A Recipe for Disharmony

An Asia Times article by Martin Hutchinson paints a very sobering picture about China’s bad debt situation. The latest estimate is reported to be between US$1.2 trillion and US$1.3 trillion, which would make the often touted sovereign wealth fund of US$200 billion look almost paltry, not to mention that one-third of this fund is slated for the purchase of bad loans from Chinese banks and another third to recapitalize China Agricultural Bank and China Development Bank which are destined for privatization. What is even scarier is that, according to Hutchinson, all of China’s foreign exchange reserves, to the tune of US$1.4 trillion, might be needed to plug holes in the banking system when the inevitable liquidity crisis occurs. The article also says that China’s banking system bad debts account for about 40 percent of her GDP and are in real terms about five times those of the United States, given her economy is around one-fifth the size of the latter’s.

The article then goes on to draw parallels between Latin America and China in terms of very high inequality, persistently high inflation and rampant corruption, highlighting the fact that China’s government lacks any genuine understanding of the free market and her economy is increasingly dominated by special interests, with a small entrenched elite gorging themselves (immorally and illegally) with the fruits of economic growth at the expense of the disfranchised masses.

It is perhaps this latter malaise that is potentially most hurtful to China’s society and future as it is a sure breeder of social discord and instability.

The stock market is one of the best places to illustrate how the masses are being taken advantage of by a small band of privileged predators who are in fact one type of special interest group, generally known as the “insiders”.

A Forbes article by Gady Epstein tells how “front-running” and other types of insider trading in the stock markets go unregulated and unbridled.

“Front-running” is essentially a scheme where a manager of a mutual fund buys shares for himself privately before his fund buys, then sells for a profit after the fund's much bigger purchase helps drive up the share price.

This passage sums up how insiders operate:

“Crucially, many of the best-placed insiders are poorly paid in relation to the power they wield. State-owned companies with extra cash can pool their resources in market-moving schemes; some big-name investment consultants, commentators and journalists collect payoffs to hype stocks; and fund managers can use their clout to favor certain listed companies. All of these industry players can team up behind "dealers"--the word in Chinese, zhuangjia, is the same used for casino dealers--to manipulate one particular stock.”

In the two years since January 1, 2006 the CSI 300 has soared 535 percent, and many investors will not feel the pain until the bottom falls out of the market, as their investments have thus far been profitable for them. What they don’t realize, (or simply ignore due to the greater-fool theory), is that more profits are being scalped off by others on their investments through fraudulent means. Fraudulent though those acts may be, few stock cheaters get caught. Lack of staff, legal authority and maybe political clout (where well-connected state-owned company bosses are concerned) is attributed to the China Securities Regulatory Commission’s ineffectiveness in prohibiting such acts, which would be forbidden in western markets. Another plausible explanation for inaction is that China’s leaders are wary about doing anything that might prick the bubble before the Olympic Games even begin. But it is unfortunate that most market players seem to count on such plausibility.

The only “outsiders” of stock transactions, or victims of insider trading, are the mutual funds’ customers and the average Chinese investors. These are the people on the street who gleefully pour their life savings into the stock market on a daily basis, oblivious to the fact that the stock investment scene is cloning Japan’s stock bubble in the 80s and Hong Kong’s dot-com mania in the late 90s. One wonders how many of the mainland investors have heard about these at all, let alone the aftermath that the eventual bubble bursting brought.

What is even more troubling is that state-owned enterprises, who can get loans easily from banks, have a habit of lending the loaned money to the securities companies instead of using it for production purpose, according to an “insider dealer” who was interviewed by Epstein. If anything, this kind of imprudent lending makes China’s domestic banking system look that much more precarious, when the system is already plagued by bad debts accumulated over the past decade as a result of “saving” money-losing state-owned companies that would otherwise have gone bankrupt.

At the end of the day, it is certainly a matter of when rather than whether China will face the backlash from her equity and debt bubbles. When she does, it is the “outsiders” who will suffer the greatest. Perhaps one good thing that will come from this is that China will be forced to look seriously at her banking and securities regulatory framework and maybe bring it up to international standards.