Two steps forward?

Gathering headwinds...
After a break from blog-posting it is interesting to see a consensus forming as doubts further crystallise around the China and BRICS growth story.  At least on one report, the IMF has joined the increasing ranks of observers who are bearish on growth prospects, while in Beijing another chapter in the grizzly Bo Xilai saga progressed when, on the eve of a national holiday, it was announced that a consensus on the persistent political questions had been reached - Bo Xilai would be expelled from the party (to face a criminal trial) and the 18th National Party Congress would take place on 8 October (apparently a date which will bring good fortune).

Good luck will be needed, because China is facing a number of headwinds, including tensions with Japan over disputed islands and the slowing economy which has even been noticed in the wealthy tech hub of Dongguan.  Aggressive positioning such as talk of rapid sales of Japanese bonds by the Chinese (at a time when it is trying to diversify its holdings of US treasuries), a no-show by Chinese banks at an IMF Conference in Japan (when Chinese banks may need assistance from the IMF sometime in the future) and announcements of ever-increasing local stimulus (which UBS called "unicorn", JP Morgan called "castles in the air" and the Beyond Brics team have taken to comparing by regional cuisine), seem counter-productive while uncertainty surrounded China's leader-in-waiting, who disappeared for 12 days recently.

The human side to the evolving atmosphere has come to the fore recently - not only with the riots at Foxconn facilities (and if you are hoping to read this on an iphone 5 - deepest sympathies), but also with deflationary prospects further reducing likelihood of a rebalancing and growth in consumer demand.  Gavekal Dragonomics has noted that given the current destocking cycle and fading CPI numbers, a little bit of inflation may be a good thing.  At the sharper end, industries like solar are desperately trying to slash costs and restructure debts.

Chinese de-stocking in action

A gold postscript
There have been some interesting commentaries about global currencies and the monetary system in the past couple of weeks, including from the Economist and from George Magnus of UBS who still sees issues from global savings imbalances.  Following on from the last post there has been some further discussion of the possibility that China is in fact stockpiling gold (here also and even that China and Russia are stockpiling in concert in response to US quantitative easing).  Ironically for both China and Russia, any suggestion of monetary system strength has been challenged by heavy use of reverse repos by the countries' central banks (by which the central banks inject cash into the domestic banks in exchange for securities  - other link here).

It was noted in the commentary of the Russian moves that the repos coincided with announcements from the Central Bank of Russia that it would not intervene to support the Ruble (Russia's currency).  While it was noted that this was a gesture likely to be received well by markets as pro-reform (like Renminbi liberalisation in China), especially given the CBR's previous failures to do so, the alternative explanation, that the central banks simply do not have sufficient resources to defend their currencies from outflows.  Parallel to this it was announced that official estimates predicted a sooner than expected ending for Russia's long established current account surplus, due to falling exports and high government expenditure.

Beyond any policy preferences the central banks may have in pursuing reverse repos (and the short term stimulus they provide), there remain risks for the central banks, namely i) that they will become less effective and ii) the central bank will run out of resources to execute the repo operations.  There is evidence of both these effects in China (links here and here).

Some analysts expect ineffective repos could lead to an RRR cut (reducing the amount banks are required to hold in deposits) which could free up lending and accelerate inflation and stoke lending and the property bubble - something it turns out is additionally caused by social factors including the one child policy according to Foreign Policy magazine.  Growth in the Chinese property market is already picking up, but as shown by Also Sprach Analyst in a current series, the current valuation models may significantly miscalculate the market.

A call for more clarity on China is probably due.  Or at least after the unicorns are gone.

Gorillas in the mist

Goldman Sachs Asset Management chairman Jim O'Neill popped up in the news this week, releasing a note to clients with some revised thinking on prospects for China's economy.  With still a favourable overall view, O'Neill considered several likely outcomes for Chinese growth, including a "pessimistic" outlook of 7% GDP growth.  An interesting point in his analysis - that in any worst case growth scenario, the Chinese government is "surely to step in", attracted some comment as many noted that given certain conflicting undercurrents and factional conflicts within the administration and the Chinese Communist Party, the Chinese authorities may not be willing or able to intervene.

Similar to the reaction when various large Chinese cities announced vast new spending programs, some observers were sceptical as to whether bold political action will be as likely be delivered as in 2008.  O'Neill's fund meanwhile has been promoting a new set of fast-growing MIST countries (Mexico, Indonesia, South Korea and Turkey) which have been the star performers in the fund's popular Next 11 fund. And the failure to even consider a less than 7% GDP growth outcome (when some commentators consider that growth may be negative) suggests O'Neill might just be missing a gorilla in the room - Asian (and Chinese) slowdown which others believe may not be priced in by the market.

A very strategic resource
The last couple of weeks saw a renewed debate considering the return of a gold standard as a way to restore stability to the global economy and encourage growth (and end America's money printing), even while the balance of opinion believes such a standard is a false hope or otherwise likely to result in the stagnation currently seen in the Eurozone (which as Peter Coy explained arguably is committed to a new gold standard).

There is an interesting angle for China in this debate, as it has been active in the gold markets.  As you may recall China has been trying a basket of different measures to manage its economy including Keynesian stimulus in 2008, enormous foreign exchange reserves, capital controls and now liberalising exchange rates (which may be countering each other in effectiveness).  In fact reports have emerged which provide detail of China's activities in gold as well.

In addition to outright purchases of the metal, interest was also expressed from Chinese companies in acquiring gold producers.  In its report of China's largest gold producer, China National, considering the acquisition of a majority stake in the African subsidiary of the world's largest gold miner, Barrick, the Beyond Brics blog reported that the company's president, Sun Zhaoxue believes that China should view gold as a "strategic resource as important as petroleum energy".  That might partly explain why there is a gold mining division in the Chinese internal security forces (the People's Armed Police).

As well as its value as a metal, reserves of gold have been argued by some as a better store of value for a national central bank than government bonds, especially in a low inflation environment where the government issuer of the bonds is engaging in monetary easing (which depresses the yield as the price increases from the asset purchases).  In China's case it is looking for an alternative store of value to offset its huge holding of US Treasuries (US government bonds) which earn low rates of interest because the US is engaging in Quantitative Easing (printing money by buying US Treasuries) and which it cannot liqidate easily.  The liberalisation of the Renminbi (i.e. the process of opening the Chinese currency to full convertibility) is seen as one step that can counter-balance China's US dollar holdings (as the greater volumes of Renminbi will be used and deposited internationally).  Sun Zhaoxue alludes to this in his article.

However it is questionable whether holding gold ipso facto will ensure greater security for China.  How so? Well looking into some of the debate around the merits of a gold standard suggested that the credibility of the system might be more important than the physical holding itself.

I hold therefore I am
Outspoken financial journalist Max Keiser, has looked at a number of commodity stories, including possible manipulation of the silver market by JP Morgan and its high frequency trading (HFT) business (background here).  In a recent broadcast Keiser examined some of the justifications given by gold bugs (especially libertarians in the US), who he found often confuse their libertarian values (such as objectivism advocated by Rand) with the behavioural principles of the "Austrian school" (advocates of a gold standard).

A key question in the discussion was the degree to which financial institutions could issue credit secured against their gold reserves - it is only physical gold which is the "ultimate extinguisher of credit", but the use of fiat (paper) money removes the gold from credit making it easier to expand credit (which if prolonged can cause inflation and is exaggerated by quantitative easing).

In his article Peter Coy blames the First World War for causing the inflationary expansion of credit which destabilised the gold standard, however according to the Cato Institute (which is apparently libertarian) in a paper on this topic, von Mises, a key figure in this analysis, believed that instead of the war, it was the attempts by bankers to get around the gold standard and increase credit in the economy, when, from the 1890s the world's central bankers relaxed the standards of inter-central bank credits:

 It was'' not the old classical gold standard, with effective gold circulation,'' that failed after 1929; what failed was'' the gold 'economizing' system and the credit policy of the central banks of issue'' 

What von Mises proposed (to address this inherent conflict) was that the gold standard should be operated completely independently of monetary matters and essentially gold should be valued at production cost.  And this is interesting because it seems to be a call for independence, similar to that underlying the Bitcoin digital currency, which operates free of any government and is instead backed by the power of the computing network of Bitcoin users (with no centralised issuing authority).

All of this would suggest that credibility is important.  As well as the amount of gold which the People's Bank of China (the central bank) or other bank may hold, financial market participants will also assess how credible those banks are in administering and valuing such reserves.  This may not be as simple an assessment as it seems.

In gold (and tungsten) we trust...

Frauds of the week
Mentions must go out to:  the Chinese Art market (worth $13 billion according to Forbes magazine) and  China Sky One Medical and its chief executive (which the SEC charged with securities fraud this week for overstating financial results).

Goodbye to BRICS?

The economies of the much talked-about BRICS countries are crumbling.  This was the headline in a post this week in the FT blog, Beyond Brics (which has these emerging economies as its focus).  Perhaps for the first time in a long while, disappointing economic news came out this week for each economy in the club first identified by Goldman Sachs' Jim O'Neill in 2001 (and formally launched in 2009).  For China, significant attention was paid to Thursday's unexpected interest rate cut by the central bank, the first since 2008.  Despite initial positive reactions, concerns were later raised that a) Chinese authorities would not have the scope to conduct loosening on the scale necessary or similar to the stimulus in 2008 (or if it did it could be detrimental) and b) that the rate cut may in fact have been driven by more serious concerns of slowdown which may be revealed by monthly production data, to be released this weekend.

Pumping in cash
Prior to the interest rate cut, the methods of stimulus were in focus with many concerned that some of the excesses of the 2008 stimulus be avoided.  Attention was paid to the National Development and Reform Commission (NDRC), a bureaucratic body which approves many large-scale development projects and had gone into overdrive in 2008/9.  Just how rapidly the NDRC rubber-stamped big ticket projects then was studied by Victor Shih (discussed in a forum last year, link here).  Meanwhile Victor noted on his twitter feed that the NDRC had also recently approved a "bad-ass project to artificially influence weather in NE China" (announcement here).

The NDRC has also approved several large steel projects, at a time when the sector is unprofitable.  As discussed with steel companies, the concern is not only that stimulus financing could be misallocated to inefficient projects which lose money (and result in increasing non-performing bank loans), but also that money provided (for bricks and mortar purposes) may be diverted into further lending and speculation.  Recent shorting of the stock of construction machinery maker Zoomlion (listed on the Shenzen and Hong Kong exchanges) has exposed the ingenuity of some operators with suggestions that even some of its concrete mixers may have been acquired to be used as collateral for further lending.

One development project which needs funding

Business as usual?
Meanwhile Chinese officials do seem to be seeking to assert more control over information in the financial sector.  Recent Wall Street Journal articles gave some interesting details about measures which have been viewed sceptically by foreign investors and regulators, including requirements for greater localisation of foreign accounting firms and a recent decision at one of the key repositories of data on Chinese companies, the State Administration of Industry and Commerce, to significantly restrict access to its records (which may have been related to the fact that these records were used by many of the foreign analysts who short-sold stocks of Chinese companies in the last 2 years).  In contrast, problems of oversight remain in the banking sector, where implementation of the Basel III banking reforms have been further delayed to commence in 2013 and the executive vice president of the Agricultural Bank of China (one of the large, listed pillar banks of the Chinese economy) was detained on corruption charges at the end of May.

Perspectives on the Chinese currency
As mentioned previously, a bit more coverage of the Chinese currency is overdue- a topic which can be a little confusing simply by the fact that it has several denominations (offshore/onshore) and two interchangeable titles in reports - Renminbi/yuan (with the latter being the unit of denomination) as well as the nickname of the "redback".  Until 2009, there was not much to say about the Renminbi except that it was in a fixed and then managed float, and was undervalued against the US dollar.  With US pressure and liberalisation measures, the value of the Renminbi has started to change recently.

Some background to note - one of the reasons China was reluctant to allow a flexible Renminbi rate was fear of "Plaza" - fear that the Renminbi could appreciate rapidly in the same manner as the Japanese Yen did after the coordinated action of central banks to devalue the US dollar in 1985 (pursuant to the Plaza Accord).  Many view the appreciation as a key causative factor in the asset bubble which triggered the collapse of the Japanese economy and the subsequent slow growth in the 1990's referred to as the "lost decade".  In China's case, the fear is that a rapid appreciation of the Renminbi (which could start upon a free float) could eat into China's export economy and threaten jobs and social harmony quite significantly.  From the US perspective, similar to 1985 position against the Yen, the undervalued Renminbi has been a key cause in the large US trade deficit with China and allowing it to float would cause an appreciation (and dollar depreciation) that would give a boost to US exporters and shrink the enormous imbalances with China (in particular the People's Republic's gargantuan holdings of US Treasuries).

While most commentators viewed a simple appreciation as neither feasible nor a solution, the policy background has become more complicated.  In particular:

i) Policy makers have favoured gradual liberalisation or "internationalisation" to diversify China's reserve holdings away from US dollars and to open up the Renminbi to use in international trade settlement and as an international reserve currency.  From 2009, measures were adopted to allow greater international use of the Renminbi, befitting China's status as a pre-eminent trading nation.  The sort of thinking underlying this move is outlined in a recent FT article.

b) A consequence of the measures which have resulted in greater circulation of the Renminbi is increasing complexity of Renminbi valuation.  In particular there are greater opportunities for capital flight and arbitrage between onshore and offshore Renminbi (including those involving stockpiled metal as collateral).  As this insightful Beyond Brics piece notes having looked at recent data from global payments network SWIFT one type of arbitrage that appears to be happening frequently is as follows:

A Chinese company places renminbi on deposit with a mainland bank, earning an interest rate of about 3.5 per cent. The company then obtains a long-dated, renminbi-denominated letter of credit from the bank, ostensibly to pay for a shipment of goods from its own subsidiary in Hong Kong.
In turn, the Hong Kong subsidiary takes the letter of credit to a local bank and uses it as collateral to obtain a US dollar loan at a lower interest rate than those available on the mainland. In many cases, the company would also use a currency derivative to eliminate the foreign exchange risk. The end result: the company has captured the difference between onshore and offshore interest rates, less banker’s fees.

and worringly:

If international trade in the renminbi is largely driven by financial arbitrage, as the extraordinary use of letters of credit implies, then Beijing’s plan to internationalise the renminbi is not exactly going according to plan.

Likewise all is not going according to plan in the offshore "dim sim" bond market where foreign companies issue bonds in Renminbi in Hong Kong (encouraging demand and use for the Renminbi denominated securities) - as noted in May, yields on dim sum bonds have been rising making it cheaper to raise finance in other currencies and markets.  And as mentioned previously, Victor Shih and others have found the impact of capital flight (on flows and valuation) by connected elites could be significant.

c) But perhaps, most significantly, the mechanism by which China recycled US dollar export earnings into reserves (and managed its currency flows domestically) is breaking down, primarily because of an export slowdown plus Europe fears and greater reluctance of exporters to settle their dollar deposits.  A detailed study out by Nomura is described here tracks the slowdown in the accumulation of dollar reserves.  The Nomura team conclude on one aspect - the slowing of the flood of US dollars gives the People's Bank of China more scope to act on monetary policy.  However, if this pattern is sustained, the other effect could be devaluation and/or a need to sell down reserves.  An ING note discussed yesterday concluded that signals to this effect were temporary but this may not be so.  Looking at April data:

The data reinforced fears that the economy was on a slippery slope to a hard landing via an overvalued currency and capital flight..

In the least the note did conclude that the Renminbi was overvalued at the moment (as did the IMF, in a shift from its recent position).  Perhaps a good concluding example of uncertainty with the Renminbi's prospects is seen in this article about a Renminbi deposit account offered by the Bank of China's New York branch.  Set up as part of the internationalisation so that foreigners can hold Renminbi, there is a question though whether they would wish to do so if there is a chance of devaluation?