China’s banks are its Roaring Twenties stock market

China’s banks have been stuffed with $500 billion in bad loans — and these are just the ones we know about. This $500 billion is equal to at least 30% of China’s GDP and the loans not yet written off are poised to consume much of the country’s $700 billion in foreign exchange reserves. China’s situation seems to us the latter days of an investment bubble. Overbuilding, overinvestment, with nary a thought for tomorrow. Despite the evident problems of China’s banks, there has been a wave of Western investment in them, though those who have done so, like Royal Bank of Scotland, say that they have gotten “appropriate warranties and protections” from the government. Meanwhile, in a bow to reality, the IPO market for Chinese banks has meanwhile cooled considerably. Let’s first look at the pretty awful situation of the banks, and then get a sense of how the bubble feels when you are in it. IHT:

Since 1998, the government has spent almost $283 billion to shift a mountain of bad loans off the books of state-owned banks. In a report last week, the Organization for Economic Development and Cooperation said $203 billion more was needed to clean up the rest. Taken together, this rescue amounts to more than 30 percent of China’s gross domestic product for 2004. And while the Finance Ministry bails, a procession of senior managers at Chinese banks have been led away to serve long prison sentences for embezzlement, fraud and theft…..

Moreover, a widely anticipated slowdown in the Chinese economy in the next 12 to 18 months could increase the risk of a fresh wave of bad loans. The Fitch report estimated that even in a moderate economic slowdown, 10 percent of loans could turn bad. A severe slowdown, with gross domestic product growth falling to 3 percent to 4 percent from the current 9.5 percent, “would likely be devastating for all Chinese banks,” it said.

With the potential for the whole sector to take a hammering, the headlong rush to invest is making some experts uneasy. For others, it is starting to feel like a bubble. Scarff said that he worried that too many investors have had the same knee-jerk response in the same way that technology stocks sparked a stampede in the 1990s. “There is an awareness that we have got to be in it,” he said. “But that smells incredibly like the tech bubble in the late ’90s: ‘Oh, God, we’d better be into tech.’ I am sure there is an element of that.”

Then let’s look again at this piece by Niall Ferguson that we alluded to earlier:

Imagine 20 Britains. Imagine 100 Londons. Now you are beginning to get the idea about China, where more than a fifth of the human race resides. Now imagine that vast country’s economy growing more than four times faster than Britain’s – growing faster, in fact, than any economy in history. According to Goldman Sachs, China’s gross domestic product will overtake Britain’s this year. By 2041 it is likely to be the biggest economy in the world. That’s what an average annual growth rate of 9 per cent can do. Your economy literally doubles in size every eight years.

What does such extraordinary material dynamism look like? Having just visited five of China’s fastest growing cities I can report that it looks like the construction of London’s Docklands, projected onto multiple plasma screens, all running in fast-forward mode. I have never seen so many cranes. And they work day and night. Not even the United States in its most hectic years – the Roaring Twenties – can have been like this. You go to sleep not knowing how the skyline through your window will look the next morning. Forget the New World. This is the New, New World.

Ah, yes, the New, New World. Just like the New, New Thing — and we remember how that ended. While we note that the OECD says that China is doing fine and has its banking problems under control, we note that the buildings so admired by Niall Ferguson have not yet shown up as non-performing loans on the books of China’s banks (via Ernst & Young), even as non-performing loans continue to rise at leading banks:

Lending to China’s real estate market may spawn as much as 525 billion yuan (S$110 billion) in new bad loans at Chinese banks, Ernst & Young LLP said. The debt would consist of ‘special-mention loans’, in which borrowers can be in arrears even though the debt hasn’t been reclassified as nonperforming, according to an Ernst & Young report released on Thursday. China’s real estate loans stand at about 6 trillion yuan, the report said. ‘Most people think China has the earnings potential to be able to write it off,’ Jack Rodman, an Ernst & Young partner who helped write the report, said in an interview on Thursday. ‘But everyone should be aware that this stuff is out there.’

China’s bad debt has emerged as a concern for some investors as state-owned lenders such as China Construction Bank plan overseas share sales. While the nonperforming loan rate fell to 9 per cent in the first half of this year from 23 per cent in 2002, some of that decline may have been masked by debt transfers to asset management companies, the report said.

So E&Y says there may be an additional $110 billion in bad loans on top of the $500 billion we already know about. That’s $600 billion, with a heavy concentration in real estate loans, which are utterly dependent on non-stop growth for their payback. In the United States in the Roaring Twenties, the margin leverage of 10 to 1 in the stock market caused great fortunes to be wiped out overnight. In China, the leverage is not in the stock market but in the banks, which have come to depend on regular bail-outs and infusions of capital from the government to rescue them from a leverage ratio of infinity. There is little doubt that the Chinese government can continue to do so, but slower growth, when it comes, produces a vicious cycle of lower investment and credit rationing.

History is chock full of real estate busts from the Roaring Twenties, to Texas after the oil boom went bad in the early 80’s, to the 1990 recession, the bankruptcy of O&Y, Canary Wharf, etc. It seems so vibrant up ’til that moment when it is not. We’ll replay the Ferguson comments, because it feels so very good and so very here-to-stay while the bubble is happening:

Having just visited five of China’s fastest growing cities I can report that it looks like the construction of London’s Docklands, projected onto multiple plasma screens, all running in fast-forward mode. I have never seen so many cranes. And they work day and night. Not even the United States in its most hectic years – the Roaring Twenties – can have been like this. You go to sleep not knowing how the skyline through your window will look the next morning. Forget the New World. This is the New, New World.

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