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China could be in for a very hard landing over the next few years.  China is still in the very early stages of its real estate crisis and we’re already finding out a lot of particularly damning facts.  This recent Associated Press article on China’s so-called “shadow banking” system is particularly insightful:

China’s unofficial lending falters, savers protest

Here are a few excerpts:

[Shadow lending’s] popularity reflects public desperation for an alternative to China’s banks, which pay low deposit rates that fail to keep up with inflation and channel savings to government companies.

So it’s clear that China’s artificially low interest rates were driving private individuals to make loans at higher interest rates to small businesses and real estate developers.  In affect, the shadow banking system acted as sort of vast collection of mini-banks, completely outside of state control.

“Underground banking is popular here,” Yao said. “They offer really good service and send the money to you just one minute after you ask. They even send the cash to your place if you want.

This quotation was particularly insightful because it says a lot about the nature of the approval process in the shadow banking system.  Since many of these individuals lending out have little to no experience with credit analysis, it stands to reason that their credit quality standards might be less than stellar.

Regulators started to worry about underground lending after high returns drew state companies and civil servants into the business, blurring the line between banks and informal lending, according to Guo.  “They could easily borrow from banks and earn a profit by re-lending the money,” he said. “If a problem happened, it would become destructive.”

Here’s one of the biggest problems with state price controls.  And let’s make no mistake about it; China’s controls on interest rates of the state banks are a price control that artificially lowers the costs of credit to certain consumers.  The problem is that in this sort of system, there’s limited supply to go around and those who are well-connected tend to be more likely to be “the winners.”  So if you’re well-connected, it makes sense to take advantage of your subsidized funding costs, then lend out at the exorbitant interest rates you can obtain in the shadow banking sphere.

The Issues with a State-Controlled Economy

While we’ve known for awhile that this “shadow banking” system was provide a considerable amount of loans, these sort of first-person accounts allow us to better understand its working and its failings.

This also exposes why government attempts to control the economy almost always fail. The “invisible hand” of the market is always pulling things back towards reality.  If you set a price ceiling, a black market will form, and those with access will profit from those who lack access.

Moreover, it shows the fallacy behind many government actions meant to reduce prices for lower or middle income individuals.  While China’s low interest rates were supposed to help people, they actually destroyed the savings of many individuals and required them to seek out underground alternatives to earn interest. All the while, the lending binge drove up real estate prices so many lower and middle income individuals could not afford to purchase housing.

There were some similar things happening in the US, with the Federal government subsidizing housing and the Federal Reserve keeping interest rates artificially low in the early ’00s, but it’s on a much grander scale in China.  It’s difficult to say with any certainty how things will play out, but I truly believe they are in for a very hard landing.  And this goes to show, China needs major reform in its banking sector before it can ever be on par with the developed world economies.