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Sunday, 20 July 2014

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...


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