Distortions in the Chinese Lending Environment

Things have been so busy this past week with various writing commitments and with the celebration of the third anniversary of my music club (four amazing shows with some of Beijing’s greatest artists and a lot of support and coverage from local music scene participants an the press) that I have been neglecting my blog. For today’s entry I don’t have any major points to make but I did want to take a look at some of the anecdotal information we are getting about the bank-part of the fiscal stimulus package.

The context is last week’s post in which I argued that the almost certain reversal over the next few years of American ability to grow consumption at a faster rate than GDP will put huge pressure on the Asian development model, and will require Asian consumption to grow much faster than Asian GDP. However if the current loan explosion is mismanaged, this may itself sharply constrain Chinese consumption growth, thus locking China into a long transition period of turgid growth.

In that light two weeks ago The Economic Observer, one of the better local newspapers, had an interesting article titled “Millions of Small Businesses Still Starved of Credit”. The growth of smaller businesses, many of which are in the service industry, is one important way for Chinese net consumption to grow, but it seems that their ability to obtain financing is being sharply limited by formal or informal policies that are driving capital into the investment sector. The article suggested that even with the explosive loan growth in the banking system, smaller companies are finding it extremely difficult to get loans.

New loans in China for the first quarter of this year would amount to nearly 4.6 trillion yuan, but behind the staggering figure, millions of small and medium-sized businesses nationwide were still struggling to raise funds.

Data from the National Association of Industry and Commerce (NAIC) showed that in January of this year, private firms had 421 billion yuan in short-term loans, a 700 million yuan decrease from December 2008. That was despite 400 billion yuan in new short-term loans released that month.

The article goes on to mention a survey of businesses in Chongqing that indicated that 82% of small and medium-sized businesses there considered the lack of funds the main hindrance to their development. Quoting Chen Yongjie, an official with the National Association of Industry and Commerce, the article goes on:

The Chinese government has recently pushed measures to solve financing problems for small and medium-sized businesses – for example, China’s Banking Regulatory Commission has required banks to open loan departments exclusively for small companies. But Chen said it was hard to tell how effective these measures would be: “What we can see clearly now from the statistics is that loans for small and medium-sized businesses are still dropping.”

It would be normally be surprising that loans are expanding so rapidly (we have already increased net new lending in the first quarter of 2009 by more than all of last year’s loan increase) while whole sectors of the economy are struggling to find financing, but my friend Dan Rosen sent me a Bloomberg article from Friday with a line which he found very funny and a tad startling. According to the article:

The largest borrower in the quarter was government-owned China Aviation Industry Corp., or AVIC, the nation’s biggest aerospace company. The Beijing-based company received 236 billion yuan from 11 Chinese banks, including ICBC, China Construction and Bank of China. It won another 100 billion yuan of credit from Export-Import Bank of China on April 16, without specifying how the money will be used.

AVIC General Manager Lin Zuoming said in an April 16 interview with Beijing-based newspaper Economic Observer that his biggest worry is how to allocate the borrowings to increase returns.

It’s the last line, of course, which Dan marked out. The largest single borrower, it turns out, has taken out around $35 billion in loans but doesn’t seem terribly certain about why he borrowed the money. I don’t want to read too much into a single throwaway line, but it is certainly consistent with all the stories and rumors we hear about banks lending not because borrowers need money for specific (hopefully profitable) projects but rather because they want to show loan growth, and the safest way to do that is to convince large companies and projects with explicit or implicit government guarantees to borrow massive amounts of money. Of course it helps that managers aren’t terribly concerned about creating value for their shareholders, but this is almost certainly a recipe for future growth in NPLs.

Obviously I (along with most of the readers of my blog) am not the only ones to realize this. Friday’s South China Morning Post had this to say:

Citic Bank Corp, the country’s seventh-largest lender, is optimistic about this year’s earnings outlook and is reining in loan growth to safeguard against a rise in bad loans. Chief executive Chen Xiaoxian said the bank would adopt stricter loan checks and had sent inspectors to those branches that had recorded a surge in discounted bill financing in the first quarter. “Banks need to take more forceful actions to increase risk controls,” he told reporters.

The article goes on to say:

Total lending by mainland banks in the first quarter reached a record 4.58 trillion yuan, close to the government’s minimum target for the whole year of 5 trillion yuan. Asked about his top concern, Mr Chen said: “Of course, it is asset quality given such fast loan growth.”

Mr Chen called the surge unsustainable. He did not disclose how much Citic Bank had lent in the first three months, but he said the pace would slow. “No matter how complicated your businesses are, you must clearly know the default rate,” he said of lessons learned from the global financial crisis.

Of course Mr. Chen is right. The current rate of loan growth is unsustainable and the biggest concern must be the risk of a sharp rise in NPLs. One would expect that all of this would quickly cause the PBoC to put the brakes on lending. The always intelligent Jim Walker of Asianomics thinks this will happen, but is nonetheless so worried about continued loan expansion he asks in an April 14 report:

Exactly why is this process dangerous?

First of all, China has an extremely high M2 to GDP ratio to begin with. As Figure 2 shows, M2 in 2008 already represented 158% of GDP. Compare this with money conditions in the US where M2 accounts for just 54% of GDP (the US ratio is read off the left-hand scale). If the US’ monetary easing efforts are such that investors are convinced that the dollar is no longer available reserve currency then the conclusion must be the same as regards the renminbi – only much more so. The only reason that the renminbi is not nose-diving in world currency markets is because domestic economic actors are not allowed to sell it.

For Walker, the explosive growth in lending is exacerbating what was already a very big problem, China’s huge bank-funded overinvestment. He goes on:

The second word of warning is that this breakneck monetary expansion will have to cease soon. The PBoC says that it will support economic growth through easy monetary conditions. It has certainly been true to its word so far but the problem will quickly become one of having a ‘tiger by the tail’. In Hayek’s analysis of economic growth he concluded that the only way an economic system hooked on credit could maintain its growth rate was for it to add ever increasing amounts of credit to that already existing. Adding the same amount of credit would result in recession-like conditions.

This, in his view, was the road to hyperinflation. The alternative, putting the brakes on monetary expansion, would lead to economic depression. On the assumption that Beijing will not wish to risk a hyperinflationary outcome we suspect that it will slam the brakes on the banks (which are clearly out of control already) within the next few months, regardless of the comments being made by the PBoC today. The next move in monetary policymaking in China will be to tighten, a move that will be badly received by markets that are already starved off profits.

Perhaps, but most analysts are betting against Walker. Xinxin Li of the Observatory Group points out that Wednesday’s decision by the State Council (effectively the equivalent of the executive cabinet) to reduce the capital ratio requirement for financing capital spending for infrastructure “is a further effort by the central government to implement its massive fiscal stimulus plan, in order to boost investment demand and support economic growth.” In his opinion the current policy environment “makes any hawkish statement from the PBoC politically incorrect. Just a couple of days ago, Vice Premier Li Keqiang said that the global financial crisis is having a deeper impact on the Chinese economy, showing that the top leaders are unlikely to drop their guard on the economic difficulties until Chinese economy firmly is on a recovery track..” In his April 28 report he concludes:

While the PBoC is concerned about the current pace of money expansion, it is unlikely to impose tightening measures to slow lending growth in the near term, due to an unclear economic outlook and the political priority on economic growth. China’s loose monetary conditions will likely persist in Q2.

The problem here is that Jim Walker’s analysis may be right but Xinxin Li’s prediction may also turn out to be right (and I suspect that Li doesn’t necessarily disagree with Walker’s analysis). Just because there is an urgent need for a policy doesn’t mean that it will happen. I remember that in early 2007 I argued aggressively that the PBoC would have to engineer a maxi-revaluation of the RMB because a slow revaluation would create huge hot money problems for the country. Of course the maxi-revaluation didn’t happen, and many of my friends seem to find my very wrong prediction a never-boring topic of conversation, but I defend myself by saying the analysis was correct, the prediction of huge hot money inflows was also correct, and soon enough the warnings about how destabilizing these inflows will be will also turn out to be correct. The global crisis intervened, and we will now see that China’s failure to have adjusted the currency much earlier, as a way of accelerating the transition from export growth to domestic-consumption growth when conditions were so good, will have a very painful cost.

So even if Jim Walker is right in that Beijing has no choice but to slow loan growth, he can still be wrong about assuming that they will. That of course would be the worst possible outcome.

Before ending, I wanted to cite a line from my friend Justin Winkle, who was responding to the comment discussed above that Dan Rosen found funny and startling. I am sure this has absolutely nothing to do with the topic under consideration, but here it is anyway.

My quote of the year is a line from Lewis Carroll appropriated by my stockbroker to describe the global economy: “If you don’t know where you are going, any road will get you there.”

As long as I am doing literary allusions I was just rereading PG Wodehouse’s classic Joy in the Morning, in which Lord Worplesdon explains to Bertie Wooster, in one of their very rare moments of camaraderie, why an American businessman they know seems so easily startled:

“Odd, this neurotic tendency in the American businessman. Can you account for it? I can. Too much coffee.”

“Coffee?”

”That and the New Deal. Over in America, it appears, life for the businessman is one long series of large cups of coffee punctuated with shocks from the New Deal.

I guess you can find economic history in the oddest places.

About Michael Pettis 166 Articles

Affiliation: Peking University

Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business.

Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups.

Visit: China Financial Markets

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