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?

Heading for the exits

A Chinese dollar?
Adding to the confusion of the different types of Chinese currency (onshore and offshore Renminbi), and some of the unintended consequences discussed previously is an interesting idea noted by the Beyond Brics team from from Richard Harris at Port Shelter Investment Management.  Given that the non-transferable offshore Renminbi (CNH) sits alongside the domestic Hong Kong Dollar (which although transferable is limited by a longstanding US Dollar peg) Harris has suggested combining the two, to make a "Chinese dollar".  Some details and a hint of some of the benefits for capital flows are set out here.

Such a move could viewed as a reverse-merger of sorts (merging the offshore Chinese currency with its onshore, established equivalent).  Reverse mergers, which were used by many Chinese companies to combine with US listed shell companies and fast track equity listings in the US - were the subject of a number of scandals in recent years, and a new battle for transparency has opened up between US and Chinese regulators (more below).

Fraud of the week
Last week, China focused US research firm Citron Research, caused a storm when it issued a strong research report condemning alleged fraudulent practices at Evergrande, a top Chinese property developer, (link here). In a similar manner to the Sinoforest debacle, the company's management responded to the release of the report and subsequent rapid stock decline with aggressive denials and Evergrande enlisted a number of its investment banks for support.  Worringly, Marketwatch's Craig Stephen raised the question as to whether a threshold had been passed, so that from now on, larger and more established companies on the Chinese mainland (including Hong Kong listed) could be subject to claims of fraud and insolvency.

Unhelpfully greater transparency which could reassure markets does not seem to be forthcoming.  There have been reports of harrasment and detention of investigators which short sellers and others have been sending to verify Chinese companies' operations on the ground (who some companies and their advisers allege are trying to spread false information), while it has been reported that access to Chinese company filings (which short sellers made great use of to publish their reports) has been restricted.  As Patrick Chovanec of Tsinghua University sets out in an interesting blog post, it is not only that company documents are becoming harder to get, but that certain requests for information by the SEC and its affiliates in respect of Chinese companies which are listed in the US have been refused by the Chinese authorities.  And as he puts it there could be serious consequences if the stand-off continues:

By the end of this year, unless a compromise can be reached, there is a very real chance that U.S. securities regulators may end up employing the “nuclear option”:  forcibly delisting every Chinese company currently listed on a U.S. stock exchange — such as Sinopec, Sina.com, China Life, and China Unicom.   It’s a potential catastrophe-in-the-making that few investors or politicians have given any serious thought to.

Meanwhile...200 stories up
Before such a calamity may eventuate, it is quite possible that one Chinese company which has been attracting a lot of attention in the property and engineering sector, Broad Sustainable Building, may have built the world's tallest skyscraper.  Announced last week, the Sky City One Project (if approved) will involve the company, which is famous for prefabricating all parts of its buildings in a factory and joining the parts together on site, erecting a building taller than the Burj Khalifa of Dubai (the world's tallest building, which took 6 years) in just 90 days.

Of course like the Burj it could be interpreted as a sure sign that the Chinese economy is heading for severe recession (some research on the correlation between skyscraper construction and the onset of economic downturns is referred to here).  A recent video from Reuters helps illustrate just how many skyscrapers are being built in China (and how quickly).

Tracking capital flight
John Hempton, a notable China short analyst attracted a lot of attention the other week with his blog post declaring China to be a kleptocracy - "of a scale never seen before in human history".  While there have previously high estimates of the scale of corruption in China (one leaked internal PBOC report identified $120 billion of illegitimate funds transferred out of China by officials in the preceding 15 year period), more details about how money is being transferred out of China has emerged recently.

In addition to laundering through trips to Macau casinos, overseas real estate has been popular, both in Asian countries and as more recently noted, in the US.  Victor Shih, of Northwestern University has been a leading light in the study of capital flight from China, and he has noted the significant impact capital flight by the wealthiest 1% of households in the Chinese hierarchy could have.

What is interesting is the connection of instances of capital flight to political tensions between factions of the Chinese Communist Party (CCP).  This report by Matt Gnaizda of NTDTV is a very helpful introduction to the Jiang and Hu Jintao factions in the CCP who are battling for prominence ahead of the expected accession of Xi Jinping to the presidency of China later this year.  Matt also mentions the connection of Bo Xilai, the recently ousted mayor of Chongqing to the Jiang faction.  Bo's wife Gu Kilai recently was reported to have admitted killing British businessman Neil Heywood to stop him disclosing the laundering of $6 billion and Bo's fate remains unknown at this time.

More broadly, the dismissal of Bo, itself a significant shift in the Chinese political landscape, may have triggered a rush of capital exits - this report from China's Forbidden News suggests increasing speed of transfers by members of the Jiang faction as the faction's position has become destabilised.  Countering this, it would seem is the recent introduction of new asset disclosure rules for top military officers (reportedly part of a Hu-led anti-corruption campaign).  This sort of maneuvering could continue for the duration of the year and its coincidence with destabilisation of the financial markets in China could be problematic.

China looks to introduce an effective anti-corruption fighter

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