Brad Setser

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Interesting recent work on China

by Brad Setser
May 31, 2006

Chinese stock markets have not been as frothy as the Chinese economy – though the Chinese market is doing better in 2006 than it has for a long time.  But what doesn’t go up as fast also doesn’t necessarily go down as fast. India, Turkey, Brazil, Russia and other emerging economies with (formerly) frothy stock markets have pushed China off the front pages of the financial press.

The US decision not to brand China a manipulator helped too.  Though I would note that China has yet to reciprocate by allowing the RMB to appreciate a bit.    China presumably wants to wait til markets are a bit calmer.   It always finds a reason to wait.

But there has been a lot of good work on China recently — work that is worth just a bit of attention.

John Makin has nicely pointed out that the combination of rapid reserve and rapid deposit growth and strict lending controls have led to an absolutely enormous build up of liquidity inside the Chinese banking system.

He doesn’t think that is a stable situation.   I tend to agree.

The World Bank’s Beijing office continues to do a great job of providing real time analysis of China’s economy.   The latest quarterly dissects the surge in bank lending, investment and exports in the first quarter.  It notes that Chinese investment continues to be biased toward the tradables sector …


The IMF hasn’t entirely conceded China to the World Bank.   I liked the section’s of the IMF’s regional economic outlook that looked at the impact of the electronics cycle on Asia.   And the data showing the surge in China’s non-oil current account surplus, which the IMF estimates will reach 14% of China’s GDP in 2006.  That is bigger than the US export sector.  So much for the argument that the value-added in China’s export sector is tiny.  

Eswar Prasad and Marvin Goodfriend’s paper lays outs why it is in China’s own interest to stop directing its monetary policy at stabilizing the exchange rate.    Targeting the exchange rate – particularly an undervalued exchange rate – ends up introducing other distortions into China’s economy.  They argue that the PBoC should anchor their policy around the goal of maintaining a low rate of inflation.  That falls short of formal inflation targeting, but it also implies no longer targeting the exchange rate.

I see echoes of Prasad's work around the world.   Eswar – more than others – has argued that China’s current peg requires administrative controls on bank lending, and thus retards China’s efforts to develop a more market oriented banking system.   He consequently is not all that impressed with all the “market” reforms that Chinese officials trumpet.   I think Eswar is right – and so apparently does the OECD.   Their latest economic outlook included a section on China (and the other BRICs). It noted:

“Rapid monetary growth coupled with lower growth in loans [Setser note: in 2005, not q1 2006] has led to abundant liquidity in the inter-bank market and has pushed down short-term interest rates to below the inflation rate, helping to reduce the pressure on the exchange rate but moving the authorities yet further from their goal of using market instruments to stabilize the economy.”

Chinese monetary policy in the second half of 2005 looks to have spurred investment and pushed Chinese growth up – hardly a counter-cyclical policy.

Jaime Marquez and John W Schindler of the Federal Reserve staff have looked at how China’s trade responds to changes in the exchange rate.   And – contrary to lots of “pop economics” commentary that says that the exchange rate doesn’t matter, they found that depreciation significantly increases China’s share of global exports.  It has a small and ambiguous impact on imports.   That makes sense: Chine imports in part because it exports.

Their conclusion shouldn’t be a total surprise.   It you look at the data on p.1 of the Bank of Finland’s quarterly report on China (hat tip New Economist), Chinese industrial production growth clearly accelerated in 2002 before reaching 17% in 2003 – a level that has been sustained since.  That is almost two times the growth rate from 1998 through 2001.  The acceleration in industrial production growth coincides with China joining the WTO.  But it also coincides with the depreciation of the RMB against the euro (see the data on p. 3 of the Bank of Finland report).   I don’t think it is an accident that export growth, investment in the tradables sector and particularly exports to Europe all took off when the RMB started to fall against the euro.

Incidentally, the expansion of Chinese exports embedded in the OECD’s forecast is nothing short of spectacular.  Goods and services exports – roughly $840b in 2005 – will hit $1275 in 2007.  They were only $485b in 2003.  The Bank of Finland data shows that China exported almost as much in the first quarter of 2006 as it did in all of 2000. 

I still think that a sharp slowdown in Chinese export growth is inevitable, and it is one of those things that is not “priced in” in any meaningful way.  Even Garber, Dooley and Folkerts-Landau’s latest work on Bretton Woods two assumes that the US trade deficit cannot expand indefinitely, which implies some deceleration in Chinese export growth.

There also has been a slew of recent work on China’s banking system – and not just from a major accounting firm.     I found Guonan Ma’s assessment of China’s efforts to move NPLs off the books of the banks to be particularly valuable.

Ma convinced me that China really has done a lot to try move old bad loans off the books of the three state banks that are being listed on the stock market …   In 2005, China really did do a lot to take bad loans off the books of ICBC.

Basically, three of the four state commercial banks (CCB, BoC and ICBC – ABC is different) are now in a lot better shape than they were two years ago.    Their bad loans have been bought by the PBoC and then sold to the asset management companies.   That improves the balance sheet of the SCBs – but damages the balance sheet of the central bank.  And adds to the hole in the AMCs balance sheet.   China traded bad banks for bad AMCs.    And at some point, those AMCs will need to be bailed out.

But that still helps the banks – AMC bonds can be discounted in a pinch by the PBoC in a way that bad loans cannot be.

That doesn’t mean that the SCBs are in as good a shape as many think.  Getting rid of bad loans from the 1990s helps, but only if the huge number of loans made during the post-2002 lending boom don’t start to go bad …

Richard Podpeira of the IMF asked whether these reforms have led the state banks to change their lending behavior.   His basic answer is not much.  And, like Ma, he provides a useful review of efforts to move bad loans off the state banks books.

Finally, an updated version of my paper on the “Chinese conundrum: external strength; domestic weakness” has also been published in CESIfo’s Economic Journal – and they generously have made an electronic version available for the world.

This article combines my by now familiar analysis of China’s balance of payments and with my attempt to assess the health of China’s banking system.  My work on China’s banks is largely derivative.  I relied on Ma, on the data from the Chinese government and on some of Jonathan Anderson’s work to estimate how many bad loans have been moved off the books of the Chinese banking system.

My analysis though differs from the standard analysis in one significant way.  Rather than focusing on the reported level of NPLs in the Chinese banking system – data that is somewhat suspect – I focused on the amount of bad loans that have been moved off the banks’ books.   In other words, I looked at the change in the banks NPLs, not the reported absolute level.

My framework lets you pick any number you want for the number of NPLs that the Chinese banks had on their books before the most recent lending boom started.   Personally, I used a higher number than the Chinese authorities.   That may be right.  Or may be wrong.  I have suspicions, but I don’t know.   

But even using a far higher number for “legacy” bad loans than reported by the Chinese authorities, I still found that there has been significant improvements in the balance sheets of the banks.   The banks aren’t as good as the government says, but they are a lot better than they were a few years ago.  

The core question is the one poised by David Dollar, among others.

“What I'm worried about is that there has been a big increase in credit and so the denominator in that ratio is expanding very rapidly," said Dollar.

"Usually when you make a loan it doesn't go bad in a month or two … so when credit is expanding rapidly you may get a somewhat deceptively low figure for NPLs."

Since most new loans haven’t gone bad (loans don’t go bad so long as the boom lasts), the current stock of NPLs largely dates from the 1990s.   However, the future health of the banks will be determined less and less by the bad loans they made in the 1990s – those have largely been moved to the AMCs – and rather by the quality of their new loans. 

The huge surge in bank lending over the past four years in China, combined with the shift of old bad loans to the AMCs, has effectively remade the banks’ balance sheet.  It is a gamble for resurrection on an enormous scale.  If all the banks new loans perform, the banks will be ok.   The AMCs will still need to be bailed out, but that has been obvious for a long time.

And if they don’t, well, China’s government will have to write another check.

Both to the big four state commercial banks.  And, I suspect, to the fast growing joint stock commercial banks.   I am betting that China will end up writing another check.  The acceleration in Chinese investment growth from under 40% of Chinese GDP back in say 2001 to nearly 50% of GDP now doesn’t seem sustainable to me.   When the boom turns to bust, watch out.


  • Posted by Joseph Wang

    My assertion is that there is so much uptapped productivity in the Chinese countryside that without some massive economic mismanagement, there won’t be a bust for another generation.

    The analogy is the post-WWII Soviet economy. You had an horrid, inefficient, and incompetent economic system but you still had two decades of massive economic growth because of the productivity that was generated by moving people from agriculture to industry. Same with Japan and Indonesia. People focus at the economic mess that happened in the 1990’s that they forget the economic boom of the 1960’s and 1970’s.

    (Also, it surprises me that people are surprised that the Communist Party hasn’t collapsed. One thing that is clear from the history of other authoritarian states is that in the early/mid phases of development, the authoritarian government strengthens its hold on power. This happened in Spain, South Korea, Taiwan, and Latin America in the 1970’s. This tends to be unstable over several decades because either the economy improves or it doesn’t.)

    Industrialization is going to sustain Chinese growth for another decade or two, and that will give it enough time to do the institutional reforms that will make sure that growth continues after the industrialization bump runs out. The big danger is not a Chinese economic bust in 2007. The big danger is that China will run into one or two decades of phenomenonal economic growth, people will grow complacent, and everything will fall apart once the industrialization engine runs out of steam around 2020.

  • Posted by Joseph Wang

    One thing I do disagree with OECD. I don’t think that the Chinese government has a goal of using market instruments to control the economy. They don’t care what the color of the cat is as long as it catches mice.

    That’s important to mention because I’ve seen this assumption that China is inevitably moving toward a American-style market economy. That’s not a good assumption. The Chinese government doesn’t have any ideological bias *for* using non-market control mechanisms, but at the same time it doesn’t have any ideological bias *against* using non-market control mechanisms.

    Whatever works.

  • Posted by Joseph Wang

    The PBC can’t discount AMC bonds. The swap that was made in 1998 was to swap bad loans for AMC bonds. If PBC discounts the bonds then it will hit the banks very hard in their balance sheets.

    What is likely to happen is that the AMC’s will dispose of what they can, and the Chinese taxpayer is going to pick up the rest. The important thing about the AMC’s is that they can’t loan money, which means that you have a pile of bad debt, but that pile shrinks rather they grows.

  • Posted by Guest

    China Faces $220 Billion in Bad-Loan Losses: The Fitch report said that China’s banking system still contains about $476 billion in nonperforming and problem loans, even after the large-scale bailouts of the country’s biggest banks. After subtracting provisions, those “watch list” loans are expected to cost China’s banks and government about $220 billion in losses — one-third more than the banking system’s total stock of capital, the report said. Fitch said the country’s foreign-exchange reserves provide more-than-sufficient funding to cover any further support for the banking sector.

    Why India and China Matter: Participation in globalization is raising productivity and growth rates for India and China. The two economies together represent 40% of the global labor supply but their share in global output is only 6.7% in nominal dollar terms (21% in PPP terms). The economic trend of globalization — that is, the cashing in of global labor arbitrage — is improving the utilization of their work forces. Indeed, their participation in the world economy as a result of globalization is redefining the macro theory applied during the era of closed economies.

  • Posted by Guest

    Martin Wolf: China’s autocracy of bureaucrats – What happens when a communist autocracy presides over a dynamic market economy? Do they live together happily ever after or does one destroy the other? [The Road Ahead for Capitalism in China]

    Birth of a military giant in modern China – China’s spending on the modernisation of its large but hitherto ill-equipped military is not wildly disproportionate or unduly alarming. What is troublesome is the level of secrecy and deception that surrounds the process. If they lie about the figures, who is to say they are not lying about their intentions? [The China Syndrome]

  • Posted by Guest

    India’s Economic Growth Accelerates to 9.3 Percent, Fastest After China – India’s economy grew at the fastest pace in more than two years last quarter as bumper harvests and hiring at computer-related companies spurred spending on housing and mobile phones.

    China’s Central Bank Says It Will Start Withdrawing From Currency Markets – China’s central bank said it will stop meddling in the country’s currency market.

  • Posted by HZ

    John Makin makes good observations of the problems, but when it comes to solutions he gives this prescription:
    “Therefore, the only viable alternative is to allow a steady, measured, substantial appreciation of the yuan, perhaps at a rate of 10 percent per year. The result would be a gradual slowdown of the liquidity flows into China and a gradual reduction in the growth rate of its traded-goods sector.”
    And this comes after calling current PBC policies foolish! One can hardly get more foolish than the above statement. A steady appreciation of 10% as suggested would attract the mother of all capital inflows, not reducing liquidity.

  • Posted by Mark

    From Makin:

    In China’s case, inflation could rise to 7 percent, given 10 percent output growth, to equal 17 percent money growth.

    If the Chinese government is suppressing an inflation problem or misrepresenting its inflation numbers, it will only succeed in doing so temporarily. There are signs that incipient inflation pressure may be building in China.

    I believe Delong was predicting that China would adjust the value of it currency through inflation rather than revaluation, or said at least something to that effect. This seems to support that.

  • Posted by Anonymous

    Joseph –

    What portion of China’s exports, high tech and not, derive from not-Chinese transnationals?

    Haven’t these sited in that nation owing to a labor surplus and associated low wages along with a coercive state and low taxes?

    What happens as these conditions change, or are they assumed permanent and if this latter, how do we speak of internal market development, how do we speak of anything other than a giant export platform, of an FDI reliant and immiserizing form of growth.

  • Posted by Anonymous

    Will this work:

    “Move to ban overseas grip in SOEs to keep control
    Last Updated(Beijing Time):2006-05-22 11:23
    China intends to enhance scrutiny over foreign investment in state-held equities at listed firms even as it pushes forward reforms with overseas help while ensuring it does not lose control in pivotal sectors.

    Regulators, while allowing foreigners to take larger or even controlling interest in state-owned enterprises, are on the contrary reluctant to grant final approval for such state-asset sales.

    Instead, they have been stepping up efforts to bolster local enterprises as part of moves to fend off possibly intense competition as the country opens further under its commitments to the World Trade Organization.

    Chinese authorities are now drafting rules to ban overseas control in as many as 40 domestic heavy-equipment makers, the Economic Observer said early this month, citing Sui Yongbin, a senior official at China Machinery Industry Federation.’ (Full – )

    Or will we see a greater tension between the global/transnational and the national.

  • Posted by Joseph Wang

    The one crucial bit of information that Makin misses is that the big four banks are mostly stored cash. Also, I’m sure that the M2 versus GDP growth numbers work out if you take into account that most of the extra money is getting saved.

    Anonymous: What is likely to happen is that transnationals get priced out of the coastal provinces and then start getting cheap labor from the interior. A lot of the capital spending is being used to build railroads and freeways which will let companies site their factories in the interior.

    Alvin Toffler’s “The Third Wave” is a good way to visualize what is going on.

  • Posted by smekhovo

    Immiserizing???! With 10%+ real income growth year-on-year?

  • Posted by DOR

    Anonymous: 57% of exports from China are by foreign-invested factories. 100% are on land that was cheaper when it was acquired.

    Brad, et al,

    “The US decision not to brand China a manipulator helped too. Though I would note that China has yet to reciprocate by allowing the RMB to appreciate a bit. ”

    “Reciprocate” for not diverting attention from the US fiscal deficit?

    Prasad & Goodfriend “. . . argue that the PBoC should anchor their policy around the goal of maintaining a low rate of inflation. That falls short of formal inflation targeting, but it also implies no longer targeting the exchange rate.”

    Any good examples of inflation targeting to follow? Oh, and without useful data, please.


  • Posted by Guest

    “…Such expansion, especially in connection with spending on luxury homes and other developments, could burden China’s banks with a mountain of bad debts, analysts fear. Directives from Beijing to curb the growth of luxury houses are not new, but they have been widely ignored by local governments…”

  • Posted by Charlie

    believe Delong was predicting that China would adjust the value of it currency through inflation rather than revaluation, or said at least something to that effect. This seems to support that.

    I would be very surprised if China adjusted their currency via inflation. Things would likely spiral out of control if they tried to contain it via some sort of price fixing. China pegs to the USD (I mean to a basket of currencies that is like 99% USD) to keep their exported goods prices down. The argument about buying commodities in USD, keeping things stable, etc… is a smokescreen. They’re pegging for the same reason as most of Asia. If the peg causes massive inflation, then it defeats the purpose of the peg. They get the worst of two worlds. Their goods cost more and they have to go through the process of intervention and sterialization. If they let the currency appreciate and eventually let it float, they can eliminate the need for intervention and sterialization.

    I agree that appreciation of 10% per year is too much. At least it’s too much to start with. I think something circa 5% per year would be a good start. As long as the currency appreciation isn’t substantially more than the interest rate differential between China and the US, I think speculative inflows can be contained. As China appreciates, so too will the rest of Asia and it will spread out the investments of those looking for gains via currency adjustments. Also, the process will likely cause interest rates in the US to go up and cause US exports to increase which, barring USD losses, will make the US a more attractive place to invest.

  • Posted by Algernon

    If what I read about the unprofitability of Chinese firms is correct–& its seems consistent with large numbers of non-performing loans–then I bet with Setser rather than Wang.

    It might not require much appreciation of the Yuan to diminish US purchases, both because of higher US interest rates & more expensive Chinese goods. And actual shrinkage of US purchases could be crippling to already unprofitable firms.

    It seems likely that the Chinese have massively misallocated resources & will pay the price in due course.

  • Posted by Joseph Wang

    Algernon: Make sure what you are reading is recent. The problem with SOE’s was very tightly wound with the NPL problem, and IMHO they are both largely fixed. The main reason the SOE’s were highly unprofitable was that they were responsible for huge amounts of social welfare benefits (which they are no longer paying).

    The weird thing is that what crippled the SOE’s in China is largely the same thing that is killing GM and major airlines right now (pensions, health care, and other benefits).

  • Posted by Algernon

    J. Wang,

    Interesting. Thanks.

  • Posted by Guest

    Joseph – still thinking about that global context. Is it all possible to provide a credible summary, naming names, that would provide us with some insights into executive compensation in China? Something that may be comparable to North American standards for disclosure? Might we assume that North American executives’ peers and clients must also reward themselves very well? Combined with creative asset allocation techniques, foreign exchange disparities, I am a bit suspicious that social benefits may not be the biggest drag on profits.

    Back to one of the very few articles I could find that mentions Chinese corporate governance issues:

    “…Webb said the rules also allow companies — especially state-run Chinese firms — to raise cash from a public listing and loan the money to an unlisted parent company or other related business in which the shareholder has no economic interest. “So there’s a risk that by co-mingling, by mixing up the money of the listed company and the parent, that you can end up with bad debt,” he said…”

  • Posted by Joseph Wang

    It’s mostly anecdotal since the Chinese bookkeepping is a total mess. One reason for the NPL problem was that in 1990, most SOE’s had no mechanisms for keeping track of their loans. Just getting things to the point where SOE’s had balance sheets was a major challenge. (Legacy of socialism, in a centrally planned economy, why would a company have a balance sheet? In a non-market economy, what’s a loan?)

    But to see what was happening, one had to go into an SOE, and the typical managers of a near-bankrupt SOE’s don’t look obviously super-rich (i.e. they aren’t driving around in Ferraris or anything like that), and then you look around and see thousands of employees whose health care, housing, retirement benefits are (or more accurately were) being paid for by the company, and you wonder were the money from that came from, since the company was producing *nothing* that people were buying.

    The tricky part of the NPL problem was how to stop the bad loans without causing massive riots. That managed to be done, but not without a huge amount of anger and resentment on the part of the people that lost their jobs and benefits.

    There are some super-rich people in China driving around in Ferraris, but invariably, they didn’t make their money off of SOE’s or the SOE’s that they are managing are doing well and are paying their loans on time.

    Bashing corruption is politically easy because it presumes that there is an easy and painless solution to a problem. The trouble is that things usually aren’t that easy. For example, one invariably gets corruption when you end up with bureaucrats that are underpaid, and one part of any anti-corruption plan is always figure out how to pay people to be honest, and to set up the incentives so that greed is socially productive.

    If you want that Ferrari, make the SOE profitable, and no one is going to complain.

  • Posted by Joseph Wang

    It really depends on the industry. In the case of banks, the holding company (Central Huijin) doesn’t have any assets and so there is no reason to transfer the assets to the holding company. Also, in most IPO’s, the major investors sign an agreement with company which gives them a seat on the board which lets them monitor these sorts of things.

    There is one very, very important provision of Chinese securities law that actually makes things favorable to small investors. Article 124 says essentially that all shareholders have equal claims on the company, which means no preferred shares or share classes. This prevents a company from issuing special shares to large investors, and means that large investors can serve as a proxy for small investors. I can’t monitor that Bank of China isn’t doing funny business, but the Royal Bank of Scotland and Temasek holdings can.

  • Posted by Gcs

    my usual adhd over glance caught this:

    ” see echoes of Prasad’s work around the world. Eswar – more than others – has argued that China’s current peg requires administrative controls on bank lending, and thus retards China’s efforts to develop a more market oriented banking system. He consequently is not all that impressed with all the “market” reforms that Chinese officials trumpet”

    which shakes these comments out of me:

    whats so great about the market taking command of investment ….
    and don’t throw a dusty old text book at me
    i’m too old and tired to duck and to experienced to be effected
    when it hits my head anyway
    maybe administrative controls are better anyway

    so why the trumpet

    well the lure effect of course

    some day gaining access
    and then
    control of the yet to be built
    private capital markets keeps
    many hi fi trans nats lobbying for policy patience in washington

  • Posted by Guest

    Thanks Joseph. I am a concerned about cutbacks to employee benefits in North America. Doesn’t make sense to me that food handlers in the slaughterhouses, kitchens and fields may not have access to healthcare or the language skills required to read and understand the labels on chemical containers.

    Appreciate your point: “…one invariably gets corruption when you end up with bureaucrats that are underpaid, and one part of any anti-corruption plan is always figure out how to pay people to be honest…” but I tend to think that honesty can’t be bought in a corrupt system – and if it can, it is fleeting and carries a high price. It’s my impression the real challenge in many industries is determining the mix of pay and benefits which may entice people to take on risk, stress and carry out their responsibilities in a way that reduces their chances of being a hazard to themselves and everybody else. I could be very wrong, but some senior officials may see their salaries as a bit of a hedge from the downside risks associated with the job, as many of them have non-salaried ways of making money, which may be enhanced by the job, but not without some risks and opportunity costs. (i.e. A Tax Rule Could Save Treasury Nominee Millions, June 2/06, Eric Dash, NYT)

    People do take note if someone is perceived to be driving a Ferrari at their expense. As long a inequities exist, they’ll do what they can to correct the imbalance, although that may be getting more difficult for the average person. There seems to be a proliferation of innovative means which may provide senior officials and wealthy HNWIs with opportunities to take profits away from viable, strategic assets – everywhere. Not to heap all the suspicion on hedgefunds, and I really would like to believe all the positive things that industry says about itself, but have to wonder about the consequences of these sorts of developments:

    “Guernsey’s senior politicians have proposed a set of fiscal changes that include a zero rate of corporate tax and capping personal tax at GBP 250,000… ‘These proposals reinforce the message that Guernsey is very much open for business and welcomes high net worth individuals… especially niche activities like hedge fund managers.’…”

    “…’hedge funds that are moving most aggressively into foreign markets are primarily funds domiciled in London that are starting to look to non-US markets and products for arbitrage opportunities in less efficient markets,’… The impact of this geographic outreach has been felt most keenly in Asia, where proliferating hedge funds are accounting for a growing share of trading volumes in a variety of markets…”

  • Posted by Guest

    “…Measuring the country’s economy is tricky by its very nature, said Masakova of the State Statistics Service. “We live in a transition economy whose structure changes rapidly,” she said. “Only in more or less developed economies do you get to work with set numbers.” – Real GDP Figures Are Anybody’s Guess, April 27, 2005, Moscow Times

  • Posted by DF

    “My assertion is that there is so much uptapped productivity in the Chinese countryside that without some massive economic mismanagement, there won’t be a bust for another generation”

    The bust is coming right now, on schedule with the US slowdown.
    In the 30’s France had 50% of its population still in the countryside, it did not prevent a slump. Indeed the crisis affected all countries worldwide, rural or not.

    Indeed the only thing one can say is that rural countries fare better in times of world economic crisis, because they are less dependant on world markets.
    The less open economies will faire the best.