July 31, 2013

UNTRUSTWORTHY NUMBERS: Black Holes At China’s Shadow Banks.

Banks are controlled by the government, with interest rates for both deposits and loans set by fiat. The government also feels free to tell banks how much to lend, and to mandate that they buy government bonds at particular prices. When I went to China in 2010, one of the bankers there told us that a huge chunk of their Tier One capital consisted of special government bonds that couldn’t be sold and paid about 5 percent interest — at a time when inflation was, according to most of the experts I talked to, well above that.

In a Western banking system, you’d expect this to lead to a crisis. But what would that even mean in China? Its currency isn’t convertible, and financial links to the outside world are tenuous. Maybe the government can just keep ordering banks to keep making loans at low interest rates, and declare by fiat that the loans are performing. That seems like a crazy thing to say, but it’s also hard to describe how a crisis would happen.

In the years since I visited China, I’ve asked various experts to explain its banking system to me in a way that makes sense. No one has been able to so far.

The fact that the mechanics of a crisis are hard to sketch out doesn’t mean that the system works well. You know those Chinese ghost cities, the eerie forests of apartment buildings and commercial complexes equipped with everything except people? Those homes are a major store of value for Chinese families. With bank account interest rates fixed, a fledgling stock market full of speculative issues, and few financial connections to the outside world, the Chinese have been forced to look into nonfinancial stores of value for their massive savings rate. Like us, they often choose real estate. But not to rent, because that would devalue the property; the Chinese place a high value on new. No, they buy the houses and keep them empty, as stores of value rather than places to live.

In recent years, China has moved to liberalize things slightly, since obviously it makes no sense to plunge so much of the nation’s investment capital into empty houses and similar “assets.” But this, too, creates issues.

Everybody hates the bust, but the real harm is done in the boom, with capital being diverted to things that don’t make sense, because the boom’s distortions make them seem to make sense.