
Can this happy balance be maintained? It’s a point that’s been heavily debated for the past couple of weeks, particularly among equity investors. And the immediate focus: the recent attempts to rein in runaway bank lending.
Has lending got out of control?
Chinese banks lent a total of Rmb9.59 trillion ($1.4 trillion) last year – a massive increase on the Rmb4.2 trillion loaned in 2008. They didn’t do this without encouragement, mind you. The big banks are state-owned and were mandated to support the government’s $586 billion stimulus package with meaty loans.
The policy proved successful. Unlike most large economies, China sailed through the crisis recession-free. Much of the credit goes to the speed with which its banks stimulated business activity – particularly through loans that helped fund the construction of roads and other infrastructure.
However, you can have too much of a good thing. By the fourth quarter, China’s GDP growth had surged by 10.7%. Fears grew of an asset bubble in the property market – fuelled in large part by excessive liquidity (see Talking Point, WiC46).
Then food prices soared. Vegetable prices rose 16% month-on-month in December, reports the Financial Times. In what became a high profile case in the local media, the makers of noodles in the city of Liuzhou raised their prices by 50%. The newsflow suggested a spike in inflation was not just imminent – it had arrived.
Plus the bankers showed no sign of slowing down. According to the 21CN Business Herald, they lent Rmb1.45 trillion ($212 billion) in the first 19 days of January. Pretty remarkable.
How did the government react?
The opening salvo was a 0.5% increase in the reserve requirement. The aim: to suck liquidity out of the banking sector. Global financial markets were spooked by the message that China was back into the tightening phase of the policy cycle.
That same message was repeated loud and clear by the country’s banking regulator at a conference in Hong Kong. Liu Mingkang told his audience that new lending would fall this year to Rmb7.5 trillion – a drop of over Rmb2 trillion versus 2009.
But the reserve requirement was not the only tactic used. There’s a famous maxim about central bankers taking the punch bowl away just as the party gets started. In China, it goes one step further: they don’t just take the bowl, they take the glasses out of the guests’ hands too.
In order to monitor credit growth, Liu’s department – the CBRC – asked banks to report all new lending on a daily basis. It had an immediate effect. Journalists from the 21CN Business Herald visited six of China’s biggest cities and found that a quarter of the banks had stopped making new housing loans completely. New Century Weekly also reckons that January’s actual increase in loans was only Rmb1.2 trillion, since big lenders like ICBC called in a large amount of overdue loans and stopped making new ones in the last 10 days of the month.
Was this the right move?
The South China Morning Post ran the headline this week: “Sharp fall in loan growth after clampdown”. Policymakers in Beijing prefer ‘administrative guidance’ to ‘clampdown’ but it boils down to the same thing. And George Soros is a fan of this approach. According to the FT, Soros “favourably contrasted China’s approach to pricking asset bubbles through ‘administrative guidance’ and control of credit with what he categorised as failed reliance on a purely monetary approach practiced by Alan Greenspan, the former chairman of the Federal Reserve.”
When it first sensed lending was accelerating beyond desired levels the CBRC preemptively made the banks raise new capital (see WiC42). The China News Service reports that the central bank has also introduced a ‘differentiated reserve ratio’, as revealed to the paper by Liu Yu-hui, a senior economist with the Chinese Academy of Social Sciences. As of January 26, an additional 0.5% reserve was demanded from four banks (ICBC, Bank of China, Citic Bank and Everbright Bank).
There’s some merit in such targeted regulation. If the regulator deems some institutions are growing loans in a faster or riskier fashion than others, why not penalise them with an extra capital requirement? Such finessed regulation may make more sense than a ‘one-size-fits-all’ approach to bank capital.
So Goldilocks resurgent?
Not quite. The lending slowdown has hit hard in some areas.
For example, the country’s ambitions to build a bigger rail network than the US may be put on hold. The railway construction boom (see WiC1) was at the heart of the early phases of the government stimulus package announced in late 2008, but the onus for raising funds rests with the local governments. Weng Zhensong, a professor at the Economic and Planning Research Institute of the Ministry of Railways has warned that some train projects will have trouble getting financed in the current climate.
“There are some projects whose economic prospects are low,” Weng told the SCMP. “Rail lines to western China will find it hard to get bank loans.”
Bad loans on the horizon?
Yes. In fact, the rail issue goes to the heart of a deeper problem relating to local government funding.
During the crisis the central government encouraged local governments to build infrastructure as a way to stimulate the economy. It pretty much gave them carte blanche to borrow from the big banks to finance these projects.
The policy led to some unwelcome side effects, says the 21CN Business Review.
In particular, local governments have created financing platforms (the newspaper terms them ‘city construction investment companies’) that operate like quasi-government departments and persuade banks to lend to local construction projects and state-owned firms. The banks do so because these ‘financing platforms’ say that they will provide a local government guarantee on any borrowing.
The Chinese Academy of Social Sciences thinks that around Rmb5 trillion was raised from banks in such a fashion last year.
But the 21CN Business Review says that such lending has got “out of control”. It is principally the activities of these financing platforms (it estimates there are now 3,800 of them) that has got the regulators worried.
That’s because it’s hard to estimate how much of the bank lending has been splurged on projects which won’t make a return sufficient to cover debt repayments.
In some ways it resembles the situation with the Korean chaebol before the 1997 crisis, where blanket guarantees from a web of related companies created huge leverage. Many of the resulting loans were squandered on unviable business ventures.
That didn’t end well.
The problem in this case is similar: the local governments have handed out guarantees far beyond their capacity to repay.
The problem: most local government revenues come from land sales, which is not a sustainable base. Last year, the returns turned out to be good ones. The China Index Academy says receipts boomed – increasing by as much as 140% across the 70 cities it surveyed. But such healthy revenues aren’t expected to last. For example, the city of Beijing is forecasting that its own land sale revenues will grow by a much-more-conservative 9% this year.
Apart from the threat of cities and provinces defaulting on their debts, the other worry for policymakers is the lack of transparency on how all this money has been spent.
21CN Business Review cites the example of an expressway project which got postponed due to an urban planning issue. But the loan wasn’t postponed with it: 30% went on buying land, 50% went into a bank account to earn interest, and 20% went into the stockmarket.
It won’t have escaped regulators’ attention that the casinos of Macau had a record month in January, either.
Yes, $1.8 billion found its way across the baccarat tables.
Liu, China’s bank regulator, seems to sense that some key decisions are approaching.
(Almost) quoting Charles Dickens, he warned the attendees at a recent conference: “These are the best of times, these are the worst of times; this is the age of wisdom, this is the age of foolishness.”
He may well have been referring to the financing activities of the local governments.
But predicting how all of this is going to turn out may well be beyond even him, let alone Larry Kudlow.
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