An Inflection Point In China's Banking Problem

By George Friedman

The month of May witnessed an interesting
phenomenon: a spate of reports on China's nonperforming-loan problem. What
is most intriguing is that these reports did not come from organizations
like Stratfor -- minor outfits that have been talking about this for a
couple of years. It came from real, solid, serious mainstream organizations
that were, and continue to be in some cases, quite positive about China on
the whole. What is important here is not that China has a serious problem
with bad loans in its banking system. That's old news. What is important is
that mainstream analysts in the West now are taking official notice of it.
The wide divergence between the Western perception of Chinese economic
health and the realities of China's economy is beginning to close. There
will be consequences to that.

The first report came from Ernst &
Young, which released a study saying that China had a substantial problem
with nonperforming loans (NPLs). We have to confess to not having seen that
report, because the accounting firm withdrew it a few days later. The
Chinese government blasted the report, using words like "ridiculous" and
"distorted." Ernst & Young, which has a substantial practice in China,
denied having retracted
the report because of pressure from the government. Whatever their reasons
for doing so, we wish we had been faster in asking for a copy.

No
matter, because May also brought studies on the same subject from
PricewaterhouseCoopers (PWC), McKinsey Global Institute, and Fitch. Each
said the same basic thing: that Chinese banks have enormous NPL numbers on
their books. The PWC report was issued by a group within the company that
specializes in making markets in NPLs. Their news was that the water in
China was fine and everyone should come in. McKinsey focused on
inefficiencies in the Chinese banking system that should be cleared up, so
that NPLs could decline and the Chinese gross domestic product could surge.
Fitch was the harshest of the three, but that firm also argued that the
Chinese had the tools in place to handle the problem. The bottom line was
that all three acknowledged that NPLs were a big issue for China, but they
took different approaches in trying to put the problem in perspective. In
other words, they gave a warning without yelling "Fire!" Some of the reports
were criticized by the Chinese, but none were blasted. Meanwhile, Moody's
Investors Service has told us that they will be releasing a report in a
couple of weeks. It will be interesting to see what their take
is.

Let's begin this analysis by looking at a couple of quotes from
these reports. McKinsey, for example, writes:

"Underlying these
reforms, however, is capital misallocation by the system. Nonperforming
loans are the most conspicuous outcome of this misallocation, but our
research shows that the much larger volume of loans to underperforming
ventures that don't go bad but yield only negligible returns are potentially
more costly to China's economy."

Fitch's report states:


"Summing all of these figures, we come up with total official
nonperforming loans of US$206 bn and other estimated problem loans of over
US$270 bn in the banking system. We would reiterate, however, that a
large portion of this latter figure is comprised of estimated Special
Mention loans or loans that currently are not classified as
nonperforming [emphasis Fitch's]. At the same time, there is an
additional US$197 bn in NPL carveouts still remaining on the balance sheets
of China's asset management companies, which no longer represent direct
losses for banks but are a future liability for the
government."

Fitch also states:

"Beyond this, estimating a
rate of flow of new nonperforming loans is not an easy exercise given
Chinese banks' extremely weak historical data and ongoing deficiencies in
accounting and disclosure. Few banks report data on NPL flows, and those
that do show recent flow rates in the extremely low single digits. We
believe these numbers understate the likely level of ultimate credit losses,
given what we know to be the slow evolution of a strong credit culture and
risk management practices and our suspicion that China's over-reliance on
investment-led growth comes at a cost to bank credit quality."

Fitch
is estimating China's bad-loan situation (our term, lumping all these
categories together) at $673 billion, but it warns that -- given Chinese
accounting and reporting, and the fact that what reporting exists is not
credible -- $673 billion is a low number. That's important. If $673 billion
was the final number, then measures that are put in place could limit the
ultimate losses to a level below that figure. If, however, the total number
of bad loans is substantially higher than $673 billion -- which is our view
of the situation -- then the system would be lucky to have to write off only
this amount.

There are numerous ways to measure the magnitude of the
problem, but one of the simplest is this. China is said to hold nearly $819
billion in foreign reserves. Fitch's conservative estimate of the bad loan
situation comes close to matching that number, and a more liberal
calculation would swallow those reserves up and then some. Put very simply,
the Chinese banking system is in deep trouble -- and with it, so is the
Chinese economy.

It has become an article of faith that China's
economy is booming. The economy certainly is growing rapidly. But growth and
size alone don't tell you how healthy an economic entity is. During the Great
Depression, the U.S. economy was enormous, but it was crippled. Japan's
economy was growing at a phenomenal rate in the 1980s, all the while heading
for its disaster. Size and growth are but two measures of an economy -- or of
a business. They do not tell you how well it is doing.

The basic
problem of the Chinese economy, as in many Asian nations, is that the banks
have not made loans with business considerations in mind. They made loans
for political reasons and to maintain social stability. In many cases, loans
were seen as being more like grants. As a result, they were invested in
enterprises that did not make enough money to repay (or even attempt to
repay) the loans. Frequently, rather than bankrupting the business or
writing off the loan, the banks lent more money to the business -- so that
it could repay old debts, and there was an appearance that the loans were
viable. Loans went into land speculation or to investments in areas that
were already overbuilt. (And this does not attempt to take into account
ancillary problems, such as corruption
and embezzlement, which also have been significant
issues for the Chinese government.)

In the first part of 2006,
there has been a huge surge in lending in China. With the economy already
growing at rates of more than 9 percent, it would seem structurally
impossible to grow it any faster. Shortages in skilled workers, management,
buildings -- all these limit the rate of growth. The truth is that a
substantial portion of the loans that went out were issued to keep bad loans
floating, like using one credit card to pay the monthly payment on another.
You can do that for a while, but you can't do it forever.

What keeps
the Chinese system alive is not domestic consumption, which is not rising in
tandem with overall growth. What keeps China afloat is exports -- exports in
ever greater numbers, and with ever-smaller profit margins. Surging exports
are critical to China, as they were to Japan before it. They generate the
cash that allows the financial system to continue operating.

This is
also the Achilles' heel of the Chinese economy, as Fitch points
out:

"Given the weaknesses already discussed, we believe Chinese
banks remain acutely vulnerable to an economic slowdown, although the
analysis above recognizes that much work has been done to tackle these
weaknesses and at a minimum suggests that Chinese banks and the government
are more equipped today than in the past to deal with problems that may
arise."

Here is the problem. The official policy of the Chinese
government is to cool off the economy. In fact, the Chinese are attempting
to cool growth only in certain sectors, where they perceive particularly
dangerous bubbles starting to form. For the most part, however, they are
doing everything they can to keep the economy hot, in order to try to manage
the financial problem. Now, Fitch argues in its report that the Chinese banks
are better equipped than in the past to deal with their problems. We agree
with that assessment; they were completely unprepared in the past and now
are abysmally prepared. You cannot prepare to deal with a loan situation as
bad as that in China. You simply keep cycling as fast as possible and hope
that something turns up.

In our view, this spate of reports on
China's financial situation marks a turning point.

One of the things
that has kept the Chinese economy booming was cheap exports. But another was
the perception in the West that, underneath it all, China was sound. This
perception induced foreign banks to invest in Chinese banks. There have, of
course, been studies detailing the Chinese debt problem for some time:
Standard & Poor's, for example, estimated the bad debt in 2002 at $600
million. That part isn't new.

However, when "irrational exuberance"
(to quote Alan Greenspan) is at its peak, it is hard to break through the
noise. Markets continue to rise, even as bad news comes out. Last week, for
example, we saw the Bank of China make its initial public offering and
shares soar, just as these financial reports were emerging. That doesn't
mean these reports are wrong or that the Chinese have things under control.
It simply means the market is ignoring news and rising on its own giddiness.


Nevertheless, a turning point has been reached that will be difficult
to ignore. Reports from Stratfor are, of course, one thing. Reports from a
single credit agency are another. But when a series of reports from highly
respected, mainstream analysts all come out within a few days of each other
-- with each, in their own way, telling the same basic story, it becomes
hard for the system to dismiss that. Western companies moving into China
have CEOs and CFOs who must exercise due diligence. There are now too many
reports out there to be simply ignored. All of them are caveated. None of
them write China off. But a critical mass is forming that will cut through
the froth in due course.

Obviously, this does not mean that China
will implode, disappear or anything like that. It will remain an enormous
economy and an important one. But this does mean that the dynamics of the
Chinese economy are shifting. The debt issue represents a deep structural
problem that China will either deal with -- as South Korea did -- or not, as
Japan did not. (Japan reaped more than a decade of economic stagnation as a
consequence. It is significant that China lacks the degree of insulation
that Japan built up; the economy has more external exposures and would not
weather a similar crisis as well.) The point is that, ultimately, the books
have to balance everywhere. That means that the huge structural imbalance of
China, which these debts represent, must be rectified. And that process, as
in all such matters, will be painful.

It is not clear how much pain
Chinese society can withstand before it fractures. This is clearly a concern
for Beijing as it tries, simultaneously, to reform the economy and to crack
down on dissent. The Chinese, like anyone in this fix, try to put the best
possible face on the situation. Which is why they exploded at Ernst & Young.
But even the government in Beijing couldn't shout down the ensuing tidal wave
of financial reports; instead, they grumbled and pointed to the passages that
said it could all be managed.

Perhaps it can. But if it can, it won't
be easy -- and we doubt that it is possible. We have been writing about this
problem for several years now, and people keep asking when the crisis will
come. Our answer is simple: If this isn't a crisis, what would a crisis look
like? The Chinese financial system is sinking under nonperforming and
underperforming loans. Mainstream Western analysts are all writing about the
problem and calling for reforms that the Chinese cannot possibly implement in
time to make a difference. At some point, the weight of evidence will shift
the behavior of the Western financial community, and that will be that.


In the meantime, let the exports flow -- for they surely will, and
in breathtaking quantities.

U.S. Perceptions of a Chinese Threat

By George Friedman

The U.S. Department of Defense released its
annual report on China's military last week. The Pentagon reported that
China is moving forward rapidly with an offensive capability in the Pacific.
The capability would not, according to the report, rely on the construction
of a massive fleet to counter U.S. naval power, but rather on development
and deployment of anti-ship missiles and maritime strike aircraft, some
obtained from Russia. According to the Pentagon report, the Chinese are
rapidly developing the ability to strike far into the Pacific -- as far as
the Marianas and Guam, which houses a major U.S. naval base.

Whether
the Chinese actually are constructing this force is less important than that
the United States believes the Chinese are doing this. This analysis is not
confined to the Defense Department but has been the view of much of the U.S.
intelligence community. There is, therefore, a consensus in Washington that
the Chinese are moving far beyond defensive capabilities or deterrence: They
are moving toward a strike capability against the U.S. Seventh
Fleet.

If this analysis is correct, then the reason for U.S. concern
is obvious. Ever since World War II, the United States has dominated all of
the world's oceans. Following that war, the Japanese and German navies were
gone. The British and French did not have the economic ability or political
will to maintain a global naval force. The Soviets had a relatively small
navy, concerned primarily with coastal defense. The only power with a global
navy was the United States -- and the U.S. Navy's power was so overwhelming
that no combination of navies could challenge its maritime
hegemony.

In an odd way, this extraordinary geopolitical reality has
been taken for granted by many. No naval force in history has been as
powerful as the U.S. Navy. The U.S. Navy does not have the ability to be
everywhere at all times -- but it does have the ability to be in multiple
places at the same time, and to move about without concerns of being
challenged. This means, quite simply, that the United States can invade
other countries, anywhere in the world, but other countries cannot invade
the United States. Whatever the outcome of the invasion once ashore, the
United States has conducted the Iraq, Kosovo, Somali, Gulf and Vietnamese
wars without ever having to fight to protect lines of supply and
communications. It has been able to impose naval blockades at will, without
having to fight sea battles to achieve them. It is this single fact that,
more than any other, has shaped global history since 1945.


Following the Soviet Strategy?

The Soviets fully
understood the implications of U.S. naval power. They recognized that, in
the event of a war in Europe, the United States would have to convoy massive
reinforcements across the Atlantic. If the Soviets could cut that line of
supply, Europe would be isolated. The Soviets had ambitious goals for naval
construction, designed to challenge the United States in the Atlantic. But
naval construction is fiendishly expensive. The Soviets simply couldn't
afford the cost of building a fleet to challenge the U.S. Navy, while also
building a ground force to protect their vast periphery from NATO and China.


Instead of trying to challenge the United States in surface warfare,
using aircraft carriers, the Soviets settled for a strategy that relied on
attack submarines and maritime bombers, like the Backfire. The Soviet view
was that they did not have to take control of the Atlantic themselves;
rather, if they could deny the United States access to the Atlantic, they
would have achieved their goal. The plan was to attack the convoys and their
escorts, using attack submarines and missiles launched from Backfire bombers
that would come down into the Atlantic through the Greenland-Iceland-United
Kingdom (GIUK) gap. The American counter was a strong anti-submarine warfare
capability, coupled with the Aegis anti-missile system. Who would have won
the confrontation is an interesting question to argue. The war everyone
planned for never happened.

Today, it appears to be the Pentagon's
view that China is following the Soviet model. The Chinese will not be able
to float a significant surface challenge to the U.S. Seventh Fleet for at
least a generation -- if then. It is not just a question of money or even
technology; it also is a question of training an entirely new navy in
extraordinarily complex doctrines. The United States has been operating
carrier battle groups since before World War II. The Chinese have never
waged carrier warfare or even had a significant surface navy, for that
matter -- certainly not since being defeated by Japan in 1895.

The
Americans think that the Chinese counter to U.S. capabilities, like the
Soviet counter, will not be to force a naval battle. Rather, China would use
submarines and, particularly, anti-ship missiles to engage the U.S. Navy. In
other words, the Chinese are not interested in seizing control of the
Pacific from the Americans. What they want to do is force the U.S. fleet out
of the Western Pacific by threatening it with ground- and air-launched
missiles that are sufficiently fast and agile to defeat U.S. fleet defenses.


Such a strategy presents a huge problem for the United States. The
cost of threatening a fleet is lower than the cost of protecting one. The
acquisition of high-speed, maneuverable missiles would cost less than
purchasing defense systems. The cost of a carrier battle group makes its
loss devastating. Therefore, the United States cannot afford to readily
expose the fleet to danger. Thus, given the central role that control of the
seas plays in U.S. grand strategy, the United States inevitably must
interpret the rapid acquisition of anti-ship technologies as a serious
threat to American geopolitical interests.

Planning for the
Worst

The question to begin with, then, is why China is pursuing
this strategy. The usual answer has to do with Taiwan, but China has far
more important issues to deal with than Taiwan. Since 1975, China has become
a major trading country. It imports massive amounts of raw materials and
exports huge amounts of manufactured goods, particularly to the United
States. China certainly wants to continue this trade; in fact, it urgently
needs to. At the same time, China is acutely aware that its economy
depends on maritime trade -- and that its maritime trade must pass through
waters controlled entirely by the U.S. Navy.

China, like all
countries, has a nightmare scenario that it guards against. If the United
States' dread is being denied access to the Western Pacific and all that
implies, the Chinese nightmare is an American blockade. The bulk of China's
exports go out through major ports like Hong Kong and Shanghai. From the
Chinese point of view, the Americans are nothing if not predictable. The
first American response to a serious political problem is usually economic
sanctions, and these frequently are enforced by naval interdiction. Given
the imbalance
of naval power in the South China Sea (and the East China Sea as well),
the United States could impose a blockade on China at will.

Now, the
Chinese cannot believe that the United States currently is planning such a
blockade. At the same time, the consequences of such a blockade would be so
devastating that China must plan out the counter to it, under the doctrine
of hoping for the best and planning for the worst. Chinese military planners
cannot assume that the United States will always pursue accommodating
policies toward Beijing. Therefore, China must have some means of deterring
an American move in this direction. The U.S. Navy must not be allowed to
approach China's shores. Therefore, Chinese war gamers obviously have
decided that engagement at great distance will provide forces with
sufficient space and time to engage an approaching American
fleet.

Simply building this capability does not mean that Taiwan is
threatened with invasion. For an invasion to take place, the Chinese would
need more than a sea-lane denial strategy. They would need an amphibious
capability that could itself cross the Taiwan Strait, withstanding Taiwanese
anti-ship systems. The Chinese are far from having that system. They could
bombard Taiwan with missiles, nuclear and otherwise. They could attack
shipping to and from Taiwan, thereby isolating her. But China does not
appear to be building an amphibious force capable of landing and supporting
the multiple divisions that would be needed to deal with Taiwan.

In
our view, the Chinese are constructing the force that the Pentagon report
describes. But we are in a classic situation: The steps that China is taking
for what it sees as a defensive contingency must -- again, under the
worst-case doctrine -- be seen by the United States as a threat to a
fundamental national interest, control of the sea. The steps the United
States already has taken in maintaining its control must, under the same
doctrine, be viewed by China as holding Chinese maritime movements hostage.
This is not a matter of the need for closer understanding. Both sides
understand the situation perfectly: Regardless of current intent, intentions
change. It is the capability, not the intention, that must be focused on in
the long run.

Therefore, China's actions and America's
interpretation of those actions must be taken extremely seriously over the
long run. The United States is capable of threatening fundamental Chinese
interests, and China is developing the capability to threaten fundamental
American interests. Whatever the subjective intention of either side at this
moment is immaterial. The intentions ten years from now are
unpredictable.

As the Pentagon report also notes, China is turning to
the Russians for technology. The Russian military might have decayed, but its
weapons systems remain top-notch. The Chinese are acquiring Russian missile
and aircraft technology, and they want more. The Russians, looking for every
opportunity to challenge the United States, are supplying it. Now, the
Chinese do not want to take this arrangement to the point that China's trade
relations with the United States would be threatened, but at the same time,
trade is trade and national security is national security. China is walking
a fine line in challenging the United States, but it feels it will be able
to pull it off -- and so far it has been right.

U.S. Defense
Policy: Full Circle

The United States is now back to where it was
before the 9/11 attacks. Defense Secretary Donald Rumsfeld came into office
with two views. The first was that China was the major challenge to the
United States. The second was that the development of high-tech weaponry was
essential to the United States. With this report, the opening views of the
administration are turning into the closing views. China is again emerging
as the primary challenge; the only solution to the Chinese challenge is in
technology.

It should be added that the key to this competition will
be space. For the Chinese, the challenge will not be solely in hitting
targets at long range, but in seeing them. For that, space-based systems are
essential. For the United States, the ability to see Chinese launch
facilities is essential to suppressing fire, and space-based systems provide
that ability. The control of the sea will involve agile missiles and
space-based systems. China's moves into space follow logically from their
strategic position. The protection of space-based systems from attack will
be essential to both sides.

It is interesting to note that all of
this renders the U.S.-jihadist dynamic moot. If the Pentagon believes what
it has written, then the question of Afghanistan, Iraq and the rest is now
pass�. Al Qaeda has failed to topple any Muslim regimes, and there is no
threat of the caliphate being reborn. The only interesting question in the
region is whether Iran will move into an alignment with Russia, China or
both.

There is an old saw that generals prepare for the last war.
The old saw is frequently true. There is a belief that the future of war is
asymmetric warfare, terrorism and counterinsurgency. These will always be
there, but it is hard to see, from its report on China, that the Pentagon
believes this is the future of war. The Chinese challenge in the Pacific
dwarfs the remote odds that an Islamic, land-based empire could pose a
threat to U.S. interests. China cannot be dealt with through asymmetric
warfare. The Pentagon is saying that the emerging threat is from a peer -- a
nuclear power challenging U.S. command of the sea.

Each side is
defensive at the moment. Each side sees a long-term possibility of a threat.
Each side is moving to deflect that threat. This is the moment at which
conflicts are incubated.

Send questions or comments on this article to analysis@stratfor.com.