How To Make Debts Disappear?

Shutterstock

Economic progress in Asia was built by credit, and a lot of that debt happened to end up in unprofitable banks and companies.

To “vaporize” bad debt, governments use capital controls to influence the difference between interest rates. But as the saying goes: “Rules are made to be broken”, meaning the already high-tensioned financial system further weakens, and how we invest in the region’s largest economy changes forever.

China the Debt Exterminator

We wrote about how China and other Asian countries, “remove” non-performing loans (NPLs) via wide interest margins to clean up its debt-laden system.

The upside of wide interest rate margins is that banks are more likely to make huge profits.

For example, if there’s a 5 percent lending rate and a 2 percent deposit rate, then the margin is 3 percent. This difference between is the source of profit for banks.

This margin also helps cover NPL-derived losses.

In the 1990s, the Chinese government started using this “tactic” to “exterminate” lethargic companies that lose cash and default on loans regularly.

Zhu Rongji (China’s then Premier) focused heavily of getting rid of “zombie” companies. His policies included closing down failing companies and broadening interest rate margins - the gap between lending and deposit rates, which ensured that banks could slowly service bad debt.

Like what the graph below shows, interest rate margins in emerging Asian markets are much wider compared to the rest of the world.

In countries like Vietnam, the margin can be over 5 percent, so that the government can fund huge development projects that have lots of NPLs.

What created this?

One Road Research

Average Net Interest Margin (NIM)

How handy are capital controls?

Capital controls exist in multiple Asian nations, particularly developing countries. Taxes, reduction or elimination of a country’s capital inflows and outflows are all capital control.

Basically, the point is to limit an economy’s flow and its amount of money.

The restriction of supply, in addition to unchanged or higher demand, leads to price increase.

In the case of capital controls, when the lending rate is raised (which increases the “cost” of borrowing) while not affecting the deposit rate, then banks can write off more loans since interest rate margin becomes larger.

Going back to the example above: 5 percent lending rate and 2 percent deposit rate adds up to a 3 percent margin. Let’s say suddenly there’s capital controls in the market, where lending rate is increased to 6 percent, then there’ll be a 4 percent margin. Although a 1 percent increase may seem small, understand that this applies to loans that are worth billions of dollars, so small changes can lead to drastic outcomes.

Closed market systems is typically where this model works best. However, China’s capital controls dropped (a process called market liberalization) after it joined the WTO in 2001.

What’s left of China’s capital controls isn’t that stable. Every year, around 8 percent of China’s GDP comes and goes without the country’s approval.

Capital controls are not meant to be “airtight”, but rather gives more market control to developing countries. Regardless, these countries prefer moving money in this way, rather than tolerating the free market.

">

Shutterstock

Economic progress in Asia was built by credit, and a lot of that debt happened to end up in unprofitable banks and companies.

To “vaporize” bad debt, governments use capital controls to influence the difference between interest rates. But as the saying goes: “Rules are made to be broken”, meaning the already high-tensioned financial system further weakens, and how we invest in the region’s largest economy changes forever.

China the Debt Exterminator

We wrote about how China and other Asian countries, “remove” non-performing loans (NPLs) via wide interest margins to clean up its debt-laden system.

The upside of wide interest rate margins is that banks are more likely to make huge profits.

For example, if there’s a 5 percent lending rate and a 2 percent deposit rate, then the margin is 3 percent. This difference between is the source of profit for banks.

This margin also helps cover NPL-derived losses.

In the 1990s, the Chinese government started using this “tactic” to “exterminate” lethargic companies that lose cash and default on loans regularly.

Zhu Rongji (China’s then Premier) focused heavily of getting rid of “zombie” companies. His policies included closing down failing companies and broadening interest rate margins - the gap between lending and deposit rates, which ensured that banks could slowly service bad debt.

Like what the graph below shows, interest rate margins in emerging Asian markets are much wider compared to the rest of the world.

In countries like Vietnam, the margin can be over 5 percent, so that the government can fund huge development projects that have lots of NPLs.

What created this?

One Road Research

Average Net Interest Margin (NIM)

How handy are capital controls?

Capital controls exist in multiple Asian nations, particularly developing countries. Taxes, reduction or elimination of a country’s capital inflows and outflows are all capital control.

Basically, the point is to limit an economy’s flow and its amount of money.

The restriction of supply, in addition to unchanged or higher demand, leads to price increase.

In the case of capital controls, when the lending rate is raised (which increases the “cost” of borrowing) while not affecting the deposit rate, then banks can write off more loans since interest rate margin becomes larger.

Going back to the example above: 5 percent lending rate and 2 percent deposit rate adds up to a 3 percent margin. Let’s say suddenly there’s capital controls in the market, where lending rate is increased to 6 percent, then there’ll be a 4 percent margin. Although a 1 percent increase may seem small, understand that this applies to loans that are worth billions of dollars, so small changes can lead to drastic outcomes.

Closed market systems is typically where this model works best. However, China’s capital controls dropped (a process called market liberalization) after it joined the WTO in 2001.

What’s left of China’s capital controls isn’t that stable. Every year, around 8 percent of China’s GDP comes and goes without the country’s approval.

Capital controls are not meant to be “airtight”, but rather gives more market control to developing countries. Regardless, these countries prefer moving money in this way, rather than tolerating the free market.

Let's block ads! (Why?)

https://www.forbes.com/sites/peterpham/2018/01/19/how-to-make-debts-disappear/