Making the new sub prime – Part 1 – Backdoor to China


by David Malone

A little over a year ago in an article called “China’s New Revolutionaries”, I wrote, “I think the mistake everyone is making is to assume that because China is a ‘communist dictatorship’ this means the party must be in control.  I think this is a dangerous assumption.”

My point back then was that while the central bank was trying to reign in lending, the regional governments, banks and developers were largely ignoring the central bank’s lending restrictions.  I looked at official versus academic estimates of the amount of debt that was swimming around in China’s economy and how little real control the central bank appeared to have over its increase.

“… according to Shih and others the REAL level of Chinese debt could reach 96% of GDP by next year.  The official IMF estimate is 22%. That 74% gap is the measure of how much the central government is NOT in control of who is taking on what debt.

My point is that we shouldn’t assume ‘China’ has a plan, or if it does, that anyone has any intention of following it.  The era of absolute power of the party is over, but not because of students in Tieneman Square fighting for freedom of speech.

The new revolutionaries aren’t students and the revolution isn’t about a desire for democratic freedom.  Those willing to challenge the party and ignore its decrees are the new aspirant middle class and they are driven by the desire to be rich.”

Since then the evidence seems to me to have accumulated.  Today I think we are seeing a major shift in power relations within China, a quiet revolution, in which the power to control China’s lending and debt is shifting away from central government.  What I think we are seeing is the opening of a financial backdoor to China.  One that lies outside of central bank and central government control.

If I am correct then this will create massive changes within China – nothing short of the crowning of a new financial elite to contest control with the old political elite of Beijing – and for the rest of us it will create a new source of sub prime securities, this time made in China.

First we need to understand a little about power relations within China.  The central government is concerned with national inflation and has been trying to reign in the lending and land speculation bubble that is, at least in part, driving that inflation.  The regional governments do not have this concern.  At least not as their priority.  Perhaps they should, but their actions say quite clearly that they don’t.  Prudence is seen as a central government concern.  Regionally, it is all about out-competing other regions to be the next new powerhouse of investment and development.

In all countries there are differences between regions/states and central government.  In China, however, the regional governments have something regions in the West do not.  They have huge untapped resources which they, not the central government ‘own’.  I put own in quotes because in theory everything is ‘owned’ by the communist party on behalf of the people.  But on a practical level the regional government’s have control over and get the proceeds from selling off land in their region.  If the central government elite tried to seize back control of or the revenue from regional land sales it would put the Beijing elite on a collision course with the regional elites throughout the rest of China.  Beijing would lose.  So in practice the regions own the land.

The regional elites are the party cadres, officials, bankers, developers and business people in each region.  Even developers who are nationally prominent have as much to gain from the regions as they do from Beijing, probably more.  In fact it is often the case that economic prospects are seen as the gift of the regions while what comes from Beijing is mainly restraining laws.

The regions have land they want to privatize.  The income from selling the land is the river of money from which each official, regional politician, developer, bureaucrat, banker and investor seeks to siphon their cup-full of wealth.  What they all need in order to make it work is a developer who can buy the land, build on it and sell the properties on.  For that the developer needs cash.  And that is where the central bank and government has been trying for over a year to exercise control by restricting the amount of lending Chinese banks can do.  They have done this through raising interest rates and by raising the amount of capital the banks must hold against their loans.  For 18 months it has just not worked.  Now, however, the pressure may finally be working.

An article at Zerohedge recently reported that property prices in the Beijing area had plunged 27% and wondered if this was the first sign of the Chinese property bubble collapsing.  A further article reports that prices that had been rising even in February, suddenly dropped in March in a number of cities.  The article suggests this might be evidence that the tightening has finally had its effect on lending and debt.  And so it might.  In which case the Chinese regions will be looking all the harder for ways of getting  funding elsewhere and by unofficial means.  If the flow of hot money from China slows it will also mean that Australia will soon be facing a property crisis.

Then, this last week we had the amazing spectacle of Wen Jiabao, the Chinese Premier, “asking” local governments to take responsibility to keep housing affordable and saying,

“The central government’s aim to control the property market is ‘clear’ and the determination is ‘firm’ …”

Since when did Communist supreme leaders “ask”?  And when did they feel it necessary to make their determination “clear” and “firm”?

The failure of the Central authorities to control the flow of loans, debt and money in to the Chinese economy for most of the last two years, is also attested to by how fast inflation is rising. A major part of inflation in China is the property bubble.

The question then, is what will now happen in the regions now that there may finally be a credit shortage from Chinese banks, and what does it have to do with Western banks and securitization?

Here is my suggestion.

On one side the regions have land to sell and developers who want to buy and develop it.  What they both need is loans to finance the enterprise.  The central government is doing its best to limit funding from those it has the power to regulate – Chinese banks and the few Western financial institutions that operate inside China.  On the other side we have a Western banking system which needs to find two things: a place or venture which will provide them with a higher return on their money than they can get at home, and a securitization system, essential to how the banks operate, which is in dire need of something to securitize.

Between the two is Hong Kong.  Western banks used to salivate over getting a licence to operate in China.  But I think that dream has faded in to a background hope while dreams of China’s billions have gravitated to Hong Kong.

Why put up with all the interference from Central authorities inside China, when you can operate ‘outside’ of mainland Chinese regulations in Hong Kong?  Hong Kong has always been the Asian portal in to the off-shore world of unregulated capital.  When they took over, the Chinese did nothing to change that aspect of Hong Kong.  Why shouldn’t China have its own off-shore conduit?  It’s like being a nuclear power – it gives a nation membership of a very exclusive club.

But the offshore world is a franchise.  Countries can have an outlet/inlet but that doesn’t mean they control it.  Hong Kong does not work primarily for China or the Chinese.  Just as London does not work primarily for Britain or the British.  Hong Kong works for the extra-territorial, supra-national interests of global capital, just like London, Jersey, the Cayman Islands and the Virgin Islands.  And there is the rub.

What is now, I believe, maturing fast in Hong Kong is a fully fledged off-shore, off-balance sheet portal into the world of shadow banking and unregulated, borderless finance.

Hong Kong now houses 148 international banks.  The most recent to have been granted a licence is LGT Bank in Liechtenstein AG.  The nature of the bank and its arrival in Hong Kong are indicative.  The bank is the largest by Tier-1 capital in Liechtenstein and is one part of the LGT Group.  The group is the largest private asset and wealth manager in Europe to be owned by one family.  In this case the royal family of Liechtenstein whose head is the reigning monarch of Liechtenstein, Prince Johannes (Hans) Adam Ferdinand Alois Josef Maria Marko d’Aviano Pius von und zu Liechtenstein.  Or just Hans-Adam II if you’re passing in the street and are in a hurry.  The Prince is the main beneficiary of the bank and the entire trust.  His personal fortune is estimated at £7.6 billion.

The bank has around 1900 employees in 20 locations which include all the major financial centres, plus Bahrain, Cayman Islands, Malaysia, Singapore, Uruguay and Hong Kong.  The presence of the Cayman Islands in the list clearly indicates the bank has an interest in providing off-shore, no questions asked financing, tax evasion and full service banking secrecy.

Back in 2008 there was a furious row between Germany and the Liechtenstein royal family when Germany accused Liechtenstein of harbouring secret bank accounts for up to 1000 of Germany’s wealthiest elite to help them evade up to €4 billion in German taxes.

It’s a wonderful little story.  One of Germany’s intelligence services paid a former Liechtenstein banker for passing bank information about the accounts of German tax evaders to the German authorities.  Prince Alois, who was caretaker ruler of Liechtenstein at the time, and furious at his country’s and his bank’s secrecy laws being breached, was quoted as saying,

“Obviously Germany wants to be a big-time receiver of stolen goods …”

Seemingly oblivious to the possibility that his bank was the receiver of ‘stolen’ German tax money.  Anyway I digress.  It would seem the bank thinks there might now be a call for its services in Hong Kong.

And I think they’re right.  Chinese Banks want to lend even as they agree not to.  Regional government officials want to sell land even as land already sold piles up.  Developers want to develop more units even as millions stand empty.  The answer to all these desires is the bond market in Hong Kong.

I’ll break here just to stop this getting too long.

In part two I will suggest that the People’s Bank of China, China’s central bank, has lost control and that the revolution has moved off-shore.