The Chinese banking system is truly the Wild West of the banking world -- or, more accurately, a "Wild East." Analysts worry that Chinese banks are hiding bad loans on their balance sheets as "investment receivables," which require little or no reserves for loan losses.
China's growing pile of bad debts is probably partly to blame on its management of its currency, creating incentive for "hot money" to flow into the country to capitalize on its appreciating currency.
In this segment of Industry Focus: Financials, The Motley Fool's Gaby Lapera and Jordan Wathen discuss how bank accounting and monetary policy decisions are intertwined.
A full transcript follows the video.
This podcast was recorded on Dec. 12, 2016.
Gaby Lapera: Another thing that's been really big in the news lately is China has decided to use this method of funding, labeling loans, that is really interesting, and is not something that's available to American banks because of the regulation that we have here. They have this thing called an investment receivable. An investment receivable is basically a loan. It's a debt that's owed to the company, but it has a lot more favorable accounting provisions than you would get for a loan. Additionally, Chinese banks don't have to keep reserves in place for receivables. So if an investment receivable were to go belly-up, Chinese banks don't have to have any capital in reserve to minimize the effects of that, which allows the banks to use more of their capital but is also super risky.
Jordan Wathen: Right. It's a problem of really bad disclosure. When it comes to financial institutions, the financial institutions you want to invest in are the ones that have great disclosures. The Wall Street Journal really ran with this story. They talk about how it's the equivalent of $2 trillion in loans that are now classified as these investment receivables. And they've grown about three times since 2013-2015. That's a two-year stretch, three times growth in that category, just because they're hiding what many people believe -- and in some cases, they probably are -- the bad loans in these investment receivable accounts.
Lapera: Yeah, which is definitely really interesting. This kind of follows, I don't know if our listeners follow China's debt problems, but China as a country has been getting in increasingly more and more debt. The official level of debt now is 2.5 times the gross domestic product. All of this vernacular here, loosey-gooseyness, is all tied together.
Wathen: Right. If we take a step back, let's go back more than a decade, let's go back to 2005. China says to the world, "OK, fine, our currency is undervalued, we will let it appreciate." So investors around the world hear that and they think, "Wow, here's a chance to make tons of money if we know, directionally, China's currency is only going to go up in value." So if you're an American, the move, if you can do it, is to basically take dollars and go buy Chinese currency, and hope for the exchange rate to change in your favor. At the time -- and this was a big deal especially during the financial crisis and thereafter -- you could borrow money in the United States at 1% and take it to China and earn 5%. So not only were you earning the difference in exchange rates as they fluctuated, but also what they call positive carry, or the interest rate differential, by taking your money overseas.
Lapera: Yeah. That's really interesting. This all ties together into what we were talking about earlier, which is that the Chinese government can kind of do whatever it wants when it comes to financial markets and their currency, which makes investors abroad trust it a lot less.
Wathen: Right. Basically, what it did was tell the world, "Hey, bring all your money to China," so the world started bringing money to China, and then you have all this money circulating around the economy. And when there's tons of money going around, that's when you get these big underwriting errors, that's when you get these loans for businesses that couldn't possibly repay them. You also get the over-investment, you get the Chinese government building houses that no one is going to live in, roads to industrial complexes that have no factories, things of that sort. This sort of hot money floating around in China has incentivized a lot of bad investments.