The fog of war

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Gorillas in the mist

Goldman Sachs Asset Management chairman Jim O'Neill popped up in the news this week, releasing a note to clients with some revised thinking on prospects for China's economy.  With still a favourable overall view, O'Neill considered several likely outcomes for Chinese growth, including a "pessimistic" outlook of 7% GDP growth.  An interesting point in his analysis - that in any worst case growth scenario, the Chinese government is "surely to step in", attracted some comment as many noted that given certain conflicting undercurrents and factional conflicts within the administration and the Chinese Communist Party, the Chinese authorities may not be willing or able to intervene.

Similar to the reaction when various large Chinese cities announced vast new spending programs, some observers were sceptical as to whether bold political action will be as likely be delivered as in 2008.  O'Neill's fund meanwhile has been promoting a new set of fast-growing MIST countries (Mexico, Indonesia, South Korea and Turkey) which have been the star performers in the fund's popular Next 11 fund. And the failure to even consider a less than 7% GDP growth outcome (when some commentators consider that growth may be negative) suggests O'Neill might just be missing a gorilla in the room - Asian (and Chinese) slowdown which others believe may not be priced in by the market.

A very strategic resource
The last couple of weeks saw a renewed debate considering the return of a gold standard as a way to restore stability to the global economy and encourage growth (and end America's money printing), even while the balance of opinion believes such a standard is a false hope or otherwise likely to result in the stagnation currently seen in the Eurozone (which as Peter Coy explained arguably is committed to a new gold standard).

There is an interesting angle for China in this debate, as it has been active in the gold markets.  As you may recall China has been trying a basket of different measures to manage its economy including Keynesian stimulus in 2008, enormous foreign exchange reserves, capital controls and now liberalising exchange rates (which may be countering each other in effectiveness).  In fact reports have emerged which provide detail of China's activities in gold as well.

In addition to outright purchases of the metal, interest was also expressed from Chinese companies in acquiring gold producers.  In its report of China's largest gold producer, China National, considering the acquisition of a majority stake in the African subsidiary of the world's largest gold miner, Barrick, the Beyond Brics blog reported that the company's president, Sun Zhaoxue believes that China should view gold as a "strategic resource as important as petroleum energy".  That might partly explain why there is a gold mining division in the Chinese internal security forces (the People's Armed Police).

As well as its value as a metal, reserves of gold have been argued by some as a better store of value for a national central bank than government bonds, especially in a low inflation environment where the government issuer of the bonds is engaging in monetary easing (which depresses the yield as the price increases from the asset purchases).  In China's case it is looking for an alternative store of value to offset its huge holding of US Treasuries (US government bonds) which earn low rates of interest because the US is engaging in Quantitative Easing (printing money by buying US Treasuries) and which it cannot liqidate easily.  The liberalisation of the Renminbi (i.e. the process of opening the Chinese currency to full convertibility) is seen as one step that can counter-balance China's US dollar holdings (as the greater volumes of Renminbi will be used and deposited internationally).  Sun Zhaoxue alludes to this in his article.

However it is questionable whether holding gold ipso facto will ensure greater security for China.  How so? Well looking into some of the debate around the merits of a gold standard suggested that the credibility of the system might be more important than the physical holding itself.

I hold therefore I am
Outspoken financial journalist Max Keiser, has looked at a number of commodity stories, including possible manipulation of the silver market by JP Morgan and its high frequency trading (HFT) business (background here).  In a recent broadcast Keiser examined some of the justifications given by gold bugs (especially libertarians in the US), who he found often confuse their libertarian values (such as objectivism advocated by Rand) with the behavioural principles of the "Austrian school" (advocates of a gold standard).

A key question in the discussion was the degree to which financial institutions could issue credit secured against their gold reserves - it is only physical gold which is the "ultimate extinguisher of credit", but the use of fiat (paper) money removes the gold from credit making it easier to expand credit (which if prolonged can cause inflation and is exaggerated by quantitative easing).

In his article Peter Coy blames the First World War for causing the inflationary expansion of credit which destabilised the gold standard, however according to the Cato Institute (which is apparently libertarian) in a paper on this topic, von Mises, a key figure in this analysis, believed that instead of the war, it was the attempts by bankers to get around the gold standard and increase credit in the economy, when, from the 1890s the world's central bankers relaxed the standards of inter-central bank credits:

 It was'' not the old classical gold standard, with effective gold circulation,'' that failed after 1929; what failed was'' the gold 'economizing' system and the credit policy of the central banks of issue'' 

What von Mises proposed (to address this inherent conflict) was that the gold standard should be operated completely independently of monetary matters and essentially gold should be valued at production cost.  And this is interesting because it seems to be a call for independence, similar to that underlying the Bitcoin digital currency, which operates free of any government and is instead backed by the power of the computing network of Bitcoin users (with no centralised issuing authority).

All of this would suggest that credibility is important.  As well as the amount of gold which the People's Bank of China (the central bank) or other bank may hold, financial market participants will also assess how credible those banks are in administering and valuing such reserves.  This may not be as simple an assessment as it seems.

In gold (and tungsten) we trust...

Frauds of the week
Mentions must go out to:  the Chinese Art market (worth $13 billion according to Forbes magazine) and  China Sky One Medical and its chief executive (which the SEC charged with securities fraud this week for overstating financial results).

China's adventures

Intrigues and dramas
This week saw news from China dominating broadcasts as political and economic affairs escalated.  The cracks in Party unity were exposed following the arrest of Gu Kailai for the murder of Neil Heywood, a British businessman who had assisted her and her husband, Bo Xilai, the former mayor of Chongqing and popular politician who was dismissed from the Central Committee and the Politburo of the Chinese Communist Party (following his dismissal from the position of mayor of Chongqing).

News services struggled to delve into the political circumstances underlying Bo's dismissal, subsequent reports have looked at allegations of corruption involving Bo and his associates, long term rivalries with other factions in the ruling elite and the significant business dealings of his wife as well as the circumstances of Mr Heywood's death.  Needless to say there was as much intrigue and mystery as a feudal saga.

One way to navigate the landscape in China (c) Chooseco LLC

An interesting economic statistic
Meanwhile there was much talk about the lower than expected first quarter GDP figure of 8.1% released on Friday for which there wasn't a consensus.  The range of views on the GDP figure included:


i) the Chinese economy is re-accelerating: DBS Bank of Singapore seem to be the strongest proponent of this view, mostly relying on GDP and inflation growth.  Definitely too bullish - Zerohedge, the economics website, tweeted that DBS overestimated the GDP number at 9% in an advance research note (and labelled DBS a "3rd tier research firm").  DBS may have a point regarding inflation (see below).

ii) the Chinese economy is growing, but at a slower pace:  Richard Jerrum, economist at the Bank of Singapore painted a favourable picture of the Chinese economy based on low inflation, sufficient capital investment and decent property growth (with means to stimulate) in an interview with Reuters.  The World Bank echoed this in its favourable report on Thursday which cut its growth forecast to 8.2 per cent for 2012 emphasising the success so far in cooling the property sector and remaining available tools for the central bank to inject liquidity.  This would be the case for a "soft landing" which the World Bank predicted as highly likely.  And Standard Chartered's Stephen Green also favoured a soft landing, expecting continued capacity for growth across the economy, a strong labour market and broad scope of tools available to the central bank.

The problem with the soft landing view its critics say, is that the underlying assumptions are simply not true, i.e. inflation is high, the property market is in a slump and the central bank does not have as many tools at its disposal (or as much scope to use them).

iii) the Chinese economy is contracting or not growing:  One key point for the hard-landing proponents is that there is simply too big a credibility gap to take statistics of the Chinese economy at face value.  The FT Alphaville blog published a short but interesting article (inspired by the above book on China) detailing a number of recent statistics which showed significant variation depending on their source or were significantly inconsistent with related statistics. The notable example was the Purchasing Manager's Index (a measure of manufacturing activity) - the official Chinese figure showed expansion while HSBC's figure showed contraction.

There was equal scepticism from some towards the inflation figures (via the Consumer Price Index which was recorded at 3.6% for March (announced at the start of the week). Not only was this number higher than expected, but Patrick Chovanec commented in an interview with Bloomberg prior to the release that a figure of such magnitude seemed vastly understated and as evidence he noted the 33% increase in the cost of his milk supply (although on Twitter he added that he thought it was due to increased delivery charges rather than the milk itself!).  More seriously he noted that in all his recent discussions with business people across China he did not come across an outlook of low inflation and higher growth consistent with a soft landing.

Meanwhile although Stephen Green's team have done some updating research which showed a recent pick up in construction activity and improvements in sentiments of developers this was tempered by research suggesting that activity is being driven in a large part through financing from less regulated shadow banking, including loans from investment trusts, which may not be a sustainable source of finance. And as mentioned in the FT Alphaville note, this week saw what could be the first bankruptcy of a property developer in China.

And a couple of articles in Reuters pointed out that tools of the central bank to stimulate demand had already been brought into use since 2011 (through cuts to the amounts of capital the banks hold, the required reserve ratio, in 2011) with resulting significant amounts of new lending likely to complicate the central bank's monetary operations in the future.  Jeremy Stevens, an economist for Standard Bank in Beijing summed up the mood:

Overall conditions seem to have stabilized, but it wouldn't take much to push sentiment in the wrong direction...

In any case due to factors like the excessive extent of local government debts and the shadow banking sector it was argued by James Kynge in the Financial Times last year that the powers of the central monetary authorities to control the supply  and price of credit are "tenuous".  A couple of others were more upfront - Satyajit Das wrote a follow-up piece to his last effort in the Australian media where he referred to recent Chinese growth as an "illusion", while economist Jim Walker in an interview with Reuters stated "economies don't have soft landings".

iv) the Chinese economy has reached the bottom and is rising again (though not necessarily fast): This view was put forward by a number of people who considered the possibility of a hard landing but had felt optimistic with recent figures. Some examples included Karine Hern of East Capital (from the property perspective) and Zhiwei Zhang of Nomura who revised his bearish estimate on GDP growth this week on a view of increased economic output and lending.  As the Beyond Brics post noted (and was noted elsewhere) the significant growth element of consumption included government spending which may have distorted the measure showing stimulus rather than genuine growth.

The verdict from the markets was negative - stockmarkets worldwide slumped on the expectation of lower growth going forwards, especially as the GDP figure was the lowest comparatively in a number of years.  Noel Roubini's report picked up on this and in a tweet he commented that the GDP figure may in fact have been 6.9%.

Unlike in the adventure books where the reader can flick through to see what outcome will occur following his choice, we will have to wait and see.