Preacherman
Member
Folks, this is a long but VERY interesting article on China's current economic problems. Given that most of us will be affected by any problems (how many of us own Chinese-sourced guns? How many of us shop at Wal-Mart?), I think this is information worth having. Highly recommended.
From the Stratfor Weekly (http://www.stratfor.com):
Please feel free to send the Stratfor Weekly to a friend
or colleague.
THE STRATFOR WEEKLY
30 April 2004
Euphoria, Meltdown and China's Economy
Summary
New lending policies in China are triggering a fundamental
rethinking of the stability of the Chinese economy. This time no
amount of damage control can hide the fact that the myth of the
Chinese economic miracle is finally -- and perhaps fatally --
breaking apart.
Analysis
Significant uncertainty erupted in Chinese banking circles this
week as reports circulated globally that the China Banking
Regulatory Commission had suspended all lending for three days.
This would effectively create a lending moratorium for well over
a week due to the upcoming May Day celebration. The story, which
appeared in the Wall Street Journal and other media, was quickly
denied. However, Western media, including Agence France-Presse,
are citing specific examples of Chinese banking officials who
claim to have seen the order. Officials at the China Merchants
Bank said they received the order from the CBRC -- and that it
was issued by the Chinese Cabinet.
The issuance of the order -- which obviously could not be kept
secret -- indicates one of two things. One, the Chinese
government, alarmed at what it sees happening in the banking
system, decided the situation was out of control and sought to
take control with a moratorium that would buy some time for
planning. When the international reaction started to roll in,
they became alarmed at a collapse of global confidence in China's
economy and pulled back. This would indicate a degree of panic. A
second explanation is that Beijing, concerned with the banking
system, issued an order it had no intention of enforcing -- in
order to fire a shot across the bow of the banking system and
generate internal discipline.
Either explanation leads to the same conclusion, as Stratfor
stated in its annual and quarterly forecasts: There are extremely
serious problems with China's economy in general -- and with its
banking system in particular. The only issue on the table is
whether the behavior of China's authorities reveals deep concern
or outright panic. That is an interesting question -- and not a
trivial one -- but it does not cut to the heart of the problem,
which is that China, contrary to popular perception or even its
extremely high economic growth rate, is in serious trouble and is
desperately searching for a soft landing -- a landing that might
not be available.
To understand China's problems, it is necessary to look at the
structure -- and failures -- of other Asian economies. We have
already seen two major systemic crackups in Asia during this
generation. Japan went from being an economic superpower that was
predicted to dominate the global economy in the 21st century to
an economic cripple during the early 1990s. East and Southeast
Asia, excluding China, similarly passed from economic miracles to
economic catastrophes in 1997. In both cases, the striking
characteristic was the speed at which overblown Western
expectations turned into disappointment. It is our view that
China, which got started later than other Asian economies, is on
course to be the third Asian meltdown in this generation. The
euphoria about China until very recently -- and China's assiduous
attempts to stoke expectations -- tracks with what happened in
the rest of Asia.
The core problem in Asia -- a problem that the Chinese government
is trying to address belatedly -- is that its banking systems do
not allocate capital based on market forces. Loan decisions are
made out of political and social considerations, and real
interest rates vary depending on these relationships. Long-term
business relationships in Asia receive favorable treatment from
banks regardless of the actual business case to be made for a
loan.
Of equal importance, these are debt rather than equity driven
economies. The major source of financing does not come from sale
of shares in businesses, but from direct loans. There are two
reasons for this. The legal structure of Asian corporations gives
limited rights and protections to shareholders, who do not
collectively control corporate boards. Therefore, maximizing
shareholder value is not a driving consideration. It also means
that a core measure of economic performance -- the rate of return
on capital -- is not a critical variable.
Cash flow is critical. The primary financial relationship of
Asian -- and Chinese -- businesses is with banks. The primary
interest of bankers, who have tremendous influence on boards, is
the repayment of loans and interest. Cash flow is therefore
critical to the system, while return on investment --
particularly in the long term -- is not a significant factor.
Investment -- and a return on investment -- is more significant
in China than in other Asian locations, but the general rule
still holds.
The Way It Works, or Doesn't
In Asia, there are two interconnected processes that must take
place. First, there has to be a forced savings system that
channels money into the banking system at low consumer rates to
generate cash for loans. This obviously limits domestic
consumption; if you are saving for your retirement because of
nonexistent or insufficient retirement plans, you are not in a
position to buy a great deal. This leads to a second, linked
process: export-oriented economies. If you must make bank
payments, and your own market has constrained demand due to high
savings rates, your only option is to sell overseas.
In forcing exports, the focus is on cash flow rather than profit
margins. This means goods are sold near cost -- and in extreme
cases below cost -- in order to cover debt service. From the
importing country's point of view, this can have a devastating
effect because domestic companies driven by return on capital
cannot compete in the short run with Asian imports that are
indifferent to profit margins. Entire industrial sectors are
taken out. At the same time, economic growth in the exporting
country -- measured simply in terms of production and sales --
surges. But underneath these apparently astounding economic
achievements, the Asian economy is actually hollowing itself out.
The core problem is that, over time, the allocation of loans
based on non-market consideration, means that the economy,
lacking market disciplines, behaves in irrational ways. Most
important, the disciplines of market economies -- from
foreclosures to recessions -- don't happen. Essentially unhealthy
businesses continue to grow due to the infusion of debt. The
infusion of debt has a number of positive results. It maintains
social stability, keeps the political system functioning and it
allows banks to avoid non-performing loans. It also has a single
devastating effect -- it creates an economy that is kept alive by
pyramiding loans that undergird an increasingly dysfunctional
system.
Non-performing loans are avoided in three ways. First, there is
the continual restructuring of debt and infusion of more money,
designed to keep bad loans off the books and maintain confidence
in the banks and the banking system. Second, companies implement
aggressive export programs to generate cash flow. Finally,
programs are put into place to induce foreign investors to put
money into joint ventures, whose boards are controlled by Asian
companies. This prevents foreign investors from really looking at
the books of the Asian parent companies, but allows the boards to
make decisions that transfer money from the joint venture into
the parent company.
In order for this latter process to work, the Asian countries
create a sense of euphoria for foreign investors. Japan in 1990,
East and Southeast Asia in 1995-1996 and China in 2003 all
created nearly hysterical environments in which foreign investors
felt they could not resist participating in various placements
and industrial joint ventures. Western investment banks play a
critical role in this process by overestimating Asian potential,
while collecting fees on placements.
This hollows out the banks. In Japan and Asia, it was the large
financial institutions that first felt their foundations
collapsing under them. At a certain point, the cash flow
requirements outstrip debt service and export demand, and foreign
direct investment can no longer make up for them. Non-performing
loans begin to accumulate. The banks wind up with more hungry
mouths than they can feed, and they scramble to maintain the
system.
The system erodes slowly but the perception of systemic failure
comes suddenly -- making the management of the flow of financial
information a critical issue. The banks, working with the
government, hold things together until they can no longer do so.
A crisis builds around the public realization that major
financial institutions are failing, vulnerable to failure or can
survive only through heroic measures. A period of sharp, intense
crisis takes place, which does not solve any fundamental
problems. A long period of malaise follows, as some recover and
others fail.
China Tries to Cope
The Chinese government is trying to prevent the crisis from
breaking out into the open, essentially by stopping the
intensifying debt production process that banks are engaged in.
Of course, if the banks stop making loans, the entire system can
hit a brick wall. You can evade the wall if foreign direct
investment increases, driven by confidence that the Chinese
government is taking steps to control the situation. You can
evade the wall if you can increase exports. But if exports are at
the maximum -- simply because you can't produce more goods and
foreign markets can't absorb them -- and global finance is thrown
into a panic by suspending loans, then the entire system can
crack.
The Chinese government knows it has a major crisis on its hands.
Its loan moratorium was designed to buy a week or so to try to
sort through this problem. Somehow, it fantasized that it could
keep the moratorium quiet. When the Wall Street Journal announced
it, the Chinese realized that a global crisis of confidence was
in the offing, so they officially suspended the moratorium.
Saying "never mind" is an interesting strategy, but essentially
Beijing has let the cat out of the bag. The banking industry is
out of control, and the government is not sure how to get it back
under control without the very public airing of some very dirty
laundry.
In reality, the enormity of the problem is dawning on everyone.
This is not a technical problem of managing a normal business
cycle. This is a banking system nearing meltdown for which the
government would like to find a technical solution that would
allow the game to go on. Beijing had hoped a $45 billion bailout
ahead of a series of initial public offerings (IPOs) of shares in
two of its leading commercial banks would help keep the system
afloat. IPOs for banks whose policies are so troubling that the
government forces them to suspend lending are not likely to be a
wildly successful. The system is crumbling.
The problem is that, as with the rest of Asia before it, the game
can't go on for China. On the other hand, the Chinese government
can't possibly take the draconian steps that would be needed to
begin the process of healing. There would be political chaos.
Therefore, the Chinese government has signaled what it would do
with political chaos by blocking elections in Hong Kong.
Therefore, we have seen a major outflow of money from China by
individuals and institutions that know the jig is up. Therefore,
China's leaders have been signaling for the past week that there
is a major crisis. They are trying to manage their way through
it. But even if they do, the best they can hope for is Japanese-
style malaise -- and China's political and social systems are not
Japan's. Malaise is not a viable option.
It is interesting to note that the Japanese and Asian meltdowns
did not affect the rest of the world as one might predict.
Certainly, investments there were devastated, and business plans
based on 10 percent growth a year were shattered. But the United
States in particular benefited from the meltdown, as panicky
money fled its way. One could argue that the impetus for both the
early 1990s surge and the late 1990s surge came from money
fleeing Asia and moving into the United States.
The sky is not falling for the global economy. It might be
falling for China. Without a convertible currency -- this is why
Beijing will not float and trade the Yuan -- China has some tools
to handle the problem that Thailand or Indonesia did not. In the
end, the economic game is ending and the political one is
beginning. As China -- slowly or quickly -- decays economically,
the political consequences will be the most important. Even if
China avoids complete meltdown, avoiding malaise will be much,
much harder. Stratfor thought all this would wait until 2005.
Right now, the Chinese do not look so lucky.
(c) 2004 Strategic Forecasting, Inc. All rights reserved.
From the Stratfor Weekly (http://www.stratfor.com):
Please feel free to send the Stratfor Weekly to a friend
or colleague.
THE STRATFOR WEEKLY
30 April 2004
Euphoria, Meltdown and China's Economy
Summary
New lending policies in China are triggering a fundamental
rethinking of the stability of the Chinese economy. This time no
amount of damage control can hide the fact that the myth of the
Chinese economic miracle is finally -- and perhaps fatally --
breaking apart.
Analysis
Significant uncertainty erupted in Chinese banking circles this
week as reports circulated globally that the China Banking
Regulatory Commission had suspended all lending for three days.
This would effectively create a lending moratorium for well over
a week due to the upcoming May Day celebration. The story, which
appeared in the Wall Street Journal and other media, was quickly
denied. However, Western media, including Agence France-Presse,
are citing specific examples of Chinese banking officials who
claim to have seen the order. Officials at the China Merchants
Bank said they received the order from the CBRC -- and that it
was issued by the Chinese Cabinet.
The issuance of the order -- which obviously could not be kept
secret -- indicates one of two things. One, the Chinese
government, alarmed at what it sees happening in the banking
system, decided the situation was out of control and sought to
take control with a moratorium that would buy some time for
planning. When the international reaction started to roll in,
they became alarmed at a collapse of global confidence in China's
economy and pulled back. This would indicate a degree of panic. A
second explanation is that Beijing, concerned with the banking
system, issued an order it had no intention of enforcing -- in
order to fire a shot across the bow of the banking system and
generate internal discipline.
Either explanation leads to the same conclusion, as Stratfor
stated in its annual and quarterly forecasts: There are extremely
serious problems with China's economy in general -- and with its
banking system in particular. The only issue on the table is
whether the behavior of China's authorities reveals deep concern
or outright panic. That is an interesting question -- and not a
trivial one -- but it does not cut to the heart of the problem,
which is that China, contrary to popular perception or even its
extremely high economic growth rate, is in serious trouble and is
desperately searching for a soft landing -- a landing that might
not be available.
To understand China's problems, it is necessary to look at the
structure -- and failures -- of other Asian economies. We have
already seen two major systemic crackups in Asia during this
generation. Japan went from being an economic superpower that was
predicted to dominate the global economy in the 21st century to
an economic cripple during the early 1990s. East and Southeast
Asia, excluding China, similarly passed from economic miracles to
economic catastrophes in 1997. In both cases, the striking
characteristic was the speed at which overblown Western
expectations turned into disappointment. It is our view that
China, which got started later than other Asian economies, is on
course to be the third Asian meltdown in this generation. The
euphoria about China until very recently -- and China's assiduous
attempts to stoke expectations -- tracks with what happened in
the rest of Asia.
The core problem in Asia -- a problem that the Chinese government
is trying to address belatedly -- is that its banking systems do
not allocate capital based on market forces. Loan decisions are
made out of political and social considerations, and real
interest rates vary depending on these relationships. Long-term
business relationships in Asia receive favorable treatment from
banks regardless of the actual business case to be made for a
loan.
Of equal importance, these are debt rather than equity driven
economies. The major source of financing does not come from sale
of shares in businesses, but from direct loans. There are two
reasons for this. The legal structure of Asian corporations gives
limited rights and protections to shareholders, who do not
collectively control corporate boards. Therefore, maximizing
shareholder value is not a driving consideration. It also means
that a core measure of economic performance -- the rate of return
on capital -- is not a critical variable.
Cash flow is critical. The primary financial relationship of
Asian -- and Chinese -- businesses is with banks. The primary
interest of bankers, who have tremendous influence on boards, is
the repayment of loans and interest. Cash flow is therefore
critical to the system, while return on investment --
particularly in the long term -- is not a significant factor.
Investment -- and a return on investment -- is more significant
in China than in other Asian locations, but the general rule
still holds.
The Way It Works, or Doesn't
In Asia, there are two interconnected processes that must take
place. First, there has to be a forced savings system that
channels money into the banking system at low consumer rates to
generate cash for loans. This obviously limits domestic
consumption; if you are saving for your retirement because of
nonexistent or insufficient retirement plans, you are not in a
position to buy a great deal. This leads to a second, linked
process: export-oriented economies. If you must make bank
payments, and your own market has constrained demand due to high
savings rates, your only option is to sell overseas.
In forcing exports, the focus is on cash flow rather than profit
margins. This means goods are sold near cost -- and in extreme
cases below cost -- in order to cover debt service. From the
importing country's point of view, this can have a devastating
effect because domestic companies driven by return on capital
cannot compete in the short run with Asian imports that are
indifferent to profit margins. Entire industrial sectors are
taken out. At the same time, economic growth in the exporting
country -- measured simply in terms of production and sales --
surges. But underneath these apparently astounding economic
achievements, the Asian economy is actually hollowing itself out.
The core problem is that, over time, the allocation of loans
based on non-market consideration, means that the economy,
lacking market disciplines, behaves in irrational ways. Most
important, the disciplines of market economies -- from
foreclosures to recessions -- don't happen. Essentially unhealthy
businesses continue to grow due to the infusion of debt. The
infusion of debt has a number of positive results. It maintains
social stability, keeps the political system functioning and it
allows banks to avoid non-performing loans. It also has a single
devastating effect -- it creates an economy that is kept alive by
pyramiding loans that undergird an increasingly dysfunctional
system.
Non-performing loans are avoided in three ways. First, there is
the continual restructuring of debt and infusion of more money,
designed to keep bad loans off the books and maintain confidence
in the banks and the banking system. Second, companies implement
aggressive export programs to generate cash flow. Finally,
programs are put into place to induce foreign investors to put
money into joint ventures, whose boards are controlled by Asian
companies. This prevents foreign investors from really looking at
the books of the Asian parent companies, but allows the boards to
make decisions that transfer money from the joint venture into
the parent company.
In order for this latter process to work, the Asian countries
create a sense of euphoria for foreign investors. Japan in 1990,
East and Southeast Asia in 1995-1996 and China in 2003 all
created nearly hysterical environments in which foreign investors
felt they could not resist participating in various placements
and industrial joint ventures. Western investment banks play a
critical role in this process by overestimating Asian potential,
while collecting fees on placements.
This hollows out the banks. In Japan and Asia, it was the large
financial institutions that first felt their foundations
collapsing under them. At a certain point, the cash flow
requirements outstrip debt service and export demand, and foreign
direct investment can no longer make up for them. Non-performing
loans begin to accumulate. The banks wind up with more hungry
mouths than they can feed, and they scramble to maintain the
system.
The system erodes slowly but the perception of systemic failure
comes suddenly -- making the management of the flow of financial
information a critical issue. The banks, working with the
government, hold things together until they can no longer do so.
A crisis builds around the public realization that major
financial institutions are failing, vulnerable to failure or can
survive only through heroic measures. A period of sharp, intense
crisis takes place, which does not solve any fundamental
problems. A long period of malaise follows, as some recover and
others fail.
China Tries to Cope
The Chinese government is trying to prevent the crisis from
breaking out into the open, essentially by stopping the
intensifying debt production process that banks are engaged in.
Of course, if the banks stop making loans, the entire system can
hit a brick wall. You can evade the wall if foreign direct
investment increases, driven by confidence that the Chinese
government is taking steps to control the situation. You can
evade the wall if you can increase exports. But if exports are at
the maximum -- simply because you can't produce more goods and
foreign markets can't absorb them -- and global finance is thrown
into a panic by suspending loans, then the entire system can
crack.
The Chinese government knows it has a major crisis on its hands.
Its loan moratorium was designed to buy a week or so to try to
sort through this problem. Somehow, it fantasized that it could
keep the moratorium quiet. When the Wall Street Journal announced
it, the Chinese realized that a global crisis of confidence was
in the offing, so they officially suspended the moratorium.
Saying "never mind" is an interesting strategy, but essentially
Beijing has let the cat out of the bag. The banking industry is
out of control, and the government is not sure how to get it back
under control without the very public airing of some very dirty
laundry.
In reality, the enormity of the problem is dawning on everyone.
This is not a technical problem of managing a normal business
cycle. This is a banking system nearing meltdown for which the
government would like to find a technical solution that would
allow the game to go on. Beijing had hoped a $45 billion bailout
ahead of a series of initial public offerings (IPOs) of shares in
two of its leading commercial banks would help keep the system
afloat. IPOs for banks whose policies are so troubling that the
government forces them to suspend lending are not likely to be a
wildly successful. The system is crumbling.
The problem is that, as with the rest of Asia before it, the game
can't go on for China. On the other hand, the Chinese government
can't possibly take the draconian steps that would be needed to
begin the process of healing. There would be political chaos.
Therefore, the Chinese government has signaled what it would do
with political chaos by blocking elections in Hong Kong.
Therefore, we have seen a major outflow of money from China by
individuals and institutions that know the jig is up. Therefore,
China's leaders have been signaling for the past week that there
is a major crisis. They are trying to manage their way through
it. But even if they do, the best they can hope for is Japanese-
style malaise -- and China's political and social systems are not
Japan's. Malaise is not a viable option.
It is interesting to note that the Japanese and Asian meltdowns
did not affect the rest of the world as one might predict.
Certainly, investments there were devastated, and business plans
based on 10 percent growth a year were shattered. But the United
States in particular benefited from the meltdown, as panicky
money fled its way. One could argue that the impetus for both the
early 1990s surge and the late 1990s surge came from money
fleeing Asia and moving into the United States.
The sky is not falling for the global economy. It might be
falling for China. Without a convertible currency -- this is why
Beijing will not float and trade the Yuan -- China has some tools
to handle the problem that Thailand or Indonesia did not. In the
end, the economic game is ending and the political one is
beginning. As China -- slowly or quickly -- decays economically,
the political consequences will be the most important. Even if
China avoids complete meltdown, avoiding malaise will be much,
much harder. Stratfor thought all this would wait until 2005.
Right now, the Chinese do not look so lucky.
(c) 2004 Strategic Forecasting, Inc. All rights reserved.
I knew it was coming, but not this quick.
