January 31, 2014 5:28 pm

Economic danger lurks in China’s shadow banks

By Simon Rabinovitch

The rescue puts off the immediate threat but raises the stakes, writes Simon Rabinovitch

Of all the economic dangers to flare up over the past week, the most unsettling was at first glance also the most esoteric: the near default of a high-yield loan product held by a few hundred small-time Chinese investors.

Set against the turmoil in other emerging marketssteep currency falls in Turkey and South Africa that prompted their central banks to raise interest rates, stubbornly high inflation in India and a collapsing currency in ArgentinaChina appears to be a bastion of economic strength. Even analysts with a bearish bent still expect its growth to come in at about 7 per cent this year. The renminbi is steady against the dollar and inflation is under control. And unlike developing countries faced with cash outflows as the US Federal Reserve winds down its monetary stimulus, China is protected by robust capital controls.

Why then has the saga of Credit Equals Gold No. 1, the Chinese investment product that was rescued from the brink of failure, so captivated global attention? There are both direct and indirect reasons; the latter are especially worrying.

First, the direct risks. Credit Equals Gold No. 1 is just one of a wave of Chinese shadow banking products that will fail to live up to their outlandishly confident names when they mature this year. The drama over repayment will be played out again and again.

Over the past decade, China’s economy has grown ever more reliant on financing outside the formal banking system. Bank loans, which used to account for more than 90 per cent of total credit, fell to little more than half of new financing last year. Lending by shadow banks now totals Rmb47tn, or 84 per cent of gross domestic product, according to JPMorgan.

Reducing the dominance of banks is part of the plan for unleashing more market forces in China – a positive development. But some of the loosely regulated institutions that have plugged the lending gap are simply reckless. It is the most buccaneering of these that are now sowing doubts about China’s financial stability.

This week’s story began in 2011 when China Credit Trust loaned Rmb3bn to Wang Pingyan, a coal mine operator in the northern province of Shanxi. Mr Wang made the ill-fated decision to scale up investment dramatically just as coal prices peaked. His company collapsed soon after receiving the loan.

If the pain had been confined to China Credit it would have been bad enough. But making matters worse, the case has shown that there is only a thin dividing wall between shadow banks and the better-regulated parts of the financial sector. China Credit had pitched the loan as an investment product, promising an annual return of 10 per cent. Rather than sell it directly, the product was marketed by Industrial and Commercial Bank of China, the country’s largest lender, to wealthy private banking clients.

The controversy in recent weeks about which party, if any, is responsible for the dud loan has drawn in all involved: the local government in Shanxi, which gave its blessing to Mr Wang’s plan; China Credit, which structured the investment product; and ICBC, which distributed it. In the end an unidentified entity bailed out investors by covering their principal, though not the full interest.

Those wondering where the next big troubled shadow bank loan might lurk need only look down the road from Mr Wang’s failed mine to another in Liulin, the same county in Shanxi province. Xing Libin, a coal tycoon who threw a Rmb70m wedding party for his daughter in 2012, is restructuring his mining company because it could not repay its loans. Among those debts is an Rmb1bn ($164m) investment product structured by Jilin Trust and distributed by China Construction Bank – that falls due in a few weeks.

In all, there are about $660bn of trust products up for repayment or refinancing this year, according to Bank of America Merrill Lynch. Chinese shadow banks, by definition, have been focused on customersminers, property developers and local governments – that regulators have deemed too risky for banks, so more problem loans are a certainty.

Shadow banks have not all been peddling junk. Many trust companies are well run and have demanded ample collateral from borrowers. And where they have been poorly managed, China’s state-owned banks have enough assets to cover much of the damage. Most investors in trust products will walk away unscathed. 

It is the indirect consequences of this week’s bailout that are more worrying. As rating agency Fitch put it, the rescue of the trust product was a “missed opportunity” to create more risk awareness in the financial sector. This could cast a shadow over Chinese markets for years to come.

Chinese investors who lend money to heavily indebted miners or property developers are not crazy. They are making a calculated gamble one that has proved mostly correct until nowthat the government or state-owned banks will bail them out if they get into trouble. Yet an accumulation of bad investment decisions explains the excess capacity that plagues manufacturers from sportswear companies to steel mills. The perception of ironclad, if implicit, government guarantees is also why overall Chinese debt levels have soared from 130 per cent of GDP in 2008 to more than 200 per cent today. Similarly fast increases have been precursors to financial crises in countries from South Korea to the US.

Hence China’s uncomfortable predicament. Because the government was unwilling to see Credit Equals Gold No. 1 collapse, fears of an imminent economic meltdown are overblown. But for precisely the same reason China’s debt powder keg is only getting more tightly packed.

Copyright The Financial Times Limited 2014.

The Global Economy Without Steroids

Sri Mulyani Indrawati

FEB 4, 2014

Newsart for The Global Economy Without Steroids

WASHINGTON, DC Economic growth is back. Not only are the United States, Europe, and Japan finally expanding at the same time, but developing countries are also regaining strength. As a result, world GDP will rise by 3.2% this year, up from 2.4% in 2013meaning that 2014 may well be the year when the global economy turns the corner.

The fact that the advanced economies are bouncing back is good news for everyone. But, for the emerging and developing economies that dominated global growth over the last five years, it raises an important question: Now, with high-income countries joining them, is business as usual good enough to compete?

The simple answer is no. Just as an athlete might use steroids to get quick results, while avoiding the tough workouts that are needed to develop endurance and ensure long-term health, some emerging economies have relied on short-term capital inflows (so-calledhot money”) to support growth, while delaying or even avoiding difficult but necessary economic and financial reforms. With the US Federal Reserve set to tighten the exceptionally generous monetary conditions that have driven this “easy growth,” such emerging economies will have to change their approach, despite much tighter room for maneuver, or risk losing the ground that they have gained in recent years.

As the Fed’s monetary-policy tightening becomes a reality, the World Bank predicts that capital flows to developing countries will fall from 4.6% of their GDP in 2013 to around 4% in 2016. But, if long-term US interest rates rise too fast, or policy shifts are not communicated well enough, or markets become volatile, capital flows could quickly plummetpossibly by more than 50% for a few months.

This scenario has the potential to disrupt growth in those emerging economies that have failed to take advantage of the recent capital inflows by pursuing reforms. The likely rise in interest rates will put considerable pressure on countries with large current-account deficits and high levels of foreign debt – a result of five years of credit expansion.

Indeed, last summer, when speculation that the Fed would soon begin to taper its purchases of long-term assets (so-called quantitative easing), financial-market pressures were strongest in markets suspected of having weak fundamentals. Turkey, Brazil, Indonesia, India, and South Africadubbed the “Fragile Five” – were hit particularly hard.

Similarly, some emerging-market currencies have come under renewed pressure in recent days, triggered in part by the devaluation of the Argentine peso and signs of a slowdown in Chinese growth, as well as doubts about these economies’ real strengths amid generally skittish market sentiment. Like the turbulence last summer, the current bout of market pressure is mainly affecting economies characterized by either domestic political tensions or economic imbalances.

But, for most developing countries, the story has not been so bleak. Financial markets in many developing countries have not come under significant pressureeither in the summer or now. Indeed, more than three-fifths of developing countriesmany of which are strong economic performers that benefited from pre-crisis reforms (and thus attracted more stable capital inflows like foreign-direct investment) – actually appreciated last spring and summer.

Furthermore, returning to the athletic metaphor, some have continued to exercise their muscles and improve their stamina – even under pressure. Mexico, for example, opened its energy sector to foreign partnerships last year – a politically difficult reform that is likely to bring significant long-term benefits. Indeed, it arguably helped Mexico avoid joining the Fragile Five.

Stronger growth in high-income economies will also create opportunities for developing countries – for example, through increased import demand and new sources of investment. While these opportunities will be more difficult to capture than the easy capital inflows of the quantitative-easing era, the payoffs will be far more durable. But, in order to take advantage of them, countries, like athletes, must put in the work needed to compete successfully – through sound domestic policies that foster a business-friendly pro-competition environment, an attractive foreign-trade regime, and a healthy financial sector.

Part of the challenge in many countries will be to rebuild macroeconomic buffers that have been depleted during years of fiscal and monetary stimulus. Reducing fiscal deficits and bringing monetary policy to a more neutral plane will be particularly difficult in countries like the Fragile Five, where growth has been lagging.

As is true of an exhausted athlete who needs to rebuild strength, it is never easy for a political leader to take tough reform steps under pressure. But, for emerging economies, doing so is critical to restoring growth and enhancing citizens’ wellbeing. Surviving the crisis is one thing; emerging as a winner is something else entirely.

Sri Mulyani Indrawati is Managing Director of the World Bank Group, and was Finance Minister of Indonesia from 2005 to 2010. She was Euromoney’s Finance Minister of the Year for 2006, Emerging Markets’s Asian Finance Minister of the Year for 2007 and 2008, and in 2008 was ranked by Forbes as one of the most powerful women in the world.

February 3, 2014 6:02 pm

The future still belongs to the emerging markets

Just as the west has emerged from crisis before, the newcomer economies will return to growth

Ingram Pinn cartoon

In 1996 a friend of mine called Jim Rohwer published a book called Asia Rising. A few months later, Asia crashed. The financial crisis of 1997 made my colleague’s book look foolish. I thought of Jim Rohwer (who died prematurely in 2001) last week as a I listened to another JimJim O’Neill, formerly of Goldman Sachsdefending his bullish views on emerging markets in a radio interview.

Mr O’Neill coined the term Brics for Brazil, Russia, India and China, just before the emerging market boom of the past decade really got going. He was rewarded for his prescience, and his ability to coin a good acronym, with guru status. Now Mr O’Neill is back, talking up the delicious-sounding Mints (Mexico, Indonesia, Nigeria, Turkey) as the next group of rising economic powers. But this year his timing is a bit off. Investors are panicking about emerging markets and Turkey – the pay-off in the Mint – is at the forefront of the crisis.

One moral of these stories is that in punditry, as in investment, timing is everything. It is possible to be right at the wrong time – and that is what happened to Rohwer. His bullishness about Asia was fully vindicated in the 17 years after the appearance of his book. It just looked badly wrong in the crucial months after publication, as the International Monetary Fund was forced to bail out South Korea, Thailand and Indonesia.

The speed of the recovery in Asia was just as startling as the speed of the collapse. South Korea is once again regarded as a model economy, and its per capita gross domestic product has almost tripled since the near disaster of 1997. Thailand and Indonesia also bounced back.

Those stories are worth remembering amid the current panic. The next year could make boosters of emerging markets, such as Mr O’Neill, look like false prophets. But over the course of the next decade, they will be proved right again.

The reason for this is that the factors that have propelled the rise of non-western economies in the past 40 years still apply. These include lower labour costs, rising productivity, huge improvements in the communications and transport that connect them to global markets, a rising middle class, a boom in world trade as tariffs have fallen and the spread of best practice in everything from management techniques to macroeconomic policy. Added to this is the drive of people all over the world – from factory hands to entrepreneurs – who have realised that they are not condemned to poverty, and that a better life is there for the taking.

In the past half century, these powerful forces have allowed emerging markets (or developing nations or rising powers, if you prefer) to grow much faster than the developed world. In their recent book, Emerging Markets, Ayhan Kose and Eswar Prasad show that the economies of a group of the most prominent emerging markets (including China, India and Brazil) have grown by about 600 per cent since 1960compared with 300 per cent for the richer, industrialised nations. Even over the past 20 years, they write, “emerging markets’ share of world GDP, private consumption, investment and trade nearly doubled”.

The effect has been to transform the global economy. Michael Spence, a Nobel Prize-winning economist, writes that in 1950 only about 15 per cent of the world’s population lived in developed economies. In the intervening 65 years, the benefits of industrialisation, trade and rapid economic growth have spread to large parts of Asia, Latin America – and now Africa.

The story is far from over. Professor Spence argues that we are in the midst of a “century-long journey in the global economy. The end point is likely to be a world in which perhaps 75 per cent or more of the world’s people live in advanced countries.” If anything, the pace is likely to increase as the implications of the communications revolution become clearer and more entrenched.

The rise of the emerging markets will, however, be punctuated by crises such as the one we are experiencing today. These, too, have been part of the story all along. The Asian financial crisis of 1997 was not an isolated event. There was the tequila crisis in Mexico in 1994 and the Indian financial crisis of 1991. If you enter the wordsLatin American financial crisis” into Google, it helpfully offers to complete the phrase with the dates 1980, 1990s, 1998 and 2002. Yet despite all this, most of the leading economies of Latin AmericaBrazil, Mexico, Chile and others – have experienced real improvements in living standards and reductions in poverty.

The emerging markets have also sometimes been rocked by political crises that led investors to panic. Most dramatically of all, there were the protests in Beijing’s Tiananmen Square and subsequent massacre in 1989. Who at the time would have predicted that in spite of all this political turmoil – the Chinese economy would more than double in size over the next decade, and then do the same again in the decade after that?

The moral of the story is that the rise of non-western economies is a deeply rooted historic shift that can survive any number of economic and political shocks. It would be a big mistake to confuse a temporary crisis with a change to this powerful trend. The bursting of the dotcom bubble in 2001 did not mean that the internet was massively overhyped, even though some people jumped to that conclusion at the time. In the same way, today’s turmoil will not change the fact that emerging markets will grow faster than the developed world for decades to come.

Copyright The Financial Times Limited 2014