Sunday, January 26, 2014

How resilient is China?

Bloomberg Briefs hosted a must-read debate for investors between Michael Pettis and Eswar Prasad about the outlook for China. Regular readers of this blog will be familiar to the work of Michael Pettis, to which I mainly subscribe. To paraphrase Pettis, he believes that China's growth strategy of credit driven export and infrastructure based growth, which depends on financial repression for cheap capital, is reaching an era of increasingly diminishing returns. In the wake of the global financial crisis of 2008, China embarked on a round hyper credit fueled infrastructure growth which created an enormous credit and property bubble. Beijing recognizes the risks and has begun to re-focus the source of growth toward the domestic consumer. Pettis believes that this transformation will move the Chinese economy towards a much slower growth rate over the next decade.

Prasad, by contrast, thinks that China can maintain growth at current levels. His conclusion is based on the observation that the Chinese leadership is doing all the right things to transform and reform the economy. China's leadership has faced growth scares before and they have a history of adroitly managing the situation before. The naysayers are wrong and there will be no crisis or any dramatic slowdown.

I believe that Prasad's arguments make sense, were it not for the risks posed by this enormous mountain of debt built up to finance unproductive bridges to nowhere.

In late innings of game
Already, the pressures are starting to build. In a response to my Seeking Alpha article entitled "What are the Bearish Triggers?", a respondent wrote the following about China [emphasis added]:
I had a conversation with a importer friend, ""what is the condition of those manufacturer in mainline?""
His answer was revealing, the more contracts accepted, the more they lose.
But, they are willing to accept more contracts, in order to get more loans. The loan would be used in speculative activities.
In 2012, June, we heard there was a cash crunch, seems, the frequencies of rumors are rising.
I don't know this respondent personally so I cannot vouch for the veracity of the remarks. However, if these comments are correct, then it indicates that financial excesses are building up quickly and the authorities are taking steps to curb speculation. We are likely in the late innings of this metaphorical baseball game.

Trust default a key test
The inflection point may be near. Bloomberg had a good summary of how the potential default of the "2010 China Credit / Credit Equals Gold #1 Collective Trust Product" on January 31 could spark a run and loss of confidence in China's shadow banking system. The Trust was marketed by ICBC, a major state-owned bank, which has indicated that it will not compensate investors for any losses. Here is a key quote from the Bloomberg story:
“This case reminds people of Lehman minibonds because complicated credit-linked products were sold to individual investors via bank channels,” said Christine Kuo, senior credit officer at Moody’s in Hong Kong. “It’s not clear whether misselling was involved due to lack of transparency. It’s also not clear who will share the loss. Regardless, both the product packager and distributor have seen their reputation suffer.”
A loss of confidence in trust and other wealth management products could have a chilling effect on the Chinese economy, notwithstanding any spillovers into the global financial system:
Goldman Sachs Group Inc. Chief Economist Andrew Tilton wrote in a Jan. 22 report that trusts are similar to structured investment vehicles prominent in the 2008 crisis in their “linkages with banks, the off-balance-sheet nature of the trusts” and the long-term projects funded by short-dated funds.

Goldman estimates the 2 trillion yuan in lending by trusts last year accounted for 10 percent of financing in the economy and a removal of credit flows from trusts would knock 0.8 of a percentage point off the nation’s growth rate. Gross domestic product will expand 7.45 percent this year, the slowest since 1990, a Bloomberg survey of economists signals.
There is no shortage of catastrophic scenarios from the Street:
The first default of a trust product in at least a decade would shake investors’ faith in their implicit guarantees and spur outflows that may trigger a “credit crunch,” according to David Cui, China strategist at Bank of America Merrill Lynch in Hong Kong. The government and state banks may bail out a significant portion of bad debt “to prevent a financial crisis,” he said. Guangdong International Trust + Investment Corp. failed to pay Yankee notes in 1998, the nation’s first default since the People’s Republic of China’s founding in 1949.
Stresses are starting to show up in the financial markets. The relative performance of Dim Sum bonds to US Treasuries have keeled over, though they remain in a relative uptrend indicating that a risk-on environment is still in effect. As we approach January 31 next week, this relative return ratio will represent a key test of the market's perception of the stress levels in China's financial system.

Similarly, my so-called Chinese canaries, or Mainland banks listed in HK, are starting to weaken. The price performance of state-owned banks continue to be healthy, though the performance of smaller and mid-sized banks (red line) have weakened more than the state-owned banks. Readings are not at panic levels as the index of smaller banks have not even declined to the initial support zone, represented by the lows reached during the 2011 eurozone crisis and the index is far above the crisis level lows set during the height of the Lehman Crisis in 2008.

The crash may not come
I believe that the outcome may not be as Apocalyptic as many China bears envisaged. Ambrose Evans-Pritchard recently reported on discussions on China's outlook at the WEF in Davos, though the discussion was based on "Chatham House rules so they cannot be quoted by name (except for one)", namely Zhang Yichen of CITIC Capital [emphasis added]:
"They are trying to deleverage without blowing the whole thing up," said CITIC's Zhang Yichen.

"The M2 money supply is 120 trillion RMB but that is still not enough cash because velocity of money is very slow, and interest rates are going up."

"My guess is that they will manage it. The US couldn't contain Lehman contagion but in China all contracts can be renegotiated, so it is very hard to have a domino effect. We'll see a slow deflating of the bubble," he said.
The remarks illustrate a very important point about Chinese culture. In China, many business deals are done on the basis of long standing relationships. One party can choose to compensate the other for a soured deal for the "sake of the relationship". On the other hand, if any western bank were to get caught too deeply in some financial blowup, chances are the bank is on its own. China expert James McGregor voiced similar views in an interview with the Financial Post about how business is done in China. It's all about trust and building the relationship:
In the west, we do business with the mentality of ‘I trust you until I don’t because I have a legal system where I can get you if you do something against what we agreed to’. In China, you start off with complete distrust and then you build trust on top of that. So, the person across the table is thinking the same way. If you offer them a fair deal, they’re going to think you’re screwing them and that they have to dial back that deal. You don’t offer someone a fair deal. You offer them an outrageous deal because then you can dial it back to be a fair deal.
There are stated rules but the rules can be flexible*:
In China, if rules don’t make sense, you don’t delete them or cancel them, you just ignore them and add some new ones. So, in order to get things done in China you go around a lot of the rules and that’s a core competency of China...
This key characteristic of the business culture suggests that while ICBC may not adopt a formal policy of making investors whole, which would create a climate of moral hazard, either the bank or the authorities may adopt a policy of a backdoor bailout, either in part or in full. The Bloomberg article suggested that back room negotiations are already under way:
ICBC and China Credit Trust may each take responsibility for 25 percent of the product’s payments, while the Shanxi government may assume the rest, Guangzhou-based Time-Weekly reported yesterday. Shanxi government denied it would take a 50 percent responsibility in a report on its website yesterday.
Formally, though, the official line is that China does not want to encourage moral hazard in its banking system:
ICBC Chairman Jiang Jianqing told CNBC in Davos, Switzerland, that the lender won’t “rigidly” pay out on the trust and the incident will be a lesson on risk for investors and a chance to educate trust companies and his own bank.

Good news, bad news
Should Beijing decide on a policy of backdoor bailouts, then it would take the tail-risk of a financial crash off the table in exchange for the re-emergence of financial repression of the household sector, which would consequently lead to a prolonged period of slow growth. It could mean a Lost Decade in China where the speed limit to growth is not more than 3-4%.

In a recent Project Syndicate column, long-time China bull Stephen Roach complained about China's strategic incoherence. Beijing was saying all the right things about reform, but when faced with threats, it took the easy way out and reform goals either got thrown out the window or got pushed out into the future. George Soros penned a piece, also at Project Syndicate, that more or less said the same thing (see my previous discussion at Is Beijing losing its nerve?)

If my hypothesis is correct, then Bejing may indeed losing its nerve, probably in the name of the ultimate goal of preserving social stability. Under such a scenario, it creates a good news-bad news situation for China and the course of global growth.

The good news is China is unlikely to crash. Reforms are likely to occur in fits and starts and China will go through reform-stimulus and bailout cycles. Under these circumstances, developments such as the disappointing the January HSBC flash PMI should be viewed by traders as buying opportunities.

The bad news is that China's economy would pay the price in a prolonged period of much slower growth than it had experienced in the past two decades. Investors should be disappointed as the longer term growth path would be much lower than what the market expects.

* The Chinese approach to rules is positively European. Everyone has the same rules, but Greece is a special case, so are the Cypriots, the Irish and so on...

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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