Thursday, January 18, 2018

Chinese Financial Control Dilemmas

by Roy C. Smith

The Wall Street Journal recently reported that “China’s housing market has defied gravity and government regulations for two years, floating on a tide of bank loans and speculation. Until now.” 

Housing prices in Beijing and Shanghai, having shot up 30% to 40%, respectively, since 2015, have fallen sharply as a result of government controls imposed last year, and are now dropping below their 2015 levels. From the government’s point of view, the good news is that its firm hand can deflate bubbles and cause markets to behave as it wants. The bad news is that heavy-handed controls can have adverse consequences of their own, and market forces can make them worse.
Despite its authoritarian controls, China is not exempt from such market-driven crises. Indeed, in 2014, after a year of monetary easing and government pressure to grow the economy and encourage stock prices so companies could refinance loans, a major effort was made to increase margin loans which grew, in aggregate, to as much as $2 trillion. So, China’s second stock market bubble in a decade suddenly began to form - the Shanghai Composite Index of stock prices rose 150% from November 2014 to a cyclical high of 5,166 in June 2015, before the bubble burst, dropping prices by 43% in a matter of a few weeks. The government intervened forcefully – requiring government controlled investors to buy stocks, and encouraging further margin buying – and the rout was halted, but the market has not fully recovered since then. Investors, fearing the unpredictability of government intervention, chose to invest in residential real estate and other assets instead, moving the speculative destination to other sectors.
Indeed, China’s 250 million “middle class,” aided by continued easy money, piled in again to residential real estate.  There have been other bubbles in real estate over the past several years, but the so-called middle class, which includes China’s growing millionaire class as well, is much larger now than before. There are now approximately $4 trillion residential mortgages outstanding. Since the stock market crash in 2015, these folks have upgraded their residences and bought additional homes as investments. According to the WSJ, “mortgages made up as much as three-quarters of all new loans in 2017.” According to Moody’s Investor Services, the housing sector generates about a third of China’s economic growth.
But the sudden price downturn has affected the resale values of all housing and the value of collateral held by banks. As we know from our own experience after house prices unexpectedly started to decline in late 2006, an avalanche of mortgage problems hit the US housing market and resulted in a major crisis. Underwater mortgages tend to be abandoned, property developers fail, and banks have little choice but to write them off. As a crisis develops, all forms of marketable credit instruments are questioned, and investors run to safer ground. Too much of this and banks get into trouble and may then either fail or have to be bailed out by the government.
If the government has to intervene to forestall a crisis (there is no indication that this is the case in China as yet), then it may have to direct investors to purchase mortgages and other debt instruments, whether they want to or not. It will also have to change mortgage availability and other policies back to what they were before. This, or course, weakens China’s efforts to improve the role of market pricing in its economy, something most analysts agree is necessary for the country to transition to developed status. Doing so also covers up the weakness of many assets on the books of Chinese financial institutions and kicks the can of having to deal with them into the future, where the problem non-performing and risky debts will only be much larger.
Indeed, China already has a large amount of questionable loans on the books of its banks ($30 trillion in assets), shadow banks ($9 trillion) and in the high-yield investment portfolios of middle class investors. Fudging over the mortgage sector could add a considerable sum to this dangerous accumulation of toxic assets. From such accumulations, financial crises arise.
Market-driven crises may be triggered by well-meaning government controls in a fully-self-confident, authoritarian system with little regard for markets. China’s marketable financial assets are about $30 trillion today, but markets are dependent on retail and speculative investors more than institutional ones. Government intervention is the solution to crises, but such periodic intervention can destroy market integrity, which weakens the economic system.
Just as the announcement of housing price declines surfaced, China announced that its annual growth rate for 2017 was 6.9%, up from 6.7% for the prior year. The news was met with considerable skepticism by international observers who considered the results to be managed. The government wants to convey a picture that it is on top of things and all is well, others see an economy that continues to be in slow decline despite many efforts by the government to prop things up.
Growth continues to be essential to the Chinese government. Only with growth can it hope to meet the expectations of its billion or so people who have not yet entered the middle class, and provide the resources required to deal with its aging population and to support its overseas and military agenda. For China, growth means continuous intervention.
Ironically, such intervention promotes price volatility in financial assets that periodically passes capital losses on to the middle class.  It is this group that the government must depend on to be the engine of consumption as the country transitions from an export-led economy to one that is more consumer-led. It is difficult to achieve such long-term objectives, however, when the government has to intervene in the short-term to prop up (and maintain) the weaker elements of the system.

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