The Banque Générale Privée was to France, as Chinese banks are to _____.
It’s not a tough analogy, that. Though the idea of comparing an 18th century French bank to modern-day Chinese financials is rather original. It comes to us from Shenyin Wanguo Securities analyst, Beijing nightclub-owner, and all ’round China expert, Michael Pettis.
Here’s his thinking:
As I see it there are broadly speaking two very different conceptions of the role of a country’s financial systems. In one, banks act largely as fiscal agents for the government or the economic elite, accumulating savings and deploying capital into projects usually selected for promotion by those elites. Typically the key objectives in this kind of banking system are rapid elite-directed growth and overall financial stability.
Since banks are in the business of taking risk, and since rapid credit expansion is inherently risky, the only way to guarantee financial stability is to extract much or all the risk from the banks and imbed them elsewhere. In practice the only “elsewhere” big enough is the state. In this kind of banking system the state typically socializes credit risk and passes losses onto taxpayers or depositors.
France’s Société Générale du Crédit Mobilier, established in 1852, is in my opinion one of the pioneers of this conception of banking, although of course state-directed banks are much older than that. The history of banks like the Bank of England and John Law’s Mississippi Company shows how closely intertwined banking and state objectives have been for a very long time.
Now, these kinds of banking systems can be enormously economically beneficial, says Pettis.
But the problem, he adds, is one of capital misallocation:
… these kinds of financial systems inevitably run into the problem of capital misallocation. It doesn’t matter if at one point they do a great job of allocating capital and generating real growth. As long as the same allocation process is maintained, it seems, at some point they begin to overinvest. Perhaps this is because the economic sectors that benefit most from the regulatory, credit and economic subsidies, not surprisingly, become increasingly powerful within the political system and increasingly reluctant to allow the system to change. Whatever the reason, this is the kind of financial system, I would argue, that has a built-in tendency eventually to misallocate capital more extravagantly.
Of course, the other type of banking system — in which “the problem of systematic capital misallocation is much reduced” — is the one where banks themselves decide where they should put their money. They’re more prone to instability of course (hello, financial crisis) but Pettis figures they’ve gotten a bad rap recently.
So what’s needed, he says, is a meaningful transition of China’s banking system from that state-directed model to a more, umm, ‘Anglo Saxon’ one. In the meantime you’ve got very probable capital misallocation and a rather uncomfortable entwining of state guarantees and financial functioning:
… Aside from the many studies I’ve cited showing that profitability in many of China’s largest companies is substantially less than the value of the financing and other subsidies, and anecdotal evidence of unnecessary real estate and infrastructure projects, just imagine what would happen to banking deposits and stock prices if the government credibly removed all guarantees on loans extended by the banks, and furthermore removed interest rate controls. I suspect most investors and depositors would assume, correctly in my opinion, a surge in non-performing loans that would wipe out the banks’ capital base, and so would sell their stocks and withdraw their deposits.
The fact that this is unlikely to happen is irrelevant. It just means that the losses are hidden and transferred to the state, and via the state, to households. If that is the case, then since the banking system can no longer easily identify economically viable projects and is in fact wasting money, the usefulness of the bank-as-fiscal-agent model is much reduced. We need now to have banks in China that can correctly identify economically useful projects in which to invest and limit their credit growth to those projects.
Related links:
Chinese finance – a shadowy presence - FT
Michael Pettis on China’s very own zaiteku - FT Alphaville
Going for broke with bank guarantees - FT Alphaville