When China's Banks, Like Dominoes Fall, Will Your Countries Banks Fall Too?

Gordon Chang had a few comments on yesterday's New York Stock Exchange fall--triggered by an even larger market dip in China the day before:

The real risk China poses to global markets is not so much the severity of a financial crisis as the unexpected nature of such an event. Today, the concern about China in the West is that the country will dominate the global economy. For many, if not most, people in the financial and business communities, the possibility of an economic crisis inside China is remote. For them, it is an “unknown unknown.” Yet all the underlying conditions necessary for such a crisis exist. When it occurs, market participants will probably be caught completely unaware as they were today. After all, how well have the markets predicted turmoil in other countries in the past?

There may be little we can do to avert a financial crisis in China, but public discussion of such a development would at least give market participants the opportunity to take that event into account, thereby making future market adjustments less painful.

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Today, Chinese state-owned enterprises [SOEs] owe banks over $2 trillion -- about the size of the entire Chinese economy. And the amount of outstanding loans is growing by $500 billion each year.

None of this will shock any student of Communist economies. This is just the way financial institutions in "soft budget constraint" socialist economies work. That is the insight of Communist Eastern Europe's only Nobel Prize caliber economist (and now Harvard professor), the Hungarian Janos Kornai. In socialist economies, cheap loans combined keep inefficient state-owned enterprise afloat. They also mean that a lot of goods are produced that shouldn't be produced in the first place. Throw in China's cheap labor and you see why the Chinese are selling Honda knock-off motorcycles at the price of their weight in scrap metal in Vietnam. This may lead to impressive rates of "top-line" economic growth in the medium term. But it also leads to the kind of massive misallocation of resources that eventually brought the Soviet Empire to its knees.

This makes the coming collapse of Chinese banks inevitable

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And the collapse could come sooner than we think. In 2007, as per the agreement China entered into upon joining the WTO, it must open up its retail banking sector to foreign banks. This is a potential tripwire. Even if only a small number of Chinese are concerned about the health of their local banks (and thus their savings), when Citibank opens up next door the run on Chinese banks could easily spin out of control. I am assuming that the government is trying to spread the notion of confidence and stability in the retail banking sector. If the Chinese do not panic come 2007 or any time in the subsequent 20 years or so, the banks should be able to reduce their NPL rate to a "more manageable 5%". It wouldn't be the first time that people have left their money in a bank that is essentially insolvent because they believe the government will cover any losses incurred. This is a questionable assumption, however, and if I was Chinese I probably would not run the risk.

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Although China labors under a long list of problems, a lack of people with economic savvy is not one of them. Until now, China's stock markets have given the highest return on investment for the Chinese people with money to invest. But if citizens suspect the banks do not have sufficient assets to cover possible withdrawals, a run on the banks is a real possiblity.

If Chinese banks start to fall, much of the rest of the world's economy will follow after. Like Gordon Chang says, it's far better to be mentally and otherwise prepared for this possibility than to be caught completely unprepared.