A year to savour?

2013 saw a lot of changes to the mood in China, with the transition of Xi Jinping and introduction of a reform agenda, launched last month at the Third Party Plenum.  There was plenty of political intrigue with the trial of Bo Xilai, endless other officials and detention of Zhou Yongkang.  The first hints of the banking crisis emerged, with spikes in the interbank market in June and early December.  Property and asset markets remained turbulent and tensions in Western China remained.  And regional tensions escalated with the declaration of the Air Defence Identification Zone over the disputed areas of the South China Sea.
 
It seems fairly likely that recent interbank stress has involved non-disclosed defaults by Mainland institutions - China Everbright Bank's default during the first Shibor Spike was only revealed this month when a note in its IPO prospectus revealed two of its branches had defaulted in June, although quickly paid up (while at the time reports of branch closures and ATM shutdowns were dismissed as due to technical errors).  As in June the PBOC did belatedly intervene to calm the markets with liquidity injections (a Christmas offering if you like), but there is little likelihood this pattern of crisis and belated resolution won't be repeated.
 
As noted on the Investing in Chinese Stocks Blog and elsewhere, the shadow banking system is rampant and a massive risk to the banking system as all manner of schemes with high and unsustainable returns have spread amidst sluggish regulated below inflation rates available in the mainstream banking system.  Worse still, as has been noted before, although the entities providing such returns (trusts and other structures sold as "wealth management products") are outside the formal banking system, their products are sold to bank customers and banks either own or have exposure to the entities.  The bankruptcy of mining giant Liangsheng (a coal acquisition group overburdened by debt) is an example likely to be seen more frequently and already of a scale which could threaten China's banking system.  Most significantly losses track back immediately to the investors and a big state owned bank -  as the FT states:

Liansheng had little trouble finding willing lenders among China’s burgeoning shadow banks, which regulators have allowed to help plug the financing gap.

From late 2011 to early 2012, Jilin Trust, one of China’s vast array of non-bank financial institutions, sold to investors an investment product worth Rmb1bn backed entirely by loans to Liansheng.

Jilin Trust warned investors at the start of this month that the first tranche of the Liansheng loans was nearing maturity and that the mining company had yet to cover what is owed, according to China Business News, a local financial newspaper.

...Liansheng’s troubles are a reminder of the thin dividing line between China’s banks and its shadow lending industry. The Liansheng loan product sold by Jilin Trust was distributed in part via China Construction Bank, the country’s second-biggest lender by assets.

Banks tell customers they do not guarantee trust products, which offer returns far higher than traditional bank deposits, but buyers often ignore the warnings in the belief they carry the banks’ implicit backing. The Liansheng investment product targeted an annual return of 9.8 per cent.

And notwithstanding the proposed interest rate liberalisation, repression in the banking system creates opportunities for the shadow banking system to flourish while as the former chief economist and spokesman of the National Bureau of Statistics in China describes it, the banking system does not work in any efficient manner at all, but rather could be run by a canine:
 

“Banking in China has become like a highway toll system,” Yao Jingyuan said at a Saturday summit on China’s economy held at Nanjing University. “Banks charge every time money goes through them.

"With this kind of operational model, banks will continue making money even if all the bank presidents go home to sleep and you replaced them by putting a small dog in their seats.”

Yao added that there were no longer any real bankers in China, and that most bankers had become “freeloaders” who latched onto the wide profit margin they could enjoy by taking advantage of interest differences between deposits and loans.(here).

With this sort of oversight it will be a wonder if any Chinese banks don't get into trouble next year. 

In the meantime, this article will be rounded out with a couple of photographs which seem to capture the mood at the moment.

"President Li buys his own steamed buns"

 

The above is the actual headline from the report of an unusual purchase by a Chinese President.  Given the clear level of deference and hierarchy still in place in China, what hope is there of genuine financial reform? For example as with the PBOC, so the shipbuilding industry has also been bailed out.

The likely outcome for the Chinese financial sector in 2014?

Xie Shuizhun, a 46-year-old man from central China's Hubei province, earns his living by charging random strangers in Guangzhou's Baiyun district to beat him up, at a rate of 5 yuan (US$0.82) per punch. He insists the punches do not hurt him because he practices the ancient Chinese art of Qigong, which allows him to inflate his belly like a rubber ball.

Back in 2014!

 

 

The rising of three suns

Recently China watchers have added to their experience of weird weather phenomena by witnessing the rising of three suns in Chifeng city - due to the presence of ice crystals high in the atmosphere which reflect the sunlight downwards.  Perhaps symbolic the phenomena occurred prior to the convening of the third plenum Party conference (that is the significant third meeting of Xi Jinping's premiership), when the most important policies and overall direction of the administration is laid out.

Reports from the main session of the plenum proceedings were mixed, commitments to market opening and deepening were contrasted with an absence of concrete measures to tackle some of the more significant issues in China, including the rampant state owned entities which distort the Chinese economy and waste resources (summary also here).  Meanwhile foreign journalists faced difficulty getting into China to report and/or (allegedly) the prospect of self-censorship of certain significant news investigations.

On the modernisation drive Bloomberg did report on developments from the new free trade zone in Shanghai, including the opening of a massive gold vault which will store up to 2,000 metric tonnes of gold.  Gold bugs are speculating on possible future outcomes from the high volumes of Chinese gold buying, constituting a seminal moment when gold had moved from "west to east".  Adding to this, speculation of the adoption of international rather than Chinese law in the free trade zones (similar to Hong Kong) suggest that much is happening.

The reality may be different however.  China's (and the world's) largest bank ICBC, has been added to the list of globally systemically important banks by the global bank regulator, the Financial Stability Board (which is hosted by the Bank of International Settlements), meaning tougher capital requirements.  And there has been declining interest in lower tier banks coming to market - mid-sized Huishang Bank, which acts as an intermediary in the shadow sector (including transactions involving entrusted loans and other interbank off-balance sheet lending) saw lacklustre demand following its recent Hong Kong IPO, with analysts divided as to whether the IPO of one of the original four Chinese bad debt vehicles, Cinda (an asset management company) expected in December will be well received.  As even profligate local governments are staring to see more scrutiny (not only in calls for action from the central government but also from their constituents), the scale of Chinese indebtedness may be fully revealed.

More abstract perhaps but there are some analysts who doubt the short term impacts of the proposed reforms to China's financial system.  Pu Yonghao, UBS's head of Asia research, says China may experience a period of economic hardship over the next two to three years.

And in other news it was reported that disgraced solar panel company Suntech has filed for provisional liquidation in the Cayman Islands (following a buyout of some of its business and attempts to save it by the local government).  There could be more to come.

The psychology of grand gestures

These days many people approach China through the lens of superlatives - massive buildings and infrastructure, dynamic fast paced growth and grand government visions.  Local press Caixin had a photo series of some of the more opulent government offices which had been built in recent years in some of the more deserted parts of China.  This correspondent can recall travelling to Shanghai in the late 1990s and being impressed by the opulence of the central square and museum and the comparative poverty of the shopping mall below - which no doubt has long since been renovated.  Perhaps, as suggested by the Independent newspaper it is easy to misinterpret what is going on in China simply by being an outsider.  Nevertheless there does seem to be some insight from reviewing what will be termed the "grand gestures" being made by the Chinese in administration (and their possible view of events through this perspective).

To start with the US however, many have argued that the Chinese administration places great weight in its actions by what is happening in the US and arguably much of China's recent policy is seen to have been calibrated with big shifts in US policy.  Hence many analysts point to the US-led financial crisis in 2008 as having caused a pivot in Chinese fiscal policy - when the administration not only decided to embark on the massive stimulus in 2009 and 2010 which saw more money lent out by the state-directed banking system than delivered by the US administration in the TARP (troubled asset relief program) which preceded the recapitalisation of the US banking system.  More particularly, those analysts note that in addition to the decision that was made at the time, it was also a time in which the top of China's government interpreted that the US economic model itself was defunct - that no serious government would let its banking system collapse and that China was wasting its time trying to emulate the US (as it had been doing for many years since its own banks had been cleaned up in the 2000s).

Of course, such an interpretation fundamentally misunderstands capitalism, and it has been noted that in seeking to construct a capitalist economy China still hasn't taken to heart the idea that businesses need to fail (such that, although pain in the solar industry, one of the worst performers is being delayed, at some point the domestic debt market will have its first default and certain poorly performing big enterprises will go bankrupt).  Nevertheless until a day of reckoning, the Chinese are doubling down on their existing policies and no doubt continuing the status quo (or trying to).  

Free China love zone
And hence the suggestion that China is drawing the same conclusions as to US decline.  As the US government went into lockdown with the impasse over the debt ceiling, reports of frustrated Chinese tourists in Washington corresponded with the response in China itself - decrying the "ugly side of partisan politics" (here). And, as per the headline, the Chinese presidential administration was responding with one grand gesture - Chinese president Xi Jinping undertaking a charm offensive to South East Asia (as Obama's trip was cancelled).  The linked article didn't touch on the delicate nature of China's relations with South East Asia following disputes in the South East China Sea, which no doubt complicate the picture.

Likewise on the economic front, China's opening of a free trade zone in Shanghai (immediately offering customs and warehousing facilities but with the suggestion of financial reform) was launched with uncertainty as regulations were still being drawn up, while many commentators, including the Economist concluded the measures were likely to disappoint (and a damp squib in fact).  For this author the significance of the recent zone opening is more in the gesture than the outcome - many other cities around China are seeking to open free trade zones which may do brisker trade than Shanghai (including Dongjiang which is seeking to become a major aviation leasing and offshore centre) and more significantly the step is being promoted as a new track of reform mirroring the opening of the Special Economic Zones in the 1980s.

The success of the zones will remain to be seen but it is unclear whether they constitute the reforms China needs.  As a gesture though, the announcement of the Shanghai zone has had an impact and that may be enough to keep positive news going for now.  On the other hand the gesture seemed to highlight current problems rather than hide them - property prices in Shanghai around the proposed zone have risen dramatically on the opening even as the included activities were not announced and there was no indication it will be successful.

If the real problems - property boom and collapse and strain in the banking sector do flare up then as a guide we must expect significant actions such as the credit squeeze of June 2013 - of which there will undoubtedly be more significant gestures to reassure confidence as real measures.  

A massive China sinkhole

Several major news outlets have reported on the problem of sinkholes in China.

Similar to the formations in the US and Central America, sinkholes often appear as a result of human activities - mining and construction or extraction of water for agriculture which alter the composition of below ground rock and soil which can then collapse.  As CNN reports these appearances can not only result in the occasional damage to pavements and roadways, but to vast swathes of often agricultural land in some areas which can end up sinking below the water level.  Relocations of infrastrucure and people can follow in what is a disturbing development for some localities such as Jining in Shandong Province.

Infrastructure revealed in China (c) AFP

Also disturbing and seemingly potentially catastrophic are emerging insights into the scale of capital shortfalls in China's banking system and economy. With the inner vaults of banks hollowed out by excessive lending, diversionary schemes and sources of risk concealed from regulators it is becoming a certainty that significant writedowns of bank assets will have to be made at some point.

It is with this in mind then that reports are emerging of steps being taken to put into operation the clean up of banking balance sheets by special "bad bank" vehicles - namely "asset management companies" (AMCs) which were set up in the late nineties to absorb bad loan portfolios from the largest Chinese "Big Four" banks - ICBC, BOC, Ag Bank and CCB (which became Cinda, Huarong, Orient and Great Wall, each taking on the bad loan portfolios of one bank).  

Fraser and Howie in their book Red Capitalism walk through the tainted origins of the AMC's which bought the bad loans at full face value and failed to achieve much running off of the portfolios (often recovering as little as 20 cents in the dollar, barely covering their costs and instead rolling over the bad loans).  Since then, apart from what the FT has investigated as seeming repayments from the central government and the AMCs taking on new debts and branching into active financing business, there has been nothing to quell serious doubts about whether the AMCs are fit for purpose (a historical perspective on the recovery process is here).   

While analysts debate the room for manoeuvre for AMCs, the scope of the task is substantial:

...In 1998, when these AMCs were formed, the first Rmb1.4tn batch of bad loans were bought at face value, or 100 cents on the dollar, which was great for the big four banks, but less good for the bad banks. They recovered only about 20 cents on the dollar. 

However, in the late 1990s, that Rmb1.4tn accounted for about 15 per cent of bank loans, according to CLSA. Ms Chu calculates that the Chinese banking system’s assets grew by $14tn between 2008 and 2013 – equivalent to adding the entire US banking system to its banks’ balance sheets. 

This illustrates why China needs more than merely a government bailout to tackle bad loans this time and that it will probably take a lot more than four privatised AMCs.

And with the application by Cinda to launch an IPO in Hong Kong, some are starting to question the viability of any such venture (given one as author contended, they have become "toxic waste dumps" of bad loan portfolios) :

...today China's four big asset management companies look on the surface like respectable universal financial services groups, with solid balance sheets and handsome earnings. In February, Cinda announced profits for last year of 14 billion yuan (HK$17.6 billion), while Huarong made 12 billion yuan. 

Sceptics claim these profits are illusory, produced by the companies trading assets among themselves at artificially inflated values....For potential investors, however, earnings quality should be only a minor concern compared with the enduring doubts that surround the strength of the asset management companies' balance sheets. 

Offsetting the liability of their bonds, their assets now consist largely of what amount to IOUs from the Ministry of Finance. These are not sovereign bonds, but merely a vague promise to pay at some point in the future....If these IOUs are comparable to similar IOUs held by state banks, then their eventual repayment is to be funded by recoveries from the bad assets injected into the "co-managed accounts". 

In short, it appears the recent restructuring of the asset management companies was nothing more than a cosmetic exercise, which still left them exposed to their original portfolios of worthless loans.  If so, their liabilities far outweigh the true value of their assets; they are insolvent. 

 And what could be the likely scale of losses in the banking sector? Goldman Sachs has come up with an estimate of $3 trillion (which presumably doesn't factor in any downward adjustment to rates of growth stemming from the fact that official Chinese GDP may be overstated by $1 trillion), which is about the size of China's coveted foreign reserves (which by the way may not be of any use in a domestic currency crisis, being held offshore and in another currency). And this may be the nail in the coffin - the backstop of every China watcher - the ability of the state to bail out any distressed entity may simply not be sufficient enough - as stated by Charlene Chu:

There is tremendous confidence in the ability and the willingness of the Chinese Communist party to bail everyone out....But as the system gets bigger and bigger, there are more questions about how feasible that is.”

Rather a large hole to fill.

In need of heroes

A motley crew of martial arts masters gathered in Xinjjiang last weekend for a martial arts conference involving training sessions, discussions and lots of photos being taken using smartphones which some Chinese internet users derided as "cosplay for the elderly".  Novelty photos aside the amount of conflicting messages now flooding out of China's economy and political management all points to authorities which are losing the initiative and are out of ideas.  Reform needs to occur, but can the recently installed team deliver?

The recession avengers?   (c) ChinaNews.com

It is telling that global markets have moved recently in a big and coordinated way on announcements of improving Chinese data - does anybody question the provenance of the official data? A few like Caixin do, but for the moment the theme is one China bringing support and stability to markets - quite absurd given the recent credit shutdown only back in June, when markets briefly went into a complete tailspin.  Expect more volatility, not less.

Policy feast

Perhaps more noteworthy than statistics were policy announcements.  A lot of them and conflicting as usual, but it seems that in pursuit of the great rebalancing, Xi and Li are ready to offer up the most sacrificial cows - could the authorities really be planning to ditch the one child policy, start radical agricultural land reforms, allow a privatisation of a major bank and ditching the hukou household registration system? These and other areas involve policies that have been established for decades and there are too many with vested interests and different objectives throughout the system to allow the process to be easy.  It must follow that there are two likely possibilities here:  (i) such announcements are pure puffery and the administration does not intend to follow through with any such reforms (this would explain bad habits like shadow financing and subsidising inefficient industries like solar are seemingly dying hard in the current administration) or (ii) the circumstances have got so desperate that officials are willing to consider anything (likely given the constraints).

One voice that is reasonably clear on this issue is Ambrose Evans-Pritchard in the Telegraph who recently commented that Chinese authorities had capitulated and given in to demands for more stimulus and to hold on reforms:

Mr Li’s implicit argument is that kicking the can down the road buys time to push through the market reforms needed as China abandons its obsolete, top-down, investment-driven, 1980s catch-up model, and switches instead to a grown-up economy. 

No doubt Mr Li genuinely hopes to push though these reforms, but he is up against an army of vested interests, and half the Standing Committee. 

As the IMF’s Article IV report makes clear, very few reforms have actually happened. Investment is still 48pc of GDP. The savings rate is still rising. China still has the most deformed economy of any major country in modern history.  

Reform under the microscope

Emerging litigation provides an excellent insight into the extent to which prior reforms have stuck and signs are not good.

The ongoing liquidation of former world leading solar cell maker Suntech in Wuxi is suggesting the recently introduced 2007 Enterprise Bankruptcy Law is not assisting an equitable distribution of assets or an efficient winding up of the bankrupt Suntech enterprise while the Wuxi government is seeming to have commandeered the process to the detriment of other creditors, including and especially foreign creditors.  

As has been noted for some time, foreign investors who use offshore structures to invest into Chinese entities (typically through holding companies in the British Virgin Islands and the Cayman Islands) often end up holding not shares but low priority claims to revenues of the onshore Chinese company, often without adequate security.  The result is several significant investors could end up with nothing:

Under Chinese law, foreign bondholders would be reimbursed only after domestic creditors, which means bondholders may end up with very little. Last week Suntech defaulted on a $541m bond issued in the Cayman Islands, which sparked a cross-default with other loans, including one from the International Finance Corporation, an arm of the World Bank.
“There are very, very few cases of defaults among offshore Chinese bonds and the recoveries have all been negotiated often with very unique circumstances, so there is no template to use to estimate the outcome in a case like Suntech,” says Kalai Pillay, Fitch Ratings’ head of industrials for Asia.
“But, no matter what, as an offshore creditor you are always structurally subordinated to onshore creditors. Any offshore bondholder has to assume that onshore creditors will get a full dollar before they get one cent.”

And in another dispute centred on the tropical island of Hainan, a British investor has been barred from leaving the island and fears for his safety while unsuccessfully pursuing claims corrupt officials with fellow local directors from his property development venture conspired to illegally transfer and strip from the project entity the key valuable asset.  It sounds more like post Soviet Russia than the great Chinese Dream Xi Jinping has been promoting of late (though the author is not quite sure exactly what that is!), leading to the question as to how many foreigners will be wiped out by an asset price collapse and general slowdown in China and how much money will they lose?

Growth is dead!! Long live growth!

It is a criticism with some basis that the pursuit of economic growth in China at all costs has become something of a mantra or cult and that even as the new fresh-faced regime seeks to move away from this to rebalancing and broader aims and social goals, western business media seem obsessive in their coverage of all pronouncements and speculation seeking to divine whether the magic number (annual GDP growth) will be 8%, 7.5%, 7.7% or something lower.  What did Finance Minister Lou Jiwei mean when he said 6.5% growth was tolerable on the sidelines of a China-US summit in Washington? That 6.5% was expected? That there was more comfort? to scare foreign speculators? To test the market impact perhaps?

Alas, since the SHIBOR shock when the PBOC cut funding in the interbank market for a time, the Chinese administration is having to posture a lot and send signals to try and guide the markets - not something it is necessarily good at!

Let's go back a step.  There are plenty of reports indicating (from the Chinese authorities themselves and from outsider's analysis) that the existing model is dead.  No more shopping centres/bridges/trains/roads to nowhere and hello consumerism.  Sounds simple enough - after all it is the lack of consuming that causes the high savings which distort the global economy and cause deficits in developed countries (which have been the centre for slowdown which is threatening China's exports and the exporting model), goes the reasoning.  Simple right?  And follows a nice circular logic?

Well not really!  Some points to consider:

Upside down fundamentals

China bull...hanging in a tree (c) CEN

The low consumption is a result of the structure of the banking system and economic policy.  The export preferencing low fx rate (in the RMB trading band) causes excess liquidity which is stored in US treasuries.  The PBOC buys the US dollars from exporters injecting RMB into the economy which must be sterilised to prevent inflation by forcing banks to buy PBOC bills and hold high reserves.  With scarce funds the banks prefer to lend to SOEs and live off the spread over fixed rate depoist source of funds which pay a low interest that is negative after inflation (due to the above).  The Chinese people get negative interest rates at the bank and can only buy gold (which they are doing in record numbers) or real estate (did we mention the world's biggest building was built in Chengdu at the size of 20 Sydney Opera Houses?!- this in addition to more shopping space in that city than much of Europe).

Regulation light wealth-management products have appeared to fill the gap offering high interest avenues for risky investments causing a further bubble, but the overlying point is that there is relatively little consumption.  Currently, ordinary people in China subsidise the state and its enterprises.  Their funds are transferred into investment.  Along with Michael Pettis who has been saying this needs to change (and will change) for a long time, many key figures have made this point, including Patrick Chovanec who said recently on twitter that the solution is to reverse the process, by liquidating the US treasuries.  Bringing the US dollars back into China to counteract receding investment and unsterilising - repurchasing the bills to put back yuan into the Chinese economy.

It is the view of this blog that this will not happen without a crisis, because i) the treasuries are impossible to liquidate easily without risking the valuation of the remainder (although that is what the US wants and is trying to force through its QE based US dollar devaluation), ii) it would fracture the edifice of China invincibility that is keeping the economy running, iii) as Victor Shih has noted, by the time it did so wealthy individuals would have already withdrawn enough of their funds from China to wipe out capital in the Chinese banking system rendering it insolvent.

That is a dire end-game scenario, but to return to the main point - consumption - no consumption is going to occur in a significant way unless all of the above happens.  Consumption can't happen without structural reform (Chovanec would probably argue that Yuanisation of US treasuries so to speak could kick start sucha process, but this is splitting hairs somewhat).

If not for anything above you should at least get a sense that consumption will take a bit more to take root than a couple more empty shopping centres!

Reactionary forces gathering
It has been noted that the SOEs, citadels of investment are fighting hard to stave off reforms and keep their privileges.  This will slow or block reforms and recent articles suggest the reform movement is slowing - investment still made up a significant and growing part of gdp in growth the second quarter.

Another more poignant example is the recent announcement of a massive ramping up of spending in the solar power sector - a sector flooded with capacity (45MW production capacity in China compared to global demand of 35MW) where high profile and industry wide bankruptcies are only starting occur. An official was quoted last year saying there would have to be consolidation and solar firms would have to close.  Instead there is this recent announcement that screams return to the bad old days:

China aims to more than quadruple solar power generating capacity to 35 gigawatts by 2015 in an apparent attempt to ease a massive glut in the domestic solar panel industry.

Within top sections of the Party there are reportedly divisions between different commissions and the Politbureau and this will only be likely to intensify.

China on consumerism: You're doing it wrong!
Many will have seen the report of a cartel seeking to sell chicken feet 46 years past its sell by date and many will have seen the reports of GSK and other multinational food and pharmaceutical companies investigated over corruption and also allegations of profiteering.  Taking a step back from the specific facts and the overall sense seems to be that China is unhappy with and unable to bring about conditions for sensible prices for certain consumer goods (feeding into high inflation and risks of unrest) and instead of addressing the underlying cause is going about in a ham-fisted manner attacking the multinationals to try and force a way around the problem.  A short term solution at best.

More fundamentally as illustrated by an excellent observational piece in the FT about passengers on China's first cruise ship, Chinese consumers are just venturing into whole new markets and are very different from preconceptions.  As with all China's modern history, things will not turn out as expected.

The fog of war

So much has happened in recent days (often behind the scenes, or at least in reporting columns) that it seems like a past era when only last Wednesday the Federal Reserve roiled world credit, equity, currency and commodity markets by announcing plans to exit (or slow down or taper) from its almost half decade QE money printing program.  Pandemonium followed across emerging markets but for the first time ever the Chinese central bank, the People's Bank of China, and its liquidity operations (or to be precise, it's lack of liquidity operations for two crucial days) stole or at least shared the limelight with the Fed.

The PBOC has been in the background supporting interbank lending and repo markets in China for some years, particularly as it does not conduct market operations around the interest rate itself (which unlike many large economies is fixed).  Instead it smooths out fluctuations in the amount of money circulating between banks by transacting in its own instruments (or that was my recollection last time I checked!) - the point being that for some time now the PBOC has stepped in and provided liquidity to the market, typically around holidays and at key points during the calendar including tax payment time.

Where it gets interesting is trying to understand what actually happened and what it means.  Some themes from this:

1) Foreigners still don't understand China.  Two examples - Ford and banks Citibank and HSBC have both announced new product offering and initiatives in recent days.  Details on this in a moment, but first to confirm a bit of terminology/details:

- wealth management products (wmps - or weapons of mass ponzi) are unregulated high risk high interest fund-style products which have become popular in China due to low official interest rates.  They are unregulated, risky and believed by many to be responsible for the massive risk exposures which will bring China's undoing. Often the underlying assets can be junk like cashflows from empty pawn shops or unbuilt buildings.

- one of the likely motivations of the cancelling of liquidity was to choke wealth management products by stopping their issuers (bank group companies) getting further credit via the banks (from the PBOC).  As a matter of fact this will never work due to the channels by which money flows through the Chinese economy, but nevertheless has been flagged and could work in theory.

So what was announced?  Ford commented that Alan Mulally is working "overtime" to rollout credit services to customers in China and the above banks announced they had permission to sell local mutual fund products.

Do you see a problem here? In a land awash with credit Ford wants to introduce more! And not just any credit - every type of credit imaginable - it was reported on several occasions last year that domestic construction equipment manufacturer Zoomlion saw many of its clients purchase concrete mixers purely for the purpose using them as collateral to take out loans.  And with HSBC and Citibank what sane manager would want to dive into an overexposed product class which has been called toxic and a threat to the Chinese financial system?!

China is a ponzi economy alright - feted insider Jim Rickards has joined the naysayers and interviewed on it this week (see here).  But if foreigners struggle to read China in a static period what hope do they have in a crisis?

There were plenty of views as to what was going on, and many focussed on the role of the PBOC.

2) the PBOC lost credibility and control - By having to change its position, precipitated by an intervening crisis, the PBOC has conceded its ability to set the policy and ended up subsidising the banking sector - back to business as usual (and in particular continuing with backstopping to the state sector).  Much of the commentary focussed on the intentions of the PBOC.

Did they intentionally pop a bubble and will it nevertheless blow anyway?  Were the regulators drawing a line in the sand against the financiers?  Were they trying to choke off only the wmp and shadow banking sector? Were they sending a warning to the new Chinese government to slow reforms and financial liberalisation (which they would argue will cause more chaos - as it happens the PBOC has always been a reactionist faction countering the modernisers at the National Development and Reform Commission)? Were they doing the bidding of the Communist Party which wants to put its stamp on things? Was the PBOC in fact irrelevant because the real momentum was with the unwinding of the carry trade (using US Dollar loans which had been priced low to borrow and speculate on the higher yielding Chinese Yuan).

FT Alphaville produced one of their series of articles (similar to gold repos, the London Whale and their previous series on Chinese Credit) which is excellent.  The BBC is covering the story in depth (finally, see also here and here).  The Economist had one reactionary article, which was more circumspect however analysing the assumptions (and questioning a couple of them) still could suggest a very concerning outcome.

Interestingly for the Economist and a subsqent article in FTAV, there is a suggestion that looking at available evidence, the Chinese Yuan may be overvalued and at risk of a currency collapse/devaluation.

If this is true, something will have to buckle soon. Either the renminbi will be forced to devalue, popping lots of dollar shorts as it goes — behold, dollar-denominated defaults galore — or China will finally be forced to release its USTs so as to avoid the messy fiasco and to honour its dollar debts, and prove it’s a credible country after all. 

To clarify, we’re not arguing the Chinese are using gold to manage the exchange rate, rather that gold is sending us an important signal that a great unwinding of the CNYUSD relationship may be upon us very soon. Also, — more importantly perhaps — that in the game of global currency wars, the Fed has come out on top. 

What happens next, of course, depends entirely on the degree to which China provides the liquidity its system is demanding and on the amount of dollar debt there actually is in the system. If it responds, the great unwind may be upon us quicker than we expected (which might explain why it’s so reluctant to do so). If it doesn’t… gold prices could be in for a rough ride in renminbi terms for some time still.

Apart from the sense of irony that the nation with the world's largest foreign reserves (acquired to protect against a devaluation) could suffer such a fate (and by the way calculations have questioned whether China's massive reserves would be sufficient in a case of full scale currency slide anyway), the outcome would be calamitous.  On this there are questions about the PBOC's ability to manage away from such an outcome.

3) Finally it is unclear if all the drama is having anything like the intended effect of slowing down alternative lending, or lending in general.  Not so says Bloomberg, while reports about the lending situation vary dramatically (see here and here). 

Mixed messages

It is becoming very difficult to read and understand news from China.  There are too many conflicting reports and inconsistent objectives and one wonders who is really in control.  Could this be a prelude to stagnation?  More on that in a moment.

Turning back the clock
In recent days the markets, the investors into and the people living in many emerging markets seem to be reaching a turning point - in currency flows, sentiment and strategy.  Recent protests which have broken out in Turkey, the Eurasian darling economy and one of the Goldman Sachs Next-11 post-BRIC  economies have been followed this week by plunging stockmarkets and questions about the future.  Prime Minister Recep Tayyip Erdogan, for a decade a popular, respected and dynamic leader, held responsible for bringing a long boom to Turkey has seemingly aggravated protests and been labelled in the international media as hubristic, tone deaf and too closely echoing an arab dictator than the enlightened leader considered previously.  Once lauded for assertive diplomacy towards Israel, Turkey had even taken steps to formulate a nuclear non-proliferation plan for Iran with Brazil, another up-and-coming power (a first since the plan was outside usual US led efforts).  The Lat-Am powerhouse is itself sliding into a deflationary spiral it seems with the falling Brazilian Real doing nothing to encourage local businesses into increased activity (contrary to predictions of finance minister Guido Mantega, who coined the term "currency war") and a recent minor bank-run has exposed the possibility of an imminent or likely popping of a domestic credit bubble.

Broadly speaking the cause for investor nervousness is the withdrawal of liquidity by the US Federal Reserve.  Having supported emerging markets for years with its money printing programs, which have sent trillions of dollars into all manner of countries searching for yield (as the US has sought to inflate away its own debts), the announcements by the Fed that, with signs of inflation and asset price bubbles in the US economy, it will now taper and start to slow its Quantitative Easing program, many investors have started to close emerging market positions and withdraw funds from these economies.

For China this matters too.  It is subject to similar trends - foreign banks like HSBC have been exiting the local market, selling their stakes in national champion banks like ICBC and exiting the market (having failed to achieve the predicted growth) and foreign investors are withdrawing funds or holding back on future investments.  As also noted however, the advent of ultra loose stimulus policies in Japan (which seek to replicate and extend the US easing policies to its own economy) poses a specific threat to China in that the rapid lowering of the Japanese yen may put a lot of pressure on Chinese exporters (causing them to have to drop their prices, at a time when labour costs are rising) and threaten to burst Chinese asset bubbles as real interest rates peak.

Apart from any particular difficulties China may face at the current moment all of the above suggests a broader shift might be underway and in fact far from a momentary pause, the current changes in fact form part of a move in economic activity as investment and fast growth dissipate from emerging markets elsewhere.  In short we would be turning back the clock to a world before the BRICs and the paradigm of decoupling emerging markets. 

Steering the train
Not that you would know any of this from reading certain news and reports.  Two books have been published which detail the global commercial empire which has been constructed for the Chinese state's foreign commercial interests, each shining light on a hitherto dark area.  

In China's Superbank, Henry Sanderson and Michael Forsythe delve into the rise of China Development Bank, the unique monolith nurtured by princeling Chen Yuan into the powerhouse which recently lent more to large infrastructure projects across the developing world than the World Bank and has been at the centre of the rapid growth of the Chinese economy (in particular inventing the controversial local government financing platforms which critics believe may become very risky for the Chinese economy soon).  In China's Silent Army, Juan Pablo Cardenal and Heriberto Araujo have explored the many outposts of China's commercial interests around the globe and drawn insight from the vast range of projects and characters they have come across.  As per an article in the New York Times on the latter, the message is that China is taking over (and in case you missed it a Chinese company Shenghui completed the biggest Chinese acquisition of an American company when it bought Smithfield Foods, America's biggest pork producer).

And similarly, news of state backed hacking by Chinese government or military units (and/or their affiliates) along with announcements that the Chinese Navy is patrolling the waters of the United States Exclusive Economic Zone for the first time all point to increased strength and more aggressive posturing of China towards its neighbours (in addition to South China Sea disputes that is).

However, all is not as it seems.  Several Chinese entities have seen their acquisition efforts falter, one example being financial behemoth CITIC which saw its $2 billion investment in an Australian iron ore mine balloon to $8 billion (with delays) compounded by further $2 billion losses on unfavourable hedging.  And as suggested in the sub-heading there may be some interesting historical parallels.

For while there are outward signs of strong successes, in China proper there are reports which suggest all is not well and possibly stagnating.  None of these will be unfamiliar to readers of this blog, but the scale of the reports is worth noting.  The Economist finally has a piece (though ostensibly told through a review of a book) suggesting the team finally acknowledge the scale of shadow banking in China and the risk dynamics.  Debt levels at Chinese companies have been described as "alarming".  The BBC and other outlets reported that China labour costs are now high enough that many factory owners are considering relocating.  And of course the administration is quietly getting on with the task of battling gargantuan corruption of state officials.

It was whilst reading about efforts at reform during the Brezhnev era of stagnation that the writer saw some detail about the failed anti-corruption campaign.  For a bureaucracy the size of the Soviet Union (or China), taming an out of control culture of inducted officials was just too difficult.  And yet meanwhile on the world stage the Soviet Union was at its zenith and projected its military and political power the furthest (though in doing so it set up the conflicts with each of the major powers that would later weaken its empire).  The economic malaise had been set in motion many years before, and hence (to finish) a joke which may offer the reader some parallels with the current situation facing China:

Vladimir Lenin, Joseph Stalin, Nikita Khrushchev and Leonid Brezhnev are all travelling together in a railway carriage. Unexpectedly the train stops. Lenin suggests: "Perhaps, we should call a subbotnik, so that workers and peasants fix the problem." Stalin puts his head out of the window and shouts, "If the train does not start moving, the driver will be shot!". But the train doesn't start moving. Khrushchev then shouts, "Let's take the rails behind the train and use them to construct the tracks in the front". But it still doesn't move. Brezhnev then says, "Comrades, Comrades, let's draw the curtains, turn on the gramophone and pretend we're moving!" 

Let them eat cake!

Dying days ahead of a revolution?
Before entering into the Chinese presidency, current leader Xi Jinping was rumoured to have been handing out copies of de Tocqueville's L'Ancien Régime et la Révolution as a signal on the need for the party to reform and commit itself to purging corruption and addressing the need for improving Chinese welfare following decades of breakneck till-we-choke economic growth.  Recent reports that the territory of Macau, a gambling enclave which also operates as a centre of excess for Chinese gamblers (and a laundry for Chinese officials' cash proceeds) will see the opening of an ultra-luxury hotel employing a descendant of the French King Louis XIII, might have many readers exclaiming "l'ironie!".  The comments of the project company's owner might suggest a reaction more along the lines of that to Marie Antoinette.

“The willingness of mainland Chinese to spend money on the very best is unprecedented,” said Mr Hung, who also plans an invite-only atelier of luxury brands offering bespoke couture. Graff Diamonds has already signed up."           

That other established luxury brands are already slowing in China (and Hong Kong) seems not to matter to much to some, but the success of the project will remain to be seen.  What was seen though were hordes of people at Chinese gold shops seeking to aquire bullion following the price drop - so perhaps luxury is second in mind for the moment?

Dirty business
Meanwhile in another corner of the Chinese economy there is plenty of unseemly behaviour being exposed in news out from the domestic bond markets - including profit skimming by traders and possibly the death of an executive who fell from an office building.  More on that later.

A number of outlets have covered recent developments in some detail.  Caixin had a long piece detailing the executives arrested for dealing and profiting at their client's expense as did Reuters (and here).  Simon Rabinovitch at the FT has also covered the issue and had a good piece explaining the involvement of reformer heavyweight Wang Qishan in not only cleaning up the interbank bond market, but also (possibly) intervening to block the NDRC from encouraging local governments to over-borrow.  Those who have read Red Capitalism by Walter and Howie or other such works will know that the conflict between the reformist PBOC and statist NDRC, is one that has carried on since the first Chinese financial liberalisation in the 1990s.  As noted in Simon's article:

"...bond traders have told beyondbrics that there may also be another, more political reason for his involvement. The interbank bond market has been carefully nurtured by the central bank, which has tried to ensure that risk is properly assessed and ultimately borne by market participants....Over the past two years, though, the NDRC has weighed into the market, pushing it as a venue for local governments to raise financing, even when their credit-worthiness is suspect. That has started to undermine the central bank’s efforts.

According to this version of events, Wang’s main target is not really the few bond traders under investigation. Rather, he is helping shine a strong light on the bond market to check the encroachment of the NDRC and keep the control in the central bank’s hands."

 and this amidst other efforts to better identify brewing risks from interbank lending (here).  In sum though Wang may be successful, it does lead to a question of how much malpractice is out there?  

Details of the death of the chairman of one securities company were to be found in the FT rather than from a whitewashed press announcement from the company's own website (which referred to death "for health reasons").

Crumbling city
And in addition to some illicit brokerages it seems the buildings housing China's financial industry themselves may be at risk of crumbling.  Vivre la différence!

More and more numbers

China watchers will have been accustomed for some time to the news around numbers coming out of China.  Last year, many headline news stories focussed on the magical figure of 8 - 8% GDP growth that is.  Eight is a lucky number in China but in particular it had for a long time served as a useful baseline for configuring policy - 8% was supposed to be the level at which i) China's economic growth would comfortably surpass and ii) any concern of civil unrest could be dismissed because there would be enough jobs and development to keep the masses happy.

Fast forward to 2013 and the new administration led by Xi Jinping has sought a reset.  Not only had the stated headline growth in fact fallen below 8% (7.4% and 7.6% in the second and third quarters of 2012), but in recent days Xi announced that the days of fast growth were over.

This is nothing new to some readers, the leadership has been hinting at this policy for some time, particularly as some of the costs of rapid growth (including air pollution in Beijing, rivers full of dead livestock, restrictions on imports of uncontaminated foreign milk powder) have become more visible.  What is interesting is that some of the other numbers by which outsiders assess the economy are also pointing to shifts in the economic direction - and possibly not before time.

The most significant statistic in this trend was that of exports to Hong Kong - as noted in a recent Bloomberg piece, and in other media, net global exports and imports rose around 10% (though imports greater leading to a sub $1 billion deficit), were overshadowed by an "astounding" 92.9% jump in exports to Hong Kong.  Many speculated about the causes for this, most likely some sort of fraud or arbitrage activity.  This blog has discussed arbitrage and speculation strategies which use recurring loans to take advantage of differentials between Hong Kong and Chinese versions of the currency (which are priced differently), often using fake invoices.  Others have noted the use of inflated invoices to simply get capital out of the country (capital flight).  Inflated tax rebates and faked local government data are also blamed, but there seem to be real questions as to the competency of Chinese authorities and the likelihood it points to weaknesses in the Chinese economy:

“The breakdown of exports by destination veers towards the absurd,” IHS economists Xianfang Ren and Alistair Thornton said in a note today. “There is plenty of anecdotal evidence to suggest that exporters are faking orders” and using a practice to obtain export-tax rebates, IHS said.Zheng Yuesheng, a customs administration spokesman, said today that the practice of false trade declarations “does exist, but is definitely not mainstream.” Exporters must bear legal responsibilities if they do that, Zheng said.The agency has made an initial probe into possible money flows disguised as trade with Hong Kong, and will “work with relevant departments to conduct deeper and more detailed investigations and research so that we can be completely clear about various reasons behind the extraordinary trade growth with Hong Kong,” Zheng said at the briefing in Beijing.

Meanwhile other numbers released pointed to the continuing trend of increasing foreign exchange reserves and gold acquisitions, falling venture capital investment and continuing reported findings of high levels of corruption amongst public officials.  The latest case involves the former head of the powerful Ministry of Railways, accused of accepting $10 million in bribes.  This follows releases of the business interests of ruling Chinese families by Bloomberg and the New York Times last year (a current investigation, by the International Consortium of Investigative Journalists has hinted at information, but not made any significant disclosures yet).  For less high profile convictions, the FCPA Blog maintains an accurate list of current reports of bribe taking).

All in a plan
Whilst looking into another topic this blog came across the latest 5 year plan for the Financial Industry (released in 2012) and there are some numbers amidst all of the vague platitudes (of what harmonious things "shall" happen to improve the efficiency, growth and resilience of all elements of the financial sector).  Overall dominant international law firm Linklaters published a summary talking up the plan as aiming "to promote the steady growth of the financial industry by introducing changes to further regulate and develop the market", but the document has several numbers and supporting statements which look odd:

"The ratio of provisions set aside by commercial banks stood at 217.7%, exhibiting significantly enhanced overall strength. The share of assets brought by the securities industry reached RMB 2.05 trillion, exhibiting a 583% surge compared to the end of 2005 and substantially enhancing its risk resilience capability"

"Small and medium commercial banks were committed to ever deepening reform, while financial asset management companies made steady progress in their transformation"

"Financial risks shall be maintained under control in general. Major financial institutions in banking industry shall preserve high capital quality and level, while the percentage of non-performing loans shall be kept at relatively low level, with increasingly stronger risk management capability"

"The balance of payments shall be led to general equilibrium. Financial policies including
interest rate, exchange rate and foreign exchange administration shall play an important role in achieving the equilibrium in the balance of payments"

The first statement while probably true suggests an out of control boom more than anything.  The other statements, while based on similarly optimistic and suggestive numbers are likely false, particularly the last (except to the extent of de facto truth due to incorrect inputs).

Discussion Topic
Since the Cypriot implosion there has been discussion of the pricing of CDS (credit default swaps, which pay out when entities default) for other Eurozone countries and, in some cases, how concern about CDS payouts (which have to be made by large investment banks) might change the profile of decision makes who are administering bailouts and devising restructuring plans (lest they be accused of stirring the markets by causing a default which triggers CDS payouts unnecesserily).  A question for readers as to what impact there could be from the implosion of large Chinese banks or a change in the risk profile (and CDS pricing) for the Chinese government?  China featured in the top 10 of CDS net notionals for governments in late 2012 and current statistics for liquid CDS (including China) published by Markit are here.  Any comments are welcome!

On a final note of this numbers themed post, a few words from rapper Mos Def and his tune, Mathematics:

Numbers is hardly real and they never have feelings
but you push too hard, even numbers got limits
Why did one straw break the camel's back? Here's the secret:
the million other straws underneath it - it's all mathematics

FURTHER NOTE - Michael Pettis has a new post on the GDP numbers which is pretty comprehensive.  Has a nice discussion of the difficulty of stripping out activity to leave true economic growth - which unsurprisingly is a lot less in China than official figures indicate (here). 

Floating corpses...

In the wonderful booming economy of China, everything is in demand, or so the official line goes. Around the world, people and businesses expect China to have an insatiable demand for everything.  Even as a recent Beyondbrics post points out, burial space - the following extract gives some flavour of the demand for sea burials in Shanghai:

And not everyone is lucky enough to be buried in Shenyang – or in fact, in the ground at all. The Shanghai government recently increased subsidies it pays for sea burial fivefold, from Rmb400 ($65) to Rmb2,000, leading to an explosion of would-be seafaring corpses. Some families were told they would have to wait until 2015 to have their relatives buried, until the government was able to persuade another ship owner to add his vessel to the sea burial fleet. It is hoped this will clear a backlog of 2,000 urns of ashes waiting to be scattered at sea.
In 2010, government officials were predicting the city could run out of room to bury its dead by the end of the decade. Shanghai Daily says so far 25,000 urns have been emptied at sea, saving more than 75,000 square meters of burial land. The city wants to boost sea burial to 2 per cent of total burials, up from 1.5 per cent now.  

As the article notes (and has been extensively reported worldwide), these are not the only corpses which are floating around China now or into the future, as recent weeks have seen discoveries of large numbers of animal carcasses in waterways, including those feeding municipal water supplies.  No reasons have been given by officials for the discoveries, although there is speculation that it may be an unintended effect of recent food safety crackdowns.

This provides an interesting backdrop amidst attempts by the top leadership to focus on greater wellbeing of ordinary citizens.  But it is reflective of the corporate atmosphere in China at the moment as well.  Last week saw the first Chinese bond default as the main subsidiary of former solar giant Suntech entered into bankruptcy.  This had been predicted by many for some time (and noted on this blog) and the fundamental weaknesses remain in the industry, as the opportunities for solar panel cells remain troubling.

How many other floating corpses will there be in China?  Probably a lot.  In addition to other Chinese solar companies like LDK and Chaori which are also facing significant weakness, signs of trouble in bigger state-owned companies were also present with news that CNPC was planning to sell stakes in certain pipeline projects (the linked article mentions strained working capital - not a good sign).

Strong earnings in the corporate sector are supposed to ensure that there is a successful rebalancing of the economy- with growth in Chinese consumer spending and slowing of exports.  At least on the consumer side that does not seem to be happening.  Local sportswear retailers, once the darlings of various stockmarkets when they listed shares a couple of years ago, are predicting tough conditions for this year, while international brand Nike has seen declining sales in comparison to this time last year.

Any doubts as to the difficulty of the consumer story in China should be satisfied by the below picture - taken from queues of people who attend a McDonald's restaurant promotion which involved a free breakfast giveaway.  While the comments section of the article was full of debate as to why those queuing would cover their faces - the below image does not suggest a land of happy rampant consumerism!

Caption competition
On a final note we are welcoming suggestions for a caption for this picture, which is of the underside of a newly built bridge in Nanning city, which unfortunately only clears a pedestrian walkway by 1.3 metres.  Prizes to be announced!