Don’t Blame the (Chinese) Banks

The main reason I disliked the Academy Award-winning documentary Inside Job was that it sought to explain America’s subprime financial crisis in terms of good guys vs. bad guys.  If only there were more good guys than bad guys, and more people listened to the good guys, then bad things wouldn’t have happened.

I don’t think you have to whitewash the misconduct that did take place to find this — intellectually, if not emotionally — a deeply unsatisfying explanation.  To me, the more interesting and important question is why so many people — good, bad, and in-between — behaved in ways that seemed rational at the time but ended up producing such a disastrous outcome.  And this, despite the fact there were at least some people who saw it coming.

Over the past few days, I’ve received numerous calls and emails from people wondering what I think about Premier Wen Jiabao’s public criticism of Chinese banks (as quoted below from Reuters):

“Frankly, our banks make profits far too easily. Why? Because a small number of major banks occupy a monopoly position, meaning one can only go to them for loans and capital,” China National Radio quoted Wen as telling local businesses at a roundtable discussion.

“That’s why right now, as we’re dealing with the issue of getting private capital into the finance sector, essentially, that means we have to break up their monopoly,” the radio news service reported Wen as saying on its website.

Now, I don’t think anyone would mistake me as an apologist for Chinese banks.  As I’ve written before on this blog and elsewhere, I think China’s state-run banks have made what will prove to be a barge-full of bad loans over the past several years, financing a property bubble and a whole host of officially-sponsored boondoggles in order to meet inflated GDP targets.  Their reported NPL ratios (approximately 1%) are a joke, which means their supposed profits (which Wen worries are too large) are a lie.   When confronted with PBOC efforts to rein in their lending, and hence their make-believe profits, the banks repackaged risky loans as investment products, which they then sold to the Chinese public with the implied suggestion that they were risk-free.  They have financed guarantee companies which, in turn — much like AIG — purport to insure those very same banks from loan losses, while investing their funds in those same bank-sponsored investment products.  In short, whether anyone realizes or admits it or not, China’s banking system is an absolute mess.

In fact, it’s the dawning realization of the extent of this mess, at China’s highest leadership levels, that likely prompted Premier Wen’s remarks.  Last October, Wen was dispatched to Wenzhou, not to deal with a high-speed train crash (as in June) but with an implosion in the city’s shadow banking system.  This emergency visit, along with the high-profile trial of Wu Ying, an otherwise typical Chinese businesswoman facing the death penalty for engaging in “illegal lending,” have cast a spotlight on the inadequacies of China’s formal banking system.  Reformers have begun arguing that “illegal” lending to small and medium entrepreneurs meets a critical economic need that China’s state-run banks are unwilling or incapable of meeting, and that bringing the sector out from the “shadows” can play a vital role in reforming the broader financial system.  That won’t be easy, but in the long-run, it’s probably correct.

But to be fair to China’s banks, they’re not really the villains here.  They are creatures of the State; they do what they are told, and incentivized, to do.  And what they have been told, and incentivized, to do is to lend generously, without counting the cost, to companies and projects that carry the imprimatur (and implicit guarantee) of the Mother State.  They know that any losses incurred in this pursuit will be forgiven, one way or the other.  They know that, given fixed deposit and minimum lending rates, the more money they lend towards this end, the greater profits they can record, regardless of the eventual outcome.

China’s state banks are not run by  “bad” people, nor are they (necessarily) entrenched and greedy interests, staving off reform.  Some of them fully recognize the problems they are contributing to, and wish they could do things differently, although most find ways to rationalize their doubts, figuring that somebody higher-up must know what they are doing and will make everything alright — deus ex machina as a business plan.

The “monopoly” or protected position that Chinese banks occupy was given to them intentionally, so that they could serve as a slush fund to promote “growth” (in the form of limitless investment) regardless of whether market conditions told them it was profitable or not.  Premier Wen is as much to blame for framing this task as anyone.  At the 2009 National People’s Congress (NPC), he outlined the following vision of how China’s economy should be managed (bold text mine):

We must continue to make use of both market mechanisms and macro-control, that is, at the same time as we keep our reforms oriented toward a market economy, let market forces play their basic role in allocating resources, and stimulate the market’s vitality, we must make best use of the socialist system’s advantages, which enable us to make decisions efficiently, organize effectively, and concentrate resources to accomplish large undertakings.

In order words, the secret to China’s success, Wen maintained, is that it can command (among other things) a captive and insulated banking system to drive growth forward, overcoming the obstacle of market forces.

I think Premier Wen was wrong then, and is right now.  I suspect the cost of playing “the socialist system’s advantages,” in the form of mounting bad debt, persistent inflation, and stagnating growth, are becoming more and more evident to him by the day.  But the solution isn’t to blame the bankers, who are mere functionaries in this equation.  It’s the system, and the system’s priorities, that need fixing.  Getting “private capital” to play a more vital role in China’s financial sector, as Wen proposes, means accepting limits on the government’s ability to define risk and allocate resources as it pleases.  That’s going to be a whole lot harder than fingering “bad guys.”