Wednesday, August 20, 2014

Are China’s Banks Next?

WASHINGTON, DC – America’s recent bout of dysfunctional politics and the eurozone’s on-again, off-again crisis should, on the face of it, present a golden opportunity to China. To be sure, the malaise in the United States and Europe is likely to hurt Chinese exports; but, over the long term, China wants to reorient its economy toward domestic consumption. With the Tea Party wing of America’s Republican Party scaring investors out of the dollar, interest in the Chinese renminbi’s potential as an international reserve currency can only increase.

This will help China to attract more investors seeking to diversify their portfolios. Chinese government debt will become an important global benchmark asset, which should help its private sector to attract funding on reasonable terms, while the predominance of the US Federal Reserve in determining worldwide monetary conditions would presumably diminish. The decades-old shift to a multipolar world for manufacturing could thus lead to a more multipolar currency world, with the renminbi as an important player.

But, despite its unique history and current advantages, China harbors a weakness that is quite similar to what has caused so much trouble in the US and Europe: big banks that have an incentive not to be careful. China’s latest moves suggest that while it may now enjoy some years of greater prominence, its encouragement of its financial institutions to go global is likely to lead to serious trouble.

Ironically, the British government, while no doubt just trying to be hospitable to foreign investors by laying out a red carpet, is helping to set a trap for Chinese financial institutions – and the broader Chinese economy. By encouraging China to build global financial institutions with light regulation, the United Kingdom is not just inviting irresponsible behavior; it could help to pull an entire economy toward ultimately unproductive and even self-destructive activities.

China has long kept tight control over its main banks. Credit policies have helped to juice the economy from time to time, but the authorities have also retained the ability to slow things down when warranted. Banking has become an instrument of economic policy to ensure GDP growth and employment creation, while keeping inflation at an acceptable level.

But the Chinese policy elite are also very taken with the idea that a first-rank country needs a prominent banking system that is active internationally. There is nothing wrong with this ambition, as long as it is handled with great caution. Unfortunately, it is now becoming clear that the hard lessons of recent financial crises have been lost on China.

Bankers never like tight regulation – and they particularly do not appreciate being required to fund their operations with more equity relative to debt. In both good times and bad, their refrain is, “We need lower capital requirements,” meaning they should be allowed to borrow more.

Iceland, Switzerland, and the UK have all learned the hard way that allowing banks to become big relative to their economies brings with it great risks. Bailouts become more expensive and – as in the case of Iceland – may actually be unaffordable. Even when, as in the UK, the cost of losses is not completely ruinous, the direct damage to domestic credit and to broader confidence can be enough to hold back the economy for a half-decade or more.

Mervyn King, the former governor of the Bank of England (BoE), is reported to have said, “Banks live globally and die locally.” In other words, when everything is going well, you may be willing to believe that it does not matter where a particular international bank gets its equity funding and in which jurisdiction its debts are issued. But when bad things happen and there is pressure on financial markets, with fear of insolvency in the air, it matters a great deal if you have a claim on an insured bank in the United States or on an essentially unregulated offshore subsidiary.

China wants to build up its banks’ international operations. And the British are welcoming an expansion of these activities in London – offering to treat Chinese banks operating there as branches (subject to Chinese regulation) rather than as subsidiaries (subject to British regulation).

Mark Carney, King’s successor at the BoE, said, “We are open for business,” in terms of providing liquidity loans to backstop big banks. But UK banks’ assets amounted to eight times the country’s GDP before the crisis and will presumably approach that level again with Carney’s encouragement. Can the BoE – and the UK Treasury – really provide downside insurance for this full amount, or are the UK authorities set on the path to becoming another Iceland (where the value of bank assets peaked at more than 11 times the country’s GDP)?

The Chinese authorities should take another look at their policies. China is like Cinderella – finally allowed to attend the ball and given a chance to become a prominent player. But midnight could come very quickly, and financial crises do not have fairytale endings.

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  1. CommentedZsolt Hermann

    Why are the banks in the US and in Europe struggling? Because the banks are bankrolling an economic system that has no natural foundations, that is based on excessive, artificial demand, requiring constant credit, inflation, constant debt ceiling raise. Today the whole global world, including China is employing this same unnatural system. It is interesting that in some parts of our lives we are strictly keeping ourselves to natural laws and principles, like we all obey the law of gravity, when we are building we create a stable foundation and only build a structure that the foundation can safely support. But in finances, economics we throw all natural laws, precautions, strict planning out, and build skyscrapers on matchsticks, inflate balloons to support other bursting ones. Then we are watching and are seemingly surprised when these buildings collapse, balloons burst, moreover since we live in an interconnected and interdependent global world, they topple each other like dominos. So are China's banks next?