The fog of war

So much has happened in recent days (often behind the scenes, or at least in reporting columns) that it seems like a past era when only last Wednesday the Federal Reserve roiled world credit, equity, currency and commodity markets by announcing plans to exit (or slow down or taper) from its almost half decade QE money printing program.  Pandemonium followed across emerging markets but for the first time ever the Chinese central bank, the People's Bank of China, and its liquidity operations (or to be precise, it's lack of liquidity operations for two crucial days) stole or at least shared the limelight with the Fed.

The PBOC has been in the background supporting interbank lending and repo markets in China for some years, particularly as it does not conduct market operations around the interest rate itself (which unlike many large economies is fixed).  Instead it smooths out fluctuations in the amount of money circulating between banks by transacting in its own instruments (or that was my recollection last time I checked!) - the point being that for some time now the PBOC has stepped in and provided liquidity to the market, typically around holidays and at key points during the calendar including tax payment time.

Where it gets interesting is trying to understand what actually happened and what it means.  Some themes from this:

1) Foreigners still don't understand China.  Two examples - Ford and banks Citibank and HSBC have both announced new product offering and initiatives in recent days.  Details on this in a moment, but first to confirm a bit of terminology/details:

- wealth management products (wmps - or weapons of mass ponzi) are unregulated high risk high interest fund-style products which have become popular in China due to low official interest rates.  They are unregulated, risky and believed by many to be responsible for the massive risk exposures which will bring China's undoing. Often the underlying assets can be junk like cashflows from empty pawn shops or unbuilt buildings.

- one of the likely motivations of the cancelling of liquidity was to choke wealth management products by stopping their issuers (bank group companies) getting further credit via the banks (from the PBOC).  As a matter of fact this will never work due to the channels by which money flows through the Chinese economy, but nevertheless has been flagged and could work in theory.

So what was announced?  Ford commented that Alan Mulally is working "overtime" to rollout credit services to customers in China and the above banks announced they had permission to sell local mutual fund products.

Do you see a problem here? In a land awash with credit Ford wants to introduce more! And not just any credit - every type of credit imaginable - it was reported on several occasions last year that domestic construction equipment manufacturer Zoomlion saw many of its clients purchase concrete mixers purely for the purpose using them as collateral to take out loans.  And with HSBC and Citibank what sane manager would want to dive into an overexposed product class which has been called toxic and a threat to the Chinese financial system?!

China is a ponzi economy alright - feted insider Jim Rickards has joined the naysayers and interviewed on it this week (see here).  But if foreigners struggle to read China in a static period what hope do they have in a crisis?

There were plenty of views as to what was going on, and many focussed on the role of the PBOC.

2) the PBOC lost credibility and control - By having to change its position, precipitated by an intervening crisis, the PBOC has conceded its ability to set the policy and ended up subsidising the banking sector - back to business as usual (and in particular continuing with backstopping to the state sector).  Much of the commentary focussed on the intentions of the PBOC.

Did they intentionally pop a bubble and will it nevertheless blow anyway?  Were the regulators drawing a line in the sand against the financiers?  Were they trying to choke off only the wmp and shadow banking sector? Were they sending a warning to the new Chinese government to slow reforms and financial liberalisation (which they would argue will cause more chaos - as it happens the PBOC has always been a reactionist faction countering the modernisers at the National Development and Reform Commission)? Were they doing the bidding of the Communist Party which wants to put its stamp on things? Was the PBOC in fact irrelevant because the real momentum was with the unwinding of the carry trade (using US Dollar loans which had been priced low to borrow and speculate on the higher yielding Chinese Yuan).

FT Alphaville produced one of their series of articles (similar to gold repos, the London Whale and their previous series on Chinese Credit) which is excellent.  The BBC is covering the story in depth (finally, see also here and here).  The Economist had one reactionary article, which was more circumspect however analysing the assumptions (and questioning a couple of them) still could suggest a very concerning outcome.

Interestingly for the Economist and a subsqent article in FTAV, there is a suggestion that looking at available evidence, the Chinese Yuan may be overvalued and at risk of a currency collapse/devaluation.

If this is true, something will have to buckle soon. Either the renminbi will be forced to devalue, popping lots of dollar shorts as it goes — behold, dollar-denominated defaults galore — or China will finally be forced to release its USTs so as to avoid the messy fiasco and to honour its dollar debts, and prove it’s a credible country after all. 

To clarify, we’re not arguing the Chinese are using gold to manage the exchange rate, rather that gold is sending us an important signal that a great unwinding of the CNYUSD relationship may be upon us very soon. Also, — more importantly perhaps — that in the game of global currency wars, the Fed has come out on top. 

What happens next, of course, depends entirely on the degree to which China provides the liquidity its system is demanding and on the amount of dollar debt there actually is in the system. If it responds, the great unwind may be upon us quicker than we expected (which might explain why it’s so reluctant to do so). If it doesn’t… gold prices could be in for a rough ride in renminbi terms for some time still.

Apart from the sense of irony that the nation with the world's largest foreign reserves (acquired to protect against a devaluation) could suffer such a fate (and by the way calculations have questioned whether China's massive reserves would be sufficient in a case of full scale currency slide anyway), the outcome would be calamitous.  On this there are questions about the PBOC's ability to manage away from such an outcome.

3) Finally it is unclear if all the drama is having anything like the intended effect of slowing down alternative lending, or lending in general.  Not so says Bloomberg, while reports about the lending situation vary dramatically (see here and here). 

Let them eat cake!

Dying days ahead of a revolution?
Before entering into the Chinese presidency, current leader Xi Jinping was rumoured to have been handing out copies of de Tocqueville's L'Ancien Régime et la Révolution as a signal on the need for the party to reform and commit itself to purging corruption and addressing the need for improving Chinese welfare following decades of breakneck till-we-choke economic growth.  Recent reports that the territory of Macau, a gambling enclave which also operates as a centre of excess for Chinese gamblers (and a laundry for Chinese officials' cash proceeds) will see the opening of an ultra-luxury hotel employing a descendant of the French King Louis XIII, might have many readers exclaiming "l'ironie!".  The comments of the project company's owner might suggest a reaction more along the lines of that to Marie Antoinette.

“The willingness of mainland Chinese to spend money on the very best is unprecedented,” said Mr Hung, who also plans an invite-only atelier of luxury brands offering bespoke couture. Graff Diamonds has already signed up."           

That other established luxury brands are already slowing in China (and Hong Kong) seems not to matter to much to some, but the success of the project will remain to be seen.  What was seen though were hordes of people at Chinese gold shops seeking to aquire bullion following the price drop - so perhaps luxury is second in mind for the moment?

Dirty business
Meanwhile in another corner of the Chinese economy there is plenty of unseemly behaviour being exposed in news out from the domestic bond markets - including profit skimming by traders and possibly the death of an executive who fell from an office building.  More on that later.

A number of outlets have covered recent developments in some detail.  Caixin had a long piece detailing the executives arrested for dealing and profiting at their client's expense as did Reuters (and here).  Simon Rabinovitch at the FT has also covered the issue and had a good piece explaining the involvement of reformer heavyweight Wang Qishan in not only cleaning up the interbank bond market, but also (possibly) intervening to block the NDRC from encouraging local governments to over-borrow.  Those who have read Red Capitalism by Walter and Howie or other such works will know that the conflict between the reformist PBOC and statist NDRC, is one that has carried on since the first Chinese financial liberalisation in the 1990s.  As noted in Simon's article:

"...bond traders have told beyondbrics that there may also be another, more political reason for his involvement. The interbank bond market has been carefully nurtured by the central bank, which has tried to ensure that risk is properly assessed and ultimately borne by market participants....Over the past two years, though, the NDRC has weighed into the market, pushing it as a venue for local governments to raise financing, even when their credit-worthiness is suspect. That has started to undermine the central bank’s efforts.

According to this version of events, Wang’s main target is not really the few bond traders under investigation. Rather, he is helping shine a strong light on the bond market to check the encroachment of the NDRC and keep the control in the central bank’s hands."

 and this amidst other efforts to better identify brewing risks from interbank lending (here).  In sum though Wang may be successful, it does lead to a question of how much malpractice is out there?  

Details of the death of the chairman of one securities company were to be found in the FT rather than from a whitewashed press announcement from the company's own website (which referred to death "for health reasons").

Crumbling city
And in addition to some illicit brokerages it seems the buildings housing China's financial industry themselves may be at risk of crumbling.  Vivre la différence!

The audacity of hope

Bears rally
A couple of provocative headlines hit the newsfeeds this week as some notably bearish Chinese analysts digested the recent stimulus announcements.  Gordon Chang's article "China is running out of money"  certainly grabbed attention and while much of the discussion about the country's central bank, the People's Bank of China (and its ability to maintain the system of foreign exchange inflows) has been covered before, details of how short some local authorities are of money right now is rather new (and emerging).

In contrast, investors' optimism about the extent of the current stimulus is well illustrated by a slide from a recent Rio Tinto investor presentation (below).  Frequent readers will recognise one of the project leaders - the National Development Development and Reform Commission (NDRC) which Victor Shih and others have identified as being at times a very effective rubber stamp executing little scrutiny of projects it approves (including earlier in the year a project to influence the weather).

Michael Pascoe of the Sydney Morning Herald is one China bull who saw only a soft landing from the stimulus and in pro-reform comments of a Bank of China official.  Similarly doveish comments from Jiang Chaoliang, chairman of pillar bank AgBank (Agricultural Bank of China) suggested a benign situation of measured reform.  However it is questionable how much the necessary reforms and consumption increases will proceed during a stimulus given fairly little progress made on such things during the last round of stimulus in 2008-9.

Meanwhile at respected magazine Caixin, Andy Xie sought to put recent conditions into perspective, with some dire forecasts for the property and finance sectors:

China's land market will experience a dramatic adjustment ahead. In most cities, land prices may fall by 80 percent. The financial consequences will be severe. Most bank loans are backed up directly or indirectly by land. If land prices fall so much, the banking system would suffer a crippling level of bad loans. Local governments increased their spending appetite during the heyday of land sales. They will have a difficult time adjusting to the new reality. Their struggle to source new revenues will be the main reason for social instability ahead.

And adding difficulty the FT's Beyond Brics blog noted, was that the fact that many statistics releases which drive the China news cycle seem to increasingly split analyst opinion (pointing to more or less future growth in equal measure).  Similar to the debates as to whether key Chinese statistics are falsified - a recent report examined opposing interpretations of rising non-performing loans data by Reuters and Bloomberg. Reuters' conclusion, that it was a positive sign (looking at the overall ratios provided by the China Banking Regulatory Commission), was favoured.

Chinese property, it's a long way down...

Reluctant consolidations
While questions remain over the long term outcomes from the new stimulus, other commentators have noted falling profits across a number of sectors and in some cases a run of bankruptcies is looking likely.  Three industries which have been observed to be at risk of widespread bankruptcies are the solar panel makers, shipbuilders and automakers.

For manufacturers of photo-voltaic cells there have been plenty of headlines for Chinese companies, themselves struggling against a backdrop of oversupply and falling prices. Suntech, the largest solar panel maker in the world, announced it had been defrauded by an Italian co-investor (who offered fake German bonds as security for a payment guarantee) and just recently obtained a worldwide freezing order against its Italian partner's assets.  Even without this, the company is struggling under a weight of debt.  LDK Solar, based in Xinyu was bailed out by the local authority last month, although some commentators doubted whether even this would be sufficient to restore the companies' prospects.

Chinese shipbuilders meanwhile are continuing to tread water through the worst conditions in a decade.  Major builders including Rongsheng and Cosco have recently been hit by profit concerns amongst falling orders and shrinking backlogs, while there have been several bankruptcies including Dalian Oriental Precision & Engineering and a major shipbuilder in Zheijiang province.

And local car manufacturers (who have been flooding dealers with unsold inventories) face the prospect of being forced into bankruptcy by local authorities due to widespread anticipation of failures.  As this report from Ken Rapoza in Forbes explained:

The Ministry said in a note published on Tuesday that it is considering the introduction of a withdrawal mechanism to force near-bankrupt automakers out of the bloated automotive industry.  China has around 1,300 automobile makers, including 171 car, truck and bus makers and more than 900 specialty vehicle manufacturers, according to the government.
Nearly a quarter of these manufacturers are on the verge of bankruptcy, barely producing anything despite obtaining production approvals from supervising authorities, the statement said.

Restructuring with Chinese characteristics
The announcement of forced restructuring of the automotive sector is interesting because it shows the role of the state in dictating the policy direction for much of the industry.  State involvement has been a feature of industry restructuring throughout China's history, and most notably during the aftermath of the Asian crisis, when  many International Trading and Investment Corporations (ITICs) - forerunners of current Local Government Financing Vehicles and investment trusts, collapsed and when the banking system was restructured.

At the time, there was no advanced nor comprehensive bankruptcy law governing the restructuring of state-owned entities and private entities.  As William Gamble, an investor with experience in that period has noted, the bankruptcy legislation applicable in 1998, when GITIC collapsed, did not recognise security interests or allow for restructuring (nor could foreigners' investments into ITICS even be registered with Chinese regulators).

A new bankruptcy regime, which is more sophisticated and borrows elements from US legislation and other jurisdictions was implemented in 2007, but its effectiveness remains to be seen as courts and other officials establish a practice of using and enforcing the new regime.  Also in a new trend, Simon Rabinovitch in an FT article this week, noted that more parties seem to be using local courts to resolve contractual and debt claims across a number of Chinese regions.  

It seems there is much more than just a simple increase in litigation volumes - generally speaking local and regional state authorities, with their close ties to businesses seem to play a very dominant role in either leading arrangements to stave off bankruptcy (causing a lighter caseload and a slimmer practice of dealing with bankruptcies) or as in the case of the automotive industry - taking a dominant role in which foreign investors may be marginalised and/or unfamiliar.  Reports of the pending bankruptcy of the Zhongdan Guarantee company (which was exposed by the collapse of the Tianyu Construction Company and 600 companies which were connected to it by a network of guarantees) indicate that the Beijing city government is directing the restructuring response which is expected to get underway later this month.  And Zhongdan apparently was also involved in selling WMPs (below).  Should there be more businesses like Zhongdan to be bankrupted, this could lead to a deterioration of market sentiment and intensification of any crisis, should it arise in China.

"No touch" regulation
Watchers of Chinese bank finances noticed a shrinking of deposits and increase in interbank liabilities in bank capital reports which many commentators are blaming on the rise of WMPs - wealth management products, unregulated speculative investments which Chinese banks have been using to source new loan capital and which are popular with bank customers as they offer interest rates far above regulated deposits.

Nothing wrong with little or no regulation in the short term (in China) you might think, however it has emerged that many of the products do not have recourse to specific assets and are increasingly appearing to have the characteristics of a pyramid or ponzi scheme (with there not being enough assets to cover redemption requests or meet all obligations), the collapse of which could trigger financial contagion.  An excellent Reuters piece uncovered one product which it likened to an American subprime mortgage (of dubious quality), being marketed to the public under the name "Golden Elephant" and whose source of income derived from property assets which were yet to be built.

While Chinese regulated banks themselves have questions to answer regarding their NPLs (which may challenge their solvency) the growth of WMPs and so-called "shadow banks" could threaten a significant crisis in the Chinese financial system.  Recent discussions on various blogs this week reminded that there are a number of precedents of this sort of scheme which could equally apply to China.  For both Russia and Albania in the 1990s (and Poland in the last few years), pyramid and ponzi schemes were able to flourish escaping weak and slow moving regulators in a changing environment and, upon collapse, causing great damage to the economy.  A great paper on the Albanian pyramid scheme phenomenon is here, while in Russia, the famous MMM and GKO scandals (the latter of which contributed to the collapse of the Russian government and precipitated the 1998 Asian crisis) have been well written about (Sergei Mavrodi restarted a new MMM-style scheme online last year).

How it all plays out in China will remain to be seen.

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?