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".

Ending a super-cycle

Metals update
Following the last post there were some more signs of China-related noise in the copper and commodities markets.  The ever vigilant FT Alphaville team reported on a note out from Standard Chartered detailing their visit to a warehouse in Shanghai which was stuffed to sinking with copper and aluminium (with some revealing photos).  Meanwhile there were reports today of new research from Nomura's China metals and mining analysts which found that after adjusting for GDP (rather than usual per capita bases) they predicted flat or low growth in China for metals.

As always, the picture for commodities is not unanimous, with teams at RBS and Barclays Capital positive to bullish on prospects for the materials sectors.  But as reported previously there do seem to be growing distortions in the commodities markets.  For the copper market, this was discussed in detail by BBC Radio back in 2011 (who spoke to industry users, staff at bursting warehouses and analysts at both bullish and bearish institutions) while FTAlphaville recently had some helpful background on unusual moves in the copper and oil markets.

Looking across different reports there seem to be four factors which could have been driving the stockpiling of metals in China (until recently):

i) domestic loan collateral and financing schemes: As set out in the last post, Chinese financial authorities have tightened the limited availability of bank credit making alternative financing schemes through informal lending popular.  Many schemes use warehoused copper or other metals as collateral for loans.

ii) schemes to arbitrage price differentials in commodities markets:  There has been specific comment on the price differential between the London and Shanghai prices for copper, and that arbitrage trades can impact on the price.  As explored in the last post, market based schemes can involve "re-export" of surplus copper from domestic warehouses in Shanghai, but in fact the copper only travels to other bonded and private warehouses which hold non-domestic (bonded) stocks.

iii) schemes to manipulate market prices of commodities: As explained in this piece by Reuters, it is a "time-honoured technique" amongst commodity traders to use private and non-disclosed inventories to restrict the apparent (and official) supply of a commodity, gain control of a substantial portion of the remaining "official" supply and then squeeze prices higher.  The article mentions current suspicions that certain traders are engaging in the practice and shifting large volumes into private warehouses, "off-warrant", creating the appearance of tight supply.

iv) schemes to arbitrage differentials between domestic ("onshore") and foreign ("offshore") exchange rates: Although China is undergoing financial liberalisation, with the movement to a more flexible yuan/renminbi rate, there still exist discrepancies between deposit rates and currency prices which can be exploited with stored metals used as collateral.  The previous Reuters investigation gave some detail on this.

End of the commodities super-cycle
With such distortions as excess inventories and incomplete price discovery it is not surprising that headlines have referred to an end of the commodities "super-cycle" - the continuation of high commodity pricing trends beyond levels suggest by fundamental indicators and drivers (which included sustained high Chinese demand).  An article in the Australian mentioned the example of one mining company topping up its own production with market purchases to meet demand, while the Financial Times considered outcomes for mining sector investments following a downturn.

Aside from the immediate hit to shareholders, there could be a couple of other impacts.  First it could be argued that in addition to the commodity traders, a number of large banks, including JP Morgan, Barclays and BlackRock could be exposed to kickback from inventory shielding schemes as they have significant warehousing and commodity investment operations.  Some have argued that certain banks which have large commodity ETF funds predicated on rising commodity demand are keen to maintain high prices to encourage subscriptions to their ETFs, regardless of fundamentals.  Hence some of the derisory comments on social media as to the slightly concerning tone of a Blackrock client blog this week which argued that it is "critical for the global economy that China lands softly".  The related growth of commodity backed structured financing does carry some risks as discussed here.

Also, it seems possible that speculation and arbitrage in the Chinese currency between offshore and onshore markets may complicate the liberalisation of Chinese exchange rates and the economy.  Martin Wolf explored the risks and complexities of liberalisation back in February, and it will be looked at in more detail in posts to come.  Meanwhile Fraser and Howie in their book Red Capitalism noted that non-convertibility of the Chinese currency is one of the pillars maintaining financial stability, with uncertain consequences if removed.

Thanks to the reader who identified the BBC Radio link!

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.

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.

An economy falling short?

The 4 billion dollar question
Like other emerging markets China is affected by significant levels of corruption and fraud across government and private enterprise.  Many different misdeeds have been reported in recent times, including endemic seizures of land from farmers and individual owners and theft of funds by government officials and employees from ministry coffers and state-owned enterprises (to the tune of $123 billion since the 1990s and more recently an alleged $2.8 billion from the Railways Ministry).  Premier Wen Jiabao recently told the State Council that corruption was the greatest danger facing the ruling party, while in his piece on land seizures for the BBC Damian Grammaticas pointed out that the combined wealth of delegates at last month's National People's Congress was ten times that of the US Congress.

Last year saw the rise of the China short sellers, a group of analysts mostly based in the US, who successfully targeted Chinese companies with overseas share listings - publicising evidence of fraud and/or inaccurate accounting and then profiting from short positions when the prices of the respective companies' shares fell.  One of the most notorious China short sellers, Carson Block (through reports of his company Muddy Waters Research) helped trigger the collapse in share prices of a number of Chinese companies, most notoriously with Sino-Forest Corp., which filed for bankruptcy last week.  Not giving up without a fight, Sino-Forest sued Block and his research outfit for defamation seeking $4 billion in damages and costs, questioning Block's tactics.

Block, confident the defamation action will fail took time out with CNN to announce that he had turned his focus closer to China - to Chinese companies listed in Hong Kong rather than in the US or Canada.  There appear to be similar signs of concern as was for the short sellers' first round, including  auditor resignations, so expect more of the same.  Interestingly there were also a few soundbites on the general state of the Chinese economy which Block called a "fixed asset bubble".

A solid foundation...on the world's newest and highest suspension bridge in Hunan

What is concerning about the short selling episode is there seem to be many of the same factors as were present in the US housing crisis of 2007-8, including failures in regulatory oversight, manipulation of obscure legal structures, failures by professional advisers, greedy investors, outright fraud and, in the end, significant value destruction.  An investigative report by Bloomberg last year illustrated the rise of the short sellers -  starting at least as early as 2009 when they started to scrutinise  the public accounts of certain Chinese companies which had been able to list their shares in the US and Canada without preparing a full disclosure.   

The trick the Chinese companies had used to list in the US was the process of a "reverse merger" (or reverse takeover), pioneered back in the early 2000's, involving the Chinese company acquiring an empty US shell company which had a small sharemarket listing enabling the combined US-Chinese entity to sell further shares.  It was cheaper than the Chinese company listing itself and involved less scrutiny.  And as detailed in this Reuters special report, a whole industry of advisers arose to facilitate the Chinese companies' speedy entry into the US capital markets:

...That industry hinges on a handful of leading "shell brokers" such as Halter who purvey paper companies; investment banks who specialize in financing a firm after a reverse merger; and auditors, usually small shops, who are lightly regulated in the U.S.--and not at all in China and Hong Kong...

While the regulators have clamped down on the use of structures like the reverse merger, the advisers, including the auditors remain liable to accusations of negligence and even fraud.  One key adviser, Benjamin Wei, whose firm New York Global Group structured a number of such deals was reported to be the subject of an investigation by the FBI in January, while auditors Deloitte, KPMG and Ernst & Young have faced scrutiny for their signing off of the accounts, in Deloittle's case, in respect of Hong Kong listed companies aswell.  An interesting piece in FTAlphaville gave some details of current attempts to deal with management conflicts at one company as outlined in letters to the shareholders.  Meanwhile regulators struggle for other solutions to protect investors.

Getting the numbers wrong

A few news reports appeared towards the end of this week suggesting other people looking at the China market are also making miscalculations in their assessments of certain companies and industries.  Reports of oversupply (in whole or in part related to the Chinese market) appeared in relation to various commodities including alumina, logs, coal, iron ore and goods and services like hotel rooms in the resort city of Sanya and automobiles.

Looking for growth (Qilai Shen/Bloomberg)

It will be interesting to see what the second quarter will bring.