China, Bankruptcy, and the Dollar
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Six years ago in China, something unexpected happened, a bankruptcy. The Guangdong International Trust and Investment Corporation (GITIC) went under. The Guangdong High People’s Court read a prepared statement to an invitation only audience of about 100 foreign and 50 domestic creditors. The bankruptcy petition of GITIC was accepted. The combined debt was $4.5 billion.
GITIC was an investment vehicle owned by the provincial government of Guangdong. It was in big trouble due to bad investments, bad management and just plain theft. The leadership in Beijing had an idea. They wanted to make an example out of GITIC and stick foreign investors with the loss. So they pulled GITIC’s plug.
Foreign investors, especially foreign banks, were not amused. Money had been lent to Chinese companies under the assumption that they were lending to the Chinese government. They were priced as sovereign risk. Bankers do not like surprises. Overnight foreign money dried up. Orders from around the world stopped all new lending to Chinese borrowers. Technical default clauses were activated as banks attempted to call in loans.
The Chinese leadership got the message. Although there were another 240 investment vehicles like GITIC, many with the same problems, there were no more bankruptcies. There was a price to pay. The price was paid by the Chinese state banks, which made massive bailouts. Their nonperforming loans soared. It resulted in the creation of Asset Management Companies, which, after the transfer of $170 billion worth of bad loans, was supposed to solve the problem. It did not.
The causes of the GITIC collapse were never addressed. The cancer which created it was never excised. Inefficient State Owned Enterprises (SOE), bad management, massive corruption, poor policies, huge subsidies, and theft on a breath taking scale have only increased with time. The government has starved efficient private firms of capital. It encouraged small foreign invested enterprises, often from the large Chinese diaspora, to take their place. The problem grows worse daily. The expansion of the Chinese economy over the past few years has been financed by more than $360 billion worth of new loans. Non performing loans, previously estimated at up to $750 billion, have probably grown to over a trillion dollars. This does not include the hundreds of millions that have simply been stolen. An economic system like China’s is not sustainable.
For the rest of us, the problem with China is that its economy is no longer on the fringes of the world economic system. It is moving toward the center. If something happened to the Chinese economy, the ripples would spread across the world faster than last year’s Tsunami.
But why would we worry about such a problem? Estimates of China’s growth rate vary from 7 to 12 percent. Financial journalists, investment advisors, television commentators, and CEOs the world over have praised the spectacular growth of China. Its leaders are the subject of envy for their skillful handling of the economy. To control China’s rapid growth, its leaders have pulled the appropriate levers and brought the overheating Chinese economy in for a soft landing. But the tumor still grows.
Financial crises, like earth quakes, are predictable. We know that they will occur, but we do not know when. Without a cloud in the economic sky, the massive pressure of the markets will shift and crush anything in its path, as trillions in various currencies move across time zones at the speed of light. It only needs something to start it. But what?
In China, the banks are the weak link. Collapsed banks are traditionally often both the cause and result of financial panic. The problems in the 1997 Asian crises, the 1998 problems with Russia, and Argentina’s ongoing debt crises have all had banking components. There are some major differences with China. The most important difference is that the previous crises were precipitated by dollar or hard currency loans from foreigners. When the local currency collapsed, local debtors had to repay in dollars. They found themselves owing two or three times the amount that they had originally borrowed. Repayments were impossible.
China does not have that problem. Quite the reverse. China’s boom has been financed by its high local savings rate, not by loans from foreign lenders. In fact, hard-working Chinese peasants have financed foreign debtors, most notably the United States, to the tune of an estimated $600 billion in treasury bills, which in some ways makes it much more dangerous. If traders dump Won, Baht, Rupiah, Pesos, Rubles, or Dinars, it hurts Koreans, Thais, Indonesians, Mexicans, Russians or Egyptians. If the Chinese needed to liquidate their dollar holdings, we all have a problem.
Examples of the problem occurred over the last two months. In February a Bank of Korea spokesman implied that Korea wanted to diversify its reserves away from the dollar. The result was a plunge of 174 points on the Dow and a fall of the dollar against the Euro by 1.5 percent. The dollar tested new lows on similar remarks from Japan. According to one commentator, the Asian central banks were playing a huge game of chicken. If they all keep buying dollars, their currencies and portfolios are safe, provided that China maintains its peg and does not start selling.
But what would trigger a sale by China of dollars? First, it might be hard to find out. China guards its reputation as an economic power house jealously. The news of the deadly virus SARS was suppressed for several months to prevent an economic slowdown. Postings of sensitive news items, including unfavorable economic news, can bring angry calls from the cabinet's Information Office. Although China is more open, foreign journalists need permission to do any interviews in the country side or any other “off-base” reporting.
When China enters international capital markets, information becomes harder to control. In Taiwan this year the government wanted to divest its interest in the state-owned bank, Changwa. A foreign shareholder was needed to help recapitalize the bank. Changwa had a problem. There was a $2 billion dollar hole in its balance sheet. Almost 8% of its outstanding loans were non-performing. The discrepancy was discovered by prospective foreign buyer’s investigations into the bank’s books. To make the sale, the government would have to grant a discount of up to 50%.
Like Taiwan, China would also like to sell stakes in its state owned banks. For the past year, the financial press has been filled with stories about western banks and private equity investors considering large stakes in Chinese banks. Scandals such as evidence of large embezzlements have slowed the process. An in depth due diligence investigation could bring it to a complete halt. The news would be out and the damage done.
Courting foreign investors for their financial system is not China’s only foray into international financial markets. To create an infrastructure that will be available if the Yuan is ever allowed to float, The State Administration of Foreign Exchange (SAFE), the foreign-exchange regulator, created the interbank China Foreign Exchange Trade System (CFETS). The system will start to trade some foreign currencies in May or June.
The idea behind CFETS is to give local banks practice in trading foreign currency before allowing them to trade the Yuan. The problem is that state owned companies including banks need practice in just doing business. They employ hundreds of thousands in tens of thousands of branches. Large bureaucratic organizations in any country tend to be dysfunctional and venal.
China Aviation Oil (CAO) recently incurred $550 million in trading losses. According to CAO’s former chief executive, the losses could have been avoided if the executives of the holding company in Beijing could have been disturbed during their holiday and had held a meeting promptly after returning instead of waiting a week. An environment where no one takes responsibility and hundreds of millions get lost, could be a recipe for disaster if introduced to the high stakes, high speed world of foreign currency exchange.
In most countries, foreign direct investment (FDI) is provided by large multinational corporations (MNC) with the capital and resources to overcome the immense problems of doing business in a country not your own. China is different. It has been very successful in attracting small foreign investors, often from the overseas Chinese diaspora. It has been speculated that the reason for this policy was to stifle local entrepreneurs, who might pose a threat to the socialist state. If that is the policy, it has been a spectacular success. There are fewer than 1,200 private companies with registered capital of more than $12 million in all of China.
Whatever the reason, the problem with foreigners is that they can always take their money home. The problem with small foreign invested enterprises, especially in China, is that they would most likely be family run. Inter-company transfers could be accomplished without a paper trail. China’s stringent currency controls could be easily avoided. These firms are probably the source of much of the “hot money” currently attracted to the Yuan in expectation of a currency revaluation. Hot money, in times of financial distress, can quickly become cold as it leaves for more profitable shores.
Speculative markets often result in panic when greater fools become scarce. Property prices in Shanghai nearly doubled between 2000 and 2004. In 2004 they rose 28% in the city center. Part of the problem is that 75% of the purchases are speculative, with buyers from both with China and overseas. At the top of the market, 80% of the apartments are being purchased by buyers from Taiwan and Hong Kong, who could quickly take their money home.
A speculative bubble is also more likely in Shanghai, because of the narrowness of its economic base. A large international metropolis like London or New York depends upon services for as much as 75% of their GDP. Shanghai service sector makes up only 48% of its GDP and that share is dropping as real estate’s share doubled from 3.71% to 7.4% in the last ten years. Shanghai’s other economic base, cars, has slowed spectacularly since last year as the government cut off lending for new cars.
What is surprising about China is that a population, who saves such an enormous amount, would place their money and their trust in insolvent banks. The most obvious answer is that they don’t know. With news restricted, it would be very difficult for them to know the true problems besetting the country’s financial system, until now.
Cell phones, text messaging, the internet, and email, even though highly regulated still form a potent force for financial panic. During the recent Chinese New Year holiday there was a record 11 billion text messages. I assume most of them were benign. What are not, are the estimated 47,000 protests that occurred in China in 2004 alone. What may be difficult to restrict is local news. For example, at on branch of a state bank, the staff looted the deposits of an entire town. Several billion text messages about this little news item could undermine trust in Chinese banking institutions. It could happen very fast, even faster if it was organized. The term ‘a run on a bank’ is used with good reason.
A problem in any one of the above events could raise serious questions about investments in China. Each event could trigger the others as the problems became widely known. If a problem does develop, the Chinese government would have several options. Given time they could simply print money. Any large debt could disappear through hyper inflation. They could raise taxes and recapitalize the banks. They could raise money on international financial markets. But these methods would take time. The fastest and the best would be to prop up their failing system by dipping into their reserves of US Treasury bills, their rainy day fund.
Large moves in any market never go unnoticed. This would be especially true if China started selling dollars to help beleaguered Chinese banks. The first ones that would likely notice would be Asian central bankers. Having watched their dollar assets decline for two years, they may not have the stomach for further losses. One of them could turn chicken and bail out of dollars. The stampede would then commence. Without the massive interventions in the foreign exchange markets, the dollar might start falling like a stone.
During the Asian crises of 1997, the IMF recommended that countries with declining currencies should raise interest rates. For the US, a very large chicken would have come home to roost. To maintain stability in capital markets, the Federal Reserve would be forced to raise interest rates.
A substantial rise in interest rates might slow the dollar slide and help our balance of payments. It would not be particularly beneficial for the US economy. Consumer debt would be especially vulnerable.
Since the dot com bust in 2000, total value of homes, shares and other assets owned by households rose by $4.5 trillion. Unfortunately total debt (public and private) has increased by a hefty $6.5 trillion since 2000. Any increase in interest rates has got to hurt, a lot.
It would be especially painful in the housing market. Last year house prices in the US rose at their fastest rate since 1979 with some markets increasing as much as 20% in some markets. The rise of interest rates has slowed the market, but the rise has been expected and measured. A rapid rise could throw the market into reverse.
With financial instability, investors become hyper risk adverse. Emerging market debt has been very attractive over the past two years. In their search for high yield debt, investors have increased their demand for emerging market debt yield spreads over US Treasuries have fallen to a record low of 3.45% on JPMorgan's EMBI+ index from their record level of 13.5 % after Russia's 1998 financial crises.
A major rise in US interest rates and a rise in global risk levels would change this situation over night. Although many emerging markets have become far more financially stable recently, over half the countries on the EMBI+ index are now rated investment grade, the lack of transparency and shaky legal infrastructures could result in some unpleasant surprises. Worse, some of the stronger currencies and economies could attract investors seeking to diversify out of dollars. This would have the perverse effect of raising the prices of exports to many of these countries’ major US market, just as that market was beginning to contract.
The impact on Japan would be especially severe. Japan has battled deflation and a contracting economy for the past fourteen years. An export driven economy requires an undervalued currency as one of its major assets. A rapidly declining dollar would most likely be reflected in an appreciating yen. Japan’s central bankers would be in a difficult situation to choose between losing the value of its reserves and potential growth of its economy.
This would be exacerbated by the turmoil in China. China has become one of Asia’s biggest markets, sometimes surpassing the US. As the problems with its financial system reverberated, those most affected would be some of its closest neighbors including Japan and Korea.
One problem that has recently been plaguing the international marketplace would probably be solved. The rise in commodity prices including oil, copper, iron ore, aluminum, zinc, coal, soybeans, coffee, raw sugar, and gold would also go into reverse. This would certainly ease energy prices, but it would destabilize the economies that depend upon high prices. The most notable would be that of Russia.
The problem with Putin’s Russia is that although Putin has been successful in gathering more power into his hands that power has not been used wisely. Rather than pass necessary legal and regulatory reforms, Putin’s Yukos fiasco simply convinced investors that the country was not ready for prime time. Rising standards of living along with a rising GDP from the rising demand for oil have papered over this inertia. Even with oil at record levels economic growth is predicted to slow. If demand for energy were to drop in the face of a world wide recession, Russia’s lost opportunity would be readily apparent.
The fall out from problems in China and a rapid fall of the US dollar would be severe. The down side of the economic cycle is never as much fun as the up. The difference, though, between a long period of economic and political instability and a short economic contraction depends on how well the bankruptcy system functions. An economically efficient bankruptcy system provides for a way to clean up bad loans, and reallocate capital to the competent, profitable firms. If the transaction costs are kept low and the system is quick, then the recovery will be as well. The problem for China and some of the other countries is that their bankruptcy system does not exist, which will exacerbate the problem and lengthen the recovery.
William B. Gamble, President of Emerging Market Strategies, appears regularly in the business media and is author of Investing in China: Legal, Financial and Regulatory Risk(Quorum Books, 2002).
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