Sunday, July 1, 2012

Can China hold things together?

Recently, there have been a number of alarmist stories coming out of China. I had pointed out a number of concerns (see Focus on China, not Europe and Ominous signs from China). In addition, Patrick Chovanec had highlighted the rising systemic risks that could lead to a "crash landing" rather than just a "hard landing" in China:
There really are two related but distinct things people have in mind when they talk about a “hard landing” for China. The first is a rapid deceleration of GDP growth – below, say, 7%. The second is some kind of financial crisis. I think we’re already seeing some signs of the first, and the second is a bigger risk than most people appreciate.
In that post, Chovanec went on to detail how the shadow banking system is unraveling:
In early April, Caixin magazine ran an article titled “Fool’s Gold Behind Beijing Loan Guarantees”, which documented the silent implosion of Zhongdan Investment Credit Guarantee Co. Ltd., based in China’s capital. “What’s a credit guarantee company?” you might ask — and ask you should, because these companies and the risks they potentially pose are one of the least understood aspects of China’s “shadow banking” system. If the risky trust products and wealth funds that Caixin documented last July are China’s equivalent to CDOs, then credit guarantee companies are China’s version of AIG.

As I understand it, credit guarantee companies were originally created to help Small and Medium Enterprises (SMEs) get access to bank loans. State-run banks are often reluctant to lend to private companies that do not have the hard assets (such as land) or implicit government backing that State-Owned Enterprises (SOEs) enjoy. Local governments encouraged the formation of a new kind of financial entity, which would charge prospective borrowers a fee and, in exchange, serve as a guarantor to the bank, pledging to pay for any losses in the event of a default. Having transferred the risk onto someone else’s shoulders, the bank could rest easy and issue the loan (which it otherwise would have been reluctant to make). In effect, the “credit guarantee” company had sold insurance — otherwise known as a credit default swap (CDS) — to the bank for a risky loan, with the borrower forking over the premium.
He went on to detail how one credit guarantee company named Zhongdan had tanked and cratered the loan books of a bunch of banks. This account brings to mind the Cockroach Theory. Where you see one cockroach, there is probably more around. Now Chovanec followed up in a new post detailing further problems with the shadow banking system with a quote from this Caixin article:
The Zhejiang government is scrambling to settle a credit crisis threatening banks and financial institutions that altogether issued about 6 billion yuan in loans to scores of companies.

Sources say 62 companies, from furniture makers to import-export traders, have been affected to varying extents by the collapse late last year of Hangzhou-based property developer Tianyu Construction Co. Ltd.

The companies were financially linked to Tianyu through a province-wide, reciprocal loan-guarantee network. Tianyu’s sudden failure raised the specter of a domino effect of defaults taking down every network participant and devastating their lenders.

“After Tianyu went bankrupt, banks in Hangzhou started calling in loans to other firms guaranteed by Tianyu,” said the owner of a company tied to the network. “That had a ripple effect and affected a number of other companies.”
Other "cockroaches" are appearing. Bloomberg ran this story about the shaky finances of local governments, which depend on land sales to finance their budgets:
The finances of China’s county-level governments are unstable and unsustainable as the majority of their fiscal income comes from sources other than taxation, the nation’s top auditor said.

About 60 percent of revenue raised last year by 54 counties investigated by the National Audit Office wasn’t derived from taxes, Liu Jiayi, the head of the agency, told a meeting of the legislature yesterday, according to a transcript of his speech on the audit office’s website. Total fiscal revenue at those counties rose 17 percent to 112 billion yuan ($17.6 billion) last year, Liu said.
The Chinese economy appears to be slowing. With stories like this one from the FT about Chinese officials forced to sell cars, cracks are appearing all over and a shadow banking systems that appears to be teetering, can China hold things together?

Listen to the market
The problem with China is that it's very opaque and economic statistics are unreliable. Outside investors have no idea of the size of the problem and therefore cannot gauge the impact of any problem. What we have left are anecdotes the like ones above that can be highly alarmist.

Under those circumstances, I prefer to watch market based indicators to look for signs of stress. Take, for example, the share prices of HK-listed Chinese banks, which are all acting reasonably well. If the markets were panicking over the state of either the official banking system or the shadow banking system, the stress should start to show up first in these banks:

  1. Agricultural Bank of China (1288.HK)
  2. Bank of China (3988.HK)
  3. China Merchant Bank (3968.HK)
  4. ICBC (1398.HK)
What about the trajectory of the Chinese economy? I look at commodity prices for signs of stress and I don't find them there either. Even if we were to ignore Friday's eurozone induced rally in risky assets such as commodities, the CRB Index appears to be trying to put in a bottom here:
Similarly, the AUDCAD cross is showing signs of a turnaround. This exchange rate is important because while both the Australian and Canadian economies are commodity sensitive, the Aussies are more levered to China while the Canadians are more tied to the American economy.
In short, despite the worrying stories coming out of China, Mr. Market is telling me that I shouldn't be worried. In fact, Deutsche Bank (via Business Insider) believes that Chinese data may be understated:
To the contrary, we believe there are several reasons why recent yoy IP (industrial production) growth rates have been (marginally) understated:
1) China's IP data published by the National Bureau of Statistics (NBS) only covers companies with annual revenue of more than RMB20m. Given that most heavy manufacturing firms (which perform worse than the overall economy due to the ongoing investment-led deceleration) are medium and large in size, the NBS tends to exaggerate the growth deceleration.
2) Direct electronic reporting of production data (from companies, rather than from local governments) to the NBS was implemented gradually from end Q1 this year. If there was a reason to believe local governments tended to overstate IP and other economic activity data under the old system, then the implementation of the direct reporting requirement should lead to an understatement of yoy IP growth in April and May (as there is now less over-reporting compared with a year ago).
Such developments must be regarded as being encouraging for the bulls.
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.

1 comment:

Amar Harolikar said...

Very insightful.

I too believe that nothing much to worry about on China side.

Just a short term business cycle. Am sure, the Chinese state, with the degree of control it exercises would able to manage the economy. Also, the Chinese markets, though bearish in near term, are showing bottomming tendencies on the chart.