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Thursday, 20 December 2012

Seeking cash...

Holes emerging in the edifice
Some of the headlines in the last couple of weeks:
- China's WMPs - wealth management products suffered their first recorded default.  Called "Weapons of Mass Ponzi" by some commentators, these lightly regulated or unregulated products are managed by various financial businesses but sold through banks and other networks to retail customers.  They are high risk and offer a higher return than typical bank products such as deposit accounts, which offer mostly negative rates of interest after inflation.  Customers of a mid-size bank Hua Xia protested when notes sold to them in one of the bank's branches defaulted.  The notes paid income from a domestic issuer unrelated to the bank and streamed income from a pawn shop and car dealership (details here).  As had previously been seen in the Zheijiang Guarantee scandal, part of the structure involved guarantees which were not met and bank staff were blamed.  More importantly questions were raised as to how many other schemes were likely to fail.

Despite assurances from regulators during the recent party congress, regulators do not know the extent of exposure and so this week the China Banking and Regulatory Commission ordered banks to check and ensure management of non-traditional products.
Take away: Expect vast amounts of these sub-prime style investment products to be flooding through the Chinese financial system.  It is doubtful that the regulators or the banks will be able to contain them for much longer or prevent contagion if too many collapse.

- Unimaginable sums of money have been flooding out of China - A report out this week covering illict flows from developing countries in 2000-2010 listed China as the top source of all flight money, with more funds leaving the country clandestinely ($2.74 trillion) than all of the other top 10 countries combined.  This is broadly in line with other studies on corruption in China (link here).  The atmosphere of corruption has remained pervasive since the recent party congress and Vice magazine had a great article covering the scope of illict behaviour of officials being reported daily across China ("Chinese officials at it again...").
Take away:  Victor Shih of Northwestern University has looked at the impacts sudden acceleration of capital flight could have on China's foreign exchange and fiscal position and this could be an unstabilising factor going forwards.

- China is seeking to attract massive amounts of new foreign capital from sovereign wealth funds and central banks - A recent relaxation by the State Administration of Foreign Exchange of an investment quota of $1 billion under the QFII program means that now, through small changes to their portfolio, reserve managers could cause large shifts of capital into China (details here).  There was speculation about motives and questioning as to how such a policy interacted with efforts to liberalise its currency,
Take away:  At a time when banks are seeing increasing shortages of cash towards the end of the year this move does suggest signifcant sums to flow into China in future.

- Chinese corporates facing tough times - An interesting piece describing actions on the ground at LDK, once the world's largest solar panel maker, but now subsisting on funds from its main state-bank creditors under the weight of an impossibly sized $3 billion debt is here.
Take away: Industries like shipbuilding and solar are at the forefront of the Chinese slowdown.  Expect to see a greater spread across industries, including the property sector and eventually (when problems find their way back to the creditors), to the financial system.  

Tuesday, 27 November 2012

Lost century?

Back to work
Following a relatively smooth 18th party congress, China Inc has got back to work, albeit with a slightly different vision for more balanced growth.  There was not so much to take away from the various press showpieces, especially since (as is usual), many of the real decisions had been made in the final days leading up to the summit.  A post mortem piece in the Chicago Tribune highlighted the role of retired senior figures still play in the party - there must have been plenty of non-Chinese wondering what Jiang Zemin was doing centre stage at the conference.  The Wen family saga  rolled on, with a second instalment from the New York Times examining the very profitable stake held in insurance blue chip Ping An insurance by Wen's family and the lobbying to Wen on behalf of Ping An in 1999.  Wen's response included being asked to be forgotten.

In the swansong atmosphere it seemed likely that press would look around for an identifiable theme and many outlets settled on comparisons with Japan at its zenith.  One comparison, in a fairly high level of detail for the BBC was quite simply titled "Will China fall flat on its face"!  One of the most concerning points of comparison, which has been noted elsewhere, was the different developmental stage between China and Japan - thanks to its one child policy and it starting form a much lower income base, China has rapidly accelerated the aging of its population to now approaching Japanese levels (though getting a dividend along the way with a relative boost of young workers which is now decelerating) and consequently may grow old before it grows rich. 

More worrying in the immediate term was the surprisingly candid, though balanced piece by Charles Dumas of Lombard Street Research who nicely brought together all of the strands of the Chinese economy which are of concern - debt, stimulus, defaults.  What is particularly worrying is the ease with which, in 2 places, Charles can lead to a conclusion of the occurrence of banking crises - as a matter of course, as inevitable as a policy setting! - without policy change (debt reduction) and with trend growth shifting down to 5 per cent, "a plague of banking crises" could be a result, as could occur if financial liberalisation proceeds.  This is not the story spun by the large financial institutions promoting use of the Chinese currency (the Yuan/Renminbi) in trade settlement and with greater convertibility.

But these two things combined paint a worrying picture.  If China has all of the preconditions of a Japanese style financial collapse - sufficient to bring about the slow burning decline of a "lost decade" or "lost generation" (a term in vogue even in the West as it pushes through austerity, or in the case of the European Union, can-kicking), then could the less favourable demographics, level of social cohesion or uncertain environment make the impact for China worse than Japan?  As it happens there are deep social divisions in China with assertive foreign policy in areas like the South China Sea stirring tensions amongst the population and with reports of inequality and division within Chinese society attracting increasing concern and attention.  The task of the Chinese Communist Party to reinvent itself for slower growth and newer ideologies also complicates things.  Added sleaze and corruption scandals make for grim prospects.

Underlying the resurgence of nationalism is a sense of continuity with the period from the mid-19th century until the mid-20th century, when the sovereignty of the Chinese empire and state was subjugated to foreign powers and influence, starting with the First Opium War until the expulsion of foreigners after the Second World War (the Century of Humiliation).  As commentators have noted, the current administration perpetuates the focus on restoration of international profile and prestige while skipping over the Party's failures. Inability for self-criticism may come to harm the Party and the nation in years to come, and should the effects of China's boom be felt across one or more generations, Chinese may have to face up to another century of lost potential in many years to come.

Cracks appear in the China bull market (c) Caixin

Tuesday, 30 October 2012

Generation game

Solar flare up
Since the last post there have been moves to further consolidation and government control of the solar industry as two of the largest players, LDK and Suntech are facing increased state involvement and even takeover.  Amidst global oversupply, plummeting prices and possible trade law sanctions, a couple of themes are present (i) use of bankruptcy is not prevalent yet (with rollovers of debt preferred) and (ii) increasing state involvement.  An excellent article by Tim Worstall in Forbes had a headline which summed up the situation - "China still hasn't got the hang of this capitalism thing", namely the importance of unprofitable enterprises going bankrupt.  It would seem fairly obvious that there are plenty of impediments to swift and orderly wind-down of institutions - loss of face, bureaucratic interference, vested local government interests and the like.

But it wasn't supposed to be like this - the article refers to an official who pronounced that the government intended the industry to consolidate - i.e. a large number of enterprises close or merge - intentions which were complicated by unwillingness of banks and local governments to toe the line.    And what a contrast from the fanfare in a previous Forbes article announcing the launch of the new US style bankruptcy regime China in 2007 - the predictions of a "high level of sophistication" and "determination to build a sound legal system" seem over-enthusiastic statements now.  Possibly due to the need to promote stability ahead of the leadership change next month, officials seem to be falling back to tried and tested methods of state interventionism, which will only continue to propagate distortions in the current financial system.

It's a family affair
At the time of writing there has been an overwhelming response to the New York Times' investigation into the wealth and connections of Chinese Premier Wen Jiabao's family.  It is not just that the Chinese administration has blocked access to the Times' website (as it did with Bloomberg and the Brookings Institution when they released similar findings regarding incoming Xi Jinping and Li Keqiang), responded with what the Financial Times referred to as a "hatchet job" piece in the People's Daily, or that unusually the administration has instructed lawyers to deny and  look at pursuing legal redress (which members of the legal community thought were poorly thought out) With the Guardian comparing it to the Pentagon Papers as the most "direct challenge to a sitting government", it is clear that the investigation has ruffled feathers at a sensitive time.

It is not clear yet if there will be a lasting impact from these revelations about China's leaders - the Economist which has a special report covering the upcoming Party Congress, concludes that all the disclosures strengthen the case for reform.  Like many similar autocracies the connected elite of China have had an entrenched position for a long time in China and it seems unlikely that this will change after the handover beyond certain personnel changes (which was the conclusion of Katherine Hille in the FT).  But could tensions between ruling factions and their connected others spillover after the transition?

Factional tension was suggested by Hille (noting rumours on Chinese social media that information in the New York Times had been provided by factional opponents of Wen) and more broadly the Wen revelations have opened a greater discussion on corruption in China, which as the FT Alphaville blog noted that perceptions of corruption were reaching levels where they could be destabilising.  Cue then a closed door lecture from a Chinese (or Hong Kong-based) academic arguing that China is in fact nearly bankrupt and a warning from permanent China bear Gordon Chang warning that there is now a "stampede" of money and even officials are now fleeing China and all does not seem well.

A light-hearted piece in the Daily Mail might suggest otherwise (with news of a marriage of the niece of president-in-waiting Xi Jinping to a young unknown British businessman, Daniel Foa) but there is a very deep family tension involved in this year's leadership trauma.  Forming part of a highly recommendable podcast of experts (comprising Chovanec, Garnaut and Anderlini) was a real insight into the the deep inter-generational enmity between Jinping and Xilai (and their factions in the Party), which had arisen between their fathers, Xi Zhongxun and Bo Yibo, during the cultural revolution.  Garnaut in particular has been in explosive form revealing casualties of the factional struggles for position in both the military and political leadership. Add to this interventions of factions led by Hu Jintao/Wen Jiabao and Jiang Zemin and things look set for an explosive mix.

An Englishman called Daniel Foa holds a book (c) ImageChina
As has been noted China's new leaders are likely to signal a clear directional change in policy very soon after the handover (as has been customary).  Whether they retain a princeling dominance and an absolute autocracy or opt for a more compromising approach (such as a management focussed Singaporean model) will remain to be seen.

Tuesday, 9 October 2012

Two steps forward?

Gathering headwinds...
After a break from blog-posting it is interesting to see a consensus forming as doubts further crystallise around the China and BRICS growth story.  At least on one report, the IMF has joined the increasing ranks of observers who are bearish on growth prospects, while in Beijing another chapter in the grizzly Bo Xilai saga progressed when, on the eve of a national holiday, it was announced that a consensus on the persistent political questions had been reached - Bo Xilai would be expelled from the party (to face a criminal trial) and the 18th National Party Congress would take place on 8 October (apparently a date which will bring good fortune).

Good luck will be needed, because China is facing a number of headwinds, including tensions with Japan over disputed islands and the slowing economy which has even been noticed in the wealthy tech hub of Dongguan.  Aggressive positioning such as talk of rapid sales of Japanese bonds by the Chinese (at a time when it is trying to diversify its holdings of US treasuries), a no-show by Chinese banks at an IMF Conference in Japan (when Chinese banks may need assistance from the IMF sometime in the future) and announcements of ever-increasing local stimulus (which UBS called "unicorn", JP Morgan called "castles in the air" and the Beyond Brics team have taken to comparing by regional cuisine), seem counter-productive while uncertainty surrounded China's leader-in-waiting, who disappeared for 12 days recently.

The human side to the evolving atmosphere has come to the fore recently - not only with the riots at Foxconn facilities (and if you are hoping to read this on an iphone 5 - deepest sympathies), but also with deflationary prospects further reducing likelihood of a rebalancing and growth in consumer demand.  Gavekal Dragonomics has noted that given the current destocking cycle and fading CPI numbers, a little bit of inflation may be a good thing.  At the sharper end, industries like solar are desperately trying to slash costs and restructure debts.
Chinese de-stocking in action
A gold postscript
There have been some interesting commentaries about global currencies and the monetary system in the past couple of weeks, including from the Economist and from George Magnus of UBS who still sees issues from global savings imbalances.  Following on from the last post there has been some further discussion of the possibility that China is in fact stockpiling gold (here also and even that China and Russia are stockpiling in concert in response to US quantitative easing).  Ironically for both China and Russia, any suggestion of monetary system strength has been challenged by heavy use of reverse repos by the countries' central banks (by which the central banks inject cash into the domestic banks in exchange for securities  - other link here).

It was noted in the commentary of the Russian moves that the repos coincided with announcements from the Central Bank of Russia that it would not intervene to support the Ruble (Russia's currency).  While it was noted that this was a gesture likely to be received well by markets as pro-reform (like Renminbi liberalisation in China), especially given the CBR's previous failures to do so, the alternative explanation, that the central banks simply do not have sufficient resources to defend their currencies from outflows.  Parallel to this it was announced that official estimates predicted a sooner than expected ending for Russia's long established current account surplus, due to falling exports and high government expenditure.

Beyond any policy preferences the central banks may have in pursuing reverse repos (and the short term stimulus they provide), there remain risks for the central banks, namely i) that they will become less effective and ii) the central bank will run out of resources to execute the repo operations.  There is evidence of both these effects in China (links here and here).

Some analysts expect ineffective repos could lead to an RRR cut (reducing the amount banks are required to hold in deposits) which could free up lending and accelerate inflation and stoke lending and the property bubble - something it turns out is additionally caused by social factors including the one child policy according to Foreign Policy magazine.  Growth in the Chinese property market is already picking up, but as shown by Also Sprach Analyst in a current series, the current valuation models may significantly miscalculate the market.

A call for more clarity on China is probably due.  Or at least after the unicorns are gone.

Wednesday, 5 September 2012

Gorillas in the mist

Goldman Sachs Asset Management chairman Jim O'Neill popped up in the news this week, releasing a note to clients with some revised thinking on prospects for China's economy.  With still a favourable overall view, O'Neill considered several likely outcomes for Chinese growth, including a "pessimistic" outlook of 7% GDP growth.  An interesting point in his analysis - that in any worst case growth scenario, the Chinese government is "surely to step in", attracted some comment as many noted that given certain conflicting undercurrents and factional conflicts within the administration and the Chinese Communist Party, the Chinese authorities may not be willing or able to intervene.

Similar to the reaction when various large Chinese cities announced vast new spending programs, some observers were sceptical as to whether bold political action will be as likely be delivered as in 2008.  O'Neill's fund meanwhile has been promoting a new set of fast-growing MIST countries (Mexico, Indonesia, South Korea and Turkey) which have been the star performers in the fund's popular Next 11 fund. And the failure to even consider a less than 7% GDP growth outcome (when some commentators consider that growth may be negative) suggests O'Neill might just be missing a gorilla in the room - Asian (and Chinese) slowdown which others believe may not be priced in by the market.

A very strategic resource
The last couple of weeks saw a renewed debate considering the return of a gold standard as a way to restore stability to the global economy and encourage growth (and end America's money printing), even while the balance of opinion believes such a standard is a false hope or otherwise likely to result in the stagnation currently seen in the Eurozone (which as Peter Coy explained arguably is committed to a new gold standard).

There is an interesting angle for China in this debate, as it has been active in the gold markets.  As you may recall China has been trying a basket of different measures to manage its economy including Keynesian stimulus in 2008, enormous foreign exchange reserves, capital controls and now liberalising exchange rates (which may be countering each other in effectiveness).  In fact reports have emerged which provide detail of China's activities in gold as well.

In addition to outright purchases of the metal, interest was also expressed from Chinese companies in acquiring gold producers.  In its report of China's largest gold producer, China National, considering the acquisition of a majority stake in the African subsidiary of the world's largest gold miner, Barrick, the Beyond Brics blog reported that the company's president, Sun Zhaoxue believes that China should view gold as a "strategic resource as important as petroleum energy".  That might partly explain why there is a gold mining division in the Chinese internal security forces (the People's Armed Police).

As well as its value as a metal, reserves of gold have been argued by some as a better store of value for a national central bank than government bonds, especially in a low inflation environment where the government issuer of the bonds is engaging in monetary easing (which depresses the yield as the price increases from the asset purchases).  In China's case it is looking for an alternative store of value to offset its huge holding of US Treasuries (US government bonds) which earn low rates of interest because the US is engaging in Quantitative Easing (printing money by buying US Treasuries) and which it cannot liqidate easily.  The liberalisation of the Renminbi (i.e. the process of opening the Chinese currency to full convertibility) is seen as one step that can counter-balance China's US dollar holdings (as the greater volumes of Renminbi will be used and deposited internationally).  Sun Zhaoxue alludes to this in his article.

However it is questionable whether holding gold ipso facto will ensure greater security for China.  How so? Well looking into some of the debate around the merits of a gold standard suggested that the credibility of the system might be more important than the physical holding itself.

I hold therefore I am
Outspoken financial journalist Max Keiser, has looked at a number of commodity stories, including possible manipulation of the silver market by JP Morgan and its high frequency trading (HFT) business (background here).  In a recent broadcast Keiser examined some of the justifications given by gold bugs (especially libertarians in the US), who he found often confuse their libertarian values (such as objectivism advocated by Rand) with the behavioural principles of the "Austrian school" (advocates of a gold standard).

A key question in the discussion was the degree to which financial institutions could issue credit secured against their gold reserves - it is only physical gold which is the "ultimate extinguisher of credit", but the use of fiat (paper) money removes the gold from credit making it easier to expand credit (which if prolonged can cause inflation and is exaggerated by quantitative easing).

In his article Peter Coy blames the First World War for causing the inflationary expansion of credit which destabilised the gold standard, however according to the Cato Institute (which is apparently libertarian) in a paper on this topic, von Mises, a key figure in this analysis, believed that instead of the war, it was the attempts by bankers to get around the gold standard and increase credit in the economy, when, from the 1890s the world's central bankers relaxed the standards of inter-central bank credits:
 It was'' not the old classical gold standard, with effective gold circulation,'' that failed after 1929; what failed was'' the gold 'economizing' system and the credit policy of the central banks of issue'' 
What von Mises proposed (to address this inherent conflict) was that the gold standard should be operated completely independently of monetary matters and essentially gold should be valued at production cost.  And this is interesting because it seems to be a call for independence, similar to that underlying the Bitcoin digital currency, which operates free of any government and is instead backed by the power of the computing network of Bitcoin users (with no centralised issuing authority).

All of this would suggest that credibility is important.  As well as the amount of gold which the People's Bank of China (the central bank) or other bank may hold, financial market participants will also assess how credible those banks are in administering and valuing such reserves.  This may not be as simple an assessment as it seems.

In gold (and tungsten) we trust...
Frauds of the week
Mentions must go out to:  the Chinese Art market (worth $13 billion according to Forbes magazine) and  China Sky One Medical and its chief executive (which the SEC charged with securities fraud this week for overstating financial results).

Wednesday, 15 August 2012

The audacity of hope

Bears rally
A couple of provocative headlines hit the newsfeeds this week as some notably bearish Chinese analysts digested the recent stimulus announcements.  Gordon Chang's article "China is running out of money"  certainly grabbed attention and while much of the discussion about the country's central bank, the People's Bank of China (and its ability to maintain the system of foreign exchange inflows) has been covered before, details of how short some local authorities are of money right now is rather new (and emerging).

In contrast, investors' optimism about the extent of the current stimulus is well illustrated by a slide from a recent Rio Tinto investor presentation (below).  Frequent readers will recognise one of the project leaders - the National Development Development and Reform Commission (NDRC) which Victor Shih and others have identified as being at times a very effective rubber stamp executing little scrutiny of projects it approves (including earlier in the year a project to influence the weather).

Michael Pascoe of the Sydney Morning Herald is one China bull who saw only a soft landing from the stimulus and in pro-reform comments of a Bank of China official.  Similarly doveish comments from Jiang Chaoliang, chairman of pillar bank AgBank (Agricultural Bank of China) suggested a benign situation of measured reform.  However it is questionable how much the necessary reforms and consumption increases will proceed during a stimulus given fairly little progress made on such things during the last round of stimulus in 2008-9.

Meanwhile at respected magazine Caixin, Andy Xie sought to put recent conditions into perspective, with some dire forecasts for the property and finance sectors:
China's land market will experience a dramatic adjustment ahead. In most cities, land prices may fall by 80 percent. The financial consequences will be severe. Most bank loans are backed up directly or indirectly by land. If land prices fall so much, the banking system would suffer a crippling level of bad loans. Local governments increased their spending appetite during the heyday of land sales. They will have a difficult time adjusting to the new reality. Their struggle to source new revenues will be the main reason for social instability ahead.
And adding difficulty the FT's Beyond Brics blog noted, was that the fact that many statistics releases which drive the China news cycle seem to increasingly split analyst opinion (pointing to more or less future growth in equal measure).  Similar to the debates as to whether key Chinese statistics are falsified - a recent report examined opposing interpretations of rising non-performing loans data by Reuters and Bloomberg. Reuters' conclusion, that it was a positive sign (looking at the overall ratios provided by the China Banking Regulatory Commission), was favoured.

Chinese property, it's a long way down...
Reluctant consolidations
While questions remain over the long term outcomes from the new stimulus, other commentators have noted falling profits across a number of sectors and in some cases a run of bankruptcies is looking likely.  Three industries which have been observed to be at risk of widespread bankruptcies are the solar panel makers, shipbuilders and automakers.

For manufacturers of photo-voltaic cells there have been plenty of headlines for Chinese companies, themselves struggling against a backdrop of oversupply and falling prices. Suntech, the largest solar panel maker in the world, announced it had been defrauded by an Italian co-investor (who offered fake German bonds as security for a payment guarantee) and just recently obtained a worldwide freezing order against its Italian partner's assets.  Even without this, the company is struggling under a weight of debt.  LDK Solar, based in Xinyu was bailed out by the local authority last month, although some commentators doubted whether even this would be sufficient to restore the companies' prospects.

Chinese shipbuilders meanwhile are continuing to tread water through the worst conditions in a decade.  Major builders including Rongsheng and Cosco have recently been hit by profit concerns amongst falling orders and shrinking backlogs, while there have been several bankruptcies including Dalian Oriental Precision & Engineering and a major shipbuilder in Zheijiang province.

And local car manufacturers (who have been flooding dealers with unsold inventories) face the prospect of being forced into bankruptcy by local authorities due to widespread anticipation of failures.  As this report from Ken Rapoza in Forbes explained:

The Ministry said in a note published on Tuesday that it is considering the introduction of a withdrawal mechanism to force near-bankrupt automakers out of the bloated automotive industry.  China has around 1,300 automobile makers, including 171 car, truck and bus makers and more than 900 specialty vehicle manufacturers, according to the government.
Nearly a quarter of these manufacturers are on the verge of bankruptcy, barely producing anything despite obtaining production approvals from supervising authorities, the statement said.

Restructuring with Chinese characteristics
The announcement of forced restructuring of the automotive sector is interesting because it shows the role of the state in dictating the policy direction for much of the industry.  State involvement has been a feature of industry restructuring throughout China's history, and most notably during the aftermath of the Asian crisis, when  many International Trading and Investment Corporations (ITICs) - forerunners of current Local Government Financing Vehicles and investment trusts, collapsed and when the banking system was restructured.

At the time, there was no advanced nor comprehensive bankruptcy law governing the restructuring of state-owned entities and private entities.  As William Gamble, an investor with experience in that period has noted, the bankruptcy legislation applicable in 1998, when GITIC collapsed, did not recognise security interests or allow for restructuring (nor could foreigners' investments into ITICS even be registered with Chinese regulators).

A new bankruptcy regime, which is more sophisticated and borrows elements from US legislation and other jurisdictions was implemented in 2007, but its effectiveness remains to be seen as courts and other officials establish a practice of using and enforcing the new regime.  Also in a new trend, Simon Rabinovitch in an FT article this week, noted that more parties seem to be using local courts to resolve contractual and debt claims across a number of Chinese regions.  

It seems there is much more than just a simple increase in litigation volumes - generally speaking local and regional state authorities, with their close ties to businesses seem to play a very dominant role in either leading arrangements to stave off bankruptcy (causing a lighter caseload and a slimmer practice of dealing with bankruptcies) or as in the case of the automotive industry - taking a dominant role in which foreign investors may be marginalised and/or unfamiliar.  Reports of the pending bankruptcy of the Zhongdan Guarantee company (which was exposed by the collapse of the Tianyu Construction Company and 600 companies which were connected to it by a network of guarantees) indicate that the Beijing city government is directing the restructuring response which is expected to get underway later this month.  And Zhongdan apparently was also involved in selling WMPs (below).  Should there be more businesses like Zhongdan to be bankrupted, this could lead to a deterioration of market sentiment and intensification of any crisis, should it arise in China.

"No touch" regulation
Watchers of Chinese bank finances noticed a shrinking of deposits and increase in interbank liabilities in bank capital reports which many commentators are blaming on the rise of WMPs - wealth management products, unregulated speculative investments which Chinese banks have been using to source new loan capital and which are popular with bank customers as they offer interest rates far above regulated deposits.

Nothing wrong with little or no regulation in the short term (in China) you might think, however it has emerged that many of the products do not have recourse to specific assets and are increasingly appearing to have the characteristics of a pyramid or ponzi scheme (with there not being enough assets to cover redemption requests or meet all obligations), the collapse of which could trigger financial contagion.  An excellent Reuters piece uncovered one product which it likened to an American subprime mortgage (of dubious quality), being marketed to the public under the name "Golden Elephant" and whose source of income derived from property assets which were yet to be built.

While Chinese regulated banks themselves have questions to answer regarding their NPLs (which may challenge their solvency) the growth of WMPs and so-called "shadow banks" could threaten a significant crisis in the Chinese financial system.  Recent discussions on various blogs this week reminded that there are a number of precedents of this sort of scheme which could equally apply to China.  For both Russia and Albania in the 1990s (and Poland in the last few years), pyramid and ponzi schemes were able to flourish escaping weak and slow moving regulators in a changing environment and, upon collapse, causing great damage to the economy.  A great paper on the Albanian pyramid scheme phenomenon is here, while in Russia, the famous MMM and GKO scandals (the latter of which contributed to the collapse of the Russian government and precipitated the 1998 Asian crisis) have been well written about (Sergei Mavrodi restarted a new MMM-style scheme online last year).

How it all plays out in China will remain to be seen.

Saturday, 28 July 2012

Learning all the right lessons

An Olympian task
With the London Olympics opening at the weekend, many have been looking back to the preceding games which were a pivotal moment for China, both in its arrival on the world stage (completed with an unprecedented opening ceremony) and its resetting of influential policy preferences.  Howie and Walter in Red Capitalism and others including Victor Shih (speaking with Carl Walter at Northwestern University hereidentified 2008 as a time when western orientated reformers finally lost favour to those with a domestic bias, when attempts to continue reforms of the banks' lending processes were abandoned and the great RMB 4 trillion (USD 586 billion) stimulus plan was rolled out.  Concerns about the after-effects of that stimulus and the launch of a second stimulus continued to be raised in the last couple of weeks with some good commentary from a number of key analysts.

Insightful analysis was sparse in vulnerable nation Australia however.  While drops in China influenced iron-ore prices pressured Australian producers like Fortescue Metals (further enriching famous short seller Jim Chanos) and a sole report from one consultancy did get some attention, the political and economic establishment was basking in a moment of relative sunshine.  Economics editor Ross Gittins continued the Australian media's trend of lionising Australian Reserve Bank Governor Glenn Stevens who was dismissive of questions to China's growth trajectory and treasurer Wayne Swan was equally confident on China's prospects, emphasising the careful management and the Chinese government's "deliberate government policy". Context is important here - as recently as the end of last year, few if anyone considered that China's GDP growth would fall below the benchmark 8% during 2012 such that any significant measures from the government would even be required.  

However new and significant measures were announced this week and an article in TIME magazine gave some good background.  The new push for growth seems to have come to life earlier in July, when Premier Wen Jiabao made some comments pointing to further investment while official GDP growth was released at a lower than expected 7.6%.  As this Reuters article points out, political concerns, chiefly the need to ensure a smooth handover in October and maintaining the current elite's legacy may have been a greater motivation for the decision makers, but this may not be wise in the long term.  In the short term, protests in Shifang and most recently Qidong (north of Shanghai) in opposition to the commencement of industrial projects no doubt encouraged authorities to focus on short term remedies.

A marketplace...being flooded with liquidity
Banking on trouble
Details of the second stimulus emerged on Friday, with Changsha, the capital of Hunan, leading a pack of other cities as it announced a huge RMB 829.2 billion (USD 130 billion) investment plan.  Immediately questions of how such amounts are to be financed spring to mind and a little investigation suggests a complete confusion in the administration's banking policy.  For most of the year Beijing's policy has focused on tightening loans in the property sector (and local government financing vehicles) to prevent price bubbles - yet the new stimulus measures aim will do the opposite.   Hence a number of contradictory headlines, indicating that the Chinese authorities wanted to maintain strict controls, yet also loosen lending, while despite Beijing's demand that local governments keep up restrictions on property purchases, at least one province capital sought to undermine the property curbs by offering cheap loans to buyers.  

Further complicating the picture is the question of where all of this leaves China's banks and financial system generally.  Plenty has been written and said about the significant issues that lurk behind the glossy profiles of China's large international banks and their smaller competitors.  Would the second stimulus result in some profitable lending for the banks? Possibly not as some of the discussion suggests the local government financing platforms which would launch the stimulus may seek funds from elsewhere - from issuing bonds and/or securitising their underlying portfolios.  Meanwhile the unregulated shadow banking sector has attracted a significant share of the market in lending to smaller businesses and attracting deposits.  Fitch has warned at the risk stored up by some of these vehicles while such a development is also dampening the effectiveness of interest rate cuts as a stimulus measure (though interest rates are not freely set in China).

Surely any doubts as to risk of further stimulus could be overcome by the end result of more infrastructure?  Probably not some experts believe.  Gordon Chang was doubtful about plans for further expansion of the airport network, while Simon Rabinovitch at the FT went so far as to find a real bridge to nowhere (or in any case a proper Japanese-style bridge with minimal traffic), the completion of which he interpreted as a signal that probably the era of big showpiece engineering led growth should come to an end.  And in light of the perceived failure of the sewers during the recent floods in Beijing, plenty think there has been misinvestment.

Stimulus or no, it appears the banks may already be heavily exposed to existing bad loans.  In a further development in the unfolding Zhejiang guarantee scheme collapse (covered previously here), Caixin reported that China Construction Bank made possibly fraudulent loans to a guarantee structure of the Zhejiang Construction conglomerate.  It could be the tip of the iceberg.

Fraud of the week
Two mentions this time.  First an allegation of insider trading by a Chinese-owned entity in the shares of Canadian company Nexen Inc., which state owned oil giant CNOOC has bid for.  News of the SEC's intervention just broke so it will be interesting to see how it develops.  Second, a listed education company called New Oriental, which has the dubious honour of being investigated by the SEC and short seller Carlson Block simultaneously.  Carlson put up his report on the Muddy Waters webpage here.  The response from Yu Minhong, New Oriental's CEO is here.

Thought for next time
Patrick Chovanec has an interesting series up on his blog, where he tries to explain recent observations of price rises for property in China.  He's midway through and examining a number of factors (in some detail and with good logic) from outright fraud to sources where some demand may have come from.  Of course given everything mentioned in this article so far it would seem that there shouldn't be a reason for property prices to increase given the fundamentals, unless there was some regulatory intervention.  A possible factor Chovanec hasn't mentioned (and this is speculation) is that perhaps a number of insiders have anticipated the stimulus measures described above and expecting prices would rise again as during 2008 onwards, have bought some more property.

The Economist also looks at the same issue, though the analysis is a bit clumsy.  It fails to explore the link between the two sectors (property and local government financing), which is the banking system, and this compromises its assumptions - e.g. it remains to be seen whether the liabilities of the local government financing vehicles don't "endanger the fiscal position of the country", or that local governments will "invest better" than in 2008.  Likewise their conclusion - if they are saying the price rise means that property in China hasn't collapsed fully yet, we should all worry.

And the playout of a collapse is really the next area for serious debate.  Given that the Chinese financial system reform period (from 2000 up to the Beijing Olympics) grew out of the last great financial system collapse - initiated with the collapse of Guangdong International Trust and Investment Corp. (GITIC, an investment arm of the Guangdong government) in 1999, it is probably a useful example to return to for guidance as to how any contagion would occur in the Chinese financial system.  Although the GITIC institution differs from modern investment trusts and local government financing platforms in China, the underlying story of excessive bad loans is similar to today.  A fair part of an Economist article from 1999 could be written verbatim today.  

One veteran of the GITIC bankruptcy is William Gamble, a lawyer who wrote a book featuring the episode. In a 2009 article cautioning creditors buying debts of any distressed Chinese companies, he noted the contagion caused by the collapse:
The effect of GITIC’s collapse was immediate. Foreign credit for China dried up almost overnight. China experienced a liquidity squeeze similar to after effects of Lehman Bros last fall. 
Thus presenting an irony - for all their hard work from 2008 to avoid the effects of Lehman Brothers' collapse, should the unlikely but possible outcome of an institutional bankruptcy occur, those effects may nevertheless occur anyway.

Monday, 9 July 2012

Lights flashing red

A hit to growth plans
Over the weekend, China was unlucky to score a mention in a list of risk factors which New York University Professor Nouriel Roubini identified could cause a "perfect storm" for a global economic collapse in 2013 (the other factors were the final climax of the Eurozone crisis, a US slowdown, slower emerging markets and US/Israeli conflict with Iran).  Data out on Monday confirmed these fears - an annual decline in the Producer Price Index (by 2.1%) and less than expected annual increase in the Consumer Price Index (2.2%, falling 0.6% compared to May) caused a flood of discussion examining for perhaps the first time that China may enter a period of deflation.

Scanning across a variety of reports the salient points seemed to be:
(i) whether or not there is actually deflation, because of China's previously stellar rates of growth, the disinflationary effects could feel just as bad (especially because of the extent of debt throughout the Chinese economy);

(ii) through measures by the central bank (the People's Bank of China) and comments from Premier Wen Jiabao, the Chinese authorities have signaled their intention to counter the declines and boost activity (either with additional reforms or new spending);

(iii) while some investors were cheered by the discussed measures, it remains to be seen weather genuine stimulus can be delivered - authorities are neither able nor willing to repeat the four trillion yuan ($586 billion) 2008/9 stimulus package (as central banks worldwide are running out of "policy bullets") - hence the ambiguous comments from Wen of "aggressive" fine tuning;

(iv) in any event for some analysts, such as those observing contraction in the money supply, severe downturn may now be inevitable - as Ambrose Evans-Pritchard has put it in the Telegraph - "China is on the cusp of a deflationary vortex"

Plans for the economy have taken a detour (c) Camera Press/TPG
China's AIG moment
For many, the excess of debt held by Chinese local governments, off-balance sheet through opaque and lightly regulated local government financing vehicles (or "financing platforms") compared strongly to the implosion of America's subprime loans, as many came close to, or did default last year.  In recent days, China based professor Patrick Chovanec has drawn another comparison between stress in networks of cross-guaranteed companies and the collapsed reinsurer AIG.  As Chovanec notes, Chinese financial newspaper Caixin has brought to light a second guarantee and cross-loan structure, around the Hangzhou-based property developer Tianyu Construction Co. Ltd, and both scandals suggest the scale of losses on these structures could be hard to predict and vast:
the inter-company guarantees at the heart of the Hangzhou Tianyu meltdown add a whole new dimension to the exposure of Chinese banks, beyond the professional guarantee companies themselves.... 
And as if to add credence to the concern, an official denial as to the scale of the problem was published at the end of last month

In a similar mindset, more publications have noted an accumulating number of anecdotal signs of stress in the Chinese economy, including attempts by governments to embrace austerity measures (including selling off fleets of luxury cars and imposing limits on official banquet expenses).

And finally, the team at FT Alphaville have continued to follow the developing story of China's large corporates having large dollar-short positions (consisting of US dollar loans which were taken out when expectations were that the dollar would continue to weaken).  There is an interesting analogy made with the Eastern European economies who struggled with large loan portfolios priced in Euros when their currencies fell during the 2008 crisis.

A China Bailout?
Discussion of China's reserves can often lead to the conclusion that though gargantuan they may not be able to be deployed in quantity or sufficiently rapidly to prevent a currency crisis or other event.  So a question for readers - if China does find itself squeezed by being short US dollars or some other crisis and it's reserves don't kill the problem - how would (or could) China be bailed out?

Tuesday, 26 June 2012

Heading for the exits

A Chinese dollar?
Adding to the confusion of the different types of Chinese currency (onshore and offshore Renminbi), and some of the unintended consequences discussed previously is an interesting idea noted by the Beyond Brics team from from Richard Harris at Port Shelter Investment Management.  Given that the non-transferable offshore Renminbi (CNH) sits alongside the domestic Hong Kong Dollar (which although transferable is limited by a longstanding US Dollar peg) Harris has suggested combining the two, to make a "Chinese dollar".  Some details and a hint of some of the benefits for capital flows are set out here.

Such a move could viewed as a reverse-merger of sorts (merging the offshore Chinese currency with its onshore, established equivalent).  Reverse mergers, which were used by many Chinese companies to combine with US listed shell companies and fast track equity listings in the US - were the subject of a number of scandals in recent years, and a new battle for transparency has opened up between US and Chinese regulators (more below).

Fraud of the week
Last week, China focused US research firm Citron Research, caused a storm when it issued a strong research report condemning alleged fraudulent practices at Evergrande, a top Chinese property developer, (link here). In a similar manner to the Sinoforest debacle, the company's management responded to the release of the report and subsequent rapid stock decline with aggressive denials and Evergrande enlisted a number of its investment banks for support.  Worringly, Marketwatch's Craig Stephen raised the question as to whether a threshold had been passed, so that from now on, larger and more established companies on the Chinese mainland (including Hong Kong listed) could be subject to claims of fraud and insolvency.

Unhelpfully greater transparency which could reassure markets does not seem to be forthcoming.  There have been reports of harrasment and detention of investigators which short sellers and others have been sending to verify Chinese companies' operations on the ground (who some companies and their advisers allege are trying to spread false information), while it has been reported that access to Chinese company filings (which short sellers made great use of to publish their reports) has been restricted.  As Patrick Chovanec of Tsinghua University sets out in an interesting blog post, it is not only that company documents are becoming harder to get, but that certain requests for information by the SEC and its affiliates in respect of Chinese companies which are listed in the US have been refused by the Chinese authorities.  And as he puts it there could be serious consequences if the stand-off continues:
By the end of this year, unless a compromise can be reached, there is a very real chance that U.S. securities regulators may end up employing the “nuclear option”:  forcibly delisting every Chinese company currently listed on a U.S. stock exchange — such as Sinopec,, China Life, and China Unicom.   It’s a potential catastrophe-in-the-making that few investors or politicians have given any serious thought to.

Meanwhile...200 stories up
Before such a calamity may eventuate, it is quite possible that one Chinese company which has been attracting a lot of attention in the property and engineering sector, Broad Sustainable Building, may have built the world's tallest skyscraper.  Announced last week, the Sky City One Project (if approved) will involve the company, which is famous for prefabricating all parts of its buildings in a factory and joining the parts together on site, erecting a building taller than the Burj Khalifa of Dubai (the world's tallest building, which took 6 years) in just 90 days.

Of course like the Burj it could be interpreted as a sure sign that the Chinese economy is heading for severe recession (some research on the correlation between skyscraper construction and the onset of economic downturns is referred to here).  A recent video from Reuters helps illustrate just how many skyscrapers are being built in China (and how quickly).

Tracking capital flight
John Hempton, a notable China short analyst attracted a lot of attention the other week with his blog post declaring China to be a kleptocracy - "of a scale never seen before in human history".  While there have previously high estimates of the scale of corruption in China (one leaked internal PBOC report identified $120 billion of illegitimate funds transferred out of China by officials in the preceding 15 year period), more details about how money is being transferred out of China has emerged recently.

In addition to laundering through trips to Macau casinos, overseas real estate has been popular, both in Asian countries and as more recently noted, in the USVictor Shih, of Northwestern University has been a leading light in the study of capital flight from China, and he has noted the significant impact capital flight by the wealthiest 1% of households in the Chinese hierarchy could have.

What is interesting is the connection of instances of capital flight to political tensions between factions of the Chinese Communist Party (CCP).  This report by Matt Gnaizda of NTDTV is a very helpful introduction to the Jiang and Hu Jintao factions in the CCP who are battling for prominence ahead of the expected accession of Xi Jinping to the presidency of China later this year.  Matt also mentions the connection of Bo Xilai, the recently ousted mayor of Chongqing to the Jiang faction.  Bo's wife Gu Kilai recently was reported to have admitted killing British businessman Neil Heywood to stop him disclosing the laundering of $6 billion and Bo's fate remains unknown at this time.

More broadly, the dismissal of Bo, itself a significant shift in the Chinese political landscape, may have triggered a rush of capital exits - this report from China's Forbidden News suggests increasing speed of transfers by members of the Jiang faction as the faction's position has become destabilised.  Countering this, it would seem is the recent introduction of new asset disclosure rules for top military officers (reportedly part of a Hu-led anti-corruption campaign).  This sort of maneuvering could continue for the duration of the year and its coincidence with destabilisation of the financial markets in China could be problematic.

China looks to introduce an effective anti-corruption fighter
I recently got some helpful comments on this blog and will be looking to implement over the next week or so.  If you have any thoughts please feel free to leave them in the box below or email direct to

Friday, 8 June 2012

Goodbye to BRICS?

The economies of the much talked-about BRICS countries are crumbling.  This was the headline in a post this week in the FT blog, Beyond Brics (which has these emerging economies as its focus).  Perhaps for the first time in a long while, disappointing economic news came out this week for each economy in the club first identified by Goldman Sachs' Jim O'Neill in 2001 (and formally launched in 2009).  For China, significant attention was paid to Thursday's unexpected interest rate cut by the central bank, the first since 2008.  Despite initial positive reactions, concerns were later raised that a) Chinese authorities would not have the scope to conduct loosening on the scale necessary or similar to the stimulus in 2008 (or if it did it could be detrimental) and b) that the rate cut may in fact have been driven by more serious concerns of slowdown which may be revealed by monthly production data, to be released this weekend.

Pumping in cash
Prior to the interest rate cut, the methods of stimulus were in focus with many concerned that some of the excesses of the 2008 stimulus be avoided.  Attention was paid to the National Development and Reform Commission (NDRC), a bureaucratic body which approves many large-scale development projects and had gone into overdrive in 2008/9.  Just how rapidly the NDRC rubber-stamped big ticket projects then was studied by Victor Shih (discussed in a forum last year, link here).  Meanwhile Victor noted on his twitter feed that the NDRC had also recently approved a "bad-ass project to artificially influence weather in NE China" (announcement here).

The NDRC has also approved several large steel projects, at a time when the sector is unprofitable.  As discussed with steel companies, the concern is not only that stimulus financing could be misallocated to inefficient projects which lose money (and result in increasing non-performing bank loans), but also that money provided (for bricks and mortar purposes) may be diverted into further lending and speculation.  Recent shorting of the stock of construction machinery maker Zoomlion (listed on the Shenzen and Hong Kong exchanges) has exposed the ingenuity of some operators with suggestions that even some of its concrete mixers may have been acquired to be used as collateral for further lending.

One development project which needs funding
Business as usual?
Meanwhile Chinese officials do seem to be seeking to assert more control over information in the financial sector.  Recent Wall Street Journal articles gave some interesting details about measures which have been viewed sceptically by foreign investors and regulators, including requirements for greater localisation of foreign accounting firms and a recent decision at one of the key repositories of data on Chinese companies, the State Administration of Industry and Commerce, to significantly restrict access to its records (which may have been related to the fact that these records were used by many of the foreign analysts who short-sold stocks of Chinese companies in the last 2 years).  In contrast, problems of oversight remain in the banking sector, where implementation of the Basel III banking reforms have been further delayed to commence in 2013 and the executive vice president of the Agricultural Bank of China (one of the large, listed pillar banks of the Chinese economy) was detained on corruption charges at the end of May.

Perspectives on the Chinese currency
As mentioned previously, a bit more coverage of the Chinese currency is overdue- a topic which can be a little confusing simply by the fact that it has several denominations (offshore/onshore) and two interchangeable titles in reports - Renminbi/yuan (with the latter being the unit of denomination) as well as the nickname of the "redback".  Until 2009, there was not much to say about the Renminbi except that it was in a fixed and then managed float, and was undervalued against the US dollar.  With US pressure and liberalisation measures, the value of the Renminbi has started to change recently.

Some background to note - one of the reasons China was reluctant to allow a flexible Renminbi rate was fear of "Plaza" - fear that the Renminbi could appreciate rapidly in the same manner as the Japanese Yen did after the coordinated action of central banks to devalue the US dollar in 1985 (pursuant to the Plaza Accord).  Many view the appreciation as a key causative factor in the asset bubble which triggered the collapse of the Japanese economy and the subsequent slow growth in the 1990's referred to as the "lost decade".  In China's case, the fear is that a rapid appreciation of the Renminbi (which could start upon a free float) could eat into China's export economy and threaten jobs and social harmony quite significantly.  From the US perspective, similar to 1985 position against the Yen, the undervalued Renminbi has been a key cause in the large US trade deficit with China and allowing it to float would cause an appreciation (and dollar depreciation) that would give a boost to US exporters and shrink the enormous imbalances with China (in particular the People's Republic's gargantuan holdings of US Treasuries).

While most commentators viewed a simple appreciation as neither feasible nor a solution, the policy background has become more complicated.  In particular:

i) Policy makers have favoured gradual liberalisation or "internationalisation" to diversify China's reserve holdings away from US dollars and to open up the Renminbi to use in international trade settlement and as an international reserve currency.  From 2009, measures were adopted to allow greater international use of the Renminbi, befitting China's status as a pre-eminent trading nation.  The sort of thinking underlying this move is outlined in a recent FT article.

b) A consequence of the measures which have resulted in greater circulation of the Renminbi is increasing complexity of Renminbi valuation.  In particular there are greater opportunities for capital flight and arbitrage between onshore and offshore Renminbi (including those involving stockpiled metal as collateral).  As this insightful Beyond Brics piece notes having looked at recent data from global payments network SWIFT one type of arbitrage that appears to be happening frequently is as follows:

A Chinese company places renminbi on deposit with a mainland bank, earning an interest rate of about 3.5 per cent. The company then obtains a long-dated, renminbi-denominated letter of credit from the bank, ostensibly to pay for a shipment of goods from its own subsidiary in Hong Kong.
In turn, the Hong Kong subsidiary takes the letter of credit to a local bank and uses it as collateral to obtain a US dollar loan at a lower interest rate than those available on the mainland. In many cases, the company would also use a currency derivative to eliminate the foreign exchange risk. The end result: the company has captured the difference between onshore and offshore interest rates, less banker’s fees.
and worringly:
If international trade in the renminbi is largely driven by financial arbitrage, as the extraordinary use of letters of credit implies, then Beijing’s plan to internationalise the renminbi is not exactly going according to plan.

Likewise all is not going according to plan in the offshore "dim sim" bond market where foreign companies issue bonds in Renminbi in Hong Kong (encouraging demand and use for the Renminbi denominated securities) - as noted in May, yields on dim sum bonds have been rising making it cheaper to raise finance in other currencies and markets.  And as mentioned previously, Victor Shih and others have found the impact of capital flight (on flows and valuation) by connected elites could be significant.

c) But perhaps, most significantly, the mechanism by which China recycled US dollar export earnings into reserves (and managed its currency flows domestically) is breaking down, primarily because of an export slowdown plus Europe fears and greater reluctance of exporters to settle their dollar deposits.  A detailed study out by Nomura is described here tracks the slowdown in the accumulation of dollar reserves.  The Nomura team conclude on one aspect - the slowing of the flood of US dollars gives the People's Bank of China more scope to act on monetary policy.  However, if this pattern is sustained, the other effect could be devaluation and/or a need to sell down reserves.  An ING note discussed yesterday concluded that signals to this effect were temporary but this may not be so.  Looking at April data:
The data reinforced fears that the economy was on a slippery slope to a hard landing via an overvalued currency and capital flight..
In the least the note did conclude that the Renminbi was overvalued at the moment (as did the IMF, in a shift from its recent position).  Perhaps a good concluding example of uncertainty with the Renminbi's prospects is seen in this article about a Renminbi deposit account offered by the Bank of China's New York branch.  Set up as part of the internationalisation so that foreigners can hold Renminbi, there is a question though whether they would wish to do so if there is a chance of devaluation?

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