China’s underground economy is beginning to emerge from the shadows, surprising is its size, its depth and tenacious hold on the country:

First to reckon is the gross amount of China debt in yuan (Daily Beast):

Indeed, China claims its debt-to-GDP ratio—the standard measure of sustainability—was a healthy 17 percent at the end of last year. Yet Beijing-based Dragonomics, a well-respected consultancy, put China’s ratio at 89 percent—about the same as America’s. Worse still, a growing number of analysts think the Chinese ratio was really 160 percent. At that astronomical level, China looks worse than Greece.

The wide discrepancy in estimates is due to the so-called hidden debts. The largest of these off-the-books obligations have been incurred by local governments and state banks. Yet there are other components, including central-government debt incurred for municipal and local projects, Ministry of Finance guarantees related to partial bank recapitalizations, and miscellaneous obligations such as grain-subsidy payments. No one actually thinks Beijing will default on its outstanding external debt, but these hidden obligations matter; to work down the crushing debt load, the country’s technocrats are adopting strategies that will cripple growth for a decade, maybe longer.

It didn’t have to happen this way. When the global downturn hit in 2008, China decided to spend its way out of the crisis. The country adopted a stimulus program that in 2009 pumped, according to my calculations, about $1.1 trillion into its then–$4.3 trillion economy. Beijing created robust growth—9.1 percent in 2009 and 10.3 percent last year—but in the process, the country’s hidden debts ballooned, as the country’s leaders forced state banks to lend to unviable projects.

Where there is a private will to borrow and spend, there is always a way. At this point the will has gotten out of hand. China has an operating two-currency regime which is similar in outline to the gold-backed regimes that existed in developed countries prior to the Great Depression. A well-run dual currency regime has many benefits which is a reason why they are promoted here on the Undertow. China’s system is far from well-run,. having fallen victim to its own press agentry: (Asia Times)

China squeeze drives boom in ‘black’ banks

Olivia Chung

China’s smaller private companies, starved of loans as the country tightens credit to fight inflation, are driving an underground banking boom by turning to unofficial sources for funds to stay in business. Some are even becoming lenders, given the prize of high returns.

About 3 trillion yuan (US$470 billion) of bank loans have been channeled into underground lending in the eastern coastal provinces, China Banking Regulatory Commission chairman Liu Mingkang told a recent closed-door conference with lenders.

Large, usually state-owned enterprises, can get bank loans at a 7.2% interest rate, compared with the one-year benchmark interest rate of 6.56%. Through third-party companies such as financing firms, they can then lend the money on at higher rates to small and medium-sized companies, Liu said, according to a copy of his speech obtained by Securities Times last week.

The funds are then lent to small-and medium-sized enterprises (SMEs) at annualized interest rates of between 36% and 60%, the paper said.

Beijing tightened monetary policies this year to combat inflation that has risen after 4 trillion yuan was pumped into the economy following the global financial crisis near the end of 2008.

Year-on-year consumer price inflation in July reached 6.5%, the fastest pace in 37 months and well above the 4% government target for the year. The central bank has raised interest rates three times this year, taking the one-year benchmark deposit rate to 3.5% and the one-year loan rate to 6.56%. In addition, it has increased the reserve requirement ratio for commercial lenders six times to a record 21.5%.

The bank’s measures appear to be having their effect on borrowing, new yuan loans falling 25.2 billion yuan in July from a year earlier to 492.6 billion yuan.

The credit tightening is hurting China’s 7.5 million or so non-state SMEs, whose predicament now is “even worse than in 2008” when the global financial crisis began, said the All China Federation of Industry and Commerce, the official chamber of commerce for non-state companies, after conducting a three-month survey of private businesses in 17 regions.

Privately owned companies account for 70% of total employment on the mainland and 60% of gross domestic product.

“Small and medium-size firms, already burdened with the rapid rise in labor costs and the soaring price of raw materials, are facing financing problems. Most of them are finding it difficult to survive,” a federation spokesman told Asia Times Online.

About 80% of the SMEs in Zhejiang province are using underground banking loans to fund their businesses, even though the black market interest rates in the province have surged as high as 10% monthly, Cai Hua, a spokesman of the Zheshang Research Association, which represents entrepreneurs in the province, said. Zhejiang and other eastern provinces accounted for 53% of the country’s GDP last year, according to the National Bureau of Statistics.

Here you see the mechanism of inflation in action: with the parallel currency rate regimes in place within China. One is yuan- centered official exchange rate version which has China’s commercial banks and ‘lending facilities’ as vassals of the People’s Bank of China. The PBoC pegs yuan to the dollar at a more or less fixed rate by way of dollar- and dollar denominated securities purchases. The central bank defends primary interest rates and bank reserve limits, currently increasing these by microscopic amounts even as the money supply expands at double digit rates at the same time.

The unofficial- or shadow banking regime trades dollars and other foreign currencies for yuan at whatever rate the market demands. The interaction of the two systems results in a currency arbitrage which has dollars priced at a certain (fixed) rate by the central bank and at a ‘more efficient’ rate offered in a restaurant across the street from the central bank.

China Banking Regulatory Commission chairman Liu Mingkang’s argument does not make much sense. Large Chinese businesses have a stream of dollars from sales of goods to the US or in the form of ‘China investment capital’ borrowed by US partners in the commercial bond market. There is little reason for Chinese businesses to borrow from the central bank when they can effectively borrow dollars in the US at a very low rate then swap these for yuan.

Because any swap with the central bank is constrained by the currency peg, it is sensible for the business to pay bribes to regulators and swap forex for yuan with Liu’s “third-party companies” at the ‘Get Rich Quick’ rate. How else do China’s well-connected jackasses get rich overnight? China has already admitted to ‘unofficial’ currency exchanges.

The third party companies lend out the yuan with all the participants splitting the proceeds after covering ‘expenses’.

It can be considered that the central bank policy is enabling the black banks. With funding scarce borrowers have little choice but to turn to them for short term loans. This loan shark economy has funds available because its desperately greedy customers are willing to pay high rates for them. Like the lottery where you ‘have to be in it in order to win it’, high rates are not a problem when the cost is shift-able to others … and where the alternative is no lottery ticket funding at all. The arbitrage becomes self-supporting as overall increases in borrowing costs constrain overground capital formation and directs more of it to the underground.

Borrowers cope by continually roll over maturing loans while shopping for speculators able to ‘buy’ loan exposure. That is, borrowers hedge by re-lending parts of their own financing at still higher rates to other more desperate borrowers/greater fools.

Right now there is no shortage of these greater fools.

The Chinese economy shifts from becoming the world’s workshop to yet another get-rich-quick pyramid scheme riddled throughout with ever rising yuan costs. These are met with central bank money printing along with savings levered into circulation by way of inflation. By the process, the People’s Bank has become a hapless participant to its own ruin because it along with the rest of the establishment is hostage to Ponzi returns in the form of ‘9% GDP growth’, The establishment has passed the point where cost effective policy actions can be taken. The rising costs shrink productive output which puts more funds chasing fewer available goods. Prices rise: meanwhile. the flood of currency and the velocity of transactions gives the impression of expanding prosperity on the surface. The challenge becomes how to make as much glossy looking garbage as possible so as to keep the ‘wealth’ illusion alive, to attract more benighted suckers.

Chinese McMansion in Shanghai suburb. (Businessweek)
 

USA McMansion god knows where (Darwin’s Finance)

“China is experiencing huge wealth creation, and there is lots of conspicuous consumption related to that,” says Goldman-Sachs analyst Jacques-Franck Dossin. “People want to show they are successful.”

In past inflationary episodes this value exhaustion process matures long before the currency in question becomes ‘worthless’ in the sense that wheelbarrows are necessary to carry paper money to a bakery to buy bread.
 

Inflation directs value away from the thrifty toward the intemperate … as did the ‘Alt-A’ borrowers and real estate speculators in the US a few short years ago. By doing so borrowers convince themselves that transitory ‘wealth effect’ represents a permanent state of change.

China’s Banks, the Only Certainty is Uncertainty

Katherine Ryder (CNN)

… companies that want better rates of return are looking at trust companies, which are unregulated and have caught the wary eye of Chinese authorities, particularly as the government has attempted to cool the country’s supposedly overheating property market. The China Securities Journal reported that span style=”color: #990000;”>trusts invested about RMB 207.8 billion ($32.4 billion) in the property market in the first half of the year. The rate at which they’re lending is upward of 20%, compared to the banks’ 6.7%, a rate at which it is easier to roll over bad loans.

The extent to which these trusts will have a major effect on the health of the Chinese banking industry is a major area of disagreement between China’s bulls and bears. The bulls say that trusts represent healthy interest rate competition, a way for corporations to put pressure on regulators to liberalize interest rate policy. The bears argue that trusts are an example of excessive credit in the aftermath of years of reckless lending, both of which will come back to haunt the Chinese economy over the next few years.

Another source of worry is China’s Asset Management Corporations (AMCs), which present more measurable off-balance-sheet loan risk. In the late 1990s, the Chinese government needed a place to dump bad loans left over from the Asian financial crisis. AMCs were created to serve this purpose. But in 2009, instead of paying off the rest of the debt, the government rolled over all the AMC bonds another ten years. The depth of the potential losses in these vehicles remains unclear.

A final source of concern is the continued use of collateralized lending. Much of this collateral is typically in the form of land or property. In an economic downturn, Chinese banks might face liquidity issues, says Jason Bedford of KPMG, a consultancy.

All the same, Bedford thinks the fears about the bad loans lurking off the balance sheet are overblown. “I’m getting one or two phone calls per week from overseas asking me about this topic,” he says, specifically referring to a July report in which Moody’s (MCO) said the Chinese government may have underreported loans made to local governments by half a trillion dollars. Bedford says his own analysis doesn’t support some of the claims in Moody’s report, particularly those relating to credit risk.

And herein lies the problem in assessing Chinas banks: figuring out whose data to trust. The Chinese banking system trades disproportionately with itself, and much of the critical information about bank stability is colored by the data sources.There are so few foreign companies trading within China’s capital markets that critical pieces of data can never be corroborated. No one knows whether asset prices are accurate, whether banks liabilities are accurately reported, or even the true depth of the lending market.

China is paying for its ‘Growth at All Costs’ approach that treats currency speculation as productive output. At 120% annual interest, no productive enterprise can pay for itself, only speculation can do so … and then only for a little while.

The two-into one economy represents a dilemma for the PBOC. Ordinary monetary policy tools are uselessly counterproductive. Should the bank clamp down harder on the supply of yuan in the overground economy, the loan sharks increase their funding rate to whatever level is needed to flush yuan out of hiding. The absence of funds whithers production: meanwhile, there is no shortage of Chinese — or Americans — aching to put cash to work on China’s street corners at 10% per month. The current rates of interest — official and otherwise — have let slip a tsunami of risk capital pouring into China. The more effective the central bank is in constraining liquidity within the above ground economy, the more business flows to the black banks.

Perhaps this is what is meant by, “healthy interest rate competition”!

The limit to rates is the where the marginal borrower cannot find the marginal saver able or willing to carry his borrowing costs. Hyperinflation is a form of cost pushing. When the marginal saver is exhausted there is no value remaining within an economy to transfer to the schemes’ intended beneficiaries. In past inflationary episodes this value exhaustion process matures long before the currency in question becomes ‘worthless’ in the sense that wheelbarrows are necessary to carry paper money to a bakery to buy bread.

What it taking place is an internal carry trade in yuan between the above ground economy and the loan sharks. The cost of money in the form of interest to sharks is added to business’ cost structure. Meanwhile, the central bank must add more yuan to the official economy to keep bank borrowing costs from exploding to the stasis level. The central bank must feed inflation in order to attempt to throttle it. It is this competition for funds between economies within economies … that gives the often noted appearance of a money shortage during inflationary episodes.

Funding for the underground economy arrives in the form of dollars (and other reserve currencies) that flow to Chinese businesses by way of overseas ‘partner’ companies acting as hedge funds. This includes the Fortune 500 companies in the US, who shifted their labor forces to China. The game at the time was to arbitrage labor costs, now the arbitrage is between competing currency exchange rates. The labor arbitrage favored Chinese exporters along with US businesses which hedged rising energy costs and pocketed the cost difference or spread between the two regimes as profit.

The exchange rate arbitrage favors speculators and property developers in China. The game ends when the cost of the currency rate arbitrage is greater than the profits from the labor arb. The rapidly rising cost of money in China pushes labor costs higher, the combination of labor, energy and borrowing costs becomes greater than importing the labor back to the US!

A consequence is the Chinese economy becomes dollarized. At a high enough rate of return (in yuan) to satisfy lenders (of dollars) the value of the yuan falls to nil.

Chinese have let the tiger out of the bag and to some degree are going to have to suffer through consequences. It has overbuilt its infrastructure leaving unrecoverable costs. It’s large banks are zombies like their American, Japanese and European counterparts. As the large banks fade away of fail, the underground economy becomes THE economy. Meanwhile, inflation cannot be ‘tamed’ when billions of dollars in cheap credit is flooding into the country. China has reached the limit of mercantilism and must move to something else … (insert pitch for capital controls, here).

China also needs to go on a ‘dollar diet’ and find some way to reduce or eliminate its ruinous dollar surplus. Having it around does nothing but feed inflation.

What is also needed is something other than a copy of the USA- waste based economy. The first steps must include energy conservation and wringing out of ‘get rich quick’ speculation. As it is now, an inflationary collapse will do all three, with the Chinese not having to do anything different from what they are doing right now.