For the last few days most financial reporting on China has been like this article from the FT.

Wen upbeat on China’s economy Wen Jiabao, China’s premier, has given his most optimistic assessment of the Chinese economy since the start of the year, saying that it had stabilised and that the government’s target of 7.5 per cent annual growth was well within reach.

Reporting on the Chinese Permier’s optimism. Or this one from yesterday’s FT reporting on Chinese Officials and their optimism.

Silver lining seen as China growth slows A slew of new data also showed accelerating investment, industrial production and retail sales in September. That prompted Chinese officials and economists to predict an imminent recovery from the weakest growth since the depths of the financial crisis.

The clear message of both articles is that things are looking up for the Chinese economy and therefore for the rest of us as well, given that growth in China is seen as essential to recovery anywhere else. Now the cynic might be tempted to say, ‘Well isn’t this nice – the financial press doing a grand job of toe-ing the required line that all is fine or at least working. China is growing so things will turn out fine here. Keep the faith, keep investing and don’t listen to anyone who says otherwise.’

In reply the FT and the financial press would say that if you read the articles with an unbiased eye you will see that at no point is the FT, or any other Mainstream news organization, offering a biased view of their own. They are simply doing their job, of reporting the news. Surely, they might ask, Premier Wen’s views are both informed and newsworthy? And indeed they are. Surely the views of Chinese officials are also both informed and important? Again – how could even a cynic disagree?

The articles solicit the opinions of informed people and clearly attribute those thoughts and opinions where they belong. Such as this quote from the ‘Silver lining’ article, which offers an explanation of how things have started to improve.

Dong Tao, an economist at Credit Suisse, said the latest activity figures from China showed the growth drop had levelled off thanks to a pick-up in real estate transactions and investment, more government investment in infrastructure and improved export orders from the US.

So, headline quotes and analysis from an independent source from outside the Chinese government as well. What could be wrong? In my opinion, taken by themselves, nothing is wrong with them. Both articles are well written and researched, and contain no lies.

So why do I mention them? Because I think that nevertheless they are examples of how public opinion is shepherded. They are good examples, I think, of how opinion is shepherded – not crudely with lies, but gently by carefully selecting which parts of the whole truth see the light of day and which parts are – not suppressed, that would be ugly – no, just lightly ignored or glossed over.

Of course the public is often lied to by those in power. We only have to look at the slew of lies that made sure we went to war in Iraq. Those weapons of mass distruction ready to fire within mere minutes but which were never actually found and indeed most probably had never existed even at the time our governments were claiming – and our news organizations were duly reporting – that they had reliable intelligence about the clear and present danger they presented.

But such outright lies are a high risk way of shepherding the sheeple to where they need to be. Rather than get caught telling lies how much better to tell the truth – just not the whole truth.

So I couldn’t help notice that while the papers and news programmes devoted time and column inches to relaying the upbeat pronouncements of Mr Jiabao, his officials and experts from the financial world, the thoughts of this man reported at length in an article in the China Daily just a few days ago got no mention at all.

Now Mr Xiao is , as his caption says, Chairman of the Board of Directors of the Bank of China. So I think he counts as both informed and official. China Daily is China’s largest circulation English language newspaper. It is state controlled and is widely seen as the official window in to China. So on every level this is as official and mainstream as it gets.

And what did the good Mr Xiao have to say? Perhaps it was boring and irrelevant and that is why we heard nothing about it? Actually no. Slightly technical perhaps but all the more important for being so and absolutely relevant to both the FT articles and the picture they presented.

The China Daily article was actually written by Mr Xiao which perhaps explains the less than tabloid excitement of its title,

Regulating shadow banking

Shadow banking may not be your idea of tea-break reading. Don’t let the title put you off. This is an important article.

Mr Xiao first explains,

…in China, shadow banking has mainly taken the form of a large amount of wealth management products, or WMPs as they are known, underground finance and off-balance-sheet lending.

Underground they may be but, as Mr Gang makes it clear, most of the trade is controlled by China’s big banks. Off balance sheet of course.

Chinese banks work closely with trust companies or other entities by packaging trust loans into WMPs, offering investors a higher yield than conventional bank deposits can. These products are mainly sold by commercial banks either at their branches or online.

What does this slightly opaque prose actually mean? In a word securitization. The Chinese banks are ‘offering’ those with large deposits or cash flow from other ‘assets’ (such as properties whose value is going up), the chance not to just get interest on their money, ‘inside’ the bank, ‘on’ its balance sheet, but to move their money in to a securitized investment vehicle which is ‘off’ the bank’s balance sheet. The banks create a securitized investment vehicle for someone who needs to raise money – lets say a property developer – and then offers the bank’s depositors the chance to invest.

The security on offer will no doubt be rated AAA but will still be able, by the magic we are all so familiar with now, to offer a far higher return on the money than if the money was just left on deposit. How? Well because the investment carries more risk – but risk which the banks know how to polish and contain and turn to gold. You remember how the story goes. (If you need reminding how securitization works please see Securitization – The Undead Heart part 1, 2 and 3)

One thing I should mention is that the banks don’t just take money on deposit and suggest the owners invest it. I am sure that sometimes happens, but to do only that would be far too vanilla. What they also do is extend a loan on the basis of the money on deposit and any other assets the client happens to have, such as property or even income from other investments. Thus the banks often leverage even before they invest.

How much money are we talking about? According to Mr Xiao’s article,

…trust companies will soon overtake insurance to become the second-largest sector in the Chinese financial industry.

So, a great deal. So much, in fact, that Mr Xiao writes,

China’s shadow banking sector has become a potential source of systemic financial risk over the next few years.

His words not mine.

Particularly worrisome is the quality and transparency of WMPs. Many assets underlying the products are dependent on some empty real estate property or long-term infrastructure, and are sometimes even linked to high-risk projects, which may find it impossible to generate sufficient cash flow to meet repayment obligations. Moreover, many WMPs are not even linked to any specific asset, rather, just to a pool of assets, whose cash inflows may often not match the timing of scheduled WMP repayments.

Stop me if any of this sounds familiar at all.

Deposits are leaving China’s banks in favour of far more lucrative but much more risky ‘sub-prime’ securities. Leaving the banks with less cash on hand and a lorry load of risky securitized, off-balance sheet investments. Which could still be OK if the risky-therefore-lucrative securities and their underlying loans all work. Sadly,

Chinese banks’ overdue loans, an indicator of future non-performing loans, are increasing at a faster pace. By the end of June, the top 10 lenders’ outstanding overdue loans reached 489 billion yuan, up 112.9 billion yuan from the beginning of this year.

Up 112.9 billion to 489 billion is nearly a 30% increase in 10 months! As Mr Xiao laconically puts it,

This indicates great pressure on banks’ asset quality as economic growth slows.

Question is, what would be the response of such a system if/when there is a slow down? Of course we all know because we can simply look at what our banks did back in 2005-7. When our banks found the investment flow in to securities slowing down due to people beginning to worry about how wise such investments might be, they simply created and funded new investment vehicles whose job was to buy up the securities they were having trouble selling.

And what does Mr Xiao think might happen in China if there is a slow down and squeeze on funding?

…when faced with a liquidity problem, a simple way to avoid the problem could be through using new issuance of WMPs to repay maturing products. To some extent, this is fundamentally a Ponzi scheme.

Ooops! Fundamentally a Ponzi scheme. A banker from China’s largest banks uses the word ‘Ponzi’ to describe what is going on. If I used the word, I would be accused of ill-informed scare-mongering. What should we call it when Mr Xiao uses it?

More to the point, what would the FT and our other mainstream financial news outlets call it? Which brings me back to the point I was making at the start. We have lots of coverage of those who talk-up recovery and none or very little of those who offer very cogent analysis suggesting the rotten underbelly of this recovery.

Think back to the quote I used from Credit Suisse expert Dong Tao in the FT article saying,

…the growth drop had levelled off thanks to a pick-up in real estate transactions and investment….

Here he is saying all is getting better because there has been more money going in to “real estate transactions” and investment. Quoted uncritically by the FT with no mention of, no connection made, to the fact that the huge growth in ‘real estate transactions’ has come via the sub-prime securitization, pumped to Ponzi proportions, by the shadow banking, off-balance sheet and therefore largely unregulated sector.

If the warning article had been obscure or by someone on the outside, like me, I could live with our media saying either they didn’t know or they didn’t believe. But the warnings are from the inside, from people who know and the warnings have been around a long time.

Mr Xiao ends by saying,

In order to prevent China’s financial systemic or regional risks from happening, it is imperative to pay more attention to shadow banking and to enhance supervision over shadow banking activities.

This seems to me to be as close as you will find a senior Chinese banker coming, to what I have argued here for over two years, namely that the central authorities do not have control over the flow of funding or the accumulation of bad debts in China. Control has leaked away from central authorities to the regions and the banks who work with them. I put this first in China’s New Revolutionaries back in March 2010 and then made the case much more fully in Making the new Sub-Prime – backdoor to China and Making the new sub prime – part two – What’s in store.

In those articles I argued for and went some way to presenting a pretty good case for saying that the central bank had lost control of the flow and accumulation of bad debts, that they were building in a dangerous way, and looked very like our own sub-prime fiasco.

If I could work out the dangers in April 2011 then the FT could certainly have done so. If I knew, they knew. Instead we still have puff pieces repackaging dodgy opinions from those leaders with the most to lose if failure is admitted. Sub-prime reporting designed to shepherd opinion. While senior inside figures now speaking up about the dangers get hardly a mention. Sub-prime all round really.