A Looming Banking Crisis

May 2005 Dr. Hans Black

For the past five years, ever since the peak in the U.S. stock market, the important element to watch in the global economy has been China. In the economic cooling period of 2001 and 2002 — post bubble and 9/11 — more and more commentators noted the importance of China as a contributor to demand in what was otherwise a desultory environment. Chinese products filled the shelves of large consumer chains as China dramatically increased its trade with its Asian neighbors and especially with Japan. Over the past eighteen months, China has also been the single most important factor in the rising price of raw materials — especially steel, copper and nickel — as well as in the price of energy. We have commented in the past that the positive growth in Japan throughout 2003 and into early 2004 was largely a result of China’s trade policies.

More recently, however, a number of indicators have revealed the situation in China is deteriorating. Firstly, the Japanese economy — and particularly those elements important to China’s trade — has slowed. Secondly, China made an important decision in 2004 to raise interest rates in an attempt to slow down its rapid economic development and particularly the growth of unchecked credit demand. During late 2003 the government bailed out two major state-owned banks, namely the Bank of China and the Chinese Construction Bank, which at the time needed close to $50 billion to write-off mountains of bad loans. As recently as April 21st, China announced it would inject $15 billion into the Industrial and Commercial Bank of China — again due to bad loans.

Although we have expressed our worries and skepticism in these pages over the past year, we must now confess to an even more apprehensive stance. China, which should be congratulated on its achievements over the past twenty-five years, is suffering from all the classic signs of over-capacity, over-building, and an out-of-control banking system where recent bailouts have but scratched the surface. Hardly a month goes by without another scandal erupting within one of the many state-run banks. We hear anecdotes of factories being built to produce items already in over supply; we hear of projects getting approval through long-term friendships with little regard for proper scrutiny or evaluation. Little wonder that the index of Chinese stocks trading in Shanghai is now at six-year lows — despite headlines proclaiming persistent growth of heroic proportions.

At the heart of these problems lies the political structure of China. Although government authorities must be well aware of these problems, there seem to be literally hundreds of conflicts between the central and regional governments supposed to be taking care of them. It is also increasingly clear that the central government in Beijing has at most tenuous control over provincial and local municipal leaders who have their own priorities and vastly different incentives. Local leaders in both government and banking sectors have every incentive to continue to lend or take kickbacks from friends over the objections of central planners and central government leaders. As the stalemate continues, it is likely that a far more public crisis will be needed to force the retirement of many older members of the bureaucracy and to allow for some fresh faces, fresh ideas and, at least a short-term slowdown. Given that China is increasingly flexing its muscles abroad, particularly with respect to Taiwan, it may well be the occurrence of an internal economic crisis that triggers an external one.