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03/06/2006 | Cosmetic Change in China's Economy

Stratfor Staff

China's central bank, the People's Bank of China, announced Wednesday that it will begin to withdraw from the country's currency market. The move, in theory, would allow investors to take a greater role in setting exchange rates.

 

Exchange rates in China, however, revolve around the PBoC's "reference rate" -- a benchmark around which the yuan is allowed to vary by a statistically insignificant amount. That's a fancy way of saying that the PBoC resets the yuan peg against the dollar at a slightly different value every day. Or, even more simply, that the Chinese government has no intention of allowing the yuan to float -- or even to strengthen appreciably in value -- anytime soon.

So, why not just say so?

For one thing, the Chinese realize that their entire system is balanced on a knife's edge. The financial system, and by the extension the entire Chinese economy, is predicated on the idea that money should be dirt cheap; companies should be able to tap credit at subsidized rates to their heart's content. In keeping with this theory, many business loans -- in fact, most of them -- were granted by state-owned banks to state-owned companies without consideration for profitability or efficiency. The result has been a bad-loan problem that various independent authorities -- among them UBS, Ernst & Young, the McKinsey Global Institute and PricewaterhouseCoopers -- have estimated at upwards of 50 percent of China's gross domestic product.

In general, the PBoC dismisses such reports as ridiculous and asserts that the bad debt issue is in the past. Taking that a step further, the deputy chairman of the China Banking Regulatory Commission, Jiang Dingzhi, on Wednesday not only rejected a May 30 Fitch report claiming that China could face some $220 billion in losses from bad loans that have not been accounted for as such -- he insisted that nonperforming loans themselves are a thing of the past.

According to Dingzhi, improved oversight by his commission has dissolved the problem. He further asserted that of the roughly $700 billion in new loans extended since 2003, only 1 or 2 percent are actually nonperforming. Put another way, after years of sporting one of the world's worst financial records, China now is supposedly sporting the best.

We find the assertion dubious.

Though the United States can hardly claim to be a paragon of virtue in the financial world -- the Enron/Arthur Andersen scandal comes to mind -- the American experience in the savings and loan (S&L) debacle of the 1980s does provide a useful comparison.

Faced with a total bad-loan amount estimated at the time to exceed $500 billion, the United States set up the Resolution Trust Corporation (RTC), which simply swallowed all of the loans made by the affected S&Ls, packaged them into groups based on estimated viability and resold them to other institutions. At S&Ls where the management was found to be lending inappropriately, people were fired, fined or incarcerated as necessary, and a great many of the S&Ls themselves were forced to close permanently. The result -- after much angst and toil -- was a broadly sound financial system.

The Chinese took parts of this example to heart when they "cleaned up" their own banks. But instead of a single RTC, they created an "asset management corporation" for each of the major state banks. Lending was not suspended and no management or policy changes were forced; instead, everything was left intact. Rather than simply having the dud loans confiscated, the banks were issued bonds worth the full face value of $307 billion -- despite the fact that only about 20 percent of them were ever paid up. All in all, the Chinese solution -- under the Dingzhi Commission's "improved oversight" -- has been little more than an elaborate shell game.

One need not peer deeply to discover why. For a financial system as dysfunctional as China's, any American-style solution would trigger mass bankruptcies for the companies that had been loaned money. This would in turn lead to mass unemployment. And Chinese leaders, knowing the colorful history of labor action in their country, grasp full well that the best that could be expected at that point would be social upheaval.

Which brings us back to the yuan. Flatly declaring a policy of a pegged yuan would be the equivalent of thumbing China's nose at the Americans.

During President Hu Jintao's recent visit to Washington, the Americans announced they were playing the national anthem of the "Republic of China" (the official name for Taiwan), and stood idly while a dissident shouted Hu down during his speech. The response from the Chinese press: stunning silence. Such insults would not be tolerated by the leader of a country with a modicum of self-respect -- unless, of course, the leader fully recognized his country's weak position and could see how easily his hosts could tip the balance.

And so the PBoC continues to make cosmetic changes to its yuan policy -- such as withdrawing from the currency markets -- in the hope that such changes will be enough to placate the Americans. Without those changes, however minor, the United States has the ability to use trade policy to smash the entire Chinese system. So far they have been enough, but given growing perceptions of a potential Chinese military threat, the time is coming when Chinese cooperation on unrelated topics -- with issues such as North Korea and Iran being front and center -- will have to be used to plug the gap.

Stratfor (Estados Unidos)

 


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