You don't really need more than one apartment, do you? Photographer: Brent Lewin/Bloomberg
You don't really need more than one apartment, do you? Photographer: Brent Lewin/Bloomberg

(This is the third article in a four-part series.)

In part two of this four-part series, I wrote about China’s shadow banks and the government’s efforts to assert more control over them.

The easiest way to curb -- even eliminate -- the shadow banks is to deregulate interest rates and erase those institutions' competitive advantage. If inefficient state-owned enterprises were also privatized, they wouldn't need to borrow at below-market rates and would lose their political and competitive advantages over smaller businesses. Putting all financial institutions under the same regulatory framework would solve a lot of problems, but powerful state-owned enterprises are resisting vigorously.

Shadow Banking

Still, some of these changes are in the offing. Actions by the central bank, the People’s Bank of China, to weaken the yuan have reduced market interest rates to the disadvantage of shadow banks. Last summer, controls on bank lending rates were lifted. And the PBOC has been working with the International Monetary Fund on the mechanics of interest-rate liberalization. These steps, of course, would allow the state banks to catch up with their shadowy counterparts in attracting deposits.

With rate deregulation, banks will need to compete for deposits. Are free toasters and gambling junkets to Macao coming soon? Higher deposit rates will give consumers more spending money but they will also raise interest costs for state-owned enterprises, which will need to restructure to survive. Banks also will need to compete with the private banks the government plans to establish, and they'll need to push up lending rates to offset higher deposit rates. That would challenge local governments, real estate developers and others that are struggling with debt repayments.

Of course, some banks are likely to get into trouble with excessive deposit rates and risky loans, so deposit insurance and a mechanism for handling busted banks are still needed. Prime Minister Li Keqiang has promised to institute both.

Nevertheless, these safeguards are no guarantee against widespread financial problems. Before deregulation in the 1980s, the financial sectors of Finland, Norway and Sweden had a number of important similarities to China's today. From 1978 to 1991, the Nordic countries liberalized their financial markets, which set off a sustained lending boom, capital inflows, rising asset prices, and rapidly increasing consumption and investment. By pegging its exchange rate to the dollar, these countries prevented monetary policy from reining in the boom with interest-rate increases. Nor were fiscal policies tightened enough to control the bonanza, although national budgets displayed large surpluses due to rising tax revenue from higher consumption, wages, property values and capital gains.

The boom turned into a bust around 1990, with capital outflows, widespread bankruptcies, falling employment, declining investments, negative economic growth, bank failures and currency crises. Eventually, the central banks of Finland, Norway and Sweden were forced to recapitalize their banks and move to flexible rates in the fall of 1992 to avert depressions.

U.S. savings and loans went through the same exercise in the 1980s. Congress sought to help the thrift industry by ending fixed deposit rates. But in doing so, it forced these firms to pursue higher-yielding loans with new risks. Meanwhile, the balance sheets of the thrifts were stuck with long-term, fixed-rate mortgages, which were made at lower rates in the 1960s and 1970s. With high inflation and competitive pressure for deposits pushing up the interest rates they had to pay, most thrift institutions reported large losses in the early 1980s.

Compounding the problem, tax-law changes touched off a huge commercial real estate boom. In order to pay higher deposit rates after deregulation, the thrifts climbed aboard. But by then, the boom was close to peaking, so they lent to the worst borrowers.

In the mid-1980s, the boom in commercial real estate went bust. The passage of the 1986 tax-reform law, which eliminated “safe harbor leasing” and other real estate tax advantages, contributed to the bust. Depositors fled from the thrifts, which failed in frightening numbers. The Federal Savings & Loan Insurance Corp., the industry’s regulator, had only $6 billion in assets. They were soon gone. So Congress created the Resolution Trust Corp. to clean up the mess. More than 1,600 thrifts were eventually closed at a taxpayer cost of $160 billion, a huge sum in the 1980s.

I have run through the short history of the U.S.'s and Scandinavia's fiascoes with overlending because it's not at all clear that the Chinese will be better at handling interest-rate deregulation.

Real estate has been an investment darling since 2009, when China countered the global recession with massive bank lending. Thrifty Chinese households save almost 30 percent of their incomes and have few other investment opportunities. Stocks continue to slide with the Shanghai Composite Index off 67 percent from its October 2007 peak. Government regulation prevents the widespread movement of investment funds abroad. Government-controlled bank deposit rates pay a trivial 0.35 percent, well below the 2.4 percent inflation rate.

So beyond the shadow banks, real estate has been the star -- much to the displeasure of Chinese leaders, who hate the related speculation. Government attempts to curb the earlier leap in real estate prices by limiting multiple apartment ownership and restricting financial leverage may finally be working.

China’s Property Climate Index, which tracks sentiment in the real estate industry, climbed 12 percent from March 2009 to a year later, but dropped 9 percent from last December through this March. Prices for new real estate in major cities such as Beijing, Shanghai, Shenzhen and Guangdong leaped 45 percent between February 2012 and this February, but then fell 7 percent through April. Given the ghost cities and other measures of extreme overbuilding, the recent slide in real estate values could evolve into a rout, with considerable loss of Chinese wealth and financial institutional failures.

China’s Managed Markets

Even if only one of the eight problems I’ve explored in this series surfaces, it’s far from clear that it can be contained without leading to a full-blown crisis, despite the best efforts of Chinese leaders. This, then, is the ninth potential problem for China: botched bailouts. Sure, the Chinese have plenty of money to pacify malcontents as they carry out their anti-corruption campaign. The PBOC, like any central bank, can create money out of thin air to bail out failing financial institutions.

But the Federal Reserve also had limitless assets when the subprime mortgage market started to crash in February 2007 -- long before the crisis spread to Wall Street. But the Fed was unaware of the unfolding subprime collapse and the near certainty that it would drag in the major banks with dire consequences.

Transcripts of the Fed’s unscheduled Jan. 21, 2008, meeting, almost a full year after the subprime collapse began, have Chairman Ben Bernanke admitting, “We are behind the curve.” The recession officially started in December 2007, but only in May 2008 did Janet Yellen, the best forecaster of the bunch, say she suspected a recession had begun.

The Fed did end up bailing out the financial sector, but it didn't act decisively until after the crisis unfolded. Of course, Congress and the George W. Bush administration were equally slow in understanding the financial risks. As with monetary policy, there was no shortage of money for fiscal stimulus. Washington certainly had plenty of incentive to prevent the deepest recession since the 1930s. The problem was a lack of understanding of the depth of the problems and the absence of early, decisive actions.

I see a distinct possibility that the Chinese government will also be slow to deal with crises if the problems I’ve enumerated explode. Sure, Chinese leaders have the benefit of seeing the tardy actions by the U.S. and other major developed countries in 2007-2008. But China may not see close parallels. For example, the PBOC has been trying to reduce excess liquidity in the system and depress the yuan. In contrast, the Fed did neither in 2007.

If the weaker yuan or runs on shadow banks cause money to leave China and liquidity to dry up quickly, would the central bank reverse gears in time? In the past decade, the PBOC has been slow to respond to huge capital inflows and may be equally tardy if the circumstances reverse.

A financial or other crisis in China would certainly be an adequate shock to shift investor sentiment from the present “risk on” to “risk off.” Furthermore, it would spread quickly to other emerging economies, especially those that depend on China to buy their commodity exports. Commodity prices would no doubt suffer further substantial declines as a result.

In part four of this series, I’ll outline investment strategies to take advantage of any severe problems in China.

To contact the writer of this column: Gary Shilling at insight@agaryshilling.com.

To contact the editor responsible for this column: Paula Dwyer at pdwyer11@bloomberg.net.