Bank cash infusion issue heats up in China

From (brrrr) chilly Denver…

The major Chinese economic conference wrapped up yesterday with the Communist government of that nation setting goals for the nation. Specifically it was decided at the Central Economic Work Conference that the nation needed to focus on: increasing domestic consumer consumption; reducing reliance on exports; closing the gap between the earnings of urban and rural Chinese; maintaining aggressive fiscal stimulus (read: government spending), and maintaining loose monetary policy for all of 2010.

In order for all of these goals to be met the Chinese need to maintain aggressive bank lending. In fact, a credit bubble has been expanding slowly and steadily in China for at least a decade. How?

The social contract in China is that in exchange for there being iron-fisted single-party government rule, the Communists promise full-employment. So the primary economic goal in China is not profits, but employment. What that means is that the Chinese will trade profitability to maintain full employment. What that means is that there are tremendous numbers of superfluous, non-profitable industries and jobs in China. The only way to maintain that condition long-term is for the Chinese central government to prop up failing and non-profitable businesses. Ouch! So it behooves us to pay attention to the lending habits of the Chinese government. After all, China is the world’s second largest economy, though it is a distant second behind the United States. Any credit market bubble bursting in China will certainly affect the global economy.

So what are the lending options facing the Chinese if they want to maintain their “growth?” And what are the possible consequences of these lending choices?

Option 1: Just give the cash to the banks.

The Chinese government in November 2008 announced a massive economic stimulus package as it saw the U.S. and Western Europe go into economic panic. So far the government has funded about 25% of that stimulus 4 trillion yuan (the Chinese currency) package. The remainder of those monies was to be provided privately. In other words, the Chinese government was reluctant to give a blank check to the banks and private citizens. This was pretty smart because in the past when the Chinese government has handed out funds to its banks, those banks have ignored risks and have made extraordinarily bad loans. So option 1 is unlikely to be undertaken.

Option 2: Government gives money to the banks in exchange for equity ownership chunks.

While this solution sounds fine to the ears of financial professionals in the U.S. and Western Europe – since we have done this ourselves – the Chinese already suffer from too much government interference. What’s more, the Chinese government has gone out of its way for the last decade to push its financial industry to being more market oriented, rather than centrally planned. Foreign investors already reel from too much bureaucracy in China. So this option is probably out, too.

Option 3: Do nothing.

The government of China could elect to do nothing. Unfortunately, doing nothing is not much of an option. This is because there are real businesses in China creating real economic goods. The last thing China wants is for non-profitable businesses to receive capital and thus squeeze out capital availability for profitable industries. Super ouch! So the Chinese banks must keep lending to maintain economic growth. Yet, to maintain levels of equity capitalization, relative to lending, that assure financial solvency, these banks need a government infusion. So doing nothing is also not an option. As you can see, the Chinese are in a bit of a pickle.

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I am not sure what the Chinese government will do. But my guess is that the Chinese do mostly nothing and hope that the world economy improves enough in 2010 that they don’t have to worry about this situation. However, this choice will backfire if worldwide GDP growth doesn’t pick up soon. So this is something for us to pay attention to going forward.

Jason