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China's Distorted Financial Markets

Is China on the road to going bust...?

THERE is still a lot of complacency about China, writes Greg Canavan for the Daily Reckoning Australia.

People think policymakers can flick a switch and domestic demand will take the reins of growth. After all, there are lots of people in China. They all need to buy stuff, right?

While that's certainly true, China's manipulated financial system holds the key to understanding why domestic demand won't pick up anytime soon. And with most of China's leadership in denial, deep and difficult reforms are not on the immediate agenda.

Consider this from yesterday's Financial Review:

'The Lujiazui Forum is one of China's many attempts to portray itself as a modern society with sufficient self-confidence to discuss its problems...But when it closed on Saturday, many delegates would have been left with the opposite message to that intended. For the most part, speakers rolled out the official line, denied there were any significant structural problems in the economy, and even tried to refute that local government debt was an issue – 30 per cent of loans are expected to go bad.'

While officials may deny it, China's economy has major structural problems. At the core lies the financial sector. China's major banks are a tool of the Communist Party. Indeed, the Party is the majority owner of the banks. It sets the borrowing rate and the deposit rate. It encourages banks to lend freely to other state owned enterprises (SOEs). And it doesn't care whether the SOEs are profitable or not. As long as they employ lots of people...profits are a secondary concern.

China's banking system is nothing like the Western banking system. While that should be an advantage, it's not. The difference lies in the fact that China doesn't allow for the free flow of capital into and out of the country. While Western banks source much of their funding needs via the corporate bond market (basically a big pool of global capital) Chinese banks rely almost exclusively on 'internal capital'.

And because the Chinese bond market is still in its formative stages, most of this capital is in the form of deposits made by the household sector. But the Party sets interest rates for savers artificially low. The deposit rate is below the rate of inflation, meaning China's savers earn a negative rate of return. What's bad for savers is good for spenders. As the Financial Review article states,

'This cheap money has made China's banks the world's most profitable and given property developers, local governments and anyone else in business a big leg-up. Put simply, China's households are subsidizing the corporate sector as the country has had negative real interest rates since 2004. If you're in business, it's been happy days.'

This easy money, combined with state-directed lending, has created major distortions in the Chinese economy. One of the speakers at the Lujiazui Forum pointed out that China devoted 40% of fixed-asset investment to the construction of industrial assets, even though overcapacity had emerged in 21 out of 24 industries as early as 2009. And still the government directs funds to these industries.

In short, the Party directs the country's savings to unprofitable investments for the sake of their own, short term gain. To give you an example of the insane spending, check out the latest Chinese ghost city...only this time it's in Angola!

Built by the state-owned China International Trust and Investment Corporation (CITIC), the city reportedly cost US$3.2 billion. But the place is mostly empty.

Apparently, the apartments cost between US$120,000 and $200,000. In Angola, where two-thirds of the population live on less than $2 a day, selling the units will be tough work.

But the real estate agent charged with this task has taken on Chinese levels of denial. Price is not the problem, he says. The lack of credit is.

So there's another US$3 billion or so of China's savings that will slowly deteriorate. The Party is destroying the nation's savings. If you think about a company that invests billions into unproductive assets, it eventually must write them off. And if the assets remain unproductive, or earn a very low rate of return, the company's share price will eventually go to zero. It will declare bankruptcy.

Well, if you think about it in the true economic sense, if it keeps doing what it's doing, going bust is not out of the question.

But what about China's US$3 trillion-plus hoard of foreign exchange reserves? How can a country go bust with that much 'money'?

It's a fair question. To explain the answer we need to go back to another form of manipulation, that of the currency. Since the 1990s, China has – in one way or another – pegged its currency to the US Dollar. It did so to promote its export sector.

While the strategy was a success from that perspective, it also led to massive trade surpluses. China sent goods to the rest of the world (particularly the US) and in return received mostly Dollar based debt, or IOUs. To maintain its currency value at the pegged rate, China had to print money to offset the flows of Dollars coming in from the trade surplus.

So on one side of the ledger you have foreign exchange reserves...and on the other side you have an increase in the domestic currency, the Yuan, flowing through the Chinese banking system and China's economy.

Put simply, China's reserves are the flip side to its savings. They're one and the same. Therefore, using its reserves to help bail out poorly invested savings is impossible.

So on its current path, China is indeed going bust. China's famed household savings are tied up in poor investments. The Party has taken the savings and used them for their own benefit. That's why the Chinese economy is weak.

Some reform-minded Party members know the old growth model is dead. They know if China doesn't change its ways it will lead to its own demise. But there are others who want to resist reform because it threatens their power base. Changing from the old model to a new one, driven by internal consumption, will be very tough indeed.

It will require liberalizing the financial markets. This means letting markets set interest rates and letting the currency float freely. In short, it means the Party will have to give up a powerful tool indeed...they will have to relinquish their control over money.

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Greg Canavan is editorial director of Fat Tail Investment Research and has been a regular guest on CNBC, ABC and BoardRoomRadio, as well as a contributor to publications as diverse as and the Sydney Morning Herald.

See the full archive of Greg Canavan.

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