During the weekend I have read of more indications that 2011 will be a challenging year in terms of profit growth, particularly in Asia.
Though accounts are anecdotal, I think taken in total there are signs that China might face a period of reduced credit growth much like what happened in the US just after the 2008 financial crisis.
There is a widespread belief that the vast majority of Chinese companies operate on extremely thin profit margins. In the face of inflation, the Central government of China is perhaps reluctant to raise interest rates as a means of cooling accelerating prices because of the huge potential negative effect to low margin businesses in the country.
Raising interest rates means a higher cost for businesses to operate. In situations where profit margins are thin across a wide percentage of industry, a dangerous situation can develop as firms fight higher debt servicing costs and struggle to remain solvent.
Inflation complicates the need for credit. As prices increase, firms need more money to purchase raw materials. In an inflationary environment, the price increases for finished goods lag the price increases for raw materials, hence the additional requirements for credit.
Many raw materials that China needs for its manufacturing-oriented economy come from outside its boarders. To a large extent, the Central government can not control these prices directly. This is one reason that I believe China chooses a policy of pegging as a means of mitigating price increases from abroad (see China's Dangerous Path Toward Distorted Energy Pricing). Of course this is to the detriment of the Chinese people and debases their purchasing power, and amplifies the effect of inflation.
A potential banking crisis in the face of inflation will likely cause intense instability in Chinese society.
It is widely believed that for the same reasons (low profit margins), Beijing is reluctant to adopt free currency exchange policies for the Yuan and continues the practice of pegging to the Dollar, something that almost certainly will have disastrous consequences for the global economy and economic growth.
This is a key summary of the Chinese banking situation published by Alan Abelson in Barron's this week (it is the view of Harald Malmgren of the Malmgren Global Fund) bold added:
"Much of that huge mountain of loans [in China] has fallen into the nonperforming category, which translates from the polite banking parlance into delinquency, big time. To avoid a financial meltdown, Harald expects, Beijing will raise capital-adequacy requirements substantially during the first few months of 2011, conceivably in incremental steps to cushion the pain. Since he anticipates Chinese banks will have trouble raising capital, he expects a large-scale shrinkage in lending."
Abelson, Alan, 2010. Insolvency stalks china's banks. Barron's, Dec. 18.
Further, Malmgren projects that besides negative credit growth, Chinese banks will probably face widespread insolvency. In my view, the overpriced real estate market for urban areas adds to the risk.
If this scenario of negative credit growth plays out in 2011 and 2012, the causes probably link to the extremely large Chinese stimulus program combined with the pegging policy, a command economy, political uniformity, too much direct foreign investment, and a general lack of transparency. Just like in the US, if credit does not grow there will not be economic growth.
The wider implications of a banking crisis in China would have a particularly significant effect on the global economy. If anything, cause and effect might force prices higher in the US. This is an issue to watch closely.
In terms of ranking worldwide banking stability, Mr. Malmgren provides the following appraisal (summarized by Mr. Abelson):
"In the current lineup of problem banks around the world, he would rank Chinese banks as the most troubled, with European banks next, followed by U.S. banks and Japanese banks probably holding down fourth place."
My long-term concern is that in a society where openness and freedom are behind global norms and expectations, a banking crisis would probably cause widespread panic and massive economic disruption. The naturally occurring, economic repair mechanisms that are available to sovereign countries with open democracies and capitalistic systems have a great deal of value during times of crisis, specifically in the re-organization of industry. It is an open question if similar value exists in the Chinese system of government and business.
For more posts on the Chinese ForEx pegging issue, see:
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