Twofish's Blog

December 24, 2008

Notes on the Chinese banking system

Filed under: china, finance — twofish @ 3:27 am

http://mpettis.com/2008/12/can-parochial-concerns-undermine-the-global-adjustment-it-has-before/

http://online.wsj.com/article/SB122961611056318369.html

I really don’t see what Victor Shih is worried about. If the government wants a bank to make a loan and the government is willing to either guarantee the loan or provide the capital for the loan, then there is no issue of risk management for the bank. All the risk managers have to do is to get that sheet of paper saying “The Central Government promises to cover the loan if it goes bad” and it’s no longer the bank’s problem.

The other thing about risk management is that you can properly risk manage things not only by decreasing risk but increasing loss reserves. It’s perfectly fine to lend to risky clients if you have the loss reserves to cover defaults.

Also his article makes it seem like the only reason that Chinese banks fixed themselves was Western pressure, and now that pressure is gone, that the government will backslide. In fact, the reason the Chinese government has spent the last ten years fixing the banking system was because they were (and still are) terrified of a banking crisis that would bring down the government.

Recent events haven’t reduced this fear, and pointing out that Chinese banks aren’t collapsing when American banks are, should be enough to keep banks doing good risk management.

If Westerners want Chinese banks to have good risk management, the thing to do is not to lecture and instead say “look you guys are geniuses and we are idiots, study what we did over the last ten years and whatever you do, don’t do the same things, but rather keep doing what you were doing.”

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6 Comments »

  1. Again, no sense of recent history in this post. Look back at the lead up to the most recent bank bail-outs in China. The banking system has been improved, but has not been fixed. I am not sure if you have any clue about what risk management and underwriting actually are. The failures of risk management in the west were magnified by excess leverage, but look at underlying actual default rates rather than the effects of a seizure in interbank markets and liquidity alone and you would change your tune. Behind the scenese Chinese authorities are far less satisified with the status quo than the nonsense in the state-run media about China’s sound prudential management would lead one to believe, because they know that with 90% of bank credit concentrated in pathetic SOEs and the stock market crash (remember that? – losses equivalent to 70% of GDP) that systemic risks have not disappeared.

    Comment by W — December 30, 2008 @ 1:10 am

  2. The high default rates of Chinese banks was largely due to the fact that the banks in the 1990’s took on the function of social welfare agencies rather than capital allocators. The solution was to separate these two functions so that you don’t have the same institution do both. Having banks operate as social welfare agencies is not the best way of setting up an economy, but as a transitional measure it worked quite well.

    Ninety percent of bank credit is in SOE’s, but the commericial banks are now lending only to the good SOE’s, and the bad SOE’s have either been shut down or moved off to other institutions. Chinese banks can’t invest directly in the stock markets. There may have been indirect investment but that seems to have been limited.

    Also “Chinese authorities” disagree about the Chinese economy just as much as Western authorities disagree about the Western economy.

    Comment by twofish — December 30, 2008 @ 5:13 am

  3. Do the good SOEs account for 90% of the economy?

    About 10% of SOEs have long-term value on a stand alone basis. How much credit should they get? Imagine the strength of the economy if over the past 20 years this 90% was spent elsewhere. What is worse is that SOEs have failed as social welfare institutions. Ever sought treatment at a Sinopec hospital after a taxi accident?

    The same proportions work on in other corners of the capital markets. The NDRC has made very clear that the commanding heights of the economy will remain state owned, and this means that they will continue to absorb most of the credit. Such a shame.

    Comment by W — December 31, 2008 @ 4:10 am

  4. > Do the good SOEs account for 90% of the economy?

    It depends on how you weight things. China started with 15,000 SOE’s most of them were one factory SOE’s that were tiny. There was an insane number of auto companies and steel companies and coal mines. The number of SOE’s that were large size was rather small, and in the beginning most of those involved breakup up a central government monopoly (airlines, telecom, banks, and oil).

    The goal has been to get the number down to about 70 reasonably sized corporations.

    > About 10% of SOEs have long-term value on a stand alone basis.

    True but misleading since the ones that are viable are the big ones. Trying to count SOE’s gets you into problems because once you start consolidating them it’s hard to keep track of them. Also, it really depends on what year you are talking about.

    > How much credit should they get? Imagine the strength of the economy if
    > over the past 20 years this 90% was spent elsewhere.

    You are confusing numbers with quantity. 99+% of SOE’s were unviable, but most of those were tiny.

    You would have had riots and probably a botched privatization like in Russia. Industrial restructuring and national development is a really tough thing to do, and I’m amazed at how well China has done compared to other places that have tried different things.

    I really don’t see how China could have spent much less than it did to close down the SOE’s. The question then is how to spend it. Trying to keep SOE’s open through bank loans may have been unusual, but it did have the advantage in that it meant that it couldn’t keep the SOE’s open indefinitely and had to do something about it.

    W: The NDRC has made very clear that the commanding heights of the economy will remain state owned, and this means that they will continue to absorb most of the credit.

    And there are people who have different ideas than NDRC about how the Chinese economy should be structured.

    In any event, one thing that is interesting is that Chinese commercial banks do not have a bias in lending toward state-owned enterprises. The bias is to large enterprises. It is true that most large enterprises in China are state-owned, but if you do a regression and look at how Chinese banks treat the few large private corporations versus small state-owned enterprise, you find that enterprise size and not state-ownership is the important factor. And this can be explained because large corporations are just better credit risks than small/medium corporations. The other thing about the big banks is that they have increasingly been diversifying their loans to consumer loans.

    Anyway if you want to see my vision of “state capitalism” that works, take a look at the United States. Much of the reason that I don’t think that there is much of a state/private distinction in ownership is because large parts of the economy are actually owned by state pension funds and university endowments. If you look at who funds private equity and hedge funds in the US, a lot of times you end up back at Calpers or some state teacher retirement fund. If you are an investment bank with bonds to sell or a private equity firm that wants investors, the first people you call up are the governmental agencies that manage these investment pools.

    One reason that I’m not too hostile to state intervention in the economy is that everywhere you look on Wall Street, you end up encountering some government agency looking over your shoulder, and for that most part, it more or less works, and when it doesn’t it’s usually because some regulator was asleep at the switch.

    Comment by twofish — December 31, 2008 @ 8:18 am

  5. It is nice that you try to find the good in things, but your assessment of the SOEs and state intervention in general, are misguided, and if you spent time on the ground with business people you woould know that the 5-yr plan and government backing still run things from the bottom of the economy to the top. We can go back and forth about the number of SOEs and their size all day long, but simply changing the category into which firms fall (SOE/stock holding/collective/other) does not alter reality. If you succeed, you are taxed mafia style. If you are fortunate enough to be working in an area inside “the plan”, it means that you have already capitulated, and will give away much of the benefit of your hard work to greedy local officials.

    Sure, if you want to sell a bond, you call the large entities most likely to buy them. If they are a state pension fund, they would by the bonds on behalf of their stakeholders, who have a voice in how they are managed and can vote to elect the governments that oversee them. It is pretty obvious as to what is missing in the Chinese context. Not democracy per se, but mechanisms for accountability. Otherwise things just turn into a nation of Madoffs.

    Comment by w — January 1, 2009 @ 5:24 am

  6. w: It is nice that you try to find the good in things, but your assessment of the SOEs and state intervention in general, are misguided, and if you spent time on the ground with business people you woould know that the 5-yr plan and government backing still run things from the bottom of the economy to the top.

    I don’t care how the system works, as long as it does. Deng Xiaoping talked about not caring whether the cat is white or black as long as it catches mice. That applies to capitalism as much as it does to socialism. I really don’t care whether a system is communist, capitalist, socialist as long as it generates value. The one criterion I have is that I’m a conservative that believes in making minimal incremental changes to a system to make it work better.

    The basic question is whether the SOE-sector is generating value or destroying it. In the 1990’s, it was clear that the SOE was destroying value in a way that was unsustainable. In the 2000’s, it’s not so clear, and Louis Kuijs and I both believe that the SOE-sector is actually generating value. Yasheng Huang and Minxin Pei disagrees, but to make the notion of SOE destroying value work, his model involves there being a productive non-state sector that is being destroyed by a parasitic state sector. If they are right then the system is unsustainable and you should be able to calculate a burn rate at which point the system self-destructs (and this sort of analysis was very good at analyzing the Soviet economy). The trouble is that whenever people have done that doomsday passes and nothing bad happens. Why? It could be that China is being propped up either by foreign direct investment or by impoverishing the countryside. The trouble with that is that the capital flows work the other way, urban->rural, China->West.

    The alternate hypothesis is that the SOE-sector is now actually generating value and the system is sustainable. Something that is interesting if you look at the data is that people don’t argue that SOE’s are destroying value and non-state sectors are producing value. The argument is that SOE’s are producing value and non-state sectors are producing even more value so we should change the SOE’s to work like non-state enterprises. The flaw in this is that SOE’s and non-state enterprises are in different sectors of the economy. Sure a growing software company will produce more return than an airline, but that doesn’t mean that we should shut down all airlines and just do software. At this point, the world view of management academics whose job it is to maximize return on investment becomes apparent.

    w: If you succeed, you are taxed mafia style. If you are fortunate enough to be working in an area inside “the plan”, it means that you have already capitulated, and will give away much of the benefit of your hard work to greedy local officials

    You have to ask why local officials are greedy, and much of turns out that they tend to be extremely underpaid, and they don’t have the tax revenue to pay for social services such as education. Local officials in China have limited tax revenue, and their budgets are always in deficit which means that they try really hard to get their hands on any sort of revenue that they can. Trying to come up with a decent tax system that can pay for these things is a hard, hard problem.

    w: Sure, if you want to sell a bond, you call the large entities most likely to buy them. If they are a state pension fund, they would by the bonds on behalf of their stakeholders, who have a voice in how they are managed and can vote to elect the governments that oversee them.

    That’s not how it works in reality. In pension funds you really want to reduce the amount of discretion elected officials have because if you have elected officials involved, then those officials will just loot the fund. Having voters oversee the officials doesn’t help, because the officials will just loot the fund and give it to the voters.

    w: It is pretty obvious as to what is missing in the Chinese context. Not democracy per se, but mechanisms for accountability

    In the financial sector there is. Ultimately what motivates the top leadership is the knowledge that if they don’t provide economic growth, they are doomed. Your greedy local official for example. He is going to demand just enough money to keep himself well paid, but he isn’t going to demand so much that people just decide to give up and not do anything.

    w: Otherwise things just turn into a nation of Madoffs.

    Madoff wasn’t Chinese. There are a lot of bad things about the Chinese economy, and I’m trying to do my best to fix them. However, there are good things about the Chinese economy, and bad things about the American economy. The problem is that over the last decade, the attitude of a lot of people was basically the US economy is perfect, the Chinese economy is a mess, and that China should just junk whatever it has and adopt the US. I’m arguing that this is non-sense, and by accusing anyone that says something good about the Chinese economy or bad about the American economy as a “Xinhua apologist” you actually blind yourself to the reality of the situation. Having worked on Wall Street, the “wonderful American economy” that people use as a standard for measuring the Chinese economy is something that seems to be a figment of people’s imagination. Sure the American economy works better than the Chinese economy, but *how* it works better is something that is something of a mystery if you look up close, and the reasons that people sometimes posit seems odd to me.

    For example, Chinese airlines and steel manufacturers are losing money and need to cut capacity. This is obviously an example of Chinese mismanagement and would be solved by making Chinese airlines and steel manufacturers work like American ones, which are also losing money and need to cut capacity. So I don’t see how privatization is going to help here.

    Comment by twofish — January 1, 2009 @ 6:48 am


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