It was only three years ago that the US financial markets handed China’s left-wing command economy conservatives a generous political gift. The mortgage crisis that plunged the world into an economic quagmire seemed, at first glance, to justify the arguments of leftists like Chen Yuan, governor of China Development Bank and an advocate for policy banking.
The free-for-all nature of the Western banking system had delivered the world’s largest economy into chaos and dragged trading partners along with it; China’s policy of semi-isolation and state control looked like foresight. Chinese leaders availed themselves of the opportunity to hector their US counterparts publicly and often. At home, they turned back to their tried-and-true financing model, encouraging the country’s allegedly market-oriented banks to engage in what was clearly a spree of policy lending.
It’s now clear that much of that policy lending will not produce the hoped-for returns. Standard Chartered predicts that US$1.4 trillion worth of loans issued by Chinese banks may go bad. With this in mind, investors have been ejecting from Chinese bank stocks all year. In October, Beijing tacitly acknowledged the seriousness of the problem by ordering state-owned Central Huijin Investment, a sovereign wealth fund that invests exclusively in domestic state-owned firms, to make a small but highly publicized purchase of stakes in the Big Four banks. The result was a dramatic recovery in valuations – 15.5% in the case of Agricultural Bank of China’s Hong Kong shares.
Past precedent
The current debt crisis does not lack antecedents. In the late 1980s, uncontrolled lending to unproductive projects engendered an inflation crisis that took China to the political brink. The late 1990s saw the infamous Hainan property bubble and the high-profile bankruptcy of the Guangdong International Trust & Investment Corporation (GITIC), from which investors – many of them foreign – recovered only 12.5 cents on the dollar.
The bailouts for these crises were handled relatively easily. The Chinese financial system of the 1980s was completely disconnected from the international system, and though the GITIC bankruptcy was embarrassing, it was only one company. Apologists for the distorted investments – some of them writing in the pages of this magazine – have argued that China is a poor country still desperately short of infrastructure and other forms of fixed capital. In the long run, they say, it will all be put to good use. Meanwhile, trusts have taken care of some of the bad loans, and the banks have proven adept at finding other ways to conceal bad assets and keep lending.
And in the context of continued strong growth and massive foreign currency reserves, it is easy to conclude that this is yet another storm in a teacup, another excuse for China bears to write panicked headlines after setting up their short positions. In other words, business as usual, and onward and upward to another year of blistering growth.
The new short target?
Were China now as isolated as it was in the ‘80s, there would indeed be less cause for concern. But the difference this time around is that China is closely integrated with the international economic system, and that system wants China to spend money on imports and overseas investment – not wasting capital covering up local mistakes.
In addition, all of China’s large banks are now listed on foreign exchanges and subject to foreign regulations. Investors have moved away from smaller Chinese firms suspected of fraud. Some are now asking whether Beijing should be allowed to list state-owned banks as if they were commercially oriented entities, and then order them to pour cash into projects where returns are primarily social and political. At other companies, such behavior could justify a shareholder lawsuit.
Obviously foreign investors are aware of the role that Beijing plays in the banking system, and those who buy shares in state-owned companies, be they banks, telecoms or insurers, are clearly investing with a high degree of confidence that Beijing will ensure everything stays on an even keel – that buying Chinese SOEs is a one-way bet. This is why Huijin only had to buy US$31 million in stock to provoke a radical lift in prices. But Dinny McMahon of the Wall Street Journal pointed out in a blog post that mainland investors appeared less impressed by the news than investors in Hong Kong; share prices of the same banks only rose by an average of 3.85% in Shanghai. Other long-term indicators are more negative; investor sentiment toward Chinese long-term bonds is gloomy, and default insurance premiums are high.
In other words, the repurchase is symbolic, and it mostly symbolizes how little the system has changed. Beijing should take no comfort in the fact that the only way for it to restore confidence in Chinese banks is to buy it.