Foreign Lenders Head For The Exits In China

(Washington, D.C.): Roughly one year ago, the Casey Institute made a bold prediction early
in
Asia’s dramatic financial downturn: “The next shoe to drop in Asia is likely to be China.” ¹ By
contrast, the conventional wisdom held that the PRC would remain insulated from the region’s
economic dislocation due to China’s non-disclosure or “fudging” of financial statistics, the
non-convertibility of its currency, its seemingly impressive hard currency reserves (which could
be
called upon to prop-up its bad-debt-laden banking sector), and the fact that it still enjoyed at the
time robust foreign direct investment (which should have enabled liquidity shortfalls to be
postponed, or at least blurred).

The attached editorial in today’s Wall Street Journal bears out the Casey
Institute’s
prognosis that nothing short of a complete restructuring of China’s financial and banking
systems would stave off a slow-motion economic train wreck in the PRC. It also
suggests
that those who bet on the conventional wisdom have learned a costly — but useful —
lesson. ²

The Squeeze

By the time China allowed Guandong International Trade and Investment Company (GITIC)
to
go under in late October of last year, the trend was apparent: Thanks, in large part, to the
“emerging market” meltdown that occurred in late 1997 and in 1998, the mainland experienced a
sharp reduction in foreign direct investment flows. As the Wall Street Journal
reported on 8
February 1999, this flow of capital suffered a roughly 50% drop-off in the corresponding periods
in 1997 and 1998. When the government walked away from one of its largest so-called
international trade and investment companies (ITICs) in Guangdong — thereby permitting it to
default on roughly $4.7 billion of hard currency debt, much of it owed to foreign investors and
creditors — an already apprehensive market was further shaken.

In the wake of this decision, the Institute pointed out that — notwithstanding the long-term
economic benefits that would accrue if such insolvent entities were allowed to go belly-up — the
short-term effect would be to exacerbate an already serious liquidity squeeze in the ensuing
months: “[T]he closing of GITIC could well be the first step toward a debilitating, nation-wide
liquidity crisis.” ³

As it happens, that liquidity crisis is continuing to intensify according to reports in the 8
February
editions of the London Financial Times: “Several foreign banks are taking more
aggressive steps
to recover money from Chinese borrowers, such as calling in loans and demanding accelerated
debt repayments[and] international lenders have begun cutting off credit to Chinese
borrowers.”

The reason for this seeming race to reduce Western credit exposure in China is clear:
Foreign
creditors and investors are now questioning the ability of Chinese entities to repay loans
and the government’s willingness to step in if default appears imminent. Unlike the cases
of
Russia, South Korea and Thailand, where sovereign debt crises served to worsen liquidity
problems in the private sector, China has taken pains to cordon off its “economic zones” from a
still-solvent central government. If the accelerated loan repayments, diminished credit lines and
declining interbank deposits seem at the moment unlikely to spur a wholesale economic collapse,
they do appear to be symptoms of more serious problems to come.

‘Red Chips’ in the Red?

In addition to the increasing financial pressure which China now confronts, a number of other
worrying indicators have hit the computer screens of global traders and investment bankers this
year:

• China’s Civil Aviation Administration has indicated that the country will have to
  delay the
  delivery of an unspecified number of new airplanes (at least 50) slated to arrive before
  the
  year 2002, ostensibly because capacity outstrips demand in a sluggish travel market.

• Shandong International Power Development Company postponed indefinitely a
  scheduled $285 million initial public offering (IPO) due to “highly volatile market
  conditions.” Of particular interest was the lead manager’s inability to garner orders from
  “the
  six investment banks it hired to help sell the shares.” More importantly, this offering —
  along
  with two others which have recently been withdrawn — was seen by many market observers as
  a litmus test of China’s post-GITIC credit environment.

• The Hang Seng index in Hong Kong has lost nearly 25% of its value
  since 1 January with
  so-called “red-chips” hit particularly hard.

Individually, any of these developments would probably be seen as constituting little
more
than a temporary glitch in the system. Taken together, however, they illustrate the fraying of
market confidence in China.

Bottom Line

Beijing’s decision not to prop up ailing regional investment trusts has proven to be, at least in
the
short-run, a momentous decision. As the Casey Institute expected, a liquidity crisis has emerged
as foreign lenders and investors quickly appreciated that “moral hazard” — or the
government
intervening to make them whole — was no longer a sure thing in China. The jury is still
out:
Has the Chinese government triaged its financial sector by permitting selected bankruptcies while
implementing needed structural reforms, particularly with respect to the huge overhang of
non-performing loans? Or will this sector wind up taking greater-than-expected hits as foreign
capital
flows contract, exports suffer (as the firms most immediately affected are manufacturers and
conduits for exports), growth slows to below 7% and China is forced to devalue its currency later
this year?

Notwithstanding some $140 billion in advertized reserves — much of it invested in U.S.
Treasuries
— the Institute predicts that the latter scenario is the more likely to materialize,
with the
consequent, serious blowback in prospect for an already beleaguered Hong Kong. The
Wall
Street Journal editorial, while largely confirming this gloomy prognosis, holds out this one
bit of
hope: Western lenders and investors may, at long last, be getting serious about their
creditworthiness and due diligence assessments in China.

If so, it is to be earnestly hoped that they will start asking questions often not delineated in
prospectuses and other documentation — such as the true identity of the Chinese borrowers and
their senior management, to whom do they report and what is the real purpose of the loans?
Should they adopt this prudent approach, chances are that not only will investors and lenders be
spared serious loses in China, but the prospect averted of serious harm to U.S. national security
arising from American capital markets underwriting what amounts to an increasingly menacing
Chinese military-industrial complex.

¹ See the Casey Institute Perspective entitled
How Bill Clinton Proposes To Spend The
‘Surplus’: Bailing Out Foreign Governments – And Their Western Underwriters ( href=”index.jsp?section=papers&code=98-C_02″>No. 98-C 02,
7 January 1998).

¹ See Market Confidence In ‘China Inc.’
Appropriately Shaken — G.I.T.I.C. Bond Default A
Taste Of What Is To Come? (No. 98-C
177, 29 October 1998).

¹See Hedging Financial Bets In China: Will ‘ITIC’s’
And Other Entities With P.L.A.
Connections Be Bailed Out By Beijing? (No.
98-C 182, 12 November 1998).