Potential for a banking crisis in China – planning for risk

Posted by on Apr 26, 2011

Predictions are for suckers . . .

Let’s start with a confession and a caution.  This article includes a discussion about the risk of a banking crisis in China. But we aren’t predicting China will experience a banking crisis in the next few years. Nor are we predicting it won’t. We’re not in the business of making predictions.

That was the confession.  And now for the caution.

We don’t think strategic planning teams should be in the prediction business, either. The conditions that could lead to catastrophe often don’t, and predictions about economics and society are notoriously inaccurate even when made by “experts”.  Even when a social or economic threat is expected, it may unfold differently and in a direction other than predicted.  They may be far less severe (e.g. Y2K) or more severe (the toxic assets crisis of 2008) than anticipated. Predicting the probability and severity of a crisis event is a crapshoot.

Planning how to respond to predicted crises can be equally risky. Strategic planning requires leaders to make decisions in an uncertain world, and without enough information.  We don’t think planners should predict crises and then bet on how they will unfold.  We think it’s more important to understand and avoid risks more generally without losing good opportunities.

Two important questions

We believe the important questions concerning strategic planning and risk are:

1. How can you improve the quality of your strategic decisions about uncertain future events and conditions?

2. How can you minimize the inherent risks without giving up good opportunities?

In this week’s article we’ll describe one potential risk that could affect many businesses in Canada – the risk of a banking crisis in China.  We’re not saying it’s the biggest or most likely threat to Canadian business. However, we think it is a legitimate threat for most Canadian businesses, and it illustrates that there are dangers lurking in some surprising corners. And it is a good example from which to begin a more general discussion of the implications for strategic planning.

Next week, we’ll provide a systematic way for thinking about the 2 questions above by providing a framework for thinking about strategy and risk.

The risk of a meltdown in the Chinese economy

For more than a year we’ve seen articles warning that a Chinese real estate market collapse could precipitate a banking crisis. Some of the evidence is compelling. Modest new apartments in major cities like Shanghai and Beijing have reached prices that are 30 to 50 times China’s average annual salary. That’s 5 to 10 times less affordable than in Canada! And while the Chinese government slapped on new taxes, higher mortgage rates and stiffer deposit requirements in major cities to cool market activity, manic buying simply moved to less regulated second tier Chinese cities. Within the past few months, it’s even moved to Vancouver and Toronto!

Compounding the potential for problems are credible reports of massive oversupply in the Chinese market. One report based on power company records estimated that 64.5 million urban apartments are sitting unoccupied. Another says there is enough vacant office space in China to provide a 50 sq. ft. cubicle for each of China’s 1.3 billion inhabitants.

As if that wasn’t enough to worry about, demographers are warning of a substantial drop in new entrants to the workforce and a proportionately large increase in the percentage of retirees by 2015 as the effects of China’s one-child policy work their way through the population.

It looks like a trifecta of potential trouble – oversupply, soaring prices, and reductions in future demand – all hitting within a few years of each other.

A Chinese meltdown probably won’t be driven by consumer debt

A Chinese bank meltdown would surprise those whose understanding of the Chinese economy is limited to the truisms that China is “awash in cash” and Chinese home buyers “don’t like mortgages”. Unlike the US real estate debacle, the Chinese version probably wouldn’t be driven by over-extended consumers, but by ballooning debt among banks and state-owned companies.

In 2009 the government pumped more money (as a percentage of GDP) into the Chinese economy than the US did with its own mammoth 2009 stimulus. Much of that liquidity went into state-directed loans to state-owned companies. Many of these companies have not repaid previous loans made over the past decade or even longer, and too many of these non-performing loans either appear at full value on banks’ balance sheets, or have been funneled off to the balance sheets of junior banks set up for that purpose.

Canadian managers wouldn’t recognize China’s banks

The essential nature of China’s banks may surprise many in the West who assume that they function much like western banks. But they’re more like state financiers than the private sector banks we know.  They’ve financed most of China’s economic growth. The “Chinese economic miracle” could not have happened without them because China’s equity markets are seriously underdeveloped and private lending is practically non-existent. But particularly since 2009 they’ve been misused as a conduit for stimulus spending rather than responsible lending.

Since 1981 China’s banks have experienced three major crises, each about a decade apart, with the last one occurring 11 years ago.  It isn’t exaggerating much to say that China’s economy has Ponzi-like characteristics. If GDP growth drops below 5 or 6% annually, there’s a significant risk of a crisis.

Indeed, a Chinese banking crisis has been predicted as 60% likely within the next 3 years by Fitch Ratings, which first noted in 2009 that some Chinese banks were moving loans off their balance sheets to lightly regulated trust companies to avoid lending caps. This was recently confirmed by The People’s Bank of China.

What would a Chinese banking crisis mean to Canada?

A major downturn in China would kick the props out from under commodity prices. That would hit Canada particularly hard because China is now our fastest–growing trading partner. Our biggest exports to China include copper, oil, nickel, iron ore, coal, lumber and potash.  These commodities and China’s economic stimulus protected Canada from the worst of the global recession. Our exports to China actually rose 7% during 2009, while exports to the US were off by 25%.

It is obvious that a major downturn in China would hurt China’s Canadian suppliers. But many businesses in Canada depend at least partly on Canadian prosperity derived indirectly from suppliers to China.  A large proportion of Canadian businesses would experience at least some of the pain of a made-in-China recession. And highly leveraged Canadian homeowners could be badly hurt – even left “under water” – if the hot China money pouring into the Vancouver and Toronto markets were suddenly to dry up.

How should you plan for this?

So how should you manage this in your strategic planning?

We don’t think most Canadian companies need complex analysis of the probability and severity of a made-in-China recession to strategize about it. But there are things you can do to insulate your strategy against crises, and to make your organization faster at seeing and responding to them. What you should do depends significantly on your organization’s agility, and on how quickly you think various potential crises may unfold.

In next week’s article, we’ll provide a conceptual framework for making your strategy more crisis-resistant depending on the kind of crisis you’re planning for and the nature of your organization.

Copyright 2011 Knowlan Consulting Group Inc.

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