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Wednesday, 26 June 2013

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). 

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