China chaos and a new normal? A year in review

Since taking a break this time last year, China's markets and their ongoing story have exploded into international consciousness.  The dawning of not only several "black" trading days, but what was characterised as China's "1929" moment.  So it would be good to note a couple of charts and comparing the similarity of the main Chinese index, the Shanghai Composite (SHCOMP) and the tech index (ChiNext) with some of the greater stock crashes of the last century:

Comparison against 1929 crash (c) Zerohedge.com

Comparison against the Nasdaq 2000 crash (c) Investinginchinesestocks.blogspot.com

The desperation with with the Chinese authorities stemmed the losses was intense, including bans on selling, enormous purchases by Chinese SOEs and brokerage companies and of course, attacking "malicious" short-sellers both in China and internationally.  News site Quartz had a good summary of steps taken so far.  In addition as Reuters noted, China sought to exert its authority even outside its jurisdiction approaching Singapore and Hong Kong exchanges to request trading records.

As plenty of sensible commentators noted, the actions by the Chinese authorities are lunacy.  A market majority of shares suspended from trading and/or owned by a state rescue fund, in which participants cannot sell will not operate as a price discovery mechanism (which is the point of a stock market) and with renewed pressure as in Japan, such measures will fail anyway.  Bridgewater Associates, one of the world's largest hedge funds issued a memo reversing its favourable view of China (which they later sought to downplay), while large corporates revised their growth forecasts downwards.  Christopher Balding, an academic in China, explained some of the links between the stock market and the real economy in a blog post.  Investment Bank UBS with a sizeable interest in China business, posted a video of its analysts falling over themselves to try and rationalise why everything would probably just fine though.

Bankers looking concerned (c) UBS

Revisiting the 1990s

It goes without saying that China's efforts to "rebalance" away from its investment driven growth model are in tatters.  Not only are key foundations of the proposed rebalancing compromised (such as likelihood of the currency RMB revaluing, or the China - HK Stock Connect mechanism for outsiders to invest in Chinese shares) but the main thrust of the stock market push, the encouragement of middle-class Chinese to invest in the stock market has failed spectacularly and once again, Chinese savers have seen a transfer of their wealth (usually it is through means such as financial repression including via low interest rates).  Stories of complete losses by amateur investors have emerged, only weeks after the heavy involvement of unsophisticated individuals had been noted in the financial media.

It is worth noting that the aggressive promotion of the Chinese sharemarket by state media had taken place during 2015 in what many interpreted as an attempt to distract from the property market bubble (seen with the collapse of apartment-builder Kaisa earlier in 2015).  In short  a messy situation!

That said though one aspect not mentioned in the discussion about the current situation is China has shut one of its markets before.  It seemed relevant given the period when China shut its market before resuming state support.  And the lessons it serves are not positive.

Referred to as the "327 Incident" (in reference to the code of the Chinese government bond traded), the taking of a significantly losing position by a subsidiary of the Ministry Finance  (a centre of factional power for the Party in the Chinese financial system) in 1995 resulted in the cancellation of trading, the imposition of losses to the securities firm which held the correctly priced profitable position and the imprisonment of its head, and, the closure of the futures market for 18 years (remaining closed throughout the 1990s and only reopening recently).  A good summary below from the Beijing Review:

February 23, 1995 was the darkest day in China's securities history.

In 1992, China had issued 24 billion yuan ($3.6 billion) in Treasury bonds (T-bonds) coded "327" that were set to mature in June 1995.  Upon reaching maturity, the bonds were to be repaid with interest and discounts that reflected inflation.

Guan Jinsheng, then General Manager of the Wanguo Securities Co. Ltd. (Wanguo), expected inflation to dip and estimated that the 327 T-bonds with a par value of 100 yuan ($15) would be repaid at 132 yuan ($20). When the bond's market price hovered around 148 yuan ($22.3), Wanguo decided to hold a short position of the 327 T-bond contracts.

In striking contrast, the China Economic Development Co. Ltd., a wholly owned subsidiary of the Ministry of Finance (MOF), held a long position, expecting the government to raise the bond's discount rate.On February 23, 1995, the MOF announced that it would repay the bond at 148.5 yuan ($22.4).

This news pushed up the bond's price to 151.98 yuan ($22.9). In a desperate attempt to recoup its losses, Wanguo sold an astonishing 1.46 trillion yuan ($220 billion) worth of 327 T-bonds eight minutes before the market closed, dragging its price down to 147.4 yuan ($22.2).

But the SSE announced that the contract sales in the last eight minutes were invalid, leading to 5.6 billion yuan ($843.4 million) in losses for Wanguo.Because of the incident, Wei Wenyuan, then General Manager of SSE, was removed from office for a lack of regulation. Guan Jinsheng was imprisoned and Wanguo was merged into Shenyin Securities Co. Ltd.

If such an approach is followed this time around, then expect a lot more pain.

The reform legacy - Part II

Since the last post there have been a couple of articles which highlight quite well the importance of the reform debate and the main themes.  As the PBOC launched further stimulus (including via a new tool called "Pledged Supplementary Lending" involving 1 trillion yuan for new lending), James MacKintosh, Investment Editor of the Financial Times filmed an interesting presentation giving some context to the resulting rise in share prices. While ordinarily share prices would be indicative of higher confidence and expectations for growth, MacKintosh noted that the sectors which had shown the greatest share price increases (and saw the best response to stimulus measures) were companies in the banking, property and industrial sectors - all sectors which the Chinese authorities wanted to steer investment away from (and into other sectors) as part of the reform and rebalancing process.  Or as James put it:

 "a return to pre-crisis business as usual...a pause in reform means less risk in property and banking as well as the old line state-owned enterprises".

"China Property Gamble" (c) Financial Times

Of course what James didn't dwell on (but certainly implied) is that there would be more risk overall and in the medium to long term (hence the need for reform to reduce the risk, sadly not carried through).  Over at FTAlphaville, the suppression of risk was covered well in an article by David Keohane who noted falling bond yields, the bailing out of one trust which had been set to default and a pessimistic analysis from reputed analyst Diana Choyleva of Lombard Street Research who noted:

 ...But the more sinister explanation [of failure of domestic demand to drive economic growth] is that the authorities are unable to provide a significant boost to growth even if they want to. They may be trying to boost credit to SMEs, but demand for loans has come off again. China needs to clean up after its debt binge, not stoke it further. The current level of debt may just about mean that Beijing has a chance to reform successfully even if that will involve a few years of meagre growth and financial distress. But the ongoing rapid rate of increase in debt suggests that policymakers do not have too long to postpone much-needed defaults...

Zerohedge meanwhile has taken a much more vigorous editorial line and especially with the Qingdao commodity financing scandal (including discussion of a note from Goldman Sachs as to the impact from an unwinding of metal-based rehypothecation).  On the new stimulus measures and their indication of the slowdown in reforms, contributorTyler Durden is blunt:
 

So whatever way you look at it, the PBOC thinks China needs more credit (through one channel or another) to keep the ponzi alive. Anyone still harboring any belief in reform, rotation to consumerism is sadly mistaken. One day of illiquidity appears to have been enough to prove that they need to keep the pipes wide open. The question is where that hot money flows as they clamp down (or not) on external funding channels.

And also:

Simply put - you can kiss goodbye any hopes of China ceasing its exuberant credit creation... (especially now that the CCFD ponzi scheme has been exposed via Qingdao -and drastically reduced that channel). Reforms are all talk and the bubble will just grow bigger with fewer and fewer attractive outlets for that hot money (now that the US real estate transmission channel has been identified and likely closed)... cue real inflation.

From those Zerohedge articles are two charts of note, the first showing the total amount of credit (bank assets) in the Chinese economy and its rapid growth:

and the second the rise in rates which preceded the recent PBOC stimulus (after it apparently stopped conducting repo operations), which corresponds nicely with the increase in share prices mentioned before (imagine the effect on share prices if repo rates continue to rise and there is no new liquidity from the PBOC?!):

 

Finally, while it will still remain for the next post to discuss some summer reading about the history of reform in China, it can be added one extra piece of reading on exactly this point - a 2013 IMF Working Paper:  "China’s Path to Consumer-Based Growth: Reorienting Investment and Enhancing Efficiency" (here), which " proposes a possible framework for identifying excessive investment".

The reform legacy - Part I

One of the most significant debates of the moment is the extent to which China is engaging in reform away from the production-heavy, subsidised, export-orientated economy towards a more balanced, consumption-led, open and lower growth (but more sustainable) model.

This is the background amidst which debates such as regarding China's target rate of GDP growth and the internationalisation of the currency (the Renminbi) have occurred and there are plenty of opinions on offer.  A good example was seen at the conference organised by the Financial Times' offshoot FTAlphaville, where celebrity guests Michael Pettis and Carson Block offered differing visions - in a short interview Pettis noted that rebalancing was proceeding in a more or less predictable manner (with reforms proceeding as announced in the Third Plenum), while for Carson Block, an impending debt crisis would likely arrive sooner and cause enough trouble as to hinder any meaningful schedule of reform. 

As it happens Pettis has considered the issue of debt quite specifically and a recent post on his blog argues its importance in understanding China's growth prospects and in understanding rebalancing - a feature of one of his recent books.  A recording of Pettis speaking at the 2013 Wine Country Conference sets out the background in excellent detail and is a real eye opener - Pettis likens the Chinese economic model to that of Japan "on steroids".  There is an interesting contrast with Pettis' blog post - which concludes asking the question of where the great losses from the excessive debt will be recognised.  In the Wine Country presentation Pettis details how losses in Japan were absorbed by the government when it took on the debts of the banking system rather than overseeing writeoffs (in a manner similar to which European sovereigns today are taking on the risk of their bloated banking sectors).  It would seem likely that the same may occur in China, where corporate debt now has surpassed that of the US and is estimated to be 200% of GDP.

Leaning to the chaotic
As Pettis notes in his presentation and elsewhere rebalancing is inevitable from a macroeconomic point of view and amidst the choices available to economic decision-makers are a range of outcomes from orderly rebalancing to chaotic.  Recent news has suggested that (i) authorities in China are trying to delay rebalancing, through measures like the "mini-stimulus" (which will only worsen the outcome later on) and (ii) events on the ground may be starting to overwhelm the ability of the authorities to maintain control such that rebalancing will not be orderly.

The mini-stimulus was unveiled in April 2014 with announcements of new spending targeting SOEs and state-focussed industries, with results appearing to show increased production by mid June and into July.  So far as expected.  But in addition to wondering where the next round of growth is going to come from since the administration's mini-stimulus has delayed SOE reform and shifting of production to the private sector, several themes have emerged in the background which could undermine the whole process.  These are:

1.  The divergence between Government and Private Economics surveys
As this article on Zerohedge notes, essentially one of the teams producing the surveys is likely just making up the numbers since private surveys show economic stagnation while government produced statistics paint a rosy picture.

One set of statistics is likely to be false and if it is the government produced statistics then the state of the Chinese economy could be grave.

2.  The property market is imploding
Daily updates on the Investing in Chinese Stocks Blog are offering a disturbing picture of financial collapse across the country with nationwide price falls in properties for sale in cities across the country, developers launching all manner of tactics to clear sales targets and credit guarantee and other private financing firms seeing their directors flee owing creditors millions.  This is getting litte attention in the Western media although an article in Zerohedge (drawing from a Bloomberg article) provides a useful summary.

3.  The commodities finance trade has frozen up
Sophisticated China watchers will be aware of the holes in the great capital wall which have allowed capital to circulate through the Chinese economy and keep it functioning, including the remittance program which allowed wealthy Chinese to evade the limit on remittances and engage in massive capital flight by transferring funds out of China to buy real estate in developed markets like Canada, Australia and the US.  One method of effecting remittances was through a hidden program at certain banks which was the subject of an expose by CCTV, the State broadcaster.  Commentators noted that the expose may have been part of a factional battle taking place between factions aligned with CCTV and the PBOC (since the programs were approved), but of even more significance is the emergence of fraud in the commodities trade.

Also arising as part of a corruption investigation, charges of fraud at the large port of Qingdao by Decheng Mining, a metals trader which offered financing and rehypothecated metal stocks (using the same collateral for multiple loans, including using forged documents) is of note not only because of the size of fraud or that international banks have been involved, but that the whole commodity financing industry in China is under threat and that as such a significant amount of liquidity for the Chinese financial sector which the commodity financing provides could be at risk.  An interesting article refers to a recent failure of a letter of credit settlement - which does remind of failures of repo trades which presaged the Lehman collapse - which can only be understood as systemic.

The next blog will look at some interesting summer reading which traces the historic background that helped lead to the current situation, but until then here is a shot from a new Chinese water park which speaks to more than just the plight of the swimmers...

 

A belief in the supernatural

Following the last post it emerged that there are another class of investors already taking losses (and expect more of these to appear).  In perhaps what could be termed the ending of the Xiaochan put (a corollary of the Greenspan put, by which US markets had been supported by intervention by the Federal Reserve), so a report from Morgan Stanley detailed the vast sums wagered by speculators positioning for a continued rise in the Chinese currency (the Yuan/Renminbi) which came to an end as the Central Bank in China, the PBOC (led by Zhou Xiaochan) sought to stunt speculation in the currency:

The seemingly incessant strengthening trend of the Chinese Yuan (much as with the seemingly inexorable rise of US equities or home prices) has encouraged huge amounts of structured products to be created over the past few years enabling traders to position for more of the same in increasingly levered ways. That was all going great until the last few weeks which has seen China enter the currency wars (as we explained here). The problem, among many facing China, is that these structured products will face major losses and as Morgan Stanley warns "real pain will come if CNY stays above these levels," leading to further capital withdrawal, illiquidity, and a potential vicious circle as it appears the PBOC is trying to break the virtuous carry trade that has fueled so much of its bubble economy.

and losses were estimated to be in the billions of dollars, and worryingly (given the deterioration going on in the Chinese economy) many of the holders of the loss-making positions were Chinese corporates:

In their previous note, MS estimated that US$350 billion of TRF have been sold since the beginning of 2013. When we dig deeper, we think it is reasonable to assume that most of what was sold in 2013 has been knocked out (at the lower knock-outs), given the price action seen in 2013...."Given that, and given what business we’ve done in 2014 calendar year to date, we think a reasonable estimate is that US$150 billion of product remains."...

...The potential for US$4.8 billion in losses for every 0.1 above the average EKI could have significant implications for corporate China in its own right, as could the need to post collateral on positions even if the EKI level is not breached... 

On the latest check this trend seemed set to continue with weak economic statistics, regulatory concern and weakness in the currency all referenced in a Bloomberg report.  As mentioned in that report, the spectre of capital flight and further destabilisation of Chinese financial markets is a not shallow risk.
 
Hope and dreams
Notwithstanding some less than pleasing numbers and off-message disclosures of some key figures in China's dynamic property sector and prices of apartments starting to be discounted in a way described as "crumbling" (and here), the facade of the great China miracle continues for the time being, even with the recent announcement of a passing of the US on one economic measure (not without criticism, including from the Financial Times).
 
As an example of the continued hopefulness and ambition the recent report of an ultra-fast lift to be incorporated in a new development in Guangzhou is a reminder of the Middle Eastern style optimism which has driven the China urban development story.  Of course reality throws up questions such as the need for a giant financial centre development in somewhere like Guangzhou but the need to maintain a motivating ideology for the continued reckless and unsustainable growth seems still to be a concern of those in power and with commercial interests.
 
This was noted by my recent reading of modern Party mouthpiece China Daily whilst transiting at an airport, which dedicated an issue to President Xi's own notion of the "China Dream", a new guiding vision for youthful and emerging China (with the cover story "Dream Debate").  While well composed and quite glossy, the feature section was disappointing as it fell into predictable patterns, including:
 

• a piece by American China apologist Robert Kuhn, who earlier said that the Bo Xilai scandal was only of interest to Westerners because it was "salacious";
• an advocacy of the status quo by Zhou Feng that contained such wonderful statements as "drastic measures are not necessary" and

"by withstanding the global financial crisis in 2008-09, the Chinese economy has become more resilient in its ability to deal with slower growth. Its trade sector, for example, has become used to operating with wafer-thin profit margins."

(that would be resilience by going bankrupt!) 

• a wonderfully titled piece by Yu Yongding "No financial meltdown to worry about", which argues that China will be fine because it does not have US subprime mortgages (trust loan anyone?)

and so on.
 
Over at Zerohedge, hyperbole notwithstanding there was a far more grim picture being painted of the situation in China currently:
 

China is a case of bastardized socialism on credit steroids. At the turn of century it had $1 trillion of credit market debt outstanding—-a figure which has now soared to $25 trillion. The plain fact is that no economic system can remain stable and sustainable after undergoing a 25X debt expansion in a mere 14 years....

...The borrowing, building and speculating mania in China has obviously gotten so extreme that even the new regime in Beijing has been desperately trying to cool it down. But this will end up as a catastrophic failure—not the “soft landing” brayed about by Wall Street bulls who do not have the slightest comprehension of the difference between free market capitalism and the phony “red capitalism” that has been confected by the party-controlled apparatus of the massive, intrusive, bureaucratic and hierarchically-driven Chinese State..

At bottom the fatal error among China bulls is the failure to recognize that the colossal boom and bust cycle that China is undergoing is not symmetrical. The much admired alacrity by which the state guided the export boom after 1994 and the infrastructure boom after 2008 is not evidence of a superior model of governance; its only proof that when credit, favors,  subsidies, franchises and speculative windfall opportunities are being passed out freely and to everyone, when there are all winners and no losers ( e. g. China’s bankruptcy rate has been infinitesimal), a statist regime can appear to walk on water....

...In short, the Chinese population “can’t handle the truth” in Jack Nicholson’s memorable line. They by now believe they are entitled to a permanent feast and have every expectation that they party and state apparatus will continue to deliver it. As a result, Beijing has resorted to a strategy of tip-toeing around the tulips in a series of start and stop maneuvers to rein-in the credit and building mania....

To the fireflies
That last paragraph raised an interesting aspect (contrasting public expectations and management by the authorities).  Exactly how well will China's population handle the transition which is to arrive once credit markets turn?  On the basis of one unlikely tourist venture, possibly not well.  The below picture (and final image of the post) is from angry holidaymakers who invaded the office of a tour company after a display of firefly insects did not materialise at an organised event:

Visitors shout at organizers during an event to release fireflies in Hangzhou, Zhejiang province, April 30, 2014. According to local media, about 10,000 people protested for a refund of their tickets, claiming they could not find fireflies to release at night. Picture taken April 30, 2014. REUTERS

 

The biggest loser?

The start of 2014 has seen a flood of commentary regarding the Chinese non-bank (trust) financial sector - with the last minute bailout of the oddly named "Credit Equals Gold" trust fund (sold through ICBC branches) in late January and a number of predicted defaults of trust funds linked to the coal sector (or actual default in the case of Jilin Trust) in February. As Bloomberg notes, yields on debt securities are also rising making finance more expensive for businesses in China, but the borrowing binge is continuing, with the FT reporting the highest rates of lending in four years (and a flood of new entrants into the trust and wealth management sector).

As longtime financing expert Charlene Chu has noted, there is increasing currency risk in the system as more borrowers resort to offshore lending.  In the same article in the Telegraph, George Magnus of UBS notes the similarity with Japan before its crash in the 1980s.  Unhelpfully as Ambrose Evans-Pritchard notes in his Telegraph comment piece, this is occurring amidst a policy of monetary tightening and contraction as the administration in China tries to rein in the heady boom of the last decade.

Notwithstanding the current focus on losses within China it is interesting to note some consideration being given to just how much will be lost by foreign lenders.  As Sean Darby, an equity strategist at Jeffries has noted there is significant exposure not only in Hong Kong (China's primary offshore investment centre), but in the banks of Australia, Europe and elsewhere.  It doesn't help that in Australia's case, the large domestic banks which are stuffed high with local real estate loans, desperate for growth opportunities are now aggressively moving into the Chinese market (see also here).

The below chart from Bloomberg (full size image here) shows the rapid growth of foreign lenders' exposure to China and in particular it is interesting to note the high exposures of British, French and Australian banks.  This may be something they come to regret.





(c) Bloomberg

 



 

The psychology of grand gestures

These days many people approach China through the lens of superlatives - massive buildings and infrastructure, dynamic fast paced growth and grand government visions.  Local press Caixin had a photo series of some of the more opulent government offices which had been built in recent years in some of the more deserted parts of China.  This correspondent can recall travelling to Shanghai in the late 1990s and being impressed by the opulence of the central square and museum and the comparative poverty of the shopping mall below - which no doubt has long since been renovated.  Perhaps, as suggested by the Independent newspaper it is easy to misinterpret what is going on in China simply by being an outsider.  Nevertheless there does seem to be some insight from reviewing what will be termed the "grand gestures" being made by the Chinese in administration (and their possible view of events through this perspective).

To start with the US however, many have argued that the Chinese administration places great weight in its actions by what is happening in the US and arguably much of China's recent policy is seen to have been calibrated with big shifts in US policy.  Hence many analysts point to the US-led financial crisis in 2008 as having caused a pivot in Chinese fiscal policy - when the administration not only decided to embark on the massive stimulus in 2009 and 2010 which saw more money lent out by the state-directed banking system than delivered by the US administration in the TARP (troubled asset relief program) which preceded the recapitalisation of the US banking system.  More particularly, those analysts note that in addition to the decision that was made at the time, it was also a time in which the top of China's government interpreted that the US economic model itself was defunct - that no serious government would let its banking system collapse and that China was wasting its time trying to emulate the US (as it had been doing for many years since its own banks had been cleaned up in the 2000s).

Of course, such an interpretation fundamentally misunderstands capitalism, and it has been noted that in seeking to construct a capitalist economy China still hasn't taken to heart the idea that businesses need to fail (such that, although pain in the solar industry, one of the worst performers is being delayed, at some point the domestic debt market will have its first default and certain poorly performing big enterprises will go bankrupt).  Nevertheless until a day of reckoning, the Chinese are doubling down on their existing policies and no doubt continuing the status quo (or trying to).  

Free China love zone
And hence the suggestion that China is drawing the same conclusions as to US decline.  As the US government went into lockdown with the impasse over the debt ceiling, reports of frustrated Chinese tourists in Washington corresponded with the response in China itself - decrying the "ugly side of partisan politics" (here). And, as per the headline, the Chinese presidential administration was responding with one grand gesture - Chinese president Xi Jinping undertaking a charm offensive to South East Asia (as Obama's trip was cancelled).  The linked article didn't touch on the delicate nature of China's relations with South East Asia following disputes in the South East China Sea, which no doubt complicate the picture.

Likewise on the economic front, China's opening of a free trade zone in Shanghai (immediately offering customs and warehousing facilities but with the suggestion of financial reform) was launched with uncertainty as regulations were still being drawn up, while many commentators, including the Economist concluded the measures were likely to disappoint (and a damp squib in fact).  For this author the significance of the recent zone opening is more in the gesture than the outcome - many other cities around China are seeking to open free trade zones which may do brisker trade than Shanghai (including Dongjiang which is seeking to become a major aviation leasing and offshore centre) and more significantly the step is being promoted as a new track of reform mirroring the opening of the Special Economic Zones in the 1980s.

The success of the zones will remain to be seen but it is unclear whether they constitute the reforms China needs.  As a gesture though, the announcement of the Shanghai zone has had an impact and that may be enough to keep positive news going for now.  On the other hand the gesture seemed to highlight current problems rather than hide them - property prices in Shanghai around the proposed zone have risen dramatically on the opening even as the included activities were not announced and there was no indication it will be successful.

If the real problems - property boom and collapse and strain in the banking sector do flare up then as a guide we must expect significant actions such as the credit squeeze of June 2013 - of which there will undoubtedly be more significant gestures to reassure confidence as real measures.  

A massive China sinkhole

Several major news outlets have reported on the problem of sinkholes in China.

Similar to the formations in the US and Central America, sinkholes often appear as a result of human activities - mining and construction or extraction of water for agriculture which alter the composition of below ground rock and soil which can then collapse.  As CNN reports these appearances can not only result in the occasional damage to pavements and roadways, but to vast swathes of often agricultural land in some areas which can end up sinking below the water level.  Relocations of infrastrucure and people can follow in what is a disturbing development for some localities such as Jining in Shandong Province.

Infrastructure revealed in China (c) AFP

Also disturbing and seemingly potentially catastrophic are emerging insights into the scale of capital shortfalls in China's banking system and economy. With the inner vaults of banks hollowed out by excessive lending, diversionary schemes and sources of risk concealed from regulators it is becoming a certainty that significant writedowns of bank assets will have to be made at some point.

It is with this in mind then that reports are emerging of steps being taken to put into operation the clean up of banking balance sheets by special "bad bank" vehicles - namely "asset management companies" (AMCs) which were set up in the late nineties to absorb bad loan portfolios from the largest Chinese "Big Four" banks - ICBC, BOC, Ag Bank and CCB (which became Cinda, Huarong, Orient and Great Wall, each taking on the bad loan portfolios of one bank).  

Fraser and Howie in their book Red Capitalism walk through the tainted origins of the AMC's which bought the bad loans at full face value and failed to achieve much running off of the portfolios (often recovering as little as 20 cents in the dollar, barely covering their costs and instead rolling over the bad loans).  Since then, apart from what the FT has investigated as seeming repayments from the central government and the AMCs taking on new debts and branching into active financing business, there has been nothing to quell serious doubts about whether the AMCs are fit for purpose (a historical perspective on the recovery process is here).   

While analysts debate the room for manoeuvre for AMCs, the scope of the task is substantial:

...In 1998, when these AMCs were formed, the first Rmb1.4tn batch of bad loans were bought at face value, or 100 cents on the dollar, which was great for the big four banks, but less good for the bad banks. They recovered only about 20 cents on the dollar. 

However, in the late 1990s, that Rmb1.4tn accounted for about 15 per cent of bank loans, according to CLSA. Ms Chu calculates that the Chinese banking system’s assets grew by $14tn between 2008 and 2013 – equivalent to adding the entire US banking system to its banks’ balance sheets. 

This illustrates why China needs more than merely a government bailout to tackle bad loans this time and that it will probably take a lot more than four privatised AMCs.

And with the application by Cinda to launch an IPO in Hong Kong, some are starting to question the viability of any such venture (given one as author contended, they have become "toxic waste dumps" of bad loan portfolios) :

...today China's four big asset management companies look on the surface like respectable universal financial services groups, with solid balance sheets and handsome earnings. In February, Cinda announced profits for last year of 14 billion yuan (HK$17.6 billion), while Huarong made 12 billion yuan. 

Sceptics claim these profits are illusory, produced by the companies trading assets among themselves at artificially inflated values....For potential investors, however, earnings quality should be only a minor concern compared with the enduring doubts that surround the strength of the asset management companies' balance sheets. 

Offsetting the liability of their bonds, their assets now consist largely of what amount to IOUs from the Ministry of Finance. These are not sovereign bonds, but merely a vague promise to pay at some point in the future....If these IOUs are comparable to similar IOUs held by state banks, then their eventual repayment is to be funded by recoveries from the bad assets injected into the "co-managed accounts". 

In short, it appears the recent restructuring of the asset management companies was nothing more than a cosmetic exercise, which still left them exposed to their original portfolios of worthless loans.  If so, their liabilities far outweigh the true value of their assets; they are insolvent. 

 And what could be the likely scale of losses in the banking sector? Goldman Sachs has come up with an estimate of $3 trillion (which presumably doesn't factor in any downward adjustment to rates of growth stemming from the fact that official Chinese GDP may be overstated by $1 trillion), which is about the size of China's coveted foreign reserves (which by the way may not be of any use in a domestic currency crisis, being held offshore and in another currency). And this may be the nail in the coffin - the backstop of every China watcher - the ability of the state to bail out any distressed entity may simply not be sufficient enough - as stated by Charlene Chu:

There is tremendous confidence in the ability and the willingness of the Chinese Communist party to bail everyone out....But as the system gets bigger and bigger, there are more questions about how feasible that is.”

Rather a large hole to fill.

Mixed messages

It is becoming very difficult to read and understand news from China.  There are too many conflicting reports and inconsistent objectives and one wonders who is really in control.  Could this be a prelude to stagnation?  More on that in a moment.

Turning back the clock
In recent days the markets, the investors into and the people living in many emerging markets seem to be reaching a turning point - in currency flows, sentiment and strategy.  Recent protests which have broken out in Turkey, the Eurasian darling economy and one of the Goldman Sachs Next-11 post-BRIC  economies have been followed this week by plunging stockmarkets and questions about the future.  Prime Minister Recep Tayyip Erdogan, for a decade a popular, respected and dynamic leader, held responsible for bringing a long boom to Turkey has seemingly aggravated protests and been labelled in the international media as hubristic, tone deaf and too closely echoing an arab dictator than the enlightened leader considered previously.  Once lauded for assertive diplomacy towards Israel, Turkey had even taken steps to formulate a nuclear non-proliferation plan for Iran with Brazil, another up-and-coming power (a first since the plan was outside usual US led efforts).  The Lat-Am powerhouse is itself sliding into a deflationary spiral it seems with the falling Brazilian Real doing nothing to encourage local businesses into increased activity (contrary to predictions of finance minister Guido Mantega, who coined the term "currency war") and a recent minor bank-run has exposed the possibility of an imminent or likely popping of a domestic credit bubble.

Broadly speaking the cause for investor nervousness is the withdrawal of liquidity by the US Federal Reserve.  Having supported emerging markets for years with its money printing programs, which have sent trillions of dollars into all manner of countries searching for yield (as the US has sought to inflate away its own debts), the announcements by the Fed that, with signs of inflation and asset price bubbles in the US economy, it will now taper and start to slow its Quantitative Easing program, many investors have started to close emerging market positions and withdraw funds from these economies.

For China this matters too.  It is subject to similar trends - foreign banks like HSBC have been exiting the local market, selling their stakes in national champion banks like ICBC and exiting the market (having failed to achieve the predicted growth) and foreign investors are withdrawing funds or holding back on future investments.  As also noted however, the advent of ultra loose stimulus policies in Japan (which seek to replicate and extend the US easing policies to its own economy) poses a specific threat to China in that the rapid lowering of the Japanese yen may put a lot of pressure on Chinese exporters (causing them to have to drop their prices, at a time when labour costs are rising) and threaten to burst Chinese asset bubbles as real interest rates peak.

Apart from any particular difficulties China may face at the current moment all of the above suggests a broader shift might be underway and in fact far from a momentary pause, the current changes in fact form part of a move in economic activity as investment and fast growth dissipate from emerging markets elsewhere.  In short we would be turning back the clock to a world before the BRICs and the paradigm of decoupling emerging markets. 

Steering the train
Not that you would know any of this from reading certain news and reports.  Two books have been published which detail the global commercial empire which has been constructed for the Chinese state's foreign commercial interests, each shining light on a hitherto dark area.  

In China's Superbank, Henry Sanderson and Michael Forsythe delve into the rise of China Development Bank, the unique monolith nurtured by princeling Chen Yuan into the powerhouse which recently lent more to large infrastructure projects across the developing world than the World Bank and has been at the centre of the rapid growth of the Chinese economy (in particular inventing the controversial local government financing platforms which critics believe may become very risky for the Chinese economy soon).  In China's Silent Army, Juan Pablo Cardenal and Heriberto Araujo have explored the many outposts of China's commercial interests around the globe and drawn insight from the vast range of projects and characters they have come across.  As per an article in the New York Times on the latter, the message is that China is taking over (and in case you missed it a Chinese company Shenghui completed the biggest Chinese acquisition of an American company when it bought Smithfield Foods, America's biggest pork producer).

And similarly, news of state backed hacking by Chinese government or military units (and/or their affiliates) along with announcements that the Chinese Navy is patrolling the waters of the United States Exclusive Economic Zone for the first time all point to increased strength and more aggressive posturing of China towards its neighbours (in addition to South China Sea disputes that is).

However, all is not as it seems.  Several Chinese entities have seen their acquisition efforts falter, one example being financial behemoth CITIC which saw its $2 billion investment in an Australian iron ore mine balloon to $8 billion (with delays) compounded by further $2 billion losses on unfavourable hedging.  And as suggested in the sub-heading there may be some interesting historical parallels.

For while there are outward signs of strong successes, in China proper there are reports which suggest all is not well and possibly stagnating.  None of these will be unfamiliar to readers of this blog, but the scale of the reports is worth noting.  The Economist finally has a piece (though ostensibly told through a review of a book) suggesting the team finally acknowledge the scale of shadow banking in China and the risk dynamics.  Debt levels at Chinese companies have been described as "alarming".  The BBC and other outlets reported that China labour costs are now high enough that many factory owners are considering relocating.  And of course the administration is quietly getting on with the task of battling gargantuan corruption of state officials.

It was whilst reading about efforts at reform during the Brezhnev era of stagnation that the writer saw some detail about the failed anti-corruption campaign.  For a bureaucracy the size of the Soviet Union (or China), taming an out of control culture of inducted officials was just too difficult.  And yet meanwhile on the world stage the Soviet Union was at its zenith and projected its military and political power the furthest (though in doing so it set up the conflicts with each of the major powers that would later weaken its empire).  The economic malaise had been set in motion many years before, and hence (to finish) a joke which may offer the reader some parallels with the current situation facing China:

Vladimir Lenin, Joseph Stalin, Nikita Khrushchev and Leonid Brezhnev are all travelling together in a railway carriage. Unexpectedly the train stops. Lenin suggests: "Perhaps, we should call a subbotnik, so that workers and peasants fix the problem." Stalin puts his head out of the window and shouts, "If the train does not start moving, the driver will be shot!". But the train doesn't start moving. Khrushchev then shouts, "Let's take the rails behind the train and use them to construct the tracks in the front". But it still doesn't move. Brezhnev then says, "Comrades, Comrades, let's draw the curtains, turn on the gramophone and pretend we're moving!" 

The Year of Transparency?

新年快乐！Kung Hei Fat Choi!  Happy Chinese New Year to readers!

- Announcement - Following on from last month's Moutai Awards" (茅台奖), we still have some uncollected Moutai Baiju so award winners please feel free to get in touch!!  -

Pollution update - Airpocalypse now

While many may have seen pictures of smog in Beijing and elsewhere, in Shanghai one young lady has been at the centre of the public concern over air quality.

(c) Shanghai Environmental Protection Bureau

This unlikely figure is the new Shanghai air quality mascot.  Posted by one locally based blogger the young girl pictured is shown in different moods which ties into the air quality - green being most satisfactory.  Currently air quality in Beijing and Shanghai is tipping the serious end of the scale, and one entrepreneur has started selling cans of fresh air.

Discomforts aside the fog in Eastern China does provide a metaphor for a few key themes we could expect to see in 2013.

Fog of war
No light matter, China (and Japan depending on your point of view) are threatening war over the islands, including the Senkaku, Diaoyu islands.  Currently air and sea patrols are ongoing and last week a Chinese ship locked on its targetting systems onto a Japanese ship. 

In tandem, both countries have recently been cited as having joined the currency war, a term coined by Guido Mantega, finance minister of Brazil in 2010, in which major economies engage in competitive devaluations of their currencies.  Commencing with the US Federal Reserves' Quantitative Easing (or money printing program) in 2008, both Japan (following an explicit announcement) and China (observed) have seen their currencies weaken this year. A recent statement by the G7 decrying a currency war and calling for stability ahead of an upcoming G20 meeting seemed to have little effect as volatility increased.

Promise of clear skies?
In one less discussed but important conflict progress is being made apparently.  Since the end of last year US authorities including the SEC and PCAOB have been negotiating with their Chinese counterparts to reach an agreement for the auditing of Chinese companies listed on US stock exchanges by US auditors (or verified by US aditors).  Paul Gillis, China accounting expert has details on his blog (here).  As had been discussed previously failure to resolve this could mean a mass delisting of Chinese companies from US exchanges.

However the China short-sellers, groups of analysts and funds seeking to expose and profit from Chinese corporate malfeasance are reportedly taking aim at Chinese companies listed in Hong Kong, of which there are many more, and for which there could be some bruising battles ahead.  Recent scandals involving Caterpillar and short favourite Zoomlion do not inspire confidence.

Bottom-up disclosure
Amidst strong speculation of future policy by outsiders, within China its leaders seem to be working hard to convey the message of a renewed focus on tackling social issues.  Several reports of top officials making impromptu visits to ordinary folk in remote areas have been reported by foreign media, including a a visit by prime minister Li Keqiang to the northern city of Baotou, where during an interview with a farmer, the farmer's son fell half-naked out of a cupboard behind the prime minister.

While applauded by bloggers as showing openness from the regime, the Baotou incident does remind one to ask just how many other things are hidden away in the closet in China and are likely to spring out at an inopportune time.

In terms of predictions for 2013, absent any big surprises it seems possible that many of the same issues will be redebated, not necessarily discovering any serious lurking issues in the background.  It seems possible that:

(i) NPLs will remain under-reported (and bad loans will continue to be unrecognised and accounted for);

(ii) Banks, especially state banks will continue lending;

(iii) another trust product, or several may fail;

(iv) large corporates will continue to load up on debt;

(v) overseas acquisitions will continue (just reading about possibly insolvent Suntech expanding into Uzbekistan);

(vi) one or more high level officials will be purged; and

(vii) great pressure will be placed on China's neighbours.

Now to wait and see...

Seeking cash...

Holes emerging in the edifice
Some of the headlines in the last couple of weeks:
- China's WMPs - wealth management products suffered their first recorded default.  Called "Weapons of Mass Ponzi" by some commentators, these lightly regulated or unregulated products are managed by various financial businesses but sold through banks and other networks to retail customers.  They are high risk and offer a higher return than typical bank products such as deposit accounts, which offer mostly negative rates of interest after inflation.  Customers of a mid-size bank Hua Xia protested when notes sold to them in one of the bank's branches defaulted.  The notes paid income from a domestic issuer unrelated to the bank and streamed income from a pawn shop and car dealership (details here).  As had previously been seen in the Zheijiang Guarantee scandal, part of the structure involved guarantees which were not met and bank staff were blamed.  More importantly questions were raised as to how many other schemes were likely to fail.

Despite assurances from regulators during the recent party congress, regulators do not know the extent of exposure and so this week the China Banking and Regulatory Commission ordered banks to check and ensure management of non-traditional products.
Take away: Expect vast amounts of these sub-prime style investment products to be flooding through the Chinese financial system.  It is doubtful that the regulators or the banks will be able to contain them for much longer or prevent contagion if too many collapse.

- Unimaginable sums of money have been flooding out of China - A report out this week covering illict flows from developing countries in 2000-2010 listed China as the top source of all flight money, with more funds leaving the country clandestinely ($2.74 trillion) than all of the other top 10 countries combined.  This is broadly in line with other studies on corruption in China (link here).  The atmosphere of corruption has remained pervasive since the recent party congress and Vice magazine had a great article covering the scope of illict behaviour of officials being reported daily across China ("Chinese officials at it again...").
Take away:  Victor Shih of Northwestern University has looked at the impacts sudden acceleration of capital flight could have on China's foreign exchange and fiscal position and this could be an unstabilising factor going forwards.

- China is seeking to attract massive amounts of new foreign capital from sovereign wealth funds and central banks - A recent relaxation by the State Administration of Foreign Exchange of an investment quota of $1 billion under the QFII program means that now, through small changes to their portfolio, reserve managers could cause large shifts of capital into China (details here).  There was speculation about motives and questioning as to how such a policy interacted with efforts to liberalise its currency,
Take away:  At a time when banks are seeing increasing shortages of cash towards the end of the year this move does suggest signifcant sums to flow into China in future.

- Chinese corporates facing tough times - An interesting piece describing actions on the ground at LDK, once the world's largest solar panel maker, but now subsisting on funds from its main state-bank creditors under the weight of an impossibly sized $3 billion debt is here.
Take away: Industries like shipbuilding and solar are at the forefront of the Chinese slowdown.  Expect to see a greater spread across industries, including the property sector and eventually (when problems find their way back to the creditors), to the financial system.