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China’s slow rot or dramatic crash?

In a country where information is tightly controlled, the size and extent of the underground economy can only be guessed. When this part of the economy goes bust, the landing will be very hard indeed

The Chinese economy, like the economies of the rest of the BRICs, is slowing. Despite some neutral official numbers, other numbers like industrial production and electricity consumption indicate that China’s growth rate may have fallen below the target of 7.5%. In May real estate values have fallen in a record 54 of 70 cities. In the first five months of 2012, real estate sales volume slowed by 9% compared to a year earlier. The central bank cut interest rates for the first time since late 2008, suggesting a weaker economy than forecast.
 
With all this bad news, China is still growing at a rate that any other country would envy. Business cycles have been part of every market in history. Have the Chinese found a way to prevent them?
 
Some people certainly think so. The famous Goldman Sachs’ economist, Jim O’Neill, and the creator of the term ‘BRIC’, still sees China as a “beacon of light”. O’Neill no longer believes that indicators like electricity consumption and industrial production, which have been so accurate in the past, still reflect the true level of China’s economic activity. Instead he has switched to indicators of consumption, including monthly retail sales, which seem to support his forecast that China’s economy is in for a ‘softer’ landing. This thesis is quite common among economists and has probably been priced in to global equity markets.
 
Other economists also do not see a “hard landing” but for other reasons. The excellent economist Andy Xie points out that economic collapses occur only when creditors fear for their loans and try to collect from defaulting debtors. There is a major difference in different economies depending on their legal infrastructures. In countries like the US, when a debt is not paid, the courts will happily enforce the contract. The creditor can satisfy the debt in cash, collect the collateral, foreclose on the real estate or force the debtor into bankruptcy. In other countries like Japan, debts are not collected. The difference is between a sharp crash and protracted slowdown.
 
Although a crash or hard landing may sound worse than a slowdown or a soft landing, in fact the soft landing is worse. Unless creditors can clear the loans and reallocate capital to more efficient enterprises, the economy cannot restart. The country’s economy becomes littered with zombie banks and mispriced assets. Growth comes to a halt, since the market is not allowed to function. The stagnation can last for over a decade.
 
This is what is occurring in China. Their 2008 bankruptcy law is unused. Defaulting debtors just leave town. Foreclosures are rare. Banks don’t force developers to repay loans on time, so developers see no need to liquidate inventories at lower prices. Prices do not crash, but sales do.
 
Most of the loans did not go to developers or private businesses. Instead they went to local governments and SOEs. With slowing real estate sales, the main source of income for local governments is drying up. Rather than trying to collect from another branch of the government, the state-owned banks simply roll the loans over.
 
Professor Michael Pettis has pointed out these problems for years. He understands the sclerosis inherent in the system, but believes that Beijing will prevent a slowdown by forcing banks to lend more to local governments for infrastructure projects. While this might be sufficient to stimulate the economy for a few months, eventually the loans for these projects or the bonds issued to finance them will end up in default as well.
 
Despite these predictions, there will in fact be a crash in China. As central banks in the US and Europe are discovering, there are limits to the ability of government to manipulate a market. The Chinese government controls the banking system, but there is a shadow banking system. This system is not only unregulated, its size and extent are unknown.
 
The concrete business is an excellent example. Families will buy a concrete mixer with vendor financing. Then the owners will double up on their debt by using the equipment as collateral for new loans. Finally mixing companies sell their ready-mixed concrete on credit to developers. This overleveraged pyramid could easily collapse like a house of cards.
 
Financial reform could make the problem worse. By controlling interest rates for loans and deposits, the government guarantees profits for its banking monopoly and creates a hidden tax on depositors to help clear bad loans. But the monopoly is breaking down. Banks have to offer higher rates to attract depositors.
 
In a country where information is tightly controlled, the size and extent of the underground economy can only be guessed. In most emerging markets it is over 50% of the regular economy. When this part of the economy goes bust, the landing will be very hard indeed.  

(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. Mr Gamble can be contacted at [email protected] or [email protected].)

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European banking crisis can choke trade, finance says India

A crisis in European banking system can choke trade, finance and economic growth not just in the Euro Zone but in the world at large

 

Bangalore: India on Friday said a crisis in the European banking system can choke trade and finance and in the process global economic growth, and called for substantially expanding the resource base of multilateral development banks, reports PTI.

"The sovereign debt crisis and the banking crisis, now on the horizon, has grave implications not only for the European economy, but also global economy," External Affairs Minister SM Krishna said.

He was addressing a joint press conference with German Foreign Minister Guido Westerwelle.

"A crisis in European banking system can choke trade, finance and economic growth not just in the Euro Zone but in the world at large," Krishna said.

Europe is of particular concern as it accounts for a significant share of the global economy and is also India's major trade and investment partner, he said.

Krishna said there is a need to substantially expand the resource base of multilateral development banks so that they have the fire-power to help developing countries pursue their developmental goals.

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Goldman Sachs, P&G paid Rajat Gupta's legal fee

As per a deal reached between Goldman and Gupta before the trial, the latter would have to reimburse the bank for the legal fees advanced to him if found guilty

 

New York: Financial services firm Goldman Sachs has paid a large chunk of the nearly $30 million legal fees for its former board member Rajat Gupta's defence, a media report said.

"Goldman Sachs has paid for the bulk of Gupta's legal defence, which has cost nearly $30 million," the New York Times reported, citing a source familiar with the matter.

Proctor & Gamble (P&G) paid the remaining balance, NYT said.

Gupta who was a board member at Goldman Sachs and Proctor & Gamble was found guilty last week of passing confidential boardroom discussions at Goldman to the former founder of hedge fund Galleon, Raj Rajaratnam.

As per a deal reached between Goldman and Gupta before the trial, the latter would have to reimburse the bank for the legal fees advanced to him if found guilty, the report noted.

In addition, Goldman Sachs must continue to pay Gupta's bills until a final resolution of Gupta's appeal, a process that could take a couple of years.

"Goldman has been advancing Gupta money to pay his lawyer's bills because the bank's by laws require it to pay the legal fees of its top officers and directors for conduct that occurred while acting on behalf of the company," the NYT said.

"And Delaware, where Goldman is incorporated has generous laws regarding indemnifying executives to protect them from incurring personal liability for their work while doing their jobs," it added.

The publication noted that Gupta's lawyer fees does not only include his month-long trial, but also two-and-a-half- year legal odyssey that led to the charges against him, including a pitched battle with the Securities and Exchange Commission in a related civil case.

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