Chinese Banks: It’s Just Like Old Times21 August, 2011, 13:19. Posted by Zarathustra
Tags: Banking, Financials, Reform
A few years ago, McKinsey Global Institute came up with a report on China’s financial system and banking reform, recommending some “western” practices of reforming the financial system. A few years ago, China was indeed going to that direction. After the financial crisis of the west, the reform in China is absolutely getting nowhere.
Here, I have been flagging the problems of the credit expansion in the China’s banking system for a while, pointing particularly to the worrying sign of local government debts overhang, which are largely used to fund projects that are probably pointless. I have also pointed out recently on the problems of high-speed rail in China, which is not financially very viable and is funded largely by debt again. As a result of that, the total “sovereign” debt to GDP ratio would be closer to 100% than to 20%, which is what the official data would lead you to believe.
In the following excellent series of videos, Carl Walter and Victor Shih, two of those who know the Chinese banking system inside-out, explained that “it’s just like old times” when it comes to Chinese banks after the financial crisis, because the leadership saw the western model as a failure. Unfortunately, the Chinese way is probably even worse. As a result, they see slowing economic growth in the years ahead (H/T Patrick Chovanec).
I do want to point out a few other points. Victor Shih pointed out that Chinese political elites are more keen on maintaining liquidity rather than maintaining price stability because it is the liquidity which helps them to make money (by whatever means). Judging from what is now happening, he is right, as I have pointed out earlier that policy makers seem to have given up on price stability. On the other hand, there is nothing to stop the global economy to slip back into a recession that produces recession in the Chinese economy.
Another thing I would like to point out is the implication of the reckless credit expansion which would invariably lead to banking crisis in “normal circumstances”. What I would suggest is that the probability of a Lehmanesque crisis is actually quite low. For one thing, the banking sector in China is still dominated by state-owned banks, and the state is still owning majority of these banks. That guarantees to you that these banks will not go bust, and you can be sure that the People’s Bank of China will be happily throwing money into the black hole.
That does not mean, however, that we just don’t need to pay any attention to this. Earlier, I pointed out that the equity capital of a bank is a leveraged bet on the bank’s asset, which makes bank’s share essentially a call option on the bank’s asset. And if these banks’ asset go bad in a severe recession and if the banks are too leveraged, the chance is the banking share will become an out-of-the-money call option on the bank’s asset. To go even one step further, given that bank loans are what drive the investment-boom in China, which is in turn the main growth driver of the Chinese economy, the Chinese banking sector shares are, I believe, call options on the Chinese economy, which only have a chance of ending up in-the-money if the Chinese economy continues to grow at 8-10% per annum in perpetuity. My conjecture is that growth will be closer to 5% per annum, or even less.
Even though the state will throw money into the black hole of the banking system so that these banks will exist forever, the “out-of-the-money call option” way of looking at Chinese banking sector would suggest that Chinese banking shares are not good investment going forward. Indeed, Chinese banking shares have been going out of favour, doing even worse than JPMorgan. So the probability of having the sort of crisis like the failure of Lehman Brothers is low, but for shareholders, I suspect it will probably feel like one at some point.