Growth is dead!! Long live growth!

It is a criticism with some basis that the pursuit of economic growth in China at all costs has become something of a mantra or cult and that even as the new fresh-faced regime seeks to move away from this to rebalancing and broader aims and social goals, western business media seem obsessive in their coverage of all pronouncements and speculation seeking to divine whether the magic number (annual GDP growth) will be 8%, 7.5%, 7.7% or something lower.  What did Finance Minister Lou Jiwei mean when he said 6.5% growth was tolerable on the sidelines of a China-US summit in Washington? That 6.5% was expected? That there was more comfort? to scare foreign speculators? To test the market impact perhaps?

Alas, since the SHIBOR shock when the PBOC cut funding in the interbank market for a time, the Chinese administration is having to posture a lot and send signals to try and guide the markets - not something it is necessarily good at!

Let's go back a step.  There are plenty of reports indicating (from the Chinese authorities themselves and from outsider's analysis) that the existing model is dead.  No more shopping centres/bridges/trains/roads to nowhere and hello consumerism.  Sounds simple enough - after all it is the lack of consuming that causes the high savings which distort the global economy and cause deficits in developed countries (which have been the centre for slowdown which is threatening China's exports and the exporting model), goes the reasoning.  Simple right?  And follows a nice circular logic?

Well not really!  Some points to consider:

Upside down fundamentals

China bull...hanging in a tree (c) CEN

The low consumption is a result of the structure of the banking system and economic policy.  The export preferencing low fx rate (in the RMB trading band) causes excess liquidity which is stored in US treasuries.  The PBOC buys the US dollars from exporters injecting RMB into the economy which must be sterilised to prevent inflation by forcing banks to buy PBOC bills and hold high reserves.  With scarce funds the banks prefer to lend to SOEs and live off the spread over fixed rate depoist source of funds which pay a low interest that is negative after inflation (due to the above).  The Chinese people get negative interest rates at the bank and can only buy gold (which they are doing in record numbers) or real estate (did we mention the world's biggest building was built in Chengdu at the size of 20 Sydney Opera Houses?!- this in addition to more shopping space in that city than much of Europe).

Regulation light wealth-management products have appeared to fill the gap offering high interest avenues for risky investments causing a further bubble, but the overlying point is that there is relatively little consumption.  Currently, ordinary people in China subsidise the state and its enterprises.  Their funds are transferred into investment.  Along with Michael Pettis who has been saying this needs to change (and will change) for a long time, many key figures have made this point, including Patrick Chovanec who said recently on twitter that the solution is to reverse the process, by liquidating the US treasuries.  Bringing the US dollars back into China to counteract receding investment and unsterilising - repurchasing the bills to put back yuan into the Chinese economy.

It is the view of this blog that this will not happen without a crisis, because i) the treasuries are impossible to liquidate easily without risking the valuation of the remainder (although that is what the US wants and is trying to force through its QE based US dollar devaluation), ii) it would fracture the edifice of China invincibility that is keeping the economy running, iii) as Victor Shih has noted, by the time it did so wealthy individuals would have already withdrawn enough of their funds from China to wipe out capital in the Chinese banking system rendering it insolvent.

That is a dire end-game scenario, but to return to the main point - consumption - no consumption is going to occur in a significant way unless all of the above happens.  Consumption can't happen without structural reform (Chovanec would probably argue that Yuanisation of US treasuries so to speak could kick start sucha process, but this is splitting hairs somewhat).

If not for anything above you should at least get a sense that consumption will take a bit more to take root than a couple more empty shopping centres!

Reactionary forces gathering
It has been noted that the SOEs, citadels of investment are fighting hard to stave off reforms and keep their privileges.  This will slow or block reforms and recent articles suggest the reform movement is slowing - investment still made up a significant and growing part of gdp in growth the second quarter.

Another more poignant example is the recent announcement of a massive ramping up of spending in the solar power sector - a sector flooded with capacity (45MW production capacity in China compared to global demand of 35MW) where high profile and industry wide bankruptcies are only starting occur. An official was quoted last year saying there would have to be consolidation and solar firms would have to close.  Instead there is this recent announcement that screams return to the bad old days:

China aims to more than quadruple solar power generating capacity to 35 gigawatts by 2015 in an apparent attempt to ease a massive glut in the domestic solar panel industry.

Within top sections of the Party there are reportedly divisions between different commissions and the Politbureau and this will only be likely to intensify.

China on consumerism: You're doing it wrong!
Many will have seen the report of a cartel seeking to sell chicken feet 46 years past its sell by date and many will have seen the reports of GSK and other multinational food and pharmaceutical companies investigated over corruption and also allegations of profiteering.  Taking a step back from the specific facts and the overall sense seems to be that China is unhappy with and unable to bring about conditions for sensible prices for certain consumer goods (feeding into high inflation and risks of unrest) and instead of addressing the underlying cause is going about in a ham-fisted manner attacking the multinationals to try and force a way around the problem.  A short term solution at best.

More fundamentally as illustrated by an excellent observational piece in the FT about passengers on China's first cruise ship, Chinese consumers are just venturing into whole new markets and are very different from preconceptions.  As with all China's modern history, things will not turn out as expected.

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). 

Heading for the exits

A Chinese dollar?
Adding to the confusion of the different types of Chinese currency (onshore and offshore Renminbi), and some of the unintended consequences discussed previously is an interesting idea noted by the Beyond Brics team from from Richard Harris at Port Shelter Investment Management.  Given that the non-transferable offshore Renminbi (CNH) sits alongside the domestic Hong Kong Dollar (which although transferable is limited by a longstanding US Dollar peg) Harris has suggested combining the two, to make a "Chinese dollar".  Some details and a hint of some of the benefits for capital flows are set out here.

Such a move could viewed as a reverse-merger of sorts (merging the offshore Chinese currency with its onshore, established equivalent).  Reverse mergers, which were used by many Chinese companies to combine with US listed shell companies and fast track equity listings in the US - were the subject of a number of scandals in recent years, and a new battle for transparency has opened up between US and Chinese regulators (more below).

Fraud of the week
Last week, China focused US research firm Citron Research, caused a storm when it issued a strong research report condemning alleged fraudulent practices at Evergrande, a top Chinese property developer, (link here). In a similar manner to the Sinoforest debacle, the company's management responded to the release of the report and subsequent rapid stock decline with aggressive denials and Evergrande enlisted a number of its investment banks for support.  Worringly, Marketwatch's Craig Stephen raised the question as to whether a threshold had been passed, so that from now on, larger and more established companies on the Chinese mainland (including Hong Kong listed) could be subject to claims of fraud and insolvency.

Unhelpfully greater transparency which could reassure markets does not seem to be forthcoming.  There have been reports of harrasment and detention of investigators which short sellers and others have been sending to verify Chinese companies' operations on the ground (who some companies and their advisers allege are trying to spread false information), while it has been reported that access to Chinese company filings (which short sellers made great use of to publish their reports) has been restricted.  As Patrick Chovanec of Tsinghua University sets out in an interesting blog post, it is not only that company documents are becoming harder to get, but that certain requests for information by the SEC and its affiliates in respect of Chinese companies which are listed in the US have been refused by the Chinese authorities.  And as he puts it there could be serious consequences if the stand-off continues:

By the end of this year, unless a compromise can be reached, there is a very real chance that U.S. securities regulators may end up employing the “nuclear option”:  forcibly delisting every Chinese company currently listed on a U.S. stock exchange — such as Sinopec, Sina.com, China Life, and China Unicom.   It’s a potential catastrophe-in-the-making that few investors or politicians have given any serious thought to.

Meanwhile...200 stories up
Before such a calamity may eventuate, it is quite possible that one Chinese company which has been attracting a lot of attention in the property and engineering sector, Broad Sustainable Building, may have built the world's tallest skyscraper.  Announced last week, the Sky City One Project (if approved) will involve the company, which is famous for prefabricating all parts of its buildings in a factory and joining the parts together on site, erecting a building taller than the Burj Khalifa of Dubai (the world's tallest building, which took 6 years) in just 90 days.

Of course like the Burj it could be interpreted as a sure sign that the Chinese economy is heading for severe recession (some research on the correlation between skyscraper construction and the onset of economic downturns is referred to here).  A recent video from Reuters helps illustrate just how many skyscrapers are being built in China (and how quickly).

Tracking capital flight
John Hempton, a notable China short analyst attracted a lot of attention the other week with his blog post declaring China to be a kleptocracy - "of a scale never seen before in human history".  While there have previously high estimates of the scale of corruption in China (one leaked internal PBOC report identified $120 billion of illegitimate funds transferred out of China by officials in the preceding 15 year period), more details about how money is being transferred out of China has emerged recently.

In addition to laundering through trips to Macau casinos, overseas real estate has been popular, both in Asian countries and as more recently noted, in the US.  Victor Shih, of Northwestern University has been a leading light in the study of capital flight from China, and he has noted the significant impact capital flight by the wealthiest 1% of households in the Chinese hierarchy could have.

What is interesting is the connection of instances of capital flight to political tensions between factions of the Chinese Communist Party (CCP).  This report by Matt Gnaizda of NTDTV is a very helpful introduction to the Jiang and Hu Jintao factions in the CCP who are battling for prominence ahead of the expected accession of Xi Jinping to the presidency of China later this year.  Matt also mentions the connection of Bo Xilai, the recently ousted mayor of Chongqing to the Jiang faction.  Bo's wife Gu Kilai recently was reported to have admitted killing British businessman Neil Heywood to stop him disclosing the laundering of $6 billion and Bo's fate remains unknown at this time.

More broadly, the dismissal of Bo, itself a significant shift in the Chinese political landscape, may have triggered a rush of capital exits - this report from China's Forbidden News suggests increasing speed of transfers by members of the Jiang faction as the faction's position has become destabilised.  Countering this, it would seem is the recent introduction of new asset disclosure rules for top military officers (reportedly part of a Hu-led anti-corruption campaign).  This sort of maneuvering could continue for the duration of the year and its coincidence with destabilisation of the financial markets in China could be problematic.

China looks to introduce an effective anti-corruption fighter

Feedback
I recently got some helpful comments on this blog and will be looking to implement over the next week or so.  If you have any thoughts please feel free to leave them in the box below or email direct to chinameltdownfeedback@gmail.com.

Goodbye to BRICS?

The economies of the much talked-about BRICS countries are crumbling.  This was the headline in a post this week in the FT blog, Beyond Brics (which has these emerging economies as its focus).  Perhaps for the first time in a long while, disappointing economic news came out this week for each economy in the club first identified by Goldman Sachs' Jim O'Neill in 2001 (and formally launched in 2009).  For China, significant attention was paid to Thursday's unexpected interest rate cut by the central bank, the first since 2008.  Despite initial positive reactions, concerns were later raised that a) Chinese authorities would not have the scope to conduct loosening on the scale necessary or similar to the stimulus in 2008 (or if it did it could be detrimental) and b) that the rate cut may in fact have been driven by more serious concerns of slowdown which may be revealed by monthly production data, to be released this weekend.

Pumping in cash
Prior to the interest rate cut, the methods of stimulus were in focus with many concerned that some of the excesses of the 2008 stimulus be avoided.  Attention was paid to the National Development and Reform Commission (NDRC), a bureaucratic body which approves many large-scale development projects and had gone into overdrive in 2008/9.  Just how rapidly the NDRC rubber-stamped big ticket projects then was studied by Victor Shih (discussed in a forum last year, link here).  Meanwhile Victor noted on his twitter feed that the NDRC had also recently approved a "bad-ass project to artificially influence weather in NE China" (announcement here).

The NDRC has also approved several large steel projects, at a time when the sector is unprofitable.  As discussed with steel companies, the concern is not only that stimulus financing could be misallocated to inefficient projects which lose money (and result in increasing non-performing bank loans), but also that money provided (for bricks and mortar purposes) may be diverted into further lending and speculation.  Recent shorting of the stock of construction machinery maker Zoomlion (listed on the Shenzen and Hong Kong exchanges) has exposed the ingenuity of some operators with suggestions that even some of its concrete mixers may have been acquired to be used as collateral for further lending.

One development project which needs funding

Business as usual?
Meanwhile Chinese officials do seem to be seeking to assert more control over information in the financial sector.  Recent Wall Street Journal articles gave some interesting details about measures which have been viewed sceptically by foreign investors and regulators, including requirements for greater localisation of foreign accounting firms and a recent decision at one of the key repositories of data on Chinese companies, the State Administration of Industry and Commerce, to significantly restrict access to its records (which may have been related to the fact that these records were used by many of the foreign analysts who short-sold stocks of Chinese companies in the last 2 years).  In contrast, problems of oversight remain in the banking sector, where implementation of the Basel III banking reforms have been further delayed to commence in 2013 and the executive vice president of the Agricultural Bank of China (one of the large, listed pillar banks of the Chinese economy) was detained on corruption charges at the end of May.

Perspectives on the Chinese currency
As mentioned previously, a bit more coverage of the Chinese currency is overdue- a topic which can be a little confusing simply by the fact that it has several denominations (offshore/onshore) and two interchangeable titles in reports - Renminbi/yuan (with the latter being the unit of denomination) as well as the nickname of the "redback".  Until 2009, there was not much to say about the Renminbi except that it was in a fixed and then managed float, and was undervalued against the US dollar.  With US pressure and liberalisation measures, the value of the Renminbi has started to change recently.

Some background to note - one of the reasons China was reluctant to allow a flexible Renminbi rate was fear of "Plaza" - fear that the Renminbi could appreciate rapidly in the same manner as the Japanese Yen did after the coordinated action of central banks to devalue the US dollar in 1985 (pursuant to the Plaza Accord).  Many view the appreciation as a key causative factor in the asset bubble which triggered the collapse of the Japanese economy and the subsequent slow growth in the 1990's referred to as the "lost decade".  In China's case, the fear is that a rapid appreciation of the Renminbi (which could start upon a free float) could eat into China's export economy and threaten jobs and social harmony quite significantly.  From the US perspective, similar to 1985 position against the Yen, the undervalued Renminbi has been a key cause in the large US trade deficit with China and allowing it to float would cause an appreciation (and dollar depreciation) that would give a boost to US exporters and shrink the enormous imbalances with China (in particular the People's Republic's gargantuan holdings of US Treasuries).

While most commentators viewed a simple appreciation as neither feasible nor a solution, the policy background has become more complicated.  In particular:

i) Policy makers have favoured gradual liberalisation or "internationalisation" to diversify China's reserve holdings away from US dollars and to open up the Renminbi to use in international trade settlement and as an international reserve currency.  From 2009, measures were adopted to allow greater international use of the Renminbi, befitting China's status as a pre-eminent trading nation.  The sort of thinking underlying this move is outlined in a recent FT article.

b) A consequence of the measures which have resulted in greater circulation of the Renminbi is increasing complexity of Renminbi valuation.  In particular there are greater opportunities for capital flight and arbitrage between onshore and offshore Renminbi (including those involving stockpiled metal as collateral).  As this insightful Beyond Brics piece notes having looked at recent data from global payments network SWIFT one type of arbitrage that appears to be happening frequently is as follows:

A Chinese company places renminbi on deposit with a mainland bank, earning an interest rate of about 3.5 per cent. The company then obtains a long-dated, renminbi-denominated letter of credit from the bank, ostensibly to pay for a shipment of goods from its own subsidiary in Hong Kong.
In turn, the Hong Kong subsidiary takes the letter of credit to a local bank and uses it as collateral to obtain a US dollar loan at a lower interest rate than those available on the mainland. In many cases, the company would also use a currency derivative to eliminate the foreign exchange risk. The end result: the company has captured the difference between onshore and offshore interest rates, less banker’s fees.

and worringly:

If international trade in the renminbi is largely driven by financial arbitrage, as the extraordinary use of letters of credit implies, then Beijing’s plan to internationalise the renminbi is not exactly going according to plan.

Likewise all is not going according to plan in the offshore "dim sim" bond market where foreign companies issue bonds in Renminbi in Hong Kong (encouraging demand and use for the Renminbi denominated securities) - as noted in May, yields on dim sum bonds have been rising making it cheaper to raise finance in other currencies and markets.  And as mentioned previously, Victor Shih and others have found the impact of capital flight (on flows and valuation) by connected elites could be significant.

c) But perhaps, most significantly, the mechanism by which China recycled US dollar export earnings into reserves (and managed its currency flows domestically) is breaking down, primarily because of an export slowdown plus Europe fears and greater reluctance of exporters to settle their dollar deposits.  A detailed study out by Nomura is described here tracks the slowdown in the accumulation of dollar reserves.  The Nomura team conclude on one aspect - the slowing of the flood of US dollars gives the People's Bank of China more scope to act on monetary policy.  However, if this pattern is sustained, the other effect could be devaluation and/or a need to sell down reserves.  An ING note discussed yesterday concluded that signals to this effect were temporary but this may not be so.  Looking at April data:

The data reinforced fears that the economy was on a slippery slope to a hard landing via an overvalued currency and capital flight..

In the least the note did conclude that the Renminbi was overvalued at the moment (as did the IMF, in a shift from its recent position).  Perhaps a good concluding example of uncertainty with the Renminbi's prospects is seen in this article about a Renminbi deposit account offered by the Bank of China's New York branch.  Set up as part of the internationalisation so that foreigners can hold Renminbi, there is a question though whether they would wish to do so if there is a chance of devaluation?

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".

Commodities watch

There's been a number of reports about projected oversupply and weak demand for various commodities in the last week due to China slowdown concerns, including zinc, steel, sugar, stainless steel and copper.  Interestingly for copper, Chinese traders are now reported to be re-exporting excess stocks of copper which had been acquired for speculation and financing.

Copper financing to slow?
There are two aspects here; firstly the giant inventories of copper which have been sitting in Chinese warehouses for the last year or so and second, future expectations of price declines (hence the desire to ship now).  On inventories there was much comment about the excess supply of copper in China last year.  Holdings data were unreliable and diverged with market estimates.   The divergence (and the distortion it caused on pricing) was noticed back in 2010 and was initially seen as being due to trading strategies, which sought to profit from the difference in prices between the London and Chinese metals exchanges or to construct hedges against inflation or currency risk.  One story by Bloomberg back in 2009 identified that pig farmers in China were acquiring stocks of copper and other metals to offset Chinese monetary stimulus measures.

But the inventory story was more complex.  During 2011 it emerged that stocks of copper had also been used as cheap collateral for loans to companies and property lenders which were struggling to get loans from regular domestic Chinese banks as Chinese banking authorities sought to restrain credit in the overheated economy.  Such financing contained increased risks and during the year Chinese regulators sought to slow down such financing schemes, closing down some activities directly.

Fast forward to 2012 and speculation has continued, as this detailed investigation by Reuters explains:

At Shanghai's Waigaoqiao port, a sprawling 10 square kilometer free-trade zone, thousands of tonnes of copper cathode plates sit in stacks turning green after years of exposure to the elements.
"They don't get shipped to end-users because they were bought for speculative reasons," said a warehouse manager at the port, who would only give his surname Zhu, standing in the port's control room overlooking yards piled high with metal....

And regulators have only been partly successful in restricting this market.  As the Reuters article points out, use of copper financing schemes is popular while credit is so contrained in the Chinese economy and there are limited other regulated sources of finance.

So why the sell offs?  On the demand side it seems that copper traders also anticipate falling prices and demand this year.  In particular, investment bank China International Capital Corporation indicated in an interview today  its expectation of slower demand growth of copper as the Chinese government maintains restrictions to slow the property market (while copper futures fell on inflation expectations earlier in April).  It seems possible copper may follow aluminium which has had a "profitability downturn" as the industry is struggling in China amidst overcapacity with CICC predicting a quantity surplus this year.  As has been seen in other markets for aluminium, conflicting interests between users and speculators may coalesce around warehoused stockpiles so there could be more comment and conflict arising in the copper warehouses of Shanghai.

Holding onto copper...for now

Rise of the Redback

This week saw the launch of the widened trading band of the Chinese currency, the Yuan (Renminbi) which is part of a number of financial liberalisation measures aiming to increase the convertibility of the Yuan and to help open up the Chinese economy and bolster economic growth.  A fuller review will be conducted in the future but it is worth pointing out that copper financing may continue to be encouraged by flows of speculative capital or "hot money" which can fund commodity-based trades and that until full convertibility exists between domestic and offshore yuan deposits, traders seek to profit from any mispricing.

Initial feedback suggests there has been no increased volatility in the currency during the first days of the new regime, but a statement from an official at the State Administration of Foreign Exchange, indicates they are remaining wary of further inflows.