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.

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...

Learning all the right lessons

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


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


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

A marketplace...being flooded with liquidity

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


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


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


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


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


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


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


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


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

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

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

Taming the galloping dragon?

Most economists understand an expression like the title to refer to the battle to restrain inflation.  For China, the dragon is a national symbol and in recent times the political elite have not only been battling inflation but struggling to steer China Inc.'s runaway growth.  Prime Minister Wen Jiabo's announcement of the lowered growth target at the annual National People's Congress this week was well covered in the international media, which used the opportunity to look back at the last decade of China's astonishing success story and speculate as to where China (and its trading partners) are now headed.

Speculation like this is not new, but it is an issue which divides - most analysts seem happy to quickly take a stand as either a China bear or as more upbeat.  Jim Chanos, famous for shorting Enron, has been one of the most vocal and consistent in pointing out the peril should a collapse in the Chinese model of over-investment and top-down directed rapid growth occur, in 2010 speaking to students at Oxford University, followed by a more recent explanation of his "long corruption short china" trade when discussing recent property price falls in China on CNN.  Meanwhile with Jim Rogers and other outspoken individuals coming to life, the Wall Street Journal felt compelled to track the ongoing exchanges in its "Chanos China Smackdown Watch" series.

Most will have seen a picture or two of an empty Chinese mega shopping mall, or even London hedge fund manager Hugh Hendry's form of disaster tourism, which involved him standing in front of lots of tall empty skyscapers in a third tier city.  What is interesting is a dynamic behind-the-scenes that may be equally or more important - weakness in the Chinese banking system.

Hugh Hendry in front of a building

This was touched on in Walter and Howie's book, though they covered all of the Chinese financial system, the domestic banks were at the core of the story.  And there was certainly at least one paradox they identified - how could China's large pillar banks, recently internationalised and amongst the largest banks in the world, be so reliant on external fundraising?  Why did rights issues follow soon after their IPOs?

Chinese banks have numerous advantages in their domestic market due to the regulation and restrictions on savings and capital in China - as one piece in the Sydney Morning Herald put it (when referring to the low deposit rates on offer to savers due to government regulation):

No wonder that one senior Chinese bank executive was embarrassed to reveal his bank's profit, or rather, the money his firm had fleeced from depositors.

The large banks have played an even larger role in executing government macro policy, including accelerating lending after 2008 and, with the People's Bank of China's elevating the reserve requirement ratio to its primary tool for slowing inflation, becoming the conduit for transmission of government targets into the economy.

Yet despite (or in spite of) such conditions, Chinese banks are not as necessarily healthy as they seem.  Not only is it likely that the size of their non-preforming loans is understated and likely to rise, there are more fundamental and deeper problems which are likely to manifest themselves.

Charlene Chu is a Fitch analyst who has brought to attention some of these weaknesses.  In this interview with Bloomberg she named a number of issues for concern.  Many are familiar and outcomes remain to be seen.  Of most interest I thought was the reference to questions about the level of capitalisation of banks.  For most the ultimate answer would be that the central government of China has sufficient foreign reserves to act as a backstop in the event of (or preventing any) contagion.  Of course as we know from the European debt crisis, any doubt or uncertainty about a government backstop can disrupt any attempts to bolster bank balance sheets.

There are plenty of toxic loans in China's banking system from legacy debt portfolios accumulated in the eighties and nineties to local government excessive borrowing in the 2000's.  This article by Anthony Hilton in today's Evening Standard (covering a gloomy note by Lombard Street Resarch) gives some more detail and it does not look pretty.  In sum, China's leaders are going to struggle with an unpredicatble dragon for some time to come.