China's Looming Crisis

In a poorly reported story, this week the Chinese government intervened to stop a serious drop in the share prices of China's largest banks. China's sovereign wealth fund further increased the government's stake in the four largest Chinese banks as an answer to international investors who are selling off their holdings in those banks. Before the investment, Beijing held majority ownership in all of these banks already.

By putting more money into shoring up these banks, the government in Beijing has effectively performed a second bank bailout albeit a mini-bailout in comparison. The first bailout was in 2008 during the height of the global economic crisis to the tune of US$586 billion. The recent bailout only cost China US$32 million, but the sum isn't my real concern.

For several decades, China has survived as a schizophrenic hybrid economic system where capitalism lives alongside rigid state control. This has led to the staggering growth in the Chinese economy over the past two decades -- but to be fair, China started at the bottom and only had one way to go. But for China, growth is now mandatory.

Decades of currency devaluation and cheap labor kept Chinese exports very attractive but that will soon unravel. 

China is still a controlled economy, regardless of the trappings of capitalism. The government still calls all the shots and that means corruption is the name of the game. In China you don't get a bank loan because you have the best business plan and a track record of success, you get the loan because your mother's cousin's second husband's college roommate is a high level mandarin in some arcane government bureaucracy and knows who to bribe to guarantee the loan. Because there are no laws on transparency, there is no way to know the economic health of those institutions.

The underlying problem with the Chinese economy is that they are not in a position to handle a real decline in GDP. Whereas the United States has weathered plenty of recessions and always manages to come out of them after plenty of pain and political blame-throwing, the Chinese economy is largely built on fiction. With China's enormous reliance on exports, the global economy is a very large factor in China's continued economic health.

But the global recovery keeps getting stalled by the European debt crisis du jour and the threat of a double-dip recession in the United States. The combined factors have slowed Chinese growth more than expected. And once that growth disappears, the real state of China's economy will rear it's ugly head because the growth won't be there to hide the losses.

Essentially, this is the same scenario that started Japan's Lost Decade except on a much, much larger scale. All Bejing managed to accomplish with this micro-bailout is to move the money around in a circle -- hide the losses in one place by transferring them somewhere else. It's the Byzantine financial equivalent of stealing from Peter to pay Paul except in this scenario they are stealing from Beijing to pay Beijing.

My advice to anyone doing business with China is to start looking into alternative sources. It is only a matter of time before this financial merry-go-round collapses.

R-Squared Computing | Lou RG | Nearly Free IT | Firm Wisdom

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