Chinese lending - a recovery built of sand

China is new to the capitalism game and I have been concerned for some time about the size of the stimulus plan. One problem is that the spike in lending is resulting in more risk being taken.

The Chinese recovery may well be built on sand and stimulus packages. This leaves me uneasy. The problem (as it was in the previous stockmarket bubble) is the lack of alternative investment homes for all the cash that is still sloshing around.

Risks Emerge as Bank Loans Hit Overdrive [Caijing.com.cn]

(Caijing.com.cn) Record bank lending in China is spawning systematic financial risks that may lead to a credit crisis.

New lending in the January-May period totaled 5.84 trillion yuan, 3.72 trillion yuan more than during the same period last year. That's an unprecedented pace for new loans, as lending levels never even reached 5 trillion yuan for an entire year between 2001 and '08.

This huge influx of borrowing, aimed at stimulating China's sluggish economy, is leading to overcapacity.

Most scholars believe China's recovery is solid and strong, but economic statistics suggest otherwise. Industrial enterprise profits and trade volume have fallen remarkably.

Between January and May, industrial enterprises with annual revenues of more than 5 million yuan booked a combined decline in profits of 22.9 percent year-on-year. Profits for big state-owned enterprises declined 41.5 percent year-on-year.

Meanwhile, China's trade volume fell between January and May by 24.7 percent year-on-year, with imports off 21.8 percent and exports down 28 percent.

Those numbers show that the world market for made-in-China products is shrinking. If China's production-driven growth model continues, the country soon may face a predicament that combines "low interest rates, high capacity and finally low growth" – a scenario that's plagued Japan since the early 1990s.

The global economy is now caught in a vicious cycle: The world expects China to lead a recovery, while China is relying on the international market to absorb its products.

And if excessive lending is a power keg, an interest rate hike will be the fuse that sets it off. Indeed, a credit crisis would ensue if China's central bank raises its interest rate.

Interest rate increases were the immediate causes of the 1988 U.S. credit crisis, implosion of Japan's economic bubble in the 1990s, and the 2007 subprime credit crisis.

China's central bank will be reluctant to raise the interest rate, however, so overcapacity in the real economy will continue.

Due to a lack of investment opportunities in the real economy, speculative investment appears to be a reasonable alternative. That leads to high prices on the stock and real estate markets. Meanwhile, low bank interest rates encourage people to transfer cash from savings deposits to asset markets.

In May 2009, total bank deposits increased by a mere 188.6 billion yuan – down 47.8 billion yuan from the same period last year.

If enterprises and individuals use bank loans and deposits to engage in high-risk speculation, assets bubbles can be expected. Commercial banks would then reduce lending to avoid high credit risks, and market interest rates would rise, puncturing asset bubbles and ruining a financial system pillar.

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