You just got off the phone with your boss, the weekly call from headquarters where he asks you to explain things in China that defy ready explanation.
This week's topic: shadow banking and China's softening car sales.
"I know banking and I know shadows," the boss says a little impatiently, "but what the hell does shadow banking mean and why does it affect us?"
"You're a smart guy, boss," you say. "Ninety percent of China's car buyers pay cash to purchase their vehicles. But have you ever wondered where they get the cash?"
"Think of shadow banking as a giant slush fund," you say, regretting the words as soon as they come out of your mouth. (Your boss will wonder how you know such things. But you can't stop now.)
That slush find is directly correlated to car sales. It allows well-connected car buyers to borrow money off the books. And if the government closes that pipeline, car sales dry up.
Industry analysts attribute slower car sales to the end of tax breaks on small cars last December. But they're missing the point.
In 2010, the government raised the sales tax on small cars to 7.5 %, up from 5%. Car sales grew 30% percent anyway. Last December, the government raised the sales tax again to 10%. This time, sales tailed off. But why would a modest tax increase matter so much more in 2011 than in 2010?
"Okay," your boss jumps in, "I guess you're going to say this so-called shadow-banking-slush-fund-whatever plays a role in the slowdown?"
"That's right, boss," you say. "Remember back in 2009 and 2010, when the Chinese government directed banks to lend like there was no tomorrow?"
The Bank of China and its brethren shuffled tens of billions of dollars into state enterprises to turbocharge economic growth. Many enterprises did not want the loans, did not need them, but they took them under pressure. Then they started to re-lend them to their friends and business partners in the shadows.
Your boss's right-hand man, the company controller, sees a 'gotcha' opportunity. He pipes up: "But you just said that Chinese car buyers don't do car loans. Ninety percent of purchases are in cash. And most car buyers are private companies and individuals -- not state companies."
You take a deep breath before thanking him for the insight. "Chinese car buyers borrow from family, from friends, from colleagues -- even from their company. They just prefer to pay interest to those they know, rather than to Volkswagen Financial or Ford Credit."
Just how big is shadow banking? Last year, Chinese purchasers spent roughly $185 billion in cash for cars. That's a figure close to Malaysia's gross domestic product.
Now that Beijing has been raising interest rates, hiking reserves requirements and curbing lending, both conventional banking and shadow banking are ebbing. That's why demand has gone soft and automakers are discounting to meet sales targets.
"You're describing a giant bubble here," the controller says, putting some choice words into your mouth.
"No," you protest. "Demand is real and will remain so for years to come. But Beijing's control of the economy's cash flow means we'll have dry patches like the one we're in right now.
"Next year will be the biggest test yet," you add. "There are all kinds of new production capacity coming on stream. If Beijing's still fighting inflation, some automakers will feel real pain."
"But not us, right?" your boss says just before signing off.
Michael Dunne is president of Dunne & Co., a Hong Kong-based investment advisory firm that specializes in Asia's automotive markets.
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