Can China experience a meltdown?

As China slows, the loan defaults will increase as will unhappy customers. In an era of social media, it will be more difficult for the government to prevent people from removing their money from the system

Zhang Ke, the vice-chairman of China’s accounting association, is worried. He and his firm audit the books of Chinese local governments. According to Mr Zhang the debts of the local governments are is “out of control” and could spark a bigger financial crisis than the US housing market crash. In a way this is not news. The only thing that is news is that a senior Chinese figure is talking about it. But if China’s debts are so big, why doesn’t it spark a panic?


Mr Zhang’s assessment of the Chinese debt situation has a lot of company. The International Monetary Fund (IMF) and the rating agencies have all flagged the issue. Recently Fitch cut China’s sovereign debt rating, the first such cut since 1999. A rare downgrade in a world where many emerging markets are seeing more optimistic outlooks.


China’s debt problems have been around since the recession of 1999. To avoid a recession in 2009, the Chinese government opened the monetary floodgates by forcing the banks to make loans and lend they did. Most of the money went to provinces, cities, counties and villages for various projects. The problem with financing projects with bank loans rather than taxes is that the projects have to generate sufficient income to service the loans. According to Mr Zhang this is not happening. The local governments were not paying back the loans, just rolling them over. “The only thing you can do is issue new debt to repay the old,” he said.


Like the US Federal Reserve, this type of stimulus has been going on for the past four years. The pile of debt is now quite high. It is estimated to be between Rmb10 trillion and Rmb20 trillion ($1.6 trillion and $3.2 trillion), equivalent to 20%-40% of the size of the Chinese economy.  It hasn’t stopped. Despite questions over solvency, the hunt for yield has allowed the local governments to issue Rmb283 billion of bonds in the first quarter of 2013. This is more than double the total for the same period last year. In theory local governments are prohibited from issuing bonds. But thanks to investment companies, a financial innovation designed to get around the restrictions, they have been flooding the market.


Sadly, like the Fed’s efforts, the massive stimulus in all forms is having a limited effect. China’s growth has slowed to 7.7%. The mercantilist money machine has been stopped by falling demand in China’s main export markets. The structure of the stimulus is aimed at the wrong segment of the Chinese economy, local governments and state-owned business rather than private businesses. The structure of the Chinese system makes it exceptionally difficult for it to rebalance. Even the economist prime minister, Li Keqiang, has admitted that the economy will have to “climb hills and cross ridges”. So China might be rolling down a hill, but will it fall off a cliff? Will China’s problem morph into a panic? To determine the answer we must look at the causes of a panic.


At their very core, business cycles are about the tension between greed and fear. Excessive optimism about the future creates greater risk taking. This can be exacerbated by extended periods of accommodative monetary policy. The expansion of credit coupled with assumed government guarantees of easy money allows fear to recede. Growth appears to be a one-way bet. With access to easy credit, investors increase their bets. This drives asset prices away from fundamentals. The combinations of imperfect information, asymmetries and ever optimistic forecasts seem to justify the inflated asset prices. After several years of this, the markets are in the middle of a full-blown credit bubble that inflates an asset bubble. Financial innovation or financial reform can change the financial system in ways that obscure the risk.


The classic example is the US collapse. Alan Greenspan and his successor Ben Bernanke convinced the markets that low interest rates would help to rejuvenate the American economy. The housing bubble was considered an accurate valuation by the market. The financial innovation of collateralized debt was seen as an efficient way to spread the risk throughout the market. Since the assumption was that collateralized debt was perfectly safe, the financial system could use huge amounts of leverage, but the exact amount was unclear and could only be estimated. The demand for collateralized debt created a market for any collateralized debt regardless of the ability of the borrower to repay the loan. The result was, of course, the Great Recession.


How does China fit into this description? As I noted above the Chinese government has been flooding the economy with money for years. Money to state-owned enterprises (SOEs) and local governments is lent at subsidized rates basically without restrictions. So there is a vast potential for leverage. Since both the locals and the SOEs are branches of the Chinese government, investors and banks have assumed that they cannot default. The Chinese government has the enviable reputation of being able to engineer one of the most successful development stories in history. So the assumption is that the country will continue to grow its way out of any temporary pull back. Recently more money was funnelled into the system through financial liberalization. The so-called shadow banking system has provided investors ways to get far better interest rates than are on offer at the state-owned banks.


Still the Chinese economy is different. It is heavily state controlled. Just because it seems to fit into the template does not mean that there will be a horrific meltdown. The estimable Financial Times Beijing bureau chief, Jamil Anderlini, doesn’t think that a panic is possible. Slow growth definitely, but no panic.


His analysis divides recent panics into three categories: interbank freeze, or foreign capital outflows, and depositor bank runs. An example of an interbank freeze would be the collapse of Lehman Brothers. The Lehman collapse was particularly horrific because the problem had to do with counterparty exposure. Large leveraged trades were made between banks. If one side defaulted the other would also lose money. When Lehman went under, no one knew who was exposed or how much. So all lending stopped. Mr Anderlini doesn’t think this is a problem in China. China’s regular financial system is composed of state-owned banks. In a crisis the Federal Reserve or the European Central Bank can only provide liquidity and hope. In China the government can actually order the lending to continue.


 Foreign capital outflows were the cause of the Asian financial crisis. Many of the Tiger countries like Thailand had borrowed in dollars. When the crisis hit, foreign investors pulled out, putting the economies into a tailspin. There is a similar issue in the Eurozone. Countries like Greece sold euro bonds to foreigners who assumed a credit rating equal to Germany. When the crunch came the foreigners left.


China does not have a convertible currency. Its exposure to international investors is quite limited. Besides it has $3.44 trillion in foreign exchange reserves. So it has the firepower to avoid a meltdown.


So far I agree. China cannot have a liquidity or a currency crisis, however, a depositor bank run in my view is possible. Mr Anderlini believes that the state-owned banks including the big three Industrial and Commercial Bank of China, China Construction Bank and Bank of China “are effectively backed by the full weight of the Communist party” and the Chinese state. This is certainly true. Chinese banks are all state-owned and too big to fail, but there has been a major change.


What is not too big to fail are the local government bonds, trust vehicles, Wealth Management Products (WMPs), real estate and other private company bonds, in short the Chinese shadow banking system. These are credit flows that have been transferred off bank books or securitized loans. The shadow banking system has increased four-fold in size since 2008 to about Rmb20 trillion ($3.2 trillion), or 40% of gross domestic product. It could be as much as Rmb24.4 trillion, or nearly 50% of GDP. Recently it has been metastasizing at an incredible rate. Conventional bank loans from the state banks made up 95% of loans in 2002. This has decreased to 58 % last year. Total financing has increased almost eight-fold during that time. Trust loans surged 679% in last December alone to 264 billion yuan from a year earlier. The recent growth of the Chinese economy would have been impossible without these loans.


But these loans suffer from two major problems. Although the purchasers assume they are as safe as bank deposits, they are not backed up by banks or anyone else. Second, there is the classic bank issue: an enormous asymmetry between the assets and liabilities. The most popular WMPs have durations of one to three months. But the funds provide financing for much longer terms, often multi-year loans.


WMPs and bonds are considered safe, because firms, especially firms connected to the government, do not default. Private firms go under. Usually the owner disappears at night. But state firms or large firms partially owned by the state are kept afloat either by mergers or by rolling over loans, until now. Recently two solar firms—Suntech and LKD’s bonds went into default. Also banks are having problems with WMPs. Customers at a China Construction Bank branch in the north-eastern province of Jilin complained to regulators that they lost more than 30%. One of CITIC’s, a large financial conglomerate, products was at risk because of an overdue loan worth more than Rmb70 million ($11 million). Losses from a product sold by Huaxia Bank, could reach up to Rmb100 million ($16 million). These losses are small, but the surprising thing is that they are happening at all.


So all the elements are in place: Financial innovation, an extended period of easy money, credit expansion, assumption of government guarantees, poor risk assessment, and worst of all, poor information. As China slows, no doubt the defaults will increase as will unhappy customers. In an era of social media, it will be more difficult for the government to prevent people from removing their money from the system. As faith in the financial system declines, no doubt so will the faith in the Communist party, which, according to a quickly terminated online survey, has an 80% disapproval rating. Like Mr Anderlini, I have no doubt that China will slow, but it could be in for something much worse as Mr Zhang noted.


(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)


Lanco Infratech settles AUD 3.5 billion litigation by Perdaman

According to a release issued by Lanco, the Australian coal miner has agreed to pay Perdaman a nominal amount of AUD7.5 million, plus legal costs to be taxed by the court, without admission of any of the allegations of Perdaman

Griffin Coal, an Australian subsidiary of Lanco Infratech, on Monday said the protracted litigation for a claim of AUD3.5 billion initiated by Perdaman Chemicals against it has been settled.


According to a release issued by Lanco, the Australian coal miner has agreed to pay Perdaman a nominal amount of AUD7.5 million, plus legal costs to be taxed by the court, without admission of any of the allegations of Perdaman.


Lanco is in a legal battle with Australia’s Perdaman Industries, which filed an AUD3.5 billion (around Rs19,600 crore as per latest exchange rate) lawsuit against Lanco in Australia in 2011, alleging non-compliance with coal supply pact for the company’s upcoming urea plant in Western Australia.


This settlement was reached pursuant to the rules of Supreme Court of Western Australia, which allows for early and cost effective resolution of such claims, the release said.


Lanco has always maintained that Perdaman's action was baseless and without any merit. If allowed to continue, this case would have taken another 12 to 14 months for the trial and judgment, resulting in significant legal costs and loss of management time, the release said.


“The purpose behind making this nominal offer was to put an end to this litigation now and move forward with our mine expansion plans,” it said.


This outcome will have a positive impact on the entire group, and especially for Griffin Coal, a 100% subsidiary of Lanco, it further said.


“In the end, Perdaman had no choice but to accept nominal offer in the settlement proposed by Lanco, which is in fact a small fraction of the original claim,” the release claimed.


The company will reinforce its focus on its business and mining operations in Western Australia, including the proposed expansion of the Collie mine and the enhancement of the export facilities at the Bunbury port, the release said.


Backed by the settlement news, shares of Lanco Infratech gained nearly 10% to Rs11.56 on the BSE in the early trade Monday.


Billions proposed for new border security. Where would the money go?

The Senate's immigration overhaul would allocate $4.5 billion in new border spending. We take a look at the current proposal, and how border money's been spent (and wasted) in the past

Federal spending on border security is at an all-time high —and it would get even higher under the Gang of Eight’s new plan. The Senate immigration proposal, released last week, would allocate $4.5 billion in the next five years to tighten control of U.S. borders.

The U.S. spent nearly $18 billion dollars on immigration enforcement agencies last fiscal year, more than all other law enforcement agencies combined.

Where would another $4.5 billion go? Here’s a closer look at what is being proposed, and how the government has spent (and often wasted) border money in recent years.

More border agents

The proposal calls for an additional 3,500 U.S. Customs and Border Protection officers. In FY 2012, the department employed 21,790 officers, up 10 percent from 2008. The bill would also add an unspecified number of Border Patrol agents, whose ranks have skyrocketed from just over 4,000 in 1993 to more than 21,000 today.

A 2011 investigation by The Center for Investigative Reporting and the Los Angeles Times showed how hurried hiring by the border agency affected screening standards and led to an increase in corruption. From 2006 to 2011, the number of investigations of customs employees charged with fraud more than tripled. Since 2004, 147 agency employees have been charged with or convicted of corruption-related offenses.

More drones

The bill requires buying as many “unmanned aerial systems” (also known as drones) as needed to have 24/7 surveillance of the Southwest border. The U.S. has already purchased 10 border drones, which cost $18 million a piece and roughly $3,000 an hour to operate.

Many question whether the current border drones are worth the investment. According to a report from the Customs and Border Protection agency, drones led to 143 arrests and the recovery of 66,000 pounds of drugs in 2012. As news outlet Fronteras calculated, “that’s less than 3 percent of all drugs seized by border agents last year, and less than 0.04 percent of the 365,000 would-be illegal border crossers caught by agents.”

In May 2012, a report by the Department of Homeland Security’s Office of the Inspector General [12] found the U.S. didn’t have enough manpower or money to effectively operate the drones they already have. The department overshot its maintenance and operational budget by over $25 million. Drones had only flown for 30 percent of the time they were supposed to be in the air.

More fencing

Another $1.5 billion would be allocated to expand the 651  miles of fencing along the Southwest border. "I think what we would do if the bill passes," Homeland Security Secretary Janet Napolitano said in a Senate hearing, "is go back and look at the type of fencing we have and say, ‘Do we want to make it triple what it is or taller?’ — or something of that sort."

More phones and radios

Remote areas along the Southwest border can have spotty cell coverage, posing a risk to border guards in an emergency. A two-year grant would provide more funding for satellite phones and radios for border staff to contact 911, local police and federal agencies.

The bill doesn’t say anything about training guards to use the new devices. In November, we reported how DHS had spent $430 million on radios that only one surveyed employee knew how to use.

More money for local cops

Some of the new DHS funds would go toward Operation Stonegarden, a $46.6 million FEMA program benefiting local law enforcement in border states. "The funds that we are getting from Stonegarden are a godsend," a county sheriff told the Arizona Daily Star in 2009. "I think we are able to provide a lot more security, a lot more visibility."

But critics say there’s little oversight of how the money has been spent. The Star’s review of Arizona police records showed grant money was funnelled toward expensive technology and overtime pay for cops doing unrelated tasks, like crowd control at city parades.

More accountability?

As Congress considers adding billions more to the border budget, lawmakers are left with a key question: is it working? Some critics on the left say the added funding may be unnecessary, as studies suggest net migration from Mexico is now below zero. Many on the right say there still aren’t enough hard metrics to judge whether Homeland Security is doing a better job of keeping undocumented immigrants out.

DHS has pointed to the drop in the number of apprehensions as a sign U.S. borders are stronger now than ever before. But critics say it’s a flawed way of judging whether the billions spent on border security are worth it. That number could mean fewer undocumented immigrants are attempting to cross the border, or that fewer are being arrested. The struggling U.S. economy also plays a big role in the overall drop in unauthorized immigration.

Under the new proposal, high-risk sections of the Southern border must reach a “90 percent effectiveness rate” within five years. That would be the “number of apprehensions and turn backs” divided by “the total number of illegal entries.”

If border states don’t reach the 90 percent target, a group of border state governors (or their appointees) and federally-appointed security experts would step in to draft a new plan to boost effectiveness—on which the DHS can spend up to $2 billion more. The new bill would also create a presidentially-appointed DHS Task Force to regularly review border enforcement policies.

Increased surveillance should help border agents get a better count of the total number of undocumented immigrants crossing the border, said Doris Meissner of nonpartisan think-tank the Migration Policy Institute. According to Meissner, this is the first time immigration legislation has included a specific metric to gauge whether money spent on border protection is resulting in fewer unauthorized crossings.

“The overall expectation that so much money has been invested, the government has to do better in really laying out how it assesses its effectiveness,” she said.


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