China’s great divergence
James Saft is a Reuters columnist. The opinions expressed are his own.
China may be about to teach the world another lesson about what happens when speculative money learns that its favored markets aren’t panning out.
In the U.S. in 2007 the subprime bubble collapsed into a still-smoldering heap when borrowers and speculators realized that real estate was topping out.
In China speculative investments including so-called “private lending” don’t promise an exact repeat but have enough elements in common to make the two situations rhyme.
One possible side effect: in a worst-case scenario the yuan CNY= might actually start to fall against the dollar.
A fascinating report released this month by Hong Kong-based strategists at Bank of America Merrill Lynch led by David Cui laid out the dynamics.
“The biggest issue for investors in China is a combination of excess liquidity and lackluster real returns; a persistent negative interest rate has resulted in speculation in financial assets (including property) while returns of the underlying “hard” assets that these financial products are built upon are getting worse,” Cui wrote in a note to clients.
“As a result, any abrupt change in investor sentiment could pull down financial asset prices sharply.”
Despite high inflation, banking and monetary policy have kept the deposit rates offered to Chinese savers quite low, resulting in a negative effective real interest rate. China is awash in liquidity, at least some of it hot money that has flowed in anticipation of the yuan going up in value. But a comparison of the one-year deposit rate and consumer inflation show that savers have been suffering negative interest rates for the past 20 months, effectively paying the banks several percentage points a year for the privilege of lending them their money.
Seeking better treatment, huge amounts of money have flowed outside of the banking sector, into trust accounts and into private lending. Private lending, done by wealthy individuals, state-owned enterprises and private companies, is a huge and growing sector. Loans are made privately, at very high interest rates, to businesses, property developers and in some cases to speculators in property or on financial markets.
The share of Chinese household savings in alternative investments, which includes private lending, has risen from 2 percent of household savings in 2009 to 7 percent in 2011. Overall underground lending is now estimated by BofA ML to be about equal to one fifth of bank lending, in other words huge.
HIGH RATES, HIGH RISK
And because the official bank lending market is constrained, and also somewhat corrupt, private lenders are able to charge huge interest rates of up to 36 percent annually. An August survey by the People’s Bank of China into private lending in Wenzhou showed that 20 percent of the money went into property, helping to keep aloft the very high real estate valuations in China.
But here’s the rub: if you charge 25 to 30 percent interest, the people you are lending money to either have to make a killing or very quickly they will default. As in the latter subprime days you don’t need a crash to cause a crash, you only need prices to level out and the crash eventually ensues as people can’t afford the high rates. And while Chinese borrowers put down far more than American ones in down payments, they may prove unwilling to cede their equity to private lenders.
The process of weakening may already be beginning, as shown in the sharp falls in shares in China, particularly financial ones. A unit of China’s $400 billion sovereign wealth fund waded into the market on Monday to purchase shares in the country’s four largest banks after prices dropped to crisis levels.
There are a host of other systemic risks that could shock China’s system, according to BofA ML. Besides falling property prices, there is the possibility that money found its way into outright Ponzi schemes, or that private businesses that were eager to borrow the money run into slight difficulties and simply can’t make the payments.
Another possibility is that exports in China get hit by events in Europe or the U.S. This could cause financial market upsets in China and encourage some of the hot money betting on yuan appreciation to flee. If hot money sells up assets or calls in loans, property prices could fall, weakening banks and reinforcing the negative cycle. The end result might be a reversal of China’s policy of slow appreciation in the yuan, despite intense international pressure.
China wants to send powerful signals, such as its share buying, that it won’t stand by and allow a scenario like this to come to pass. That’s probably the central scenario, but like Las Vegas real estate five years ago, China has enough of the Wild West about it that it bears watching.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)