Feb 2005
Politicians are fond of blaming others for their problems. In this regard, China has been a useful scapegoat for the United States. If only China's currency were allowed to rise, some imagine, the US trade deficit would shrink, American consumers would get their financial affairs squared away, and all would be well with the world. Right? Not exactly.
The odd truth is that, by playing out their adversary roles, Beijing and Washington actually help each other. Each side gains from the belligerent exchange of rhetoric.
The United States benefits by means of diversion. By blaming the trade deficit on outside forces (i.e., China's mercantilist monetary policy), attention is diverted from America's ludicrous spending habits. Consumers are reassured they are not to blame for the current mess... or at the very least, that someone else is being set up to take the blame for them.
The politicians get a good deal also: instead of racking their brains in search of pain-free spending cuts, they get to speechify on emotionally charged subjects like "economic fairness," while giving the appearance of "doing something" about the problem.
And what does China gain from America's loud complaints? The illusion of financial stability.China is more than willing to take heat for its currency peg, because American complaints rest on a critical assumption: the notion that China can safely revalue the yuan at will. As long as this fiction persists, it is assumed the mandarins have control of the situation. In reality, they do not.
China is something of a paradox. To the rest of the world, China is an economic juggernaut… and the economic power China wields is very real. But the juggernaut has a weak heart. As China manages its relations and lays the groundwork for future plans, there are a number of internal risks Beijing must consider... any one of which could wreak havoc. In the end, all of China's roads lead to gold. Here we shall examine why.
Bad bankers, bad debt
China's "big four" commercial banks—the Bank of China, the Industrial and Commercial Bank of China, China Construction Bank, and the Agricultural Bank of China—are drowning in bad debt as of this writing. By a recent Standard & Poors estimate, Chinese banks are shouldering a staggering $846 billion in nonperforming loans. That is nearly half of gross assets, with still more trouble ahead. Three months from now, the balance sheets could look even worse.
Numbers like this don't exactly inspire consumer confidence. Would you put your money in the local bank if you knew that almost half the outstanding loans were forfeit... that the bank was technically insolvent by general accounting standards... and that the government was force feeding even more garbage onto the balance sheet?
This is the exact situation Chinese depositors face.
How did things get so bad? It goes back to the middle kingdom's particular mix of capitalism and statism. China's State Owned Enterprises—commonly referred to as SOEs—were originally employment vehicles in Chairman Mao's socialist economy, guaranteeing a job for life. Run by political hacks and untainted by profit motive, the SOEs today appear little unchanged from Chairman Mao's time. Now they are simply industrial tools… bloated companies that are little more than pawns, moved at Beijing's whim.
The political advantages are clear. Need to build a strategic relationship quickly? Just ring up a SOE puppet, er, president and let him know which country he'll be investing in next. Potential uprising in a sensitive province? Have a local SOE hire on the protesters and pacify them with paychecks. With no bottom line to speak of, the cost of payroll doesn't matter.
As you can imagine, SOEs can be quite useful to the mandarins. There's only one drawback: many of them (if not most) are financial black holes. So Beijing keeps them afloat by ordering the banks to lend billions at nominal rates of interest... and of course the banks have nil chance of earning a return.
The politically driven SOEs are not only sucking the lifeblood out of China's banking system, they are acting as a drag on their respective industries. By refusing to pull the plug on failing SOEs, Beijing forces legitimate private companies to deal with zombie competition kept alive by the state.
As if this weren't enough to make Chinese depositors run and hide, there's more. China's hapless bank managers aren't just innocents saddled with bad loans; more than a few are outright thieves, tempted by a lax system with laughable internal controls.
The latest is Gao Shan, an obscure branch manager in Heilongjiang province. Gao, still at large as of this writing, has made off with "several hundred million yuan" worth of deposits. Gao was not a high ranking bank official or a criminal mastermind. He was, for all intensive purposes, a plain vanilla manager in a plain vanilla bank branch. To get a visual, imagine Dagwood Bumstead casually skipping town with $35 million. This is only one example. There are many more.
Is it any wonder Chinese businessmen (and women) are in the market for an alternative... any alternative... to the local banks?Who wouldn't consider hard assets in a situation like this?
China's banks cannot "fail" in the traditional sense (if they can rack up bad loans worth 50% of gross assets with no visibly adverse consequences, why not 100%), but their ‘technical' insolvency could create a ‘real' problem if Beijing is perceived to be losing control.
With the existing dollar peg in place, the situation is stable and predictable. A revaluation invites fluctuation and reassessment, which in turn puts the illusion of stability at risk. Beijing cannot afford to let that happen.
Night of the living dead
China's debt laden SOEs have rotted out the banking system, undermining consumer confidence with their mountains of bad loans. But China cannot put the zombies out of their misery without facing another internal risk... the political consequences of mass layoffs. Beijing's outside advisers are urgently recommending that bankruptcies go forward, to allow for cleansing and industry consolidation. Bankruptcy legislation, however, is stuck in a permanent mire of political opposition. For the Mandarins, always mindful of being toppled, the perceived risk of uprising is just too great.
In the SOEs, China is facing a problem that only threatens to get worse as bad loans compound. The dragon must find new jobs for its people to transfer them out of SOE positions; jobs that are commercially viable and self-sustaining, not perpetually financed by Beijing.
And here we see a key reason for China's sense of urgency in seeking export-led employment at the cost of holding dollars; jobs must be created so that the vicious SOE circle can be broken, before the event of mass uprising or banking collapse.
Managing the end game
If China can extricate itself from the scylla and charybdis of rotten banks and ravenous SOEs, one great challenge remains: managing the end game with the United States.
For quite some time, China and the US have been playing for high stakes, both with much to lose. The terms of engagement are simple: easy credit in exchange for mass employment. Via huge and ongoing purchases of US Treasuries, China effectively finances the reckless spending habits of the American consumer. In exchange, the American consumer uses his generously supplied line of credit to purchase Chinese exports, facilitating the mass employment China needs for stability and growth.
It's a lovely arrangement. If it could go on forever, it just might. But unfortunately, it has to end at some point. China cannot extend an infinite line of credit to the American consumer; nor can the American consumer borrow an infinite sum (much as he or she might like to). This leaves the problem of the endgame: how do the involved parties extricate themselves without doing each other grave harm?
If China were to leave the game suddenly, the US bond market would go into freefall, creating a sharp jump in interest rates that would impale US consumers like a railroad spike. The Federal Reserve would have no choice other than opening the floodgates; for central bankers, inflation is always and everywhere a lesser hell than deflation and depression.
In contrast, if the US withdrew from the game first, China's export-based economy might grind to a near halt… with drastic consequences for Beijing. The mandarins would then dump US treasuries in a panic effort to lay hold of hard currency and regroup, leading back to square one.
The key to the endgame, if possible, is for both sides to manage a graceful exit. China's way out lies in transition: shifting the primary source of demand from the US consumer to a more diversified stable of customers. When the United States unshoulders the demand burden, Asia, Europe, and to some degree China itself will have to pick up the slack.
America's endgame challenge is to cut up the credit cards, enroll in Debtors Anonymous, and start showing real fiscal discipline. Reliance on credit must be reduced, albeit gradually, through a balanced program of savings and repayment.
America and China will have to cooperate if they desire the best outcome. If either party drops the ball, both will suffer immensely. China will not have the time and leeway necessary to develop alternate sources of demand if America refuses to cooperate in the transition; America cannot swear off its credit binge unscathed without China's patient help over the course of withdrawal.
Slim chances
And so now the full picture is on display. China's citizens have every reason to shun the rotten banking system and look to an alternative store of value; as first hand observers, they know the true nature of things. As the immovable dead weight of the SOEs bears down on Beijing, potential for sudden collapse only grows.
Doing nothing is not an option; the endgame must be managed, or it will end violently of its own accord. If either party falls, the other is pulled down too... regardless of who falls first. Given the Fed's fully predictable liquidity response, odds of an eventual currency crisis approach 100%. (This is where gold shines.)
The one scenario in which crisis is averted requires the exquisitely timed cooperation of two leviathans, acting in near perfect balance, with no distractions or disruptions, for an unprecedented period of time.
