Twofish's Blog

November 5, 2006

More about managers v. bankers and the Chinese economy

Filed under: china, finance — twofish @ 8:55 am

Provides a nice counterpoint to the Goldman Research article…

Here is another database in the continuing debate between optimistic bankers and pessimistic managers about the Chinese economy.

I line myself among the optimistic bankers. The thing about the industrial sector in China is that it is inefficient, but during the 1990’s, it was value destroying. Chinese industries may be making small profits right now, but during the 1990’s, they were making losses. The other thing that is missing from that article is discussion on how the structure of Chinese banking has changed between 1996 and now.

Some specific comments:

At issue is whether China allocates and uses capital efficiently enough so that it produces a return on capital at par or better than international markets. The question is: By international standards, how efficient is China in using its capital?

Actually that’s not the issue I’m interested in. The question I’m interested in is whether or not the Chinese economy is going to collapse. If Chinese companies are producing a return on equity that is low, that’s not much of a problem. The problem is if Chinese companies are producing a *negative* return. The former is sustainable for one generation as long as China doesn’t open its capital markets completely. The latter is an immediate crisis that you have to resolve in three to five years.

But assuming corporate savings are mathematically equal to 60% of corporate investments, can we therefore conclude, as the World Bank does, that corporate savings finance 60% of China’s corporate investments? The answer is still an emphatic no. In fact, there is absolutely no way anyone can draw any inference on how firms finance their investments in aggregate from corporate or national savings data. Even if the amount of corporate savings exceeds corporate investments, as in the United Sates, bank loans can still finance as much as 100% of corporate investments.

I think that the author is missing the point of the World Bank article. Chinese corporate investment is *ultimately* now being financed by current corporate profits. This wasn’t true in the mid-1990’s, when the industrial sector was not making enough money to fund new investment. As a result the ultimate source of the money for the loans in the mid-1990’s was borrowing from households through expectations of future growth. The former is sustainable for a few decades. The later situation was a road to a massive crisis.

The fact that the source of current bank loans consists of retained earnings is a big difference from the late-1980’s, when you have triangular debt. C owes money to the A who owes money to B who owes money to C.

Yes it’s possible that banks will be stupid and loan money to people they shouldn’t, but as long as they have good money coming in, this problem is fixable. If there isn’t good money coming in, then you are just writing IOU’s backed by household savings with no real plan for repaying them which is what the banks were doing in the 1990’s.

The reason that banks accumulate bad loans or suffer losses is because they overlend or underprice their risks. This allows the borrowing firms to overinvest or invest in projects which do not produce returns sufficient to cover their risks.

Nope. The reason that Chinese banks had bad loans was that they were funding social security payments to employees at unprofitable companies. They aren’t doing that anymore.

I think the main thing that the article misses is how bad things were in the 1990’s. As with most of these banker v. manager arguments, the weird thing is that discussions about what needs to be done (increase capital efficiency). But I think it’s really important to recognize how bad things were before, and how much better things are now (if they really are better which is another argument).

The interesting thing about this debate is that you get the “blind men feeling an elephant” feeling when reading the articles. People quote different statistics, and come up with different conclusions because they are looking at different parts of the problem.

It will be interesting to follow this debate…….


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