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Friday 25 May 2012

Is the Economist wrong?

That got your attention!  Well there has been a flurry of news and reports about China including a special report and lead piece just out from the Economist (more on this later).  To understand it all (given it has been a cyberspace minute since the last post) it's probably worth having a catch up.....

Rolling news feed
Although the quantity of news peaked recently, the underlying story is in a pattern to what has gone before.  Data for output, production, activity and spending in April (and on early figures, May) indicated declines, weakness and contraction, prompting the Central Bank (the People's Bank of China) to cut domestic banks' reserve requirements as stimulus, as commentators renewed fears of a bursting property bubble and contracting money supply.  Ratings agencies issued warnings on the property and banking sectors and more companies were impacted by accusations of fraud.  Commodity companies and resource exporting nations were nervous, while Wen Jiabao sought to reassure all that a sensible course would be steered.  Chinese banks didn't lend much money to anyone (and here), while Chinese consumers looked like they weren't buying much of anything.  As Ken Rapoza of Forbes explained, it is like 2008 all over again with the Chinese government poised to launch fresh stimulus measures like infrastructure investment, except this time they may not be effective (or possible).

Time for a challenge
Not a problem! says the Economist in its full feature just out.  Despite facing significant problems, the last article in the feature contends, China will "handle" weak demand and a poor financing environment and is "more resilient than its critics think" for now.  A bit of context is useful here - this is the first time in a while the Economist has started to address arguments about weakness as it previously maintained a position that there hasn't been substantial over-investment in China's economy and that China is following a "well-worn development path".  However looking at some of its arguments and its previous analysis seems to suggest otherwise.

When it last looked at Chinese over-investment in 2009 (as taps turned on after the 2008 stimulus were in full flow), it closely predicted the rate of growth of investment (over 20% when adjusted) and stated the benchmarks for assessing effectiveness were whether the new investment added useful capacity to a sector which needed it - in short, whether the investments efficiently allocated capital.  The verdict at least from anecdotal evidence is surely not, the new investment did not entirely add capacity which is useful now - Chinese shipyards are shuttered, Chinese steel firms are entering into other businesses like pig farming and the investments into rail have seen episodes of corruption and safety concerns on a monumental scale, most recently with concern about safety and performance issues with new rail line equipment.

In a subtle shift, the Economist's latest argument sidesteps the issue by saying that although not all of the very large investment may have been productive:

a) the investment did go somewhere and it wasn't so big,
b) it was inevitable given the country's savings rate and
c) it wasn't a complete waste because there were underlying productivity gains.

Hence the metaphor of China's economy being like the fictional character Robinson Crusoe who builds a not very useful canoe using primitive methods - at the end of the day he still built a canoe.
A product of China Inc?
There is a fundamental flaw in this analysis in that it fails to distinguish between the efficient, private and export-focused parts of the Chinese economy, and the inefficient, public and domestic parts of the economy.  Walter and Howie explain in their book Red Capitalism how the State Owned Enterprises (SOEs) which now dominate the Chinese economy were aggregated together in the early 2000s combining small and inefficient regional entities and how they have remained inefficient compared to the entrepreneurial and small to medium enterprises which have traditionally had an export focus.  The Economist recognises that if these private firms or SMEs had had a greater share of the investment it would have been more efficient, but what it doesn't say is that this allocation has made the Chinese economy less resilient and is indicative of long-term policies which have made the Chinese economy less resilient.  In particular:

a) the investment went to inefficient locations i.e. SOEs and was big, relative to the SME sector;
b) the country's savings rate was made high by specific financial policies (financial repression) and the Chinese economy is locked into the policy's effects; and
c) while productivity has risen on average capital and investment has mostly flowed to those parts of the economy which are unproductive.

To modify the Economist's metaphor, it is more realistic to think of the Chinese economy operating on a beach in which Robinson Crusoe has been slaving away building a useless but very big canoe, while a modern and efficient maker of speedboats nearby has closed due to a lack of funds.

It's been well discussed about the clear division in the Chinese banking system between regulated banks which mostly lend to SOEs and the smaller unregulated operations or "shadow banks" which have traditionally stepped in to finance SMEs.  Attempts have been made to reconcile the two systems or to look for new sources of capital altogether (such as a bond market for SMEs).  But more immediately there are pressing concerns as to the stability of those intermediaries which have accepted risks of SMEs and Patrick Chovanec has put out an article taking a look at China's credit guarantee companies - the "least understood part of the shadow banking system" which he compares to AIG.

And just like the collapse of AIG during the 2007-8 global financial crisis, the broader picture of the Chinese economy is one of increased risk.  Michael Pettis confirmed some of his earlier forecasts for the Chinese economy in a recent post, in particular and in opposition to the Economist, that China does have a serious debt and/or over-investment problem with investment being misallocated "on a massive scale".  His prediction on falling consumption has been seen and the underlying cause, financial repression remains in place.

Financial repression encompasses measures used by governments to direct flows of money in their economies but as Pettis and Nicholas Lardy of the Peterson Institute have made clear, the measures of financial repression in China are wrongly set and will compromise the Chinese economy.  Pettis calls it the "heart of China's problem", while Lardy's 2008 paper attributes repression as the cause for pretty much every macroeconomic problem in the Chinese economy, including the shadow banking system, low consumption and the inability to reduce exposure to the export economy.  The net effect? A handicapping of growth - Pettis has a 2 way bet with the Economist on the prospects of the Chinese economy and Pettis is on the bearish side.  My money's with Michael.

Fall of the Redback?
Analysis of what is going on with China's currency will come soon (no room now unfortunately!).  However there has been some reports this week of Yuan / Renminbi weakness.  Just to refresh, the official line is that the Chinese currency continues its glorious path to attaining reserve currency status and breaking into the dominant position for global trade settlements (cue inspirational video from the FT) - with the US hoping for some corresponding appreciation to give their exporters some relief.  Seeds of doubt from the FT - falling export orders seem to be leading to a shortfall of dollars at the People's Bank of China while the acute risk of capital flight which Victor Shih first raised in 2008 has attracted some comment too - something Shih said, could attract an "enormous impact".







Wednesday 9 May 2012

Ending a super-cycle

Metals update
Following the last post there were some more signs of China-related noise in the copper and commodities markets.  The ever vigilant FT Alphaville team reported on a note out from Standard Chartered detailing their visit to a warehouse in Shanghai which was stuffed to sinking with copper and aluminium (with some revealing photos).  Meanwhile there were reports today of new research from Nomura's China metals and mining analysts which found that after adjusting for GDP (rather than usual per capita bases) they predicted flat or low growth in China for metals.

As always, the picture for commodities is not unanimous, with teams at RBS and Barclays Capital positive to bullish on prospects for the materials sectors.  But as reported previously there do seem to be growing distortions in the commodities markets.  For the copper market, this was discussed in detail by BBC Radio back in 2011 (who spoke to industry users, staff at bursting warehouses and analysts at both bullish and bearish institutions) while FTAlphaville recently had some helpful background on unusual moves in the copper and oil markets.

Looking across different reports there seem to be four factors which could have been driving the stockpiling of metals in China (until recently):

i) domestic loan collateral and financing schemes: As set out in the last post, Chinese financial authorities have tightened the limited availability of bank credit making alternative financing schemes through informal lending popular.  Many schemes use warehoused copper or other metals as collateral for loans.

ii) schemes to arbitrage price differentials in commodities markets:  There has been specific comment on the price differential between the London and Shanghai prices for copper, and that arbitrage trades can impact on the price.  As explored in the last post, market based schemes can involve "re-export" of surplus copper from domestic warehouses in Shanghai, but in fact the copper only travels to other bonded and private warehouses which hold non-domestic (bonded) stocks.

iii) schemes to manipulate market prices of commodities: As explained in this piece by Reuters, it is a "time-honoured technique" amongst commodity traders to use private and non-disclosed inventories to restrict the apparent (and official) supply of a commodity, gain control of a substantial portion of the remaining "official" supply and then squeeze prices higher.  The article mentions current suspicions that certain traders are engaging in the practice and shifting large volumes into private warehouses, "off-warrant", creating the appearance of tight supply.

iv) schemes to arbitrage differentials between domestic ("onshore") and foreign ("offshore") exchange rates: Although China is undergoing financial liberalisation, with the movement to a more flexible yuan/renminbi rate, there still exist discrepancies between deposit rates and currency prices which can be exploited with stored metals used as collateral.  The previous Reuters investigation gave some detail on this.

End of the commodities super-cycle
With such distortions as excess inventories and incomplete price discovery it is not surprising that headlines have referred to an end of the commodities "super-cycle" - the continuation of high commodity pricing trends beyond levels suggest by fundamental indicators and drivers (which included sustained high Chinese demand).  An article in the Australian mentioned the example of one mining company topping up its own production with market purchases to meet demand, while the Financial Times considered outcomes for mining sector investments following a downturn.

Aside from the immediate hit to shareholders, there could be a couple of other impacts.  First it could be argued that in addition to the commodity traders, a number of large banks, including JP Morgan, Barclays and BlackRock could be exposed to kickback from inventory shielding schemes as they have significant warehousing and commodity investment operations.  Some have argued that certain banks which have large commodity ETF funds predicated on rising commodity demand are keen to maintain high prices to encourage subscriptions to their ETFs, regardless of fundamentals.  Hence some of the derisory comments on social media as to the slightly concerning tone of a Blackrock client blog this week which argued that it is "critical for the global economy that China lands softly".  The related growth of commodity backed structured financing does carry some risks as discussed here.

Also, it seems possible that speculation and arbitrage in the Chinese currency between offshore and onshore markets may complicate the liberalisation of Chinese exchange rates and the economy.  Martin Wolf explored the risks and complexities of liberalisation back in February, and it will be looked at in more detail in posts to come.  Meanwhile Fraser and Howie in their book Red Capitalism noted that non-convertibility of the Chinese currency is one of the pillars maintaining financial stability, with uncertain consequences if removed.

Thanks to the reader who identified the BBC Radio link!