Earlier this week I was talking to my grad student Shang Ning about the awful markets around the world, and he suggested that maybe it was a good thing that Chinese stock markets were closed this week for National Day since this would act as an extended circuit breaker that might protect them from collapsing in sympathy with the rest of the world.  We agreed, however, that whether or not next week would open with a big downward break would depend crucially on whether the rescue bill was passed by the US Congress and, if so, would cause markets around the world to soar.

Well, the bill was passed Friday, but markets continued to fall.  Hong Kong’s Hang Seng Index lost 2.9% yesterday capping the fifth consecutive losing week with a loss of 5.4%.  Unless the government announces some extraordinary measure over the weekend to boost stock prices I expect that next week is going to start out badly.

It would be only reasonable if it did.  On Friday the US government reported that the US economy had lost 159,000 jobs in September, making it the ninth consecutive month that the US job market has contracted, and suggesting that it is going to be harder and harder for the US to avoid a slowdown in consumption.  China has bet its economic future very heavily on sustained US consumption driving its economy forward, and faltering US demand – coupled, as it is almost sure to be, with faltering European demand – cannot help but slow China’s export growth.

This is, in my opinion, one of the two most likely channels by which global financial difficulties will become Chinese financial difficulties (the other is if perceptions of rising risk cause liquidity outflows from the banks).  If exports slow, and domestic consumption is unable to accelerate sufficiently to replace it – and in fact I expect domestic private demand to slow – there is a good chance that domestic investment will also slow, after a lag that sees rising inventories.  In that case three of the four pistons in China’s economic engine will falter. 

This is dangerous for the financial system, of course, because any economic slowdown will finally put the Chinese financial system to its first real test since the massive expansion of the past four years, and I am not sure it will pass the test very easily.  The current issue of Caijing actually has an interesting article on the subject, indicating that quite a lot of people are becoming increasingly worried about that particular risk.  The article says:

It’s the most pain China’s commercial banks have felt since a reform of the shareholding system began under fairly good economic conditions. Now, as economic growth slows, factors such as changing liquidity positions, fluctuating equity prices, loan quality downgrades and policy adjustments may bring adverse effects.  All this change has given commercial banks a full-scale test, especially in terms of incentive mechanisms, risk control maintenance and income growth styles. This testing process has five key aspects.

First, the NPL ratio is likely to bounce. The overall ratio in the banking industry may rise if most economic adjustments occur in the nation’s eastern coastal area.  Data show NPL ratios for loans to small- and medium-sized enterprises have been rising in this region.  

Second, the loan growth rate is falling.  Commercial bank income from intermediary business has expanded steadily in recent years, but interest income is still the main income source.  With a guaranteed loan-deposit interest rate differential, banks rely heavily on loan growth to generate profit.