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    A Decade of Revolution Declare Your Research Independence

Takeaway: China: can the Forbidden Economy be rescued? One expert says Yes – but there’s work to be done.

Will China Break?

Hedgeye hosted a conference call on Monday with Dr. Carl Walter, author of Red Capitalism: The Fragile Foundation of China’s Extraordinary Rise.  Dr. Walter received his PhD in political science from Stanford University, where he has now returned as a visiting scholar.  Dr. Walter spent two decades in Beijing in the investment banking sector, including a decade as chief executive officer of JPMorgan’s China banking subsidiary.  

Dr. Walter led off with his conclusion: in his opinion, China will not break.  But it may bend quite significantly.

Who’s In Charge?

While many in the West view China as a centralized one-party dictatorship, Dr. Walter says this is simplistic and wrong.  China’s consolidated power structure is made up of a complex web of interconnected entities, each with their own interest, and each with their own levers of power.  Dr. Walter compares the China of today to Europe.  Even though the nation is run by a central Party, much of the actual power is de-centralized across geographic and economic mini-centers.  

And Power is what it is all about.  The challenge every political official faces is, How to stay in power?  The answer in every case is, Create economic growth and do it in a way that reinforces social stability.  The average Western observer may not appreciate how delicate China’s social fabric feels.  If the head that wears a crown lies uneasy, imagine being one of a small cluster of crowned heads – all with competing interests – with 1.3 billion potentially dissatisfied subjects.  Clearly, it’s not all dumplings and wine at Central Party HQ.

Banking On It

The big banks are the pillar of China’s economic system, providing the funding that drives economic programs.  Individual Chinese do not deposit their money in small local banks, because they know local institutions are essentially powerless.  China’s five biggest banks hold over 60% of the nation’s deposits, with a more than equivalent share of influence.  

Policy makers pushed for greater corporate capital raising in recent years, in their efforts to stimulate growth.  The banks dominated the marketplace, but without a developed capital market, “capital expansion” was really expansion further into the banks’ balance sheets.  New bank loans accounted for over 85% of capital raised in 2009 – the peak year for corporate capital expansion, with over 11 billion reminbi (RMB) raised.  The balance was corporate bonds – zero equity capital was raised that year – and most of the bonds are, in turn, bought by the large banks.  Where does the money go?  

Seventy-five percent of corporate bonds are issued by State-Owned Enterprises (SOEs), while 20% go to the financial platforms of a host of joint ventures and other private financial vehicles, much of it in connection with local economic programs.  Financing from private deposits is already used up, and there is little or no equity financing, making China’s economy look like the serpent that swallows its own tail.     

The drain on bank balance sheets is exacerbated by China’s rating agencies, which rate all corporate bond issues and corporate loans as investment grade.  These means the banks have to make only minimal loss provisions – or none at all – as they continue to expand outstanding credit to an ever-larger percentage of their asset base.

There is no liquid trading market for corporate bonds, which means the prices don’t fluctuate.  “Marking to market” can only happen if the market actually exists.  With no trading in the bonds, the prices don’t change, so banks don’t have to reflect lower asset values on their balance sheets.

Like any enclosed economic construct, this system functions perfectly well, until it doesn’t.

Bulls – And  Bears – In China’s Shop

The banks over-lent in the 1980s and were reined in during the 1990s, giving way to a brief inflationary period in the early 2000s, all while China’s central planners were trying to figure out how to best grow their economy to keep the largest numbers of citizens content.

Now the banks are lending but not generating economic growth.  The central authorities recognize that banking may no longer be the economic solution for China and the discussion now is about changing business models.

But to what?

Any business model requires fundamental underpinnings.  With the banks so dominant in China’s economy, Dr. Walter says corporate governance is a glaring weak point.

Even though the major banks are listed on the Hong Kong exchange, and even though they are subject to public company audits, Dr. Walter says the real management of the banks is not their boards of directors, but the Party committee.  In fact, until recently it was not even Beijing, but regional party committees who directed bank operations, as so much lending was tied to regional projects.  

In the past, local officials or Party cadres who wanted to advance their careers would lean on banks to over-lend locally to drive economic growth in their region.  In the 1980s, when the banks prepared to list on the Hong Kong exchange, control was centralized to Beijing.  In 2008, when the central Party announced their intention to lend in order to stimulate the economy, provincial party officials went into a feeding frenzy.  Local projects were proposed and approved left and right and, says Dr. Walter, “the banks lent like crazy.”  In this scenario, Beijing lost a significant amount of influence over the banking system even while nominally retaining control.

China still has far to go before it develops credible capital markets.  Dr. Walter calls China’s stock market an economic “afterthought.”  The stock markets were primarily a policy tool to permit China’s SOEs to incorporate and establish a presence and a valuation for their securities.  Out of tens of millions of trading accounts on China’s exchanges, only about 7% actually execute transactions.  

Where To Next?

China’s big banks are the economy.  This goes beyond Too Big To Fail.  The Chinese will not allow their big banks to fail.  When Lehman was put into bankruptcy, says Dr. Walter, the Chinese were flabbergasted.  They simply could not understand how the US government could allow a “flagship name” institution to fail.  Could it be, they wondered, the US was actually too weak to rescue a major investment bank?  

China will have a difficult time creating a financial marketplace.  Until it does, there will be no market discipline to accurately price its securities, bonds and loans, to attract serious inflows of foreign capital, or to drive growth.

Government policy has distorted the pricing of bank portfolios.  Currently, there is a 3% differential in yields between corporate loans and bonds.  Since the same entities that issue bonds also take out bank loans, there is no incentive to create a bond trading market.  The banks continue to dominate – or to be stuck with – the lion’s share of Chinese debt.  Chinese households own less than 5% of the nation’s bonds, while foreigners own less than 2%.  Despite noises from such potential buyers as Australia, there is no significant outside market to create accurate pricing or provide liquidity for China’s banks.

Without liquid markets, how do the banks stay afloat?  Remember that the bonds don’t trade – which means no liquidity for the banks (bad) – but it also means the price of the bonds in their portfolios never changes (good!)  Far better[easier] than issuing new bonds to pay off the old ones, China’s banks simply extend maturities – extend and pretend.

This is simply [at worst] unsustainable [and at best economically unhealthy].  All the more so as Chinese local governments and the SOEs turn out to be bad credit risks.  In the 1990s, says Dr. Walter, banks loans rose as high as 75% of GDP – and up to 25% of loans went bad.  Now, the level of problem loans has declined slightly – around 20% in 2010 – but total loans have soared to over 130% of GDP.

In the past decade, the more banks have loaned, the slower China’s economy has grown.  Lending has continued to flow to massive projects driven more by concerns over social stability than by economic justification.  Local debt continues to pile up – by some estimates it could be up to RMB 16 trillion today – a RMB 6 trillion increase over 2011 – on a current GDP of about RMB 45 trillion.  China has borrowed itself into a quagmire, by borrowing from itself for dubious projects.  It has perhaps not been more profligate in its misuse of debt than the West – indeed, Dr. Walter says a global economic recovery will [would] play a significant role in revitalizing China’s economy.  


China’s Party officials remain deeply concerned over potential civil unrest and will continue to focus on local economic programs.  But the country is already significantly overbuilt.  At the same time, economic inequality continues to grow. 

Some 300 million people have been brought up out of poverty in China in the last 20 years – but that leaves one billion people who have not.  Central Party officials and their hangers-on will continue to grow richer, as will those living and working in the prosperous coastal regions.  Dr. Walter expects the rest of the society to decline economically, leading to ever-greater inequality.  China’s aging population does not have Medicare or 401(K) accounts – they have only their savings – and less of a younger generation to rely on, thanks to years of the one child per family policy.  

The difficulty of establishing a consumer-based economy under these circumstances could pale next to a very real possibility of severe social problems, and possible social unrest, in the coming 3-5 years.  This has Party officials constantly looking over their shoulders.

Dr. Walter says China’s banks are not headed for collapse.  There are plenty of assets available to fill the gap left by an unreliable financial system.  But China does not have a good record on financial reform.  Its most significant players – the SOEs, the banks, and the local party organizations – are opposed to it, as each sees the current dysfunction as working to their advantage.  It will take ingenuity and cooperation and the forceful exercise of political authority to bring meaningful change, and the key to how well and how quickly the Chinese ship can be righted lies with the personalities at the center.  

Walter says Xi Jinping, the new General Secretary, is an excellent man for the job: he is outgoing, relaxed and confident in public, and has the support of the military.  But one man is not sufficient to change the course of the gargantuan ship of the Chinese state.  

Finally, China is a major piece of the global financial puzzle.  It will not recover on its own.  Its own recovery will be both a result of, and an influence on global economic trends.