The reform legacy - Part II

Since the last post there have been a couple of articles which highlight quite well the importance of the reform debate and the main themes.  As the PBOC launched further stimulus (including via a new tool called "Pledged Supplementary Lending" involving 1 trillion yuan for new lending), James MacKintosh, Investment Editor of the Financial Times filmed an interesting presentation giving some context to the resulting rise in share prices. While ordinarily share prices would be indicative of higher confidence and expectations for growth, MacKintosh noted that the sectors which had shown the greatest share price increases (and saw the best response to stimulus measures) were companies in the banking, property and industrial sectors - all sectors which the Chinese authorities wanted to steer investment away from (and into other sectors) as part of the reform and rebalancing process.  Or as James put it:

 "a return to pre-crisis business as usual...a pause in reform means less risk in property and banking as well as the old line state-owned enterprises".

"China Property Gamble" (c) Financial Times

Of course what James didn't dwell on (but certainly implied) is that there would be more risk overall and in the medium to long term (hence the need for reform to reduce the risk, sadly not carried through).  Over at FTAlphaville, the suppression of risk was covered well in an article by David Keohane who noted falling bond yields, the bailing out of one trust which had been set to default and a pessimistic analysis from reputed analyst Diana Choyleva of Lombard Street Research who noted:

 ...But the more sinister explanation [of failure of domestic demand to drive economic growth] is that the authorities are unable to provide a significant boost to growth even if they want to. They may be trying to boost credit to SMEs, but demand for loans has come off again. China needs to clean up after its debt binge, not stoke it further. The current level of debt may just about mean that Beijing has a chance to reform successfully even if that will involve a few years of meagre growth and financial distress. But the ongoing rapid rate of increase in debt suggests that policymakers do not have too long to postpone much-needed defaults...

Zerohedge meanwhile has taken a much more vigorous editorial line and especially with the Qingdao commodity financing scandal (including discussion of a note from Goldman Sachs as to the impact from an unwinding of metal-based rehypothecation).  On the new stimulus measures and their indication of the slowdown in reforms, contributorTyler Durden is blunt:
 

So whatever way you look at it, the PBOC thinks China needs more credit (through one channel or another) to keep the ponzi alive. Anyone still harboring any belief in reform, rotation to consumerism is sadly mistaken. One day of illiquidity appears to have been enough to prove that they need to keep the pipes wide open. The question is where that hot money flows as they clamp down (or not) on external funding channels.

And also:

Simply put - you can kiss goodbye any hopes of China ceasing its exuberant credit creation... (especially now that the CCFD ponzi scheme has been exposed via Qingdao -and drastically reduced that channel). Reforms are all talk and the bubble will just grow bigger with fewer and fewer attractive outlets for that hot money (now that the US real estate transmission channel has been identified and likely closed)... cue real inflation.

From those Zerohedge articles are two charts of note, the first showing the total amount of credit (bank assets) in the Chinese economy and its rapid growth:

and the second the rise in rates which preceded the recent PBOC stimulus (after it apparently stopped conducting repo operations), which corresponds nicely with the increase in share prices mentioned before (imagine the effect on share prices if repo rates continue to rise and there is no new liquidity from the PBOC?!):

 

Finally, while it will still remain for the next post to discuss some summer reading about the history of reform in China, it can be added one extra piece of reading on exactly this point - a 2013 IMF Working Paper:  "China’s Path to Consumer-Based Growth: Reorienting Investment and Enhancing Efficiency" (here), which " proposes a possible framework for identifying excessive investment".

The reform legacy - Part I

One of the most significant debates of the moment is the extent to which China is engaging in reform away from the production-heavy, subsidised, export-orientated economy towards a more balanced, consumption-led, open and lower growth (but more sustainable) model.

This is the background amidst which debates such as regarding China's target rate of GDP growth and the internationalisation of the currency (the Renminbi) have occurred and there are plenty of opinions on offer.  A good example was seen at the conference organised by the Financial Times' offshoot FTAlphaville, where celebrity guests Michael Pettis and Carson Block offered differing visions - in a short interview Pettis noted that rebalancing was proceeding in a more or less predictable manner (with reforms proceeding as announced in the Third Plenum), while for Carson Block, an impending debt crisis would likely arrive sooner and cause enough trouble as to hinder any meaningful schedule of reform. 

As it happens Pettis has considered the issue of debt quite specifically and a recent post on his blog argues its importance in understanding China's growth prospects and in understanding rebalancing - a feature of one of his recent books.  A recording of Pettis speaking at the 2013 Wine Country Conference sets out the background in excellent detail and is a real eye opener - Pettis likens the Chinese economic model to that of Japan "on steroids".  There is an interesting contrast with Pettis' blog post - which concludes asking the question of where the great losses from the excessive debt will be recognised.  In the Wine Country presentation Pettis details how losses in Japan were absorbed by the government when it took on the debts of the banking system rather than overseeing writeoffs (in a manner similar to which European sovereigns today are taking on the risk of their bloated banking sectors).  It would seem likely that the same may occur in China, where corporate debt now has surpassed that of the US and is estimated to be 200% of GDP.

Leaning to the chaotic
As Pettis notes in his presentation and elsewhere rebalancing is inevitable from a macroeconomic point of view and amidst the choices available to economic decision-makers are a range of outcomes from orderly rebalancing to chaotic.  Recent news has suggested that (i) authorities in China are trying to delay rebalancing, through measures like the "mini-stimulus" (which will only worsen the outcome later on) and (ii) events on the ground may be starting to overwhelm the ability of the authorities to maintain control such that rebalancing will not be orderly.

The mini-stimulus was unveiled in April 2014 with announcements of new spending targeting SOEs and state-focussed industries, with results appearing to show increased production by mid June and into July.  So far as expected.  But in addition to wondering where the next round of growth is going to come from since the administration's mini-stimulus has delayed SOE reform and shifting of production to the private sector, several themes have emerged in the background which could undermine the whole process.  These are:

1.  The divergence between Government and Private Economics surveys
As this article on Zerohedge notes, essentially one of the teams producing the surveys is likely just making up the numbers since private surveys show economic stagnation while government produced statistics paint a rosy picture.

One set of statistics is likely to be false and if it is the government produced statistics then the state of the Chinese economy could be grave.

2.  The property market is imploding
Daily updates on the Investing in Chinese Stocks Blog are offering a disturbing picture of financial collapse across the country with nationwide price falls in properties for sale in cities across the country, developers launching all manner of tactics to clear sales targets and credit guarantee and other private financing firms seeing their directors flee owing creditors millions.  This is getting litte attention in the Western media although an article in Zerohedge (drawing from a Bloomberg article) provides a useful summary.

3.  The commodities finance trade has frozen up
Sophisticated China watchers will be aware of the holes in the great capital wall which have allowed capital to circulate through the Chinese economy and keep it functioning, including the remittance program which allowed wealthy Chinese to evade the limit on remittances and engage in massive capital flight by transferring funds out of China to buy real estate in developed markets like Canada, Australia and the US.  One method of effecting remittances was through a hidden program at certain banks which was the subject of an expose by CCTV, the State broadcaster.  Commentators noted that the expose may have been part of a factional battle taking place between factions aligned with CCTV and the PBOC (since the programs were approved), but of even more significance is the emergence of fraud in the commodities trade.

Also arising as part of a corruption investigation, charges of fraud at the large port of Qingdao by Decheng Mining, a metals trader which offered financing and rehypothecated metal stocks (using the same collateral for multiple loans, including using forged documents) is of note not only because of the size of fraud or that international banks have been involved, but that the whole commodity financing industry in China is under threat and that as such a significant amount of liquidity for the Chinese financial sector which the commodity financing provides could be at risk.  An interesting article refers to a recent failure of a letter of credit settlement - which does remind of failures of repo trades which presaged the Lehman collapse - which can only be understood as systemic.

The next blog will look at some interesting summer reading which traces the historic background that helped lead to the current situation, but until then here is a shot from a new Chinese water park which speaks to more than just the plight of the swimmers...

 

A belief in the supernatural

Following the last post it emerged that there are another class of investors already taking losses (and expect more of these to appear).  In perhaps what could be termed the ending of the Xiaochan put (a corollary of the Greenspan put, by which US markets had been supported by intervention by the Federal Reserve), so a report from Morgan Stanley detailed the vast sums wagered by speculators positioning for a continued rise in the Chinese currency (the Yuan/Renminbi) which came to an end as the Central Bank in China, the PBOC (led by Zhou Xiaochan) sought to stunt speculation in the currency:

The seemingly incessant strengthening trend of the Chinese Yuan (much as with the seemingly inexorable rise of US equities or home prices) has encouraged huge amounts of structured products to be created over the past few years enabling traders to position for more of the same in increasingly levered ways. That was all going great until the last few weeks which has seen China enter the currency wars (as we explained here). The problem, among many facing China, is that these structured products will face major losses and as Morgan Stanley warns "real pain will come if CNY stays above these levels," leading to further capital withdrawal, illiquidity, and a potential vicious circle as it appears the PBOC is trying to break the virtuous carry trade that has fueled so much of its bubble economy.

and losses were estimated to be in the billions of dollars, and worryingly (given the deterioration going on in the Chinese economy) many of the holders of the loss-making positions were Chinese corporates:

In their previous note, MS estimated that US$350 billion of TRF have been sold since the beginning of 2013. When we dig deeper, we think it is reasonable to assume that most of what was sold in 2013 has been knocked out (at the lower knock-outs), given the price action seen in 2013...."Given that, and given what business we’ve done in 2014 calendar year to date, we think a reasonable estimate is that US$150 billion of product remains."...

...The potential for US$4.8 billion in losses for every 0.1 above the average EKI could have significant implications for corporate China in its own right, as could the need to post collateral on positions even if the EKI level is not breached... 

On the latest check this trend seemed set to continue with weak economic statistics, regulatory concern and weakness in the currency all referenced in a Bloomberg report.  As mentioned in that report, the spectre of capital flight and further destabilisation of Chinese financial markets is a not shallow risk.
 
Hope and dreams
Notwithstanding some less than pleasing numbers and off-message disclosures of some key figures in China's dynamic property sector and prices of apartments starting to be discounted in a way described as "crumbling" (and here), the facade of the great China miracle continues for the time being, even with the recent announcement of a passing of the US on one economic measure (not without criticism, including from the Financial Times).
 
As an example of the continued hopefulness and ambition the recent report of an ultra-fast lift to be incorporated in a new development in Guangzhou is a reminder of the Middle Eastern style optimism which has driven the China urban development story.  Of course reality throws up questions such as the need for a giant financial centre development in somewhere like Guangzhou but the need to maintain a motivating ideology for the continued reckless and unsustainable growth seems still to be a concern of those in power and with commercial interests.
 
This was noted by my recent reading of modern Party mouthpiece China Daily whilst transiting at an airport, which dedicated an issue to President Xi's own notion of the "China Dream", a new guiding vision for youthful and emerging China (with the cover story "Dream Debate").  While well composed and quite glossy, the feature section was disappointing as it fell into predictable patterns, including:
 

• a piece by American China apologist Robert Kuhn, who earlier said that the Bo Xilai scandal was only of interest to Westerners because it was "salacious";
• an advocacy of the status quo by Zhou Feng that contained such wonderful statements as "drastic measures are not necessary" and

"by withstanding the global financial crisis in 2008-09, the Chinese economy has become more resilient in its ability to deal with slower growth. Its trade sector, for example, has become used to operating with wafer-thin profit margins."

(that would be resilience by going bankrupt!) 

• a wonderfully titled piece by Yu Yongding "No financial meltdown to worry about", which argues that China will be fine because it does not have US subprime mortgages (trust loan anyone?)

and so on.
 
Over at Zerohedge, hyperbole notwithstanding there was a far more grim picture being painted of the situation in China currently:
 

China is a case of bastardized socialism on credit steroids. At the turn of century it had $1 trillion of credit market debt outstanding—-a figure which has now soared to $25 trillion. The plain fact is that no economic system can remain stable and sustainable after undergoing a 25X debt expansion in a mere 14 years....

...The borrowing, building and speculating mania in China has obviously gotten so extreme that even the new regime in Beijing has been desperately trying to cool it down. But this will end up as a catastrophic failure—not the “soft landing” brayed about by Wall Street bulls who do not have the slightest comprehension of the difference between free market capitalism and the phony “red capitalism” that has been confected by the party-controlled apparatus of the massive, intrusive, bureaucratic and hierarchically-driven Chinese State..

At bottom the fatal error among China bulls is the failure to recognize that the colossal boom and bust cycle that China is undergoing is not symmetrical. The much admired alacrity by which the state guided the export boom after 1994 and the infrastructure boom after 2008 is not evidence of a superior model of governance; its only proof that when credit, favors,  subsidies, franchises and speculative windfall opportunities are being passed out freely and to everyone, when there are all winners and no losers ( e. g. China’s bankruptcy rate has been infinitesimal), a statist regime can appear to walk on water....

...In short, the Chinese population “can’t handle the truth” in Jack Nicholson’s memorable line. They by now believe they are entitled to a permanent feast and have every expectation that they party and state apparatus will continue to deliver it. As a result, Beijing has resorted to a strategy of tip-toeing around the tulips in a series of start and stop maneuvers to rein-in the credit and building mania....

To the fireflies
That last paragraph raised an interesting aspect (contrasting public expectations and management by the authorities).  Exactly how well will China's population handle the transition which is to arrive once credit markets turn?  On the basis of one unlikely tourist venture, possibly not well.  The below picture (and final image of the post) is from angry holidaymakers who invaded the office of a tour company after a display of firefly insects did not materialise at an organised event:

Visitors shout at organizers during an event to release fireflies in Hangzhou, Zhejiang province, April 30, 2014. According to local media, about 10,000 people protested for a refund of their tickets, claiming they could not find fireflies to release at night. Picture taken April 30, 2014. REUTERS

 

The biggest loser?

The start of 2014 has seen a flood of commentary regarding the Chinese non-bank (trust) financial sector - with the last minute bailout of the oddly named "Credit Equals Gold" trust fund (sold through ICBC branches) in late January and a number of predicted defaults of trust funds linked to the coal sector (or actual default in the case of Jilin Trust) in February. As Bloomberg notes, yields on debt securities are also rising making finance more expensive for businesses in China, but the borrowing binge is continuing, with the FT reporting the highest rates of lending in four years (and a flood of new entrants into the trust and wealth management sector).

As longtime financing expert Charlene Chu has noted, there is increasing currency risk in the system as more borrowers resort to offshore lending.  In the same article in the Telegraph, George Magnus of UBS notes the similarity with Japan before its crash in the 1980s.  Unhelpfully as Ambrose Evans-Pritchard notes in his Telegraph comment piece, this is occurring amidst a policy of monetary tightening and contraction as the administration in China tries to rein in the heady boom of the last decade.

Notwithstanding the current focus on losses within China it is interesting to note some consideration being given to just how much will be lost by foreign lenders.  As Sean Darby, an equity strategist at Jeffries has noted there is significant exposure not only in Hong Kong (China's primary offshore investment centre), but in the banks of Australia, Europe and elsewhere.  It doesn't help that in Australia's case, the large domestic banks which are stuffed high with local real estate loans, desperate for growth opportunities are now aggressively moving into the Chinese market (see also here).

The below chart from Bloomberg (full size image here) shows the rapid growth of foreign lenders' exposure to China and in particular it is interesting to note the high exposures of British, French and Australian banks.  This may be something they come to regret.





(c) Bloomberg