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.

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".

Toxic loans and all that...

Satyajit Das, a China scholar has written a piece for ABC TV (in Australia) which surveys much of the misalignment in the Chinese economy and links well some of the different concepts (like over-investment and over-indebtedness) which have been covered in this blog and elsewhere.  It can be found here.

A good question you might ask is why an Australian TV channel?  Well it just so happens that people in countries like Australia and Canada (key exporters to, and dependent on, China) are starting to ask what could happen if China's growth slows (more than currently) and the answers are not simple or necessarily complementary.  More on this in a moment.

A loan for every occasion

The point has been made in several places that the Chinese banking system is weighed down by a variety of different loans, the two major types being (i) legacy loans prior to 2008 which had been accumulated over decades (often to state-owned entities) which were in default or non-performing and (ii) loans directed to be made after 2008 encouraged by bullish central government policy aimed at stimulating the Chinese economy.

As has been mentioned the first type of loans were hived off from bank balance sheets - often into separate run-off vehicles called Asset Management Companies (or AMCs).  As this article on a WSJ blog explains, the AMCs have failed to recover and dispose of the bad debts, and strangely enough are still operating and looking for new investment (possibly through IPOs).  An article by Simon Rabinovitch for the FT details proposed injections of funds from Standard Chartered and UBS. It also mentions a lucrative side venture the AMCs got into - snapping up bank licences.  This is not the only venture - apparently AMCs have been investing in the real estate sector, and in distressed real estate vehicles aswell.   As the WSJ article made clear, debt resolution companies should not have ongoing business (well, unless they are owned by the UK government!).

So far, so well hidden, but added to this is a weight of recent government supported lending.  During mid 2011, the full extent of a lending binge was hinted at when it was findings by the National Audit Office and the People's Bank of China were released, including the headline figure that Chinese local governments owed a total of $1.65 trillion in debt - equivalent to 27% of China's GDP.  As this article in the FT stated

Local governments have accumulated an unprecedented mountain of debt in the wake of the 2008 financial crisis after Beijing opened credit floodgates, backing state-owned banks to lend to state-backed infrastructure projects...

while an article in Bloomberg gave some details about some of the vanity projects involved, such as the building a replica of New York City in Tianjin.  Victor Shih was one of the first to fully explore how this came about (a good summary of his analysis and in general is here) and one of the key ways was the use of trusts.  Historically local governments had been profilgate and were barred from borrowing directly and so had to seek revenue from land sales (which fed the real estate boom).  To sidestep this they would set up third party entities which were opaque and raised the financing for government projects.

Last year many trusts faced cash squeezes as revenue from the underlying projects dried up while obligations on the trusts to start repaying the loans kicked in.  The Yunnan Highway was the first platform which was reported to be close to default on loans, while the FT Alphaville blog reported the first possible default by a Chinese corporate on a bond issue.

Cleaning up

Arguably the Chinese have shown similar enthusiasm for cleaning up the debt as for building the underlying projects themselves.  In 2011 a plan equal to or greater than the US TARP was announced and this year has seen suggestions that overdue loans will be tackled with a combination of new money, rollovers and maturity extensions (see here).  Michael Pettis discusses the issue (and likelihood of success) in some detail in his latest blog post.  It should only be added that (i) similarly unusual "trust" structures have popped up in the private real estate and industrial sectors targeting businesses that cannot get credit and consumers seeking higher returns than in the regulated banking system (more on this later) and (ii) let's hope they do a better job than the photoshop artists who were asked to spruce up a shot of some local officials inspecting a newly paved road...

A newly laid road in Huili, south west China

What will the neighbours say?

China's trading partners are sensitive to unfavourable or unpredictable developments (the bans on rare earth mineral exports and Brazilian mega iron ore ships, or the arrest of Australian citizen Stern Hu, Rio Tinto's iron ore negotiator in 2009) and the recent announcement of lower growth targets saw much discussion about future prospects for countries such as Canada.  Canada has recent experience of private sector loss of confidence in China from the recent Sinoforest debacle.  However it is Australia which is perhaps most vulnerable to a China downside shock and which there has been lively debate.

The Economist identified in 2010 that the Australian property market was overvalued back in 2010 and there hasn't been any significant data to dampen that view.  Meanwhile last week S&P produced a report predicting steep falls in house prices if China growth was below target (see here).  The report was strongly criticised by Michael Pascoe in the Sydney Morning Herald, but the property market is a key focus of the Australian economy and weakness would be a strong signal for the rest of the economy.  Meanwhile and more significantly there were warnings about threats to commodity prices from a China slowdown which could be even more serious, both in Australia and globally.

China's Financial Architecture

So what do we know about China's financial system?
A good place to start is with a recent work by Walter and Howie called "Red Capitalism". I came across the volume by the two veteran China bankers in Hong Kong over a year ago.

It's a bit of a technical read, but the pair give a thorough analysis of the Chinese financial system and fill in with a lot of the history (you can buy it here).  It was well reviewed and one by John Plender in the Financial Times really gets to the crux of the matter:

There are, in effect, two Chinese economies. One is dominated by foreign-owned and family-run private companies that generate phenomenal growth mainly in Guangdong and the Yangtze River Delta......Then there is the slower-growth economy dominated by state-owned enterprise, which still provides some social security for its workers. This is a bank-based model.....
While the state-owned system has many of the trappings of western financial models such as stock exchanges, bond markets, interbank markets and so forth, Walter and Howie argue that this is just camouflage.....

Such "trappings" are problematic because as Walter and Howie show (in figures if not in explanation),   China's modern institutions are intertwined with each other in shared political and bureaucratic expediencies.  Inefficiencies, perverse incentives and corruption abound. A good example is the rise of the asset management companies (or AMCs) which were formed to absorb and run off liabilities from the bank insolvencies of the 1990's.  Not much debt has been written off and today they actually compete as active players in the financial markets, contributing to increases in debt.

Throughout the financial system historical debts have not been run off and new ones have been accumulated on a massive scale.  The book covers Premier Zhu Rhonji's partially successful efforts to clean up some of the excess in the 2000's which allowed the largest Chinese banks to restructure their operations and list their shares on international stock markets.  By 2008 however these efforts had been abandoned and banks were lending rapidly to stimulate the economy (on government orders) in response to the global crisis.

A video of Carl Walter and Victor Shih leading a discussion forum on this is here.  Victor Shih is particularly expert on the functioning of government departments in China and touches on the problematic procedures which occurred with some of the post-crisis lending approvals.

So what does all this mean?

Well it probably means there will be a meltdown of some sort in China.

In the short term, China has a large debt overhang with private sector and governmental loans defaulting at just the time when the economy is slowing in response to global pressures.  Chinese statistics as to non-performing loans, manufacturing and the state of the economy are questioned by many.

An asset price bubble (in particular in the property sector) is currently deflating and some commentators are raising concerns about capital flight and decline in bank deposits (with liberalisation of the restrictions on trade in the Chinese currency and reductions in the bank reserve ratio by the Central government).

In the long term, the World Bank issued a report last week saying that without changes to its state sector, China would face a bleak long term future, with innovation stifled and the country falling into the "middle income trap", when growth stalls. A Financial Times article with the details is here.

For China, low growth means unrest.  The rule of thumb is that social stability has previously maintained if GDP growth is 8% or higher (which it has been for a decade).  Patrick Chovanovec makes the point that any growth is hard for China to maintain now after 3 explosive years in this interview with Noel Roubini.

Could there be political as well as economic instability in the near future? While there has been no arab-spring style revolution in China yet such an outcome is at the forefront of the Chinese leadership's concerns.  More on this later.