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The rout in global stocks is a tempest in the teapot of China’s command economy

posted on January 28, 2010 at 7:52 pm
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We’re getting a lesson in exactly how messy a command economy can be in China right now. And it’s roiling stock markets around the globe.

I’m sure that voters from Homer, Alaska, to Lubec, Maine, (and from Tokyo to Athens for that matter) have watched in envy over the last year as the leaders of China’s command economy have delivered the robust economic recovery that the leaders of the United States, Japan, Greece, and other countries have only promised.

I’m sure I’m not the only person in those parts of the globe that aren’t growing at 10% a year that’s fanaticized about trading Anglo-Saxon or Japanese or social democratic capitalism for the kind of order-it-done-and-it-gets-done economics that China practices.

Be careful what you wish for.

The current turmoil sweeping China’s financial markets is a result of exactly this command economy.

And the ripples that have spread out from China to produce declines in stock markets in Brazil, India, and other emerging countries are so powerful because so many investors outside China don’t understand how China’s command economy actually works to produce extraordinary short-term volatility that really doesn’t signify much of anything in the long run.

The whole current brouhaha starts with a relatively simple command from China’s government to its banks: You will reduce lending in 2010 from last year’s huge $1.4 trillion in loans (9.5 trillion renminbi).

The government set a target for 2010 of $1.1 trillion (7.5 trillion renminbi) in new loans.

That doesn’t seem like a huge reduction.

It’s about 20% down from 2009’s lending spree after Beijing removed strict lending quotas in November 2008. (That was also the month when China’s government announced its $586 billion economic stimulus package.)

And it’s still a huge 60% above the $4.6 trillion renminbi total for bank lending for all of 2008.

So the new target hardly represents a draconian reduction in lending that would put China’s economic recovery in danger.

But the reduction was still enough to set off a huge power struggle inside a command economy that, theoretically, have other power centers that can challenge the government in Beijing.

Think what would happen if U.S. President Barack Obama had set out a 20% reduction in bank lending as new U.S. economic policy. Nothing, of course, would change immediately. An army of banking lobbyists would descend on Capitol Hill to help write the new legislation—or simply to kill it. Senators and Representatives would scratch this back and roll that log. A bill might eventually get passed. And then the agencies involved would set up a task force to write the regulations for putting it into action. At which point banking lobbyists would get another shot at making changes to the policy.

In China, in contrast, once the leadership decides on a policy that’s the new policy. Immediately. No lobbying. No influencing the regulations.

Well, not officially anyway. Even though China’s government tries to control China’s economy from the center, there are lots and lots of stakeholders who influence, unofficially, how policy gets implemented on the ground. No matter what Beijing decides.

These various economic stakeholders, who often don’t have any official way to influence decisions by the central government, game the system to get more favorable results—for them–out of a government decision. And they’ve had a lot of practice doing this. And they’re very, very good at it.

Take the current bank lending target reduction as an example.

Certainly everyone in the China’s banking industry knew it was coming. Beijing had clearly telegraphed its intention of clamping down on lending in 2010 after the runaway increase—roughly a 110% jump in bank loans over 2008– in lending in 2009.

So what did China’s banks do? They rushed to get as many loans done in January as they could before the government moved to clamp down on lending. The result was a huge surge in lending in the first 20 days of January. Banks made new loans of 900 billion renminbi. At that rate instead of the announced target of 7.5 trillion renminbi for 2010, Beijing was actually looking at total bank lending of 15.6 trillion renminbi in 2010.

Beijing shouldn’t have been very surprised. This is exactly what China’s banks do every year: they front-end load their lending because they know that it’s much easier to get approval from the central government for a loan in January than for one in December. In 2009, for example, banks lent out 20% of the target for the year in the first four weeks of January. In 2008 they lent out 20% of the annual target in the first three weeks of January.

China’s banks and their customers have gotten this front-end loading down to an art. For example, banks will offer extraordinarily low interest rates in January to entice customers who may not actually need a loan at the moment to sign up for one anyway. The interest rate on that loan is often negotiated higher later in the year but bank customers get cheap money for a while—to put into real estate or stocks, for instance—and the banks get a loan on their books before the government gets really strict about its lending targets as the end of the year approaches.

Gaming the system like this is absolutely essential to China’s banks because they get a huge majority of their operating revenue from interest on loans. In 2008 the 12 publicly-listed Chinese banks got 66% of operating revenue from interest income, according to Fitch Ratings. Fewer loans, less income, and a sinking stock price. (In contrast a U.S. bank such as Wells Fargo(WFC) recorded $11.5 billion in net interest income in the fourth quarter and $11.2 billion in noninterest income.)

It’s not clear to me whether banks mis-read how serious Beijing was about reducing lending in 2010 or whether they simply decided to game the system until the ax fell (I suspect the latter), but the January surge of lending this year clearly brought a much bigger than usual response from the central government.

Banks were told in no uncertain terms not just to cut lending but to stop lending completely.

And the really odd thing that now happened is that banks actually did exactly as Beijing demanded. On January 26 branches of Industrial and Commercial Bank of China (IDCBY.PK), the country’s biggest bank, China Citic Bank (CHBJF.PK), for example stopped all lending. The Bank of China (BACHY.PK) said that it would stop all lending for January.

I have a suspicion that this swing from lending surge (that the banks knew was against government policy) to lending shutdown (that shows the banks are good citizens doing what the government orders) is just another way of gaming the system. The banks know that a total lending shutdown isn’t sustainable. They know that Beijing is desperate not to crimp economic growth by more than a percentage point or two to from the fourth quarter’s pace of 10.7% annual growth. A total shutdown is a way for the banks to push back against the central government without seeming like they’re challenging the government in any way.

Who me? I’m just doing what you told me to do.

The result has been absolute consternation in global investment markets. China’s growth is going to collapse, some investors apparently actually worry, because China’s government has shut down all bank lending. China is going to cut lending back too much, other slightly less frantic investors worry, on the basis of a shut down in bank lending that’s evidence not of government policy but of the way that economic interests such as banks push back in a political system that doesn’t give them any official way to change policy.

I see jockeying for power and advantage. I see bargaining while seeming not to bargain. I see a command economy that oscillates around extreme results before it finally settles down to a (temporary) policy equilibrium. I see a central government that doesn’t have as easy a job getting its commands obeyed as outside observers often assume.

But what I don’t see despite all this chaos is any evidence that the government in Beijing won’t do everything within its power to make sure that the Chinese economy grows by 8% or more a year.

If that requires a complete about face in a month to a policy of relatively expansive bank lending, that’s exactly what the government will order.

Of course, exactly how that command will be obeyed by the other players in this command economy is another question entirely.

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  • atulwokhlu on 28 January 2010

    Hi Jim,

    I have been following you for quite some time but this is the first time I am writing to you. Great work!

    I was wondering if you have read or read Jeremy Grantham at GMO. I have been reading his views for some time now and he thinks that essentially we are setting for another asset bubble.



  • tostoryteller on 28 January 2010

    Good post. You’re certainly right about the 8% threshold that the government will hit come hell or high water. As you pointed out, the order-it-done-and-it-gets-done economics that China practices can result in something that I found totally perplexing while trying to do business there. In a nutshell, there are no economic laws that we typically think of as checks and balances in the west – you know, the supply demand kind of logic that most rely on.
    Switching to an idea. What about LNVGY, Lenovo? Have you looked at it? My logic is quite simple. FACE. Lenovo came about as the result of the merger of Legend Holdings in China and IBM’s Personal Computing Division in the United States. I think the merger is a watershed event in global business with the potential for integrating two disparate cultures, languages, processes and markets. As a result, Lenovo embodies the unique market possibilities in combining the best of East and West — joining North American and China-based technology in developed and emerging markets alike. My view China won’t let it fail. FACE.

  • davcbr on 29 January 2010

    I work in a big company.
    For what it’s worth, this view of China makes me think they run the country like we run a corporation. Just try to get that new piece of equipment in November or January. Spend ALL of your budget, because that is an indicator of your dept’s needs. If you spend less, you’ll get less.
    Sounds like they have over a billion employees.

  • amateur on 29 January 2010

    Hi Jim,
    I’ve been following you for quite some time too.

    Wow! What an insight!

    Thank you very much for helping us understand the why and the way the market works. You have a gift.

  • Mises00 on 29 January 2010

    China began from such a low level of development with such a horrible system, that any efforts to free up their markets should and did yield rapid growth. China is a combination fascistic style command economy at the top with a mix of laissez faire capitalism in parts of the economy. This system has yielded excellent results for some time, but seems to be mounting malinvestments occurring that will take a significant correction to deleverage unless the Chinese government is able to prevent them from getting out of control in the first place.
    The problems of overcapacity and reliance on export markets that are weak are problems that will not be easily resolved. The amount of resource reallocation that will be necessary is significant.

  • DJBarber on 30 January 2010

    Zhu Says China to Keep Yuan Policy, Fight Inflation (Update1)
    “Zhu said overcapacity also poses challenges for the government, which is continuing efforts to rebalance the economy toward domestic consumption and away from export-led growth. Overcapacity in steel, cement and shipbuilding should be reined in, he said. ”



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