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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?





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