Monday, June 11, 2012

Ominous signs from China

As I write these words, markets are surging in the wake of the news of a bailout of Spanish banks. I had written before that the principal macro risk wasn't coming from Europe, but China (see Focus on China, not Europe). I had expected that the eurozone would lurch in a crisis to rescue to crisis cycle and the Spanish banking rescue is more of the same. Already, there is a chorus of voices of why the bailout won't work (see examples from Goldman Sachs, BoA and Bruce Krasting). For now, it doesn't matter as the markets have interpreted the move as a stay of execution - as the cycle of crisis and rescue continues.

What is more ominous are the signs coming from China.

Technical outlook negative
First of all, the technical outlook has turned negative as the Shanghai Composite is in a wedge formation that has resolved itself bearishly.

Next door in Hong Kong, the Hang Seng Index is in a downtrend, which confirms the bearish technical outlook for China.

China's economy is weakening
The signs of weakness in China's economy are becoming more evident. There was a dump of economic data over the weekend and most of the numbers came in below expectations. The weakness is likely to spill over to the Chinese stock market. Thomson Reuters reports that StarMine expects severe negative earnings surprises out of Chinese stocks [emphasis added]:
StarMine models suggest that it’s still too early to embark on any bargain-hunting expeditions in Asia, where stock prices have underperformed most other regions of the world. In China alone, stock prices are down 16% from their March highs, but the value created by that selloff comes with big risks attached. Now, a new analysis of the most recent data suggests that the picture doesn’t appear likely to change any time soon. The “Predicted Surprise” – for earnings – the percentage difference between StarMine’s SmartEstimate, which puts more weight on recent forecasts and top-ranked analysts, and the mean estimate of all analysts – for emerging Asian markets earnings as a whole, currently stands at -1.6%. Among all markets in the region, China’s Predicted Surprise is -2%, second only to that of Sri Lanka, which comes in with a -2.8% Predicted Surprise.
No wonder we saw the surprise rate cut last week. Dong Tao of Credit Suisse (via Also Sprach Analyst) believes that actions by the PBoC won't be enough, because the central bank is in a liquidity trap and rate cuts are pushing on a string:
However, we believe that a cut in the lending rate will only have limited impact in stimulating investment. We believe China is in a liquidity trap. With a low interest rate environment, further cuts in interest rates may not get much of an additional impact. Today’s problem in China is not about funding cost or bank liquidity, but demand for loans for real businesses. As companies in the real businesses struggle with surging costs, over-capacity, and weakened demand, the incentive to conduct real investments is low. It would take some structural changes to jump-start the momentum of investments in the private sector, instead of just through easing monetary policy.
As the economic picture deteriorates, expect more cranky commentaries like this one from John Hempton (The Macroeconomics of Chinese kleptocracy):
I start this analysis with China being a kleptocracy – a country ruled by thieves. That is a bold assertion – but I am going to have to assert it. People I know deep in the weeds (that is people who have to deal with the PRC and the children of the PRC elite) accept it. My personal experience is more limited but includes the following:
(a). The children and relatives of CPC Central Committee members are amongst the beneficiaries of the wave of stock fraud in the US,

(b). The response to the wave of stock fraud in the US and Hong Kong has not been to crack down on the perpetrators of the stock fraud (so to make markets work better). It has been to make Chinese statutory accounts less available to make it harder to detect stock fraud.

(c). When given direct evidence of fraudulent accounts in the US filed by a large company with CPC family members as beneficiaries or management a big 4 audit firm will (possibly at the risk to their global franchise) sign the accounts knowing full well that they are fraudulent. The auditors (including and arguably especially the big four) are co-opted for the benefit of Chinese kleptocrats.

This however is only the beginning of Chinese fraud. China is a mafia state – and Bo Xilai is just a recent public manifestation. If you want a good guide to the Chinese kleptocracy – including the crimes of Bo Xilai well before they made the international press look at this speech by John Garnaut to the US China Institute.
Hempton concluded that Chinese State Owned Enterprises (SOEs) depend on negative interest rates as a source of cheap funding and falling inflation is the real economic threat to the Chinese economy [emphasis added]:
The Chinese kleptocracy – and indeed several major trends in the global economy – depend on copious quantities of savings at negative expected rates of return by middle and lower income Chinese...
The more serious threat is deflation – or even inflation at rates of 1-3 percent. If inflation is too low then the SOEs – the center of the Chinese kleptocratic establishment will not generate enough real profit to sustain the level of looting. These businesses can be looted at a negative real funding rate of 5 percent. A positive real funding rate - well that is a completely different story.

The real threat to the Chinese establishment is that the inflation rate is falling - getting very near to the 1-3 percent range.

Low Chinese inflation rates will mean reasonable returns on savings for Chinese lower and middle income savers. Good news for peasants perhaps.

But that changing division of the spoils of economic progress will destroy the Chinese establishment (an establishment that relies on a peculiar and arguably unfair division of the spoils). The SOEs will not be able to pay positive real returns to support that new division of spoils. The peasants can only receive positive real returns if the SOEs can pay them - and paying them is inconsistent with looting.

If the SOEs cannot pay then the banks are in deep trouble too.
If the banking system gets into trouble, then we are not just looking at a hard landing scenario, defined as sub-par economic growth, but a crash landing, which I define as zero or even negative GDP growth.

Ursa Minor romps in China?
For now, the good news is that the risk of a crash landing appears to be off the table. I had written in my previous post that systemic risks in the Chinese shadow banking could result in a crash landing and speculated about the possibility of Chinese capital flight.
Those risks appear to be contained for now. I had written that I was watching the share price of HSBC as a barometer of financial risk in China. A Hong Kong based investment banker informs me that HSBC is not thought of as a good gauge of the risks to the Chinese financial system as the bank had diversified its exposure. Better to watch the Chinese banks listed in Hong Kong, such as:
  1. Agricultural Bank of China (1288.HK)
  2. Bank of China (3988.HK)
  3. China Merchant Bank (3968.HK)
  4. ICBC (1398.HK)
Right now, none of the shares of these banks are falling in a way that suggests market fears of an uncontrolled implosion of the shadow banking system. But watch this space!

Current conditions are suggestive of an attack by Ursa Minor, or a minor bear market, in China. Nevertheless, such a scenario is one that hasn't largely been discounted by the global financial markets. So watch out.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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