China Faces Liquidity Crunch

Despite China’s seeming economic might, it was only a few years ago that the hidden losses in among its banks were a frequent subject of discussion in the Western press. Indeed, in 2006, Ernst & Young hastily withdrew a detailed report that estimated that bad debt losses among Chinese banks were well above prevailing assumptions, and the volte face, clearly the result of official pressure, was viewed with considerable skepticism. But from then onward, discussion of the fragility of the Chinese financial system appeared to retreat to the background.

Those concerns may be coming to the fore again as the credit crunch hits China, and banks start to be saddled with real estate losses. The trigger is not residential mortgages (mortgages are not widely used and LTVs are much lower than in most Western countries) but loans to developers.

The article does not mention a second risk, highlighted by Brad Setser: China has experienced a huge influx of hot money seeking to benefit from the appreciation of the RMB. If these expectations fail to be met (CICC is forecasting that the RMB will fall slightly versus the dollar next year rather than continue to rise), some of this hot money will flee. Even for a country with China’s massive FX reserves, a shift of that magnitude would be destabilizing.

From Stratfor (hat tip reader Marshall, subscription required)

The People’s Bank of China (PBoC) predicted Oct. 31 that in the coming two years housing prices would slide by 10 percent to 30 percent and that the market would not begin to recover until 2010. Even more important, the bank also publicly revealed its worries about a liquidity crunch among real estate companies and banks.

Thus far into the global financial crisis, China has appeared calm and in control, with all the assurance of a country sitting on $1.9 trillion worth of foreign currency reserves with which to provide liquidity should credit run short. The assumption has been that China is mostly insulated from the credit crunch and that the major threat to its economy is only in the form of the knock-on effects of the credit crisis on China’s crucial export sector…

Stratfor has seen anecdotes, from problems with trade credits to issues related to the real estate sector, suggesting that the image of China being insulated from the global crisis is in part a fabrication by the Chinese government…

The Oct. 31 announcement by the PBoC is the first official acknowledgment that China could be facing a domestic credit crunch. The bank’s predictions suggest not only that real estate prices are dropping drastically because of falling demand but also that the effect on real estate companies, especially in urban areas, is now amounting to tightened capital flows. Moreover, the PBoC warned that the situation poses “a relatively large risk” to the commercial banks that have made loans to the construction and development companies because these companies use property as collateral and their collateral is now losing value. Anywhere from 20 percent to 40 percent of the total loans granted by these commercial banks have been devoted to the real estate sector, according to the PBoC.

The prospect of China seeing urban real estate bubbles burst and developers and lenders fail is a cause of great concern among authorities. If the prospect comes true it could have dire consequences for the world’s fourth-largest economy.

China’s domestic economy depends on subsidized, below market rate credit to maintain rapid growth rates and employment. If a credit crunch strikes in China, it would be unusual and unintended, and the system might not be fully prepared to cope with it. The central government is likely to act quickly with its reserves to prevent emerging liquidity shortages from spreading, but as we have already seen in the West, credit crunches have a way of getting out of control.

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  1. Anonymous

    I think we should send unemployed Americans to work in China. Give them the highest paying jobs.

    We have no problem giving away US jobs to Chinese scientists, engineers, programmers, etc.

    If you were to mention this to a Chinese he’d laugh in your face.

    You rich bankers have used the same lies about employment in this country as you did about sub-prime.

    You should all be imprisoned.

  2. bena gyerek

    i am not buying equities again until a chinese recession (and the resulting social turmoil) is priced in by the market.

  3. Anonymous


    You’re completely right about very, very low LTV in residential real estate in China. Also keep in mind that it’s all recourse debt, meaning banks are well insulated from direct shocks from the consumer.

    As far as commercial loans… I used to be a long-time Stratfor subscriber, and have not been impressed by its Asia analysis in general. I’m not sure I’m qualified to summarize its commentary on other issues… but on Asia, it’s relied on “anecdotes” far more than you’d expect from any sort of serious analyst. I’d trust investment bank economist opinions of the Chinese economy ahead of Stratfor… and Stratfor is clearly too hysterical on this point.

    There is clearly a recession coming in China, but to speak of banking collapse is simply not accurate.

  4. satan

    China has options the US Fed dreamed it had. The chinese government can make their bankers do things that no one in the US would suggest in polite company.

    On the other hand it is a much more volatile country. Things could go very wrong once they lose control.

  5. Matt Dubuque

    Thought experiment:

    Would you, as a country, rather face a liquidity crunch with 2 trillion in foreign exchange reserves or 2 trillion in the hole?

    Also, Setser dramatically overstates the problem of “hot” money in China. The Chinese are not fools and recall the dramatic difference between how the Thais and Malaysians fared in 1998.

    You will recall how Rogoff and various free market jihadis ridiculed Malaysia for imposing controls on hot money during that Aisan banking crisis.

    IMF internal studies later lauded that step and admitted their errors.

    The money in China is far less “hot” than elsewhere around the world, despite continual pressure from the West to “reform” their financial system in this way.

    Matt Dubuque

  6. Anonymous

    I’m no professional economist or financial person, so please correct me if I’m wrong. (I hope I am actually). My view here is that his could have serious, serious repercussions for the US. If the Chinese economy encounters problems in the near to intermediate future on a large scale, as this article and Yves comment about hot money inflows suggest it might, they could very quickly draw down their dollar holdings bailing out their own banks and defending their currency. In turn, they would be less able to purchase treasuries to fund our debts and bailouts, even if they wanted to. Might this be what pricks the bubble many think currently exists in the treasury market?

  7. Anonymous

    With the Treasury trying to float 1/2 Trillion in debt I think that it is possible that China could say no to purchasing any and then what?

    A 3rd world country with nukes.

  8. thomas j

    Well, well, well. This should at last put to rest the ludicrous notion that China will come to the rescue of the global financial system while becoming a major IMF sponsor. The PBoC will need all of its reserves simply to bail out its collapsing financial system and address its growing set of economic calamities.

    The problem Chinese authorities will have going forward is keeping money from fleeing the country. In the near future, I anticipate we will here more and more about widespread disillusionment with Western style capitalism. And foreign factory owners will be scurrying back home along with what remains of their capital investments.

  9. Matt Dubuque

    Thomas J.-

    The Chinese never adopted Western style capitalism. That is a bizarre myth believed by Westerners and is divorced from reality.

    Not even close.

    Ever tried to place a bond offering in China when you weren’t a member of the CCP?

    Can you name just ONE person on the Board of Directors of ANY Chinese bank who is NOT a member of the CCP?

    You may think this is irrelevant.

    The Chinese KNOW it is not.

    Matt Dubuque

  10. S

    Friedman used to have a blog where he posted articles and had comments but moved away from the format. He didn’t like peer review.

  11. k

    So I settled comfortably in my chair, sipped my morning coffee, and started to scan the headlines from my RSS Reader.

    Naked Capitalism, “China Faces Liquidity Crunch.”

    Yahoo China, Economy Section (in Chinse), “SAFE adopts new regulations to prevent flee of hot money.”

    I almost spilled coffee all over my computer.


    One quibble Yves. It’s not CIC which predicts a slight depreciation of RMB in 2009. CICC made that call. But again, who can tell the difference?

  12. Anonymous

    I find “Yes on Proposition 8” advertisements from Google completely offensive. I understand you are trying to make some money from your considerable effort but it’s clear that Google does not allow you to specify that you don’t want political advertisements on your site. At least I am assuming you don’t.

    And I hope you don’t support Yes on 8 because that would be very disappointing. And, no, I’m not gay.

  13. thomas j


    I agree China never truly adopted Western style free market capitalism. But rest assured free market capitalism will be blamed for China’s current economic woes.

    As the situation deteriorates, critics of the Chinese government will not restrain themselves anymore than Sarkozy refrained from criticizing the so-called “laissez faire” policies of George Bush for causing the credit crunch when in reality Bush’s policies constitute nothing more than crony capitalism.

  14. doc holiday

    Yah know, yah take this another step and you have Roubini wall art:

    volvita, from L. volvere "to roll;

    Is it me, or the LHC?

    This is Re: "prevailing assumptions, and the volte face,"

    > I guess this is some weird inside joke or a way to poke at the reality of illusions?

  15. doc holiday

    * world markets have lost about $16.22 trillion

    This just in from deep space:

    World equity markets lost an estimated $5.79 trillion during October, the biggest monthly loss ever, Standard & Poor's Index Services said Monday.
    The October loss eclipsed the previous record, which was set just one month earlier, when 52 global equity markets lost a combined $4 trillion.
    Through the first 10 months of the year, world markets have lost about $16.22 trillion, according to S&P research.
    Though U.S. markets accounted for nearly 40 percent of the losses during the month, they performed better than the average world market.
    The U.S. accounted for $2.27 trillion of October's losses, as S&P's broad market index for the nation fell 18 percent. The global average decline was 20.7 percent during the month.

  16. Juan

    Capitalism in China has become progressively less state determined while, same time, transnational firms have increasingly shaped the accumulation process there and within E. Asia.


  17. Anonymous

    I don’t see how china will crash.
    maybe some sector (eg: garment or toy manufacturing, etc)

    but overall, china manufacturing is not highly integrated and most of the workers are recent urbanites. It doesn’t take much to stabilize their condition. (eg. go back to farming, inject littl emoney to move domestic economy, infrastructure spending, etc)

    is not like the chinese are deep in mortgage funk or credit card debt.

    So as long as the overal chinese economy is moving, things will adjust. (maybe stop making toys for US market and start catering domestic market, etc)

    Now, if we are looking at highly integrated industry like in the US. when GM, or DOW chemical going bankrupt…

    that’s it. End of the world

  18. mxq

    anon 11:28

    Unemployment is the big problem.

    China must maintain a relatively high rate of growth just to assimilate new workers into the workforce…otherwise, it leads to huge social problems.

    FT just quoted China’s PM saying:

    ““We must be crystal-clear that without a certain pace of economic growth, there will be difficulties with employment, fiscal revenues and social development . . . and factors damaging social stability will grow,””

    Domestic consumption is sorely lacking, so it is going to take a heroic effort for the Chinese to convert from the export model into a system capable of sustaining itself.

  19. daveg

    I find “Yes on Proposition 8” advertisements from Google completely offensive…

    This is way I CAN’t STAND the left.

    While I am mildly sympathetic to the no on 8, people on the left side of the isle constantly want to silence other people views. It is like a compulsion with them.

    Stop telling people to pull ads and loose revenue and argue on the merits.

  20. Anonymous

    The Chinese central bank recently ordered commercial banks to reduce mortgage rates and down payments for borrowers obtaining their first mortgage, while the Finance Ministry reduced the stamp tax on real estate purchases for first-time home buyers. The consensus of opinion seems to be that these measures were not enough and further measures will need to be taken. Chinese banks pay 0.7 percent on short term household deposits and this is used to fund most of there lending at 4.6 percent to house buyers and commercial firms. Despite real estate developers threats to take the banks with them reports from Moodys and UBS suggest there is little to be concerned about for most large banks.
    I perceive four potential risks arising from these problems. The first being that the Chinese central back will use its reserves and liquidate US Treasury, US Agency and US Dollar holdings to invest resources to resolve the problem. I doubt that any large scale liquidation will take place though, but expect china to severely scale back buying new issuance of US debt. The second risk is that I don’t expect them to need to buy dollars to prevent the Chinese currency rising as they continue to drop interest rates. The third risk is from social unrest in china as lots of workers loose their jobs, and the authorities are forced to be fairly ruthless as a result. This will most likely result in a withdrawal of foreign capital and a downward trend in the Chinese currency, again causing a slow down in the buying of dollars. The fourth risk is that they reduce interest rates and allow inflation to run riot for a while, which will most probably be exported to the US.
    Systemic risk in China would appear to be unlikely even though the real estate developer bubble is bursting. We should remember that they introduced a quota system and specific limits in 2004 to protect banks. The steps that they will take to resolve the problem even if small could however make the US economy unstable.

  21. mft

    For anyone who can remember the bull on Japan in the early 1980s, the bull on China is all too familiar – they’re the future, they have invincible economic strength, etc, etc. History tells us that in fact economic growth on the scale of China eventually comes to an end, and more often than not with a bang rather than a whimper.

    Yves, I’m glad you are covering the China story more intensively now. I’ve for some time feared that perhaps the real parallel to the USA in the 1930s may turn out to be China in 2009-?.

  22. mft


    I think you are alluding to the political consequences in Germany. I hope none of us will go down that road this time round. The resemblance in the situation then and now really boils down to the underlying global imbalances which led to the great deflation in the 1930s. That time round it was US lending in the post-WWI period to Europe above all. This time it is China lending to the USA. I acknowledge that this is very simplified , but I think there may be a kernel of truth in it.

  23. Anonymous

    daveg: “While I am mildly sympathetic to the no on 8, people on the left side of the isle constantly want to silence other people views. It is like a compulsion with them.

    Stop telling people to pull ads and loose revenue and argue on the merits.”

    Haha, same reason I can’t stand anyone on the Right.

  24. CEO

    Probably too many amateur china pundits on your website. I invite them all to visit China, not Shanghai or Gunagzhou, but east to west, inland as well as coastal. You would then realize that two thirds of China doesn’t really depend much on globalisation and majority of its population has never done a transaction with a bank. And all the current chinese banks have collapsed more than 3 times over the last 2 decades, China is still around.

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