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!"