Wednesday, October 03, 2007

The Paper Dragon redux...

Markets are, as evidenced by the recent peformance of the Hang Seng, finally waking up to the Macro prospects for China in light of a depreciating dollar against a Yuan that the PRC will not allow to
appreciate. Something has to give, and it will. As I have said many times, China (which I have pejoratively called "The Paper Dragon") is in deep trouble. If it allows the Yuan to appreciate, its export industry will be "adversely effected". If it does not, rampant money creation (read: inflation) is the result.

Now, academics (in China, no less) are waking up to the facts of life as well. China will now face an immense challenge to its legal rule set as the temptation to keep politically connected (yet functionally bankrupt) businesses afloat...which is the "objective necessity" (to borrow from the incomprehensible Marxist lexicon) of central planning. Ruling with an Iron Hand on a sliding scale indeed.



Not all of my readers will agree that large Chinese banks are basically insolvent, but I am very skeptical that the published figures correctly state the extent of bad loans. They almost certainly understate the extent of expected bad loans associated with the surge in new lending over the past three years.

The option framework predicts that in such a case investor perceptions of the quality of management or of levels of non-performing loans will have little to no impact on the share price performance of Chinese banks. Instead share prices will primarily reflect investor perceptions of changes in China’s underlying economic volatility. China’s banks are expensive, in other words, not because they are in good shape, but rather because there is so much future uncertainty about the Chinese economy, and it is increases in that uncertainty, not improvements in the quality of the banks, that are most likely to drive prices up.

This has happened in many countries undergoing reform besides China. For example when Mexico’s 18 banks were privatized in 1991-92 as part of the massive economic and political reforms the country was undergoing (I was part of the team at credit Suisse First Boston that advised the government on the privatization), their purchase prices far exceeded even the most optimistic estimates provided by the advisors, the government, and the banking industry, which were largely based on discounting expected earnings.

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