In need of heroes

A motley crew of martial arts masters gathered in Xinjjiang last weekend for a martial arts conference involving training sessions, discussions and lots of photos being taken using smartphones which some Chinese internet users derided as "cosplay for the elderly".  Novelty photos aside the amount of conflicting messages now flooding out of China's economy and political management all points to authorities which are losing the initiative and are out of ideas.  Reform needs to occur, but can the recently installed team deliver?

The recession avengers?   (c) ChinaNews.com

It is telling that global markets have moved recently in a big and coordinated way on announcements of improving Chinese data - does anybody question the provenance of the official data? A few like Caixin do, but for the moment the theme is one China bringing support and stability to markets - quite absurd given the recent credit shutdown only back in June, when markets briefly went into a complete tailspin.  Expect more volatility, not less.

Policy feast

Perhaps more noteworthy than statistics were policy announcements.  A lot of them and conflicting as usual, but it seems that in pursuit of the great rebalancing, Xi and Li are ready to offer up the most sacrificial cows - could the authorities really be planning to ditch the one child policy, start radical agricultural land reforms, allow a privatisation of a major bank and ditching the hukou household registration system? These and other areas involve policies that have been established for decades and there are too many with vested interests and different objectives throughout the system to allow the process to be easy.  It must follow that there are two likely possibilities here:  (i) such announcements are pure puffery and the administration does not intend to follow through with any such reforms (this would explain bad habits like shadow financing and subsidising inefficient industries like solar are seemingly dying hard in the current administration) or (ii) the circumstances have got so desperate that officials are willing to consider anything (likely given the constraints).

One voice that is reasonably clear on this issue is Ambrose Evans-Pritchard in the Telegraph who recently commented that Chinese authorities had capitulated and given in to demands for more stimulus and to hold on reforms:

Mr Li’s implicit argument is that kicking the can down the road buys time to push through the market reforms needed as China abandons its obsolete, top-down, investment-driven, 1980s catch-up model, and switches instead to a grown-up economy. 

No doubt Mr Li genuinely hopes to push though these reforms, but he is up against an army of vested interests, and half the Standing Committee. 

As the IMF’s Article IV report makes clear, very few reforms have actually happened. Investment is still 48pc of GDP. The savings rate is still rising. China still has the most deformed economy of any major country in modern history.  

Reform under the microscope

Emerging litigation provides an excellent insight into the extent to which prior reforms have stuck and signs are not good.

The ongoing liquidation of former world leading solar cell maker Suntech in Wuxi is suggesting the recently introduced 2007 Enterprise Bankruptcy Law is not assisting an equitable distribution of assets or an efficient winding up of the bankrupt Suntech enterprise while the Wuxi government is seeming to have commandeered the process to the detriment of other creditors, including and especially foreign creditors.  

As has been noted for some time, foreign investors who use offshore structures to invest into Chinese entities (typically through holding companies in the British Virgin Islands and the Cayman Islands) often end up holding not shares but low priority claims to revenues of the onshore Chinese company, often without adequate security.  The result is several significant investors could end up with nothing:

Under Chinese law, foreign bondholders would be reimbursed only after domestic creditors, which means bondholders may end up with very little. Last week Suntech defaulted on a $541m bond issued in the Cayman Islands, which sparked a cross-default with other loans, including one from the International Finance Corporation, an arm of the World Bank.
“There are very, very few cases of defaults among offshore Chinese bonds and the recoveries have all been negotiated often with very unique circumstances, so there is no template to use to estimate the outcome in a case like Suntech,” says Kalai Pillay, Fitch Ratings’ head of industrials for Asia.
“But, no matter what, as an offshore creditor you are always structurally subordinated to onshore creditors. Any offshore bondholder has to assume that onshore creditors will get a full dollar before they get one cent.”

And in another dispute centred on the tropical island of Hainan, a British investor has been barred from leaving the island and fears for his safety while unsuccessfully pursuing claims corrupt officials with fellow local directors from his property development venture conspired to illegally transfer and strip from the project entity the key valuable asset.  It sounds more like post Soviet Russia than the great Chinese Dream Xi Jinping has been promoting of late (though the author is not quite sure exactly what that is!), leading to the question as to how many foreigners will be wiped out by an asset price collapse and general slowdown in China and how much money will they lose?

Is the Economist wrong?

That got your attention!  Well there has been a flurry of news and reports about China including a special report and lead piece just out from the Economist (more on this later).  To understand it all (given it has been a cyberspace minute since the last post) it's probably worth having a catch up.....

Rolling news feed
Although the quantity of news peaked recently, the underlying story is in a pattern to what has gone before.  Data for output, production, activity and spending in April (and on early figures, May) indicated declines, weakness and contraction, prompting the Central Bank (the People's Bank of China) to cut domestic banks' reserve requirements as stimulus, as commentators renewed fears of a bursting property bubble and contracting money supply.  Ratings agencies issued warnings on the property and banking sectors and more companies were impacted by accusations of fraud.  Commodity companies and resource exporting nations were nervous, while Wen Jiabao sought to reassure all that a sensible course would be steered.  Chinese banks didn't lend much money to anyone (and here), while Chinese consumers looked like they weren't buying much of anything.  As Ken Rapoza of Forbes explained, it is like 2008 all over again with the Chinese government poised to launch fresh stimulus measures like infrastructure investment, except this time they may not be effective (or possible).

Time for a challenge
Not a problem! says the Economist in its full feature just out.  Despite facing significant problems, the last article in the feature contends, China will "handle" weak demand and a poor financing environment and is "more resilient than its critics think" for now.  A bit of context is useful here - this is the first time in a while the Economist has started to address arguments about weakness as it previously maintained a position that there hasn't been substantial over-investment in China's economy and that China is following a "well-worn development path".  However looking at some of its arguments and its previous analysis seems to suggest otherwise.

When it last looked at Chinese over-investment in 2009 (as taps turned on after the 2008 stimulus were in full flow), it closely predicted the rate of growth of investment (over 20% when adjusted) and stated the benchmarks for assessing effectiveness were whether the new investment added useful capacity to a sector which needed it - in short, whether the investments efficiently allocated capital.  The verdict at least from anecdotal evidence is surely not, the new investment did not entirely add capacity which is useful now - Chinese shipyards are shuttered, Chinese steel firms are entering into other businesses like pig farming and the investments into rail have seen episodes of corruption and safety concerns on a monumental scale, most recently with concern about safety and performance issues with new rail line equipment.

In a subtle shift, the Economist's latest argument sidesteps the issue by saying that although not all of the very large investment may have been productive:

a) the investment did go somewhere and it wasn't so big,
b) it was inevitable given the country's savings rate and
c) it wasn't a complete waste because there were underlying productivity gains.

Hence the metaphor of China's economy being like the fictional character Robinson Crusoe who builds a not very useful canoe using primitive methods - at the end of the day he still built a canoe.

A product of China Inc?

There is a fundamental flaw in this analysis in that it fails to distinguish between the efficient, private and export-focused parts of the Chinese economy, and the inefficient, public and domestic parts of the economy.  Walter and Howie explain in their book Red Capitalism how the State Owned Enterprises (SOEs) which now dominate the Chinese economy were aggregated together in the early 2000s combining small and inefficient regional entities and how they have remained inefficient compared to the entrepreneurial and small to medium enterprises which have traditionally had an export focus.  The Economist recognises that if these private firms or SMEs had had a greater share of the investment it would have been more efficient, but what it doesn't say is that this allocation has made the Chinese economy less resilient and is indicative of long-term policies which have made the Chinese economy less resilient.  In particular:

a) the investment went to inefficient locations i.e. SOEs and was big, relative to the SME sector;
b) the country's savings rate was made high by specific financial policies (financial repression) and the Chinese economy is locked into the policy's effects; and
c) while productivity has risen on average capital and investment has mostly flowed to those parts of the economy which are unproductive.

To modify the Economist's metaphor, it is more realistic to think of the Chinese economy operating on a beach in which Robinson Crusoe has been slaving away building a useless but very big canoe, while a modern and efficient maker of speedboats nearby has closed due to a lack of funds.

It's been well discussed about the clear division in the Chinese banking system between regulated banks which mostly lend to SOEs and the smaller unregulated operations or "shadow banks" which have traditionally stepped in to finance SMEs.  Attempts have been made to reconcile the two systems or to look for new sources of capital altogether (such as a bond market for SMEs).  But more immediately there are pressing concerns as to the stability of those intermediaries which have accepted risks of SMEs and Patrick Chovanec has put out an article taking a look at China's credit guarantee companies - the "least understood part of the shadow banking system" which he compares to AIG.

And just like the collapse of AIG during the 2007-8 global financial crisis, the broader picture of the Chinese economy is one of increased risk.  Michael Pettis confirmed some of his earlier forecasts for the Chinese economy in a recent post, in particular and in opposition to the Economist, that China does have a serious debt and/or over-investment problem with investment being misallocated "on a massive scale".  His prediction on falling consumption has been seen and the underlying cause, financial repression remains in place.

Financial repression encompasses measures used by governments to direct flows of money in their economies but as Pettis and Nicholas Lardy of the Peterson Institute have made clear, the measures of financial repression in China are wrongly set and will compromise the Chinese economy.  Pettis calls it the "heart of China's problem", while Lardy's 2008 paper attributes repression as the cause for pretty much every macroeconomic problem in the Chinese economy, including the shadow banking system, low consumption and the inability to reduce exposure to the export economy.  The net effect? A handicapping of growth - Pettis has a 2 way bet with the Economist on the prospects of the Chinese economy and Pettis is on the bearish side.  My money's with Michael.

Fall of the Redback?
Analysis of what is going on with China's currency will come soon (no room now unfortunately!).  However there has been some reports this week of Yuan / Renminbi weakness.  Just to refresh, the official line is that the Chinese currency continues its glorious path to attaining reserve currency status and breaking into the dominant position for global trade settlements (cue inspirational video from the FT) - with the US hoping for some corresponding appreciation to give their exporters some relief.  Seeds of doubt from the FT - falling export orders seem to be leading to a shortfall of dollars at the People's Bank of China while the acute risk of capital flight which Victor Shih first raised in 2008 has attracted some comment too - something Shih said, could attract an "enormous impact".

All those reserves....

Flow on effects
A recent comment from one reader questioned the likely effects of a China slowdown on some of its key trading partners.  As has been discussed previously there is concern amongst exporting economies of the effect of a China slowdown.  The previous week saw negative reaction to BHP executive Ian Ashby's comments of flat predicted Chinese steel demand, while recently the currency and stock markets in Canada, Australia and New Zealand have all declined on expectations of lower Chinese growth.  The FT Alphaville blog had some interesting figures out from researchers showing the growth of imports into China as exports have stagnated and which also singled out Australia and Brazil as having a particularly high share of their exports to China thereby making them vulnerable to a slowdown.

For Canada, which has a US focus but is vulnerable through commodity prices and by the fact that many Chinese companies and companies with China exposure are listed on its sharemarkets, this piece from Reuters had a couple of soundbites from researcher Murray Leith at Odlum Brown in Vancouver:

...The Canadian stock market is very geared to economic growth in China. If China slows, commodity prices moderate and because resource stocks constitute close to half the index that has negative implications....

It will be interesting to see how this develops.

Keeping a big rock in place
To a more long term issue, a fairly common point reached in China discussions in the size of the country's foreign reserves. They're huge, over $3 trillion and are considered by most to provide a sufficient firewall for any potential crisis the country faces.  A lighthearted survey by the Economist of just how many enormously sized things such an amount could buy is here.

Substantial foreign reserves have been de rigeur for emerging market economies for over a decade - in order to protect against fluctuations and rapid devaluations which can follow foreign investors quickly withdrawing direct investments (including speculative capital flows or "hot money") compounded by short sellers wading in to make quick profits betting on further declines in the midst of a crisis.  The lesson many Asian and emerging market countries drew from the Asian Crisis in 1997 was to build up an arsenal of foreign reserves to out-buy any speculators and compensate for any rapid capital flow shortfalls in future.

This need for security against financial contagion seemingly dovetailed nicely with China's longstanding trade policy, which is to achieve large trade surpluses by relying on an undervaluation of its currency, the Yuan or Renminbi (RMB) in particular with its largest trading partner the US (and its currency, the dollar).  As Krugman explained early on in the crisis, this policy wasn't necessarily anticipated or deliberate, but certainly China was locked into accumulating foreign reserves early on - with one problem being that China's reserves were concentrated in US dollars (through China's holdings of US Treasury Notes or debt) which made them vulnerable to falls in the dollar.

At the time there were calls to expand the use of Special Drawing Rights as an alternative to US dollars, although these fell silent and China's planners instead launched the internationalisation of the RMB, which is now used in trade settlements, some instruments and limited capital flows.

China's FX agency...has a few spare yuan down the back of the desk...

However steps to liberalise the capital regime have been gradual and even with some diversification by China into currencies such as the Euro and some overseas M&A, China's gargantuan foreign reserves still have weaknesses.  They do still hold a large position in US Treasuries which would be hard to liquidate (lest their remaining US dollar reserves would fall in value).  The amount of dollars they have to buy makes maintaining the currency peg - buying up all the excess dollars, expensive, while the Central Bank also has to  drain the resulting excess resulting RMB liquidity from the financial system by "sterilising" (requiring banks to buy debt or increase the amount that they must hold in reserve), an imprecise procedure when the Central Bank uses the same tool to conduct domestic interest rate policy.

In general there is no transparency about the precise nature of the reserves and the extent to which the reserves are in fact reinvested into domestic entities (and therefore less valuable) is not known (though Victor Shih has speculated).

The Rising Sun in the Currency Wars
A quite disturbing risk is that China might be unwittingly drawn into the ongoing "currency wars" and in particular a devaluation of the Japanese Yen.  The term "currency wars" came into frequent use in 2010 (Guido Mantega, the Brazilian finance minister used the term often) to describe the series of quantitative easing by developed country central banks (especially the UK and US) to lower their exchange rates and restore competitiveness relative to emerging markets.  Developing countries and especially emerging markets responded by introducing capital controls and restrictions, seeking to fight the tide of liquidity as investors moved money from developed to developing economies to seek returns.

Japan (like Switzerland) was seen as a safe haven, having a sound economy and currency which was seen as still a good store of value.  With increasing flows the value of the Yen has risen to very high levels, eating into the already declining competitiveness of Japan's export industries.  Coupling with a now crippling level of debt and effects from the earthquake, the Bank of Japan has also been involved in easing although it may not be done yet.  A few are now speculating that i) Japan has further easing to do and ii) China may feel the need to respond with its own devaluation to ensure its currency remains cheaper than Japan.  As Mike Dolan points out for Reuters, devaluing the RMB will bring China into conflict with the US, while Andy Xie argues that a big Yen devaluation could cause China's banking system to sink.  It is not clear how Andy imagines the collapse - whether by loss of confidence or speculation however there seems to be enough to at least mount a rebuttal to Michael Pettis who last year in a podcast stated that there was no doubt China's foreign reserves would be sufficient to repel any currency contagion.

And right now?
Of course a country's capital account is in flux and it is worth taking into account money flowing out from a country as well as in.

This year has seen a reversal in that China's foreign reserves shrank for the first time since 1998, while the slowing rate of RMB appreciation has seen China's central bank struggling to find a balance between trying to dampen the impact of investors withdrawing from bets on appreciation and inadvertently causing uncertainty which could encourage substantial capital outflows:

The central bank wants to widen that band to allow greater two-way flexibility, discouraging investors from taking one-way bets on yuan appreciation by bringing speculative capital into the country....But China's central bank still lives in the long shadow of the Asian financial crisis, when sudden outflows of capital brought neighbouring countries to their knees.

Further complicating the picture is the very hard to estimate extent of capital flight which anecdotal evidence suggests is high - "The errors and omissions in China’s balance of payments ($60bn in 2010) suggest tens of billions might be involved in such capital flight though it is difficult to distinguish between hot money outflows and capital flight".  A thorough analysis presented in an interview by Victor Shih, is here.