A year to savour?

2013 saw a lot of changes to the mood in China, with the transition of Xi Jinping and introduction of a reform agenda, launched last month at the Third Party Plenum.  There was plenty of political intrigue with the trial of Bo Xilai, endless other officials and detention of Zhou Yongkang.  The first hints of the banking crisis emerged, with spikes in the interbank market in June and early December.  Property and asset markets remained turbulent and tensions in Western China remained.  And regional tensions escalated with the declaration of the Air Defence Identification Zone over the disputed areas of the South China Sea.
 
It seems fairly likely that recent interbank stress has involved non-disclosed defaults by Mainland institutions - China Everbright Bank's default during the first Shibor Spike was only revealed this month when a note in its IPO prospectus revealed two of its branches had defaulted in June, although quickly paid up (while at the time reports of branch closures and ATM shutdowns were dismissed as due to technical errors).  As in June the PBOC did belatedly intervene to calm the markets with liquidity injections (a Christmas offering if you like), but there is little likelihood this pattern of crisis and belated resolution won't be repeated.
 
As noted on the Investing in Chinese Stocks Blog and elsewhere, the shadow banking system is rampant and a massive risk to the banking system as all manner of schemes with high and unsustainable returns have spread amidst sluggish regulated below inflation rates available in the mainstream banking system.  Worse still, as has been noted before, although the entities providing such returns (trusts and other structures sold as "wealth management products") are outside the formal banking system, their products are sold to bank customers and banks either own or have exposure to the entities.  The bankruptcy of mining giant Liangsheng (a coal acquisition group overburdened by debt) is an example likely to be seen more frequently and already of a scale which could threaten China's banking system.  Most significantly losses track back immediately to the investors and a big state owned bank -  as the FT states:

Liansheng had little trouble finding willing lenders among China’s burgeoning shadow banks, which regulators have allowed to help plug the financing gap.

From late 2011 to early 2012, Jilin Trust, one of China’s vast array of non-bank financial institutions, sold to investors an investment product worth Rmb1bn backed entirely by loans to Liansheng.

Jilin Trust warned investors at the start of this month that the first tranche of the Liansheng loans was nearing maturity and that the mining company had yet to cover what is owed, according to China Business News, a local financial newspaper.

...Liansheng’s troubles are a reminder of the thin dividing line between China’s banks and its shadow lending industry. The Liansheng loan product sold by Jilin Trust was distributed in part via China Construction Bank, the country’s second-biggest lender by assets.

Banks tell customers they do not guarantee trust products, which offer returns far higher than traditional bank deposits, but buyers often ignore the warnings in the belief they carry the banks’ implicit backing. The Liansheng investment product targeted an annual return of 9.8 per cent.

And notwithstanding the proposed interest rate liberalisation, repression in the banking system creates opportunities for the shadow banking system to flourish while as the former chief economist and spokesman of the National Bureau of Statistics in China describes it, the banking system does not work in any efficient manner at all, but rather could be run by a canine:
 

“Banking in China has become like a highway toll system,” Yao Jingyuan said at a Saturday summit on China’s economy held at Nanjing University. “Banks charge every time money goes through them.

"With this kind of operational model, banks will continue making money even if all the bank presidents go home to sleep and you replaced them by putting a small dog in their seats.”

Yao added that there were no longer any real bankers in China, and that most bankers had become “freeloaders” who latched onto the wide profit margin they could enjoy by taking advantage of interest differences between deposits and loans.(here).

With this sort of oversight it will be a wonder if any Chinese banks don't get into trouble next year. 

In the meantime, this article will be rounded out with a couple of photographs which seem to capture the mood at the moment.

"President Li buys his own steamed buns"

 

The above is the actual headline from the report of an unusual purchase by a Chinese President.  Given the clear level of deference and hierarchy still in place in China, what hope is there of genuine financial reform? For example as with the PBOC, so the shipbuilding industry has also been bailed out.

The likely outcome for the Chinese financial sector in 2014?

Xie Shuizhun, a 46-year-old man from central China's Hubei province, earns his living by charging random strangers in Guangzhou's Baiyun district to beat him up, at a rate of 5 yuan (US$0.82) per punch. He insists the punches do not hurt him because he practices the ancient Chinese art of Qigong, which allows him to inflate his belly like a rubber ball.

Back in 2014!

 

 

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.

Learning all the right lessons

An Olympian task
With the London Olympics opening at the weekend, many have been looking back to the preceding games which were a pivotal moment for China, both in its arrival on the world stage (completed with an unprecedented opening ceremony) and its resetting of influential policy preferences.  Howie and Walter in Red Capitalism and others including Victor Shih (speaking with Carl Walter at Northwestern University here) identified 2008 as a time when western orientated reformers finally lost favour to those with a domestic bias, when attempts to continue reforms of the banks' lending processes were abandoned and the great RMB 4 trillion (USD 586 billion) stimulus plan was rolled out.  Concerns about the after-effects of that stimulus and the launch of a second stimulus continued to be raised in the last couple of weeks with some good commentary from a number of key analysts.


Insightful analysis was sparse in vulnerable nation Australia however.  While drops in China influenced iron-ore prices pressured Australian producers like Fortescue Metals (further enriching famous short seller Jim Chanos) and a sole report from one consultancy did get some attention, the political and economic establishment was basking in a moment of relative sunshine.  Economics editor Ross Gittins continued the Australian media's trend of lionising Australian Reserve Bank Governor Glenn Stevens who was dismissive of questions to China's growth trajectory and treasurer Wayne Swan was equally confident on China's prospects, emphasising the careful management and the Chinese government's "deliberate government policy". Context is important here - as recently as the end of last year, few if anyone considered that China's GDP growth would fall below the benchmark 8% during 2012 such that any significant measures from the government would even be required.  


However new and significant measures were announced this week and an article in TIME magazine gave some good background.  The new push for growth seems to have come to life earlier in July, when Premier Wen Jiabao made some comments pointing to further investment while official GDP growth was released at a lower than expected 7.6%.  As this Reuters article points out, political concerns, chiefly the need to ensure a smooth handover in October and maintaining the current elite's legacy may have been a greater motivation for the decision makers, but this may not be wise in the long term.  In the short term, protests in Shifang and most recently Qidong (north of Shanghai) in opposition to the commencement of industrial projects no doubt encouraged authorities to focus on short term remedies.

A marketplace...being flooded with liquidity

Banking on trouble
Details of the second stimulus emerged on Friday, with Changsha, the capital of Hunan, leading a pack of other cities as it announced a huge RMB 829.2 billion (USD 130 billion) investment plan.  Immediately questions of how such amounts are to be financed spring to mind and a little investigation suggests a complete confusion in the administration's banking policy.  For most of the year Beijing's policy has focused on tightening loans in the property sector (and local government financing vehicles) to prevent price bubbles - yet the new stimulus measures aim will do the opposite.   Hence a number of contradictory headlines, indicating that the Chinese authorities wanted to maintain strict controls, yet also loosen lending, while despite Beijing's demand that local governments keep up restrictions on property purchases, at least one province capital sought to undermine the property curbs by offering cheap loans to buyers.  


Further complicating the picture is the question of where all of this leaves China's banks and financial system generally.  Plenty has been written and said about the significant issues that lurk behind the glossy profiles of China's large international banks and their smaller competitors.  Would the second stimulus result in some profitable lending for the banks? Possibly not as some of the discussion suggests the local government financing platforms which would launch the stimulus may seek funds from elsewhere - from issuing bonds and/or securitising their underlying portfolios.  Meanwhile the unregulated shadow banking sector has attracted a significant share of the market in lending to smaller businesses and attracting deposits.  Fitch has warned at the risk stored up by some of these vehicles while such a development is also dampening the effectiveness of interest rate cuts as a stimulus measure (though interest rates are not freely set in China).


Surely any doubts as to risk of further stimulus could be overcome by the end result of more infrastructure?  Probably not some experts believe.  Gordon Chang was doubtful about plans for further expansion of the airport network, while Simon Rabinovitch at the FT went so far as to find a real bridge to nowhere (or in any case a proper Japanese-style bridge with minimal traffic), the completion of which he interpreted as a signal that probably the era of big showpiece engineering led growth should come to an end.  And in light of the perceived failure of the sewers during the recent floods in Beijing, plenty think there has been misinvestment.


Stimulus or no, it appears the banks may already be heavily exposed to existing bad loans.  In a further development in the unfolding Zhejiang guarantee scheme collapse (covered previously here), Caixin reported that China Construction Bank made possibly fraudulent loans to a guarantee structure of the Zhejiang Construction conglomerate.  It could be the tip of the iceberg.


Fraud of the week
Two mentions this time.  First an allegation of insider trading by a Chinese-owned entity in the shares of Canadian company Nexen Inc., which state owned oil giant CNOOC has bid for.  News of the SEC's intervention just broke so it will be interesting to see how it develops.  Second, a listed education company called New Oriental, which has the dubious honour of being investigated by the SEC and short seller Carlson Block simultaneously.  Carlson put up his report on the Muddy Waters webpage here.  The response from Yu Minhong, New Oriental's CEO is here.


Thought for next time
Patrick Chovanec has an interesting series up on his blog, where he tries to explain recent observations of price rises for property in China.  He's midway through and examining a number of factors (in some detail and with good logic) from outright fraud to sources where some demand may have come from.  Of course given everything mentioned in this article so far it would seem that there shouldn't be a reason for property prices to increase given the fundamentals, unless there was some regulatory intervention.  A possible factor Chovanec hasn't mentioned (and this is speculation) is that perhaps a number of insiders have anticipated the stimulus measures described above and expecting prices would rise again as during 2008 onwards, have bought some more property.


The Economist also looks at the same issue, though the analysis is a bit clumsy.  It fails to explore the link between the two sectors (property and local government financing), which is the banking system, and this compromises its assumptions - e.g. it remains to be seen whether the liabilities of the local government financing vehicles don't "endanger the fiscal position of the country", or that local governments will "invest better" than in 2008.  Likewise their conclusion - if they are saying the price rise means that property in China hasn't collapsed fully yet, we should all worry.


And the playout of a collapse is really the next area for serious debate.  Given that the Chinese financial system reform period (from 2000 up to the Beijing Olympics) grew out of the last great financial system collapse - initiated with the collapse of Guangdong International Trust and Investment Corp. (GITIC, an investment arm of the Guangdong government) in 1999, it is probably a useful example to return to for guidance as to how any contagion would occur in the Chinese financial system.  Although the GITIC institution differs from modern investment trusts and local government financing platforms in China, the underlying story of excessive bad loans is similar to today.  A fair part of an Economist article from 1999 could be written verbatim today.  


One veteran of the GITIC bankruptcy is William Gamble, a lawyer who wrote a book featuring the episode. In a 2009 article cautioning creditors buying debts of any distressed Chinese companies, he noted the contagion caused by the collapse:

The effect of GITIC’s collapse was immediate. Foreign credit for China dried up almost overnight. China experienced a liquidity squeeze similar to after effects of Lehman Bros last fall. 

Thus presenting an irony - for all their hard work from 2008 to avoid the effects of Lehman Brothers' collapse, should the unlikely but possible outcome of an institutional bankruptcy occur, those effects may nevertheless occur anyway.

An economy falling short?

The 4 billion dollar question
Like other emerging markets China is affected by significant levels of corruption and fraud across government and private enterprise.  Many different misdeeds have been reported in recent times, including endemic seizures of land from farmers and individual owners and theft of funds by government officials and employees from ministry coffers and state-owned enterprises (to the tune of $123 billion since the 1990s and more recently an alleged $2.8 billion from the Railways Ministry).  Premier Wen Jiabao recently told the State Council that corruption was the greatest danger facing the ruling party, while in his piece on land seizures for the BBC Damian Grammaticas pointed out that the combined wealth of delegates at last month's National People's Congress was ten times that of the US Congress.

Last year saw the rise of the China short sellers, a group of analysts mostly based in the US, who successfully targeted Chinese companies with overseas share listings - publicising evidence of fraud and/or inaccurate accounting and then profiting from short positions when the prices of the respective companies' shares fell.  One of the most notorious China short sellers, Carson Block (through reports of his company Muddy Waters Research) helped trigger the collapse in share prices of a number of Chinese companies, most notoriously with Sino-Forest Corp., which filed for bankruptcy last week.  Not giving up without a fight, Sino-Forest sued Block and his research outfit for defamation seeking $4 billion in damages and costs, questioning Block's tactics.

Block, confident the defamation action will fail took time out with CNN to announce that he had turned his focus closer to China - to Chinese companies listed in Hong Kong rather than in the US or Canada.  There appear to be similar signs of concern as was for the short sellers' first round, including  auditor resignations, so expect more of the same.  Interestingly there were also a few soundbites on the general state of the Chinese economy which Block called a "fixed asset bubble".

A solid foundation...on the world's newest and highest suspension bridge in Hunan

What is concerning about the short selling episode is there seem to be many of the same factors as were present in the US housing crisis of 2007-8, including failures in regulatory oversight, manipulation of obscure legal structures, failures by professional advisers, greedy investors, outright fraud and, in the end, significant value destruction.  An investigative report by Bloomberg last year illustrated the rise of the short sellers -  starting at least as early as 2009 when they started to scrutinise  the public accounts of certain Chinese companies which had been able to list their shares in the US and Canada without preparing a full disclosure.   

The trick the Chinese companies had used to list in the US was the process of a "reverse merger" (or reverse takeover), pioneered back in the early 2000's, involving the Chinese company acquiring an empty US shell company which had a small sharemarket listing enabling the combined US-Chinese entity to sell further shares.  It was cheaper than the Chinese company listing itself and involved less scrutiny.  And as detailed in this Reuters special report, a whole industry of advisers arose to facilitate the Chinese companies' speedy entry into the US capital markets:

...That industry hinges on a handful of leading "shell brokers" such as Halter who purvey paper companies; investment banks who specialize in financing a firm after a reverse merger; and auditors, usually small shops, who are lightly regulated in the U.S.--and not at all in China and Hong Kong...

While the regulators have clamped down on the use of structures like the reverse merger, the advisers, including the auditors remain liable to accusations of negligence and even fraud.  One key adviser, Benjamin Wei, whose firm New York Global Group structured a number of such deals was reported to be the subject of an investigation by the FBI in January, while auditors Deloitte, KPMG and Ernst & Young have faced scrutiny for their signing off of the accounts, in Deloittle's case, in respect of Hong Kong listed companies aswell.  An interesting piece in FTAlphaville gave some details of current attempts to deal with management conflicts at one company as outlined in letters to the shareholders.  Meanwhile regulators struggle for other solutions to protect investors.

Getting the numbers wrong

A few news reports appeared towards the end of this week suggesting other people looking at the China market are also making miscalculations in their assessments of certain companies and industries.  Reports of oversupply (in whole or in part related to the Chinese market) appeared in relation to various commodities including alumina, logs, coal, iron ore and goods and services like hotel rooms in the resort city of Sanya and automobiles.

Looking for growth (Qilai Shen/Bloomberg)

It will be interesting to see what the second quarter will bring.