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".

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?

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). 

Lost century?

Back to work
Following a relatively smooth 18th party congress, China Inc has got back to work, albeit with a slightly different vision for more balanced growth.  There was not so much to take away from the various press showpieces, especially since (as is usual), many of the real decisions had been made in the final days leading up to the summit.  A post mortem piece in the Chicago Tribune highlighted the role of retired senior figures still play in the party - there must have been plenty of non-Chinese wondering what Jiang Zemin was doing centre stage at the conference.  The Wen family saga  rolled on, with a second instalment from the New York Times examining the very profitable stake held in insurance blue chip Ping An insurance by Wen's family and the lobbying to Wen on behalf of Ping An in 1999.  Wen's response included being asked to be forgotten.

In the swansong atmosphere it seemed likely that press would look around for an identifiable theme and many outlets settled on comparisons with Japan at its zenith.  One comparison, in a fairly high level of detail for the BBC was quite simply titled "Will China fall flat on its face"!  One of the most concerning points of comparison, which has been noted elsewhere, was the different developmental stage between China and Japan - thanks to its one child policy and it starting form a much lower income base, China has rapidly accelerated the aging of its population to now approaching Japanese levels (though getting a dividend along the way with a relative boost of young workers which is now decelerating) and consequently may grow old before it grows rich. 

More worrying in the immediate term was the surprisingly candid, though balanced piece by Charles Dumas of Lombard Street Research who nicely brought together all of the strands of the Chinese economy which are of concern - debt, stimulus, defaults.  What is particularly worrying is the ease with which, in 2 places, Charles can lead to a conclusion of the occurrence of banking crises - as a matter of course, as inevitable as a policy setting! - without policy change (debt reduction) and with trend growth shifting down to 5 per cent, "a plague of banking crises" could be a result, as could occur if financial liberalisation proceeds.  This is not the story spun by the large financial institutions promoting use of the Chinese currency (the Yuan/Renminbi) in trade settlement and with greater convertibility.

But these two things combined paint a worrying picture.  If China has all of the preconditions of a Japanese style financial collapse - sufficient to bring about the slow burning decline of a "lost decade" or "lost generation" (a term in vogue even in the West as it pushes through austerity, or in the case of the European Union, can-kicking), then could the less favourable demographics, level of social cohesion or uncertain environment make the impact for China worse than Japan?  As it happens there are deep social divisions in China with assertive foreign policy in areas like the South China Sea stirring tensions amongst the population and with reports of inequality and division within Chinese society attracting increasing concern and attention.  The task of the Chinese Communist Party to reinvent itself for slower growth and newer ideologies also complicates things.  Added sleaze and corruption scandals make for grim prospects.

Underlying the resurgence of nationalism is a sense of continuity with the period from the mid-19th century until the mid-20th century, when the sovereignty of the Chinese empire and state was subjugated to foreign powers and influence, starting with the First Opium War until the expulsion of foreigners after the Second World War (the Century of Humiliation).  As commentators have noted, the current administration perpetuates the focus on restoration of international profile and prestige while skipping over the Party's failures. Inability for self-criticism may come to harm the Party and the nation in years to come, and should the effects of China's boom be felt across one or more generations, Chinese may have to face up to another century of lost potential in many years to come.

Cracks appear in the China bull market (c) Caixin