the developing Chinese credit squeeze

a new broom

The new administration in Beijing has begun to crack down on a series of abuses in the domestic Chinese financial system that pose a long-term threat to the stability of the economy.

I think this is a very positive development for China, and one that’s crucial to the central government’s efforts to channel resources toward domestic consumer-oriented industries and away from low value-added export-oriented manufacturing.

I don’t know the details of Beijing’s plans the way I might if the domestic market were open to foreign private investors like you and me–and, for the same reason, I’m not particularly interested in finding out.  But I think it’s safe to say that sectors like real estate and finance won’t be happy places over the next six months or so, nor will highly leveraged, labor-intensive export-oriented manufacturing.

where it’s sweeping

As I see it, there are three avenues to the government’s attack on out-of-control credit growth.  Much of this follows very familiar patterns:

1.  non-bank financials.  Regulators tell banks to stop speculative lending, usually in real estate.  The banks counter by forming non-bank subsidiaries–out of the regulators’ purview–and continue imprudent lending.  Political “contributions”  to powerful legislators keep the regulators at bay.

The “Keating Five” in the US during the savings and loan crisis are a good example of the last.  The Five, all Senators–including former astronaut John Glenn and Vietnam war hero John McCain, become famous for intimidating regulators into not acting on a massive financial fraud perpetrated by Charles Keating, who preyed on lower-income workers and the elderly at the Lincoln S&L in California.

2.  loans to “zombie” companies.  During the 1990s, Tokyo forced Japanese banks to continue to lend to highly inefficient, loss-making companies–apparently in order to avoid layoffs.  One consequence was that these “zombies” destroyed the businesses of healthy, well-run firms that were not receiving continuing large infusions of cash.

The Chinese analogue is state-owned enterprises in mature industries.  Also think:  almost any state-controlled business in the EU or the auto industry in the US.

3.  lending to state and local government projects.  This is a particularly Chinese problem.  Mayors and governors are officials in the Communist Party, as are the heads of local banks.  The former get promoted by keeping the local workforce employed and GDP growing.  An easy way to do this is to sponsor (dubious) construction projects and armtwist bankers into providing the finance.  As the adage goes, “The mountains are high and the emperor is far away.”

my thoughts

Long-term, the crackdown is a very positive development.

The extent of crazy lending, and attendant political corruption, is invariably much larger than anyone realizes.

This may be a years-long project for Beijing, in which it applies pressure to uneconomic lending until GDP begins to wilt and then backs off for a short while.  That’s how the central government has been reducing the size of the state-owned sector since the days of Deng.

Although I don’t expect any significant negative effects for world economies or stock markets, this is another (big, I think) piece of bad news for suppliers (like natural resources and basic materials companies) to construction and low-end manufacturing companies in China.

We’re already seeing spillover into Hong Kong of downward pressure on Chinese stocks.  At some point, this will create a big buying opportunity.  Maybe not right now, though.

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