Fraser Howie is the co-author of three books on the Chinese financial system, including “Red Capitalism,” named a Book of the Year 2011 by The Economist magazine. For 20 years, he has been trading, analyzing and writing about Asian markets. During that time he has worked in Hong Kong, Beijing, and Singapore for companies like Bankers Trust, Morgan Stanley, CICC, and CLSA.
Epoch Times: Mr. Howie, last time we spoke about the history of Chinese debt. Let us now talk about the technicalities of coming defaults. First of all, should we view Chinese bank debt as Chinese government debt?
Fraser Howie: Certainly the market does that. While you can have smaller level defaults in China as we’ve already seen, I don’t think there can be any doubt the banking system will be bailed out by the [regime].
Having said that. Many people take comfort and say “It’s ok; the government will bail it out.” That doesn’t mean there isn’t a cost there. Because the cost comes through higher inflation, printing money, higher government debt.
China is still a relatively poor country. Remember, if you are bailing out banks, you are bailing out corporates. The banks are only losing money because the people they lent money to can’t afford to pay. So you are talking there about state owned enterprises (SOEs) and all these property developers and all the local government financing vehicles that borrowed money and can’t pay it back. The banks are certainly going to be bailed out.
Epoch Times: How do you view this year’s corporate bond defaults, the first ever?
Mr. Howie: I wouldn’t say it can be disregarded. But at the same time I don’t think it’s an avalanche in the sense that a growing number of defaults lead to some great big credit event. I think you will have more defaults. I think things will be somehow controlled and managed.
What the process will not be is market driven.
At the third plenum last fall, the reforms that came out last year, there was very much a focus on market driven processes, with the market being the decisive factor. I don’t see that at all.
A default is a highly politicized event in China: How many people does the factory employ; how are their political connections; how big is the default; what are their connections to the local or provincial government; who is on the hook down the line; is there some state bank involved somewhere?
There are a number of factors there, many of them noneconomic, which are ultimately going to define and decide who suffers and who doesn’t. You will see more defaults and that’s part of the costs.
Epoch Times: Why do they handle it like that?
Mr. Howie: One of the big problems in China has been the mixing of economics and politics to such a degree that the [regime] has been in charge and that the [Communist Party] has been so central to the economic development.
Epoch Times: Most people think China can handle a deleveraging rather easily because they have $3 trillion in foreign exchange reserves (FER).
Mr. Howie: First of all the FER, I think they are a bit of a red herring. The FER are just that: they are foreign. They are not renminbi (RMB); they are not money that can be brought to bear domestically.
Put another way, having the reserves dismisses any fear of a balance of payments crisis. China clearly has enough foreign currency for servicing foreign debt in a way that many Asian countries did not have in the Asian crisis. So that takes that pressure off.
But anything that China wants to do domestically, like bailing out banks and printing money can all be done without the FER. The FER don’t give greater freedom to manage things domestically. I look at the FER as the cost of China not reforming.
If China had been much more open in its capital account and had been more willing to let the RMB appreciate more aggressively, you would not have built up such large foreign exchange reserves, but you would also have a much more competitive and healthy economy.
Epoch Times: So how will the regime handle the deleveraging?
Mr. Howie: They will muddle through. They will allow some defaults; they will allow some nonperforming loans; they will bail out some entities; they will provide support and guarantees where they can.
As growth slows, they will put a bit of stimulus on. Growth picks up again, they'll remove the stimulus. Growth will slow again and they will manage this process as well as they can. I don’t see them solving this problem; I see them managing the problem.
They are managing slower growth, and they are managing higher debt. They certainly won’t just sit back and let the market decide. They will be interventionist and try to control things as best as they can. But they are not going to escape from lower growth and higher debt levels.
The China we have been used to with this supercharged growth is a China of the past. I don’t see that coming back anytime soon. You are going to have a China of much slower growth and much tougher economic conditions.
Epoch Times: How can the central government raise debt for the bailouts?
Mr. Howie: There is a government debt market in China. About half of the debt in China is government debt. It’s sold into the insurance companies; it’s sold into the banks. It’s certainly doable. They certainly can expand their debt relatively easily.
Epoch Times: But if the central government sells debt to the banks it wants to bail out, isn’t that a circular process?
Mr. Howie: Welcome to China, it is a largely circular argument of thought. It takes corporate liability and makes it state liability. There is a large pool of savings in China, there are large insurance companies, there are pension companies. There is a host of people there that can buy government debt.
That’s the problem though. Anytime you are not taking the write-down, then you always have the circular argument about someone moving money from one pocket to the other.
It doesn’t solve the problem and manages it for a time until things are a bit more stable and you are in a better position. So they rolled over the bad bank debts from 15 years ago, they are still there believe it or not. When you keep rolling you get to the stage where they are now a much smaller portion of the economy, so in that sense they have succeeded, they have grown their way out of the problem.
Epoch Times: That doesn’t sound too bad.
Mr. Howie: But they didn’t learn from their problems. If you roll debt over, you are only going to do the same things again and again. That’s where you have this problem. Even after a miracle decade of growth post [accession to the World trade Organization], you are talking about a debt crisis and a banking problem. And you ask yourself: How did we get here?
There is a lot of talk about changing the economic model, bring about genuine greater reform. Remove the dependence on investment and credit driven growth. Improve the balance of the economy between consumption and investment. There is an appreciation that things need to change. But that’s a lot of work. And there is no guarantee that this will work at the same time when economic conditions are a lot harder.
There was a period from 2000 to 2008 where you had very strong economic conditions, where they could have brought in a lot of reform and be a lot more aggressive but they did not choose to do so.
It was easier to just default to the old model and just ride the wave of investment. And now they are finding they have missed these opportunities to make changes. Now I think they are much more constrained.
Epoch Times: What about global repercussions?
Mr. Howie: A decade ago, China could afford to have a bankrupt banking system. Because China was a long way away and nobody cared about Chinese banks or had any investments in Chinese banks. It wasn’t relevant in the global economy.
China now is the world’s second largest economy. Its banks are internationally listed, held by a large number of shareholders foreign and domestic. China is clearly front-page news every day.
Now you have a scenario where what China does or does not do has an impact on global markets and global investors. That is very different from a decade ago.
Even though it’s relatively isolated and insulated in terms of capital controls and not fully integrated into the capital flows globally, China has an impact in the global economy it has not had before.
Epoch Times: Final verdict?
Mr. Howie: When you look at all this, nothing strikes me as the miracle economy. Instead, China strikes me as a bubble economy. Nothing miraculous, in fact a lot of policy mismanagement rather than anything else.
This is part 2 of a two-part series. Read the full interview here .
The interview has been edited for brevity and clarity.
