Tuesday, October 29, 2013

The stakes are rising for China's Third Plenary

Further to my last post (see Watching for China-related volatility in November), a number of articles have indicated how the stakes are rising for China in the Third Plenary which is to be held November 9-12.

Middle-income trap = Slowing growth
First of all, Akio Egawa, who is a visiting fellow at Bruegel, studied the issue of a middle-income trap (otherwise known as the Lewis turning point where long-term growth slows) for Asian countries, he concluded:
A sensitivity analysis for three Asian upper-middle-income countries(China, Malaysia and Thailand) also shows that the situation related to a middle-income trap is worse than average in China and Malaysia. These two countries, according to the result of the sensitivity analysis, should urgently improve access to secondary education and should implement income redistribution measures to develop high-tech industries, before their demographic dividends expire. Income redistribution includes the narrowing of rural urban income disparities, benefits to low-income individuals, direct income transfers, vouchers or free provision of education and health-care, and so on, but none of these are simple to implement.

BIS warning
In addition, Ambrose Evans-Pritchard at The Telegraph highlighted a BIS report warning of the risks of rising foreign currency loans to China and Chinese companies:
Foreign loans to companies and banks in China have tripled over the last five years to almost $900bn and may now be large enough to set off financial tremors in the West, and above all Britain, the world’s banking watchdog has warned.

“Dollar and foreign currency loans have been growing very rapidly,” said the Bank for International Settlements in a new report.

Should we see a policy error that results in an slowdown, we could see financial contagion spread to the rest of the world because of the size of these foreign currency loans. Loans to SOEs are one thing, but private companies cannot be expected to get rescued [emphasis added]:
The Chinese state holds the world’s largest foreign reserves at $3.7 trillion and the country has capital controls, so there is little danger that China itself could suffer the sort of currency crisis that hit Korea, Indonesia, or Thailand in the 1990s. That does not mean foreign banks will necessarily get their money back if they lent too much to over-indebted Chinese companies.

The Chinese state has already signalled that it will not rescue private firms with too much debt, letting the solar company Suntech Power default on $541m of notes. Premier Li Keqiang is pledging market discipline as part of his liberalization and reform drive.

For China itself the risk is that a dollar funding crisis becomes the trigger for an internal financial crisis. Chinese credit has soared from 125pc to 200pc of GDP in just five years, prompting a string of warnings from Fitch Ratings over the stability of the financial system. A dollar squeeze could come at a very unwelcome moment.

A necessary adjustment?
Andy Xie believes that the authorities should change direction and the bubble should be pricked now [emphasis added]:
GDP targeting no longer serves a good purpose. It sends a dangerous signal for resisting economic restructuring and sustaining speculation. Continuation of GDP targeting would lead to an economic hard landing and massive non-performing loans.

The recent upturn in GDP growth is not good news for China. It has occurred by further increasing the economic imbalance and prolonging speculation. It merely delays the inevitable economic restructuring and increases its final cost.

The bursting of the property bubble is a necessary step in China's economic restructuring. It decreases funding for investment and increases it for consumption. Prolonging the property bubble is equivalent to resisting economic restructuring.
Either unwind it in an orderly way now, or in a chaotic way later:
Market forces are likely to trigger China's bubble to deflate again, following the 2012 downturn, within six months. Liquidity will be squeezed between demand from growing fixed-asset investment and downward pressure due to the Fed tapering. The available liquidity for the property bubble will decrease as a consequence.

Further, China's credit creation increasingly depends on the shadow banking system. The higher interest rate in its credit creation makes the property bubble unstable. Even if the liquidity squeeze does not pop the bubble, the breakdown in credit circulation, due to fears of underlying asset quality, may do the bubble in anyway, just like in the United States in 2008.
As an aside, see this WSJ article about a how a prospectus frankly discusses how Chinese banks make money from the shadow banking system without utilizing their capital.

Xie ended his commentary with an ominous forecast for 2014:
The will to end the bubble seems absent. Only market forces will bring it to the end. Dark clouds are emerging on both the liquidity and credit creation fronts. It appears that China's property bubble is likely to sink big in 2014.
Steven Barnett of the IMF expressed a similar sentiment as Andy Xie, though not as forcefully. Rebalance now and hurt a little, but the payoffs will be greater longer term:
Somewhat slower growth in the near-term is a tradeoff worth making for higher future income. This is clearly good not only for China, but also the world economy. By 2030 China—especially with successful reforms—will almost certainly be the world’s largest economy. So China’s success—which will substantially increase income in China—will also mean much higher global demand and will thus be hugely important for a robust and healthy global economy.

Less growth in China today in exchange for more, much more, income in the future. So, less is indeed more.

High risk of a policy error
Chinese macro policy makers have only experienced hyper-growth their entire lives. Even with the best of intentions, the risk of a policy mistake is high. As an example, consider the impact of the Fed's tapering message in May and the subsequent reversal in September on emerging market currencies and bond yields (from the Council on Foreign Relations):

Nope, nothing to see here. Move along...

While a number of analysts have some general idea of what gets announced at the Third Plenary, I have no idea of how the market will interpret the announcements. Get ready for greater macro volatility in a few weeks.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

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 blog 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 I may hold or control long or short positions in the securities or instruments mentioned.

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