Tuesday, September 30, 2014

China Worries Austrians

News from China gives rise to significant worry that China faces a recession for the first time since the market-oriented reforms under Deng Xiaoping in 1978.  At least in the minds of those of us that think the Austrian school of economics has the right of it on business cycle theory.

When bank credit rates are low relative to the real time preference level in the economy people borrow money.  They then invest it, often poorly.

Some researchers indicate a high preference for current consumption in China, the "Cash is King" way of thinking.  This would create a very high inter-temporal discount rate.  Bank credit rates are lower at 6% for prime credits.  People would borrow a lot.  Others rate Chinese time preferences as similar to those in the US and Western Europe.

Bank credit has grown significantly and significantly in proportion to the economy.
"Partners Capital, a private investment bank based in London, Boston and Hong Kong, the country’s financial system has accumulated some $23.3-trillion in assets – loans made to companies and individuals – equivalent to about 260 per cent of gross domestic product. That’s up by a whopping $15-trillion in only five years."
It is highly unlikely that a 200% growth in loans in 5 years has all been invested in good, money making projects.

Increased loans seek ever  more questionable projects.  Increased mal investment is likely funding bad projects and the investors and their lenders won't get cash out of the projects to pay the loans.
 "China's real-estate sector, which accounts for more than 20% of the economy when related industries such as steel and construction are included, is swooning. Average new home prices nationwide fell in May and June, according to data provider China Real Estate Index System, the first month-on-month decline in two years." - WSJ 7/15/2014
Stories of ghost towns, built, but unoccupied abound.  Similar stories from the industrial sector are harder to identify, but they are there nevertheless.  

"“If something cannot go on forever, it will stop.” - the late Herb Stein, AEI
Participants in the real estate sector are often highly leveraged, they expect the proceeds of each successful project to pay for itself and often others. Industrial projects are not all that different in terms of how they are chosen, but there are often other assets to cushion the blow.
Eventually participants realize that all the projects cannot be completed with the available money.  The credit expansion stops.  The poorly chosen projects are declared mal investment by those that are investing in them.   They stop. Those projects become insolvent.  Depending on the capacity of the borrower and their leverage, the borrowers default and go bankrupt.

Banks write off bad loans.  Because many projects are discovered to be mal investment when the realization comes, all at once there are many bad loans now all going bad all at once.  If there is a large size of loans lost relative to bank balance sheet sizes, then the banks become insolvent.  Insolvency occurs when enough loans have been declared bad and written off to exceed the loan loss reserves and the equity capital of the bank. All credit stops.

Another phenomenon also takes place because banks are managed and regulated by humans. One of the ways that banks decide a loan has gone bad is if they stop getting paid.  Often, it is if they have not been paid in a quarter they must declare the loan bad.  Managing the bank's collection efforts can often 'manage' the flow of loans to the bad category.  Another way is collecting the borrower's financial statements, analyzing them and then deciding they are not going to get paid.  Managing the level of effort in doing this work can control the flow of bad loans.

Each quarter, the bank makes money at the operating level and then estimates how much it must add or subtract from its bad loan reserve.  This number is driven by the processes above.  By slow playing the discovery of bad loans the bank can eat through its reserves while replenishing them with income from the operating business.  This is the way they try to survive in a crunch.  This is a Zombie bank, made famous in Japan.  It is a bank that doesn't lend to expand the economy.

Because banks are trying to spread their losses over time, they hinder borrower action to liquidate the mal investments and move the remaining assets after the loss into productive investments.  This is one of the reasons it takes so long to recover from a credit driven rather than an inventory driven recession.

Accurate Reality:  It is difficult to forecast the timing, but there are signs of a significant credit based recession looming in China.  As Fred Sanford used to say, "This could be the big one.' 

No comments:

Post a Comment