Banking in China continued

China financial markets has a post on the RMBs potential as a reserve currency. Pettis correctly points out that this is unlikely in the near future.

What is more interesting is his comment on the state of the banking sector. In this we yet again share the same view. This is a massive problem waiting to happen.

The dollar, the RMB and the euro?

I will write a lot more about this in the next month or so, but for now it is worth pointing out that the Chinese banking system is one of the least efficient in the world when it comes to assessing risk and allocating capital, and would be bankrupt without repressed interest rates and the implicit (and sometimes explicit) socialization of credit risk. Beijing accepts this because of the tradeoff that gives it banking stability

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The impending bank crisis in China

I have become increasingly convinced that a bank crisis is just around the corner for China. The planets are lining up.

In my view it is all about property prices. This is a bubble by any name and the reasons for the bubble would take many a blog post but I am convinced that this bubble is there and it is large. The other problem is "bad loans". There are a lot of them, a real lot of them.

This very recent Wall Street Journal article saves me the time of writing up my worries.

It is impressive that Fitch Ratings have shown some balls to make this call.

A 60% chance of a banking crisis by 2013 seems pretty darn high to me actually (and fairly accurate. It is therefore important to understand exactly what the implications would be.

Fitch’s Bold Call on China Banking-System Risk [WSJ]

Fitch Ratings has developed a strong record on China’s banking sector in recent years, thanks largely to the perspicacious analysis of its lead banks analyst in Beijing, Charlene Chu. She was one of the first observers, back in 2009, to flag how Chinese banks were moving loans off their balance sheets to lightly regulated trust companies to avoid government lending caps. This past December, she and her colleagues published a report estimating that China’s banks had used trusts and other tools to blow past the government’s 7.5 trillion yuan ($1.14 trillion) quota for new yuan loans 2010 to the tune of an additional three trillion yuan not recorded on their balance sheets.

Last month, the People’s Bank of China effectively validated Ms. Chu’s analysis, saying that its longstanding measure of new bank lending failed to capture actual credit flows, and that the banks were responsible for creating around 11.5 trillion yuan of new credit last year.

So it turned a few heads Tuesday when an analyst elsewhere at Fitch was quoted saying that China has a 60% probability of experiencing a banking crisis by 2013. Ms. Chu’s analysis had pointed to significant flaws in China’s banking system, but this call put Fitch out there toward the Jim Chanos end of China Cassandra spectrum.

The analyst, Richard Fox, a London-based senior director at Fitch, told Bloomberg News that Fitch sees risks of “holes in bank balance sheets” should a property bubble burst.

The jarring assessment was based on the Macro-Prudential Risk Monitor, a sort of analytical tripwire system that Fitch developed in 2005 to flag potential bank crises. Using a formula based on credit-growth rates and asset-price increases, Fitch places national banking systems in three categories based on their “Macro-Prudential Indicator” scores, with MPI 1 being the least risky and MPI 3 the most.

As noted by Bloomberg, which said it interviewed Mr. Fox by phone on March 4, Fitch actually assigned China to the MPI 3 category back in June. But the move went largely unnoticed.

According to Fitch, an emerging-market economy like China has a 60% chance of experiencing a banking crisis within three years of being designated MPI 3. Thus it would follow there’s a better-than-even chance that D-Day will dawn for Beijing sometime before mid-2013.

Fitch bases that assertion on surveying almost 40 past banking crises. It says that a combination of abnormally fast growth in credit, assets prices, and the real effective exchange rate is a solid predictor of ill fortune for countries’ financial sectors.

Some countries enter MPI 3 and are removed without undergoing banking crises, among them, in the last three years, are Brazil, France, Denmark and New Zealand. On the other hand, according to Bloomberg’s interview MPI 3 correctly sounded the alarm for countries including Ireland and Iceland.

“We look at indicators and conditions which have preceded past crises,” Mr. Fox said in an email exchange with The Wall Street Journal on Tuesday. “MPI 3 shows these are present in China. Past evidence suggests there is therefore a 60% chance of a crisis in three years.”

If China does indeed fall into a banking crisis in the next 28 months, Fitch’s prediction will be lauded for its prescience—though it would also be grim news for the world economy. It’s safe to say that few experts in China who follow the banking system closely think there is a probability of a crisis in such a short period of time—including those who agree that China’s lending binge since 2009 has inevitably created a mountain of new bad loans that will someday have to be reckoned with.

News of the Fitch assessment apparently infuriated Ting Lu, China economist for Bank of America-Merrill Lynch, who blasted the 60% assessment in a note Wednesday. “Being cautious is one thing, exaggerating risks is quite another,” he wrote.

A Fitch spokesman declined to comment on the remark.

Certainly China’s loan growth is worrisome. The volume of outstanding yuan loans in the banking system has jumped by more than half in just the past two years. It’s almost impossible to imagine such a flood of credit being issued without sizeable mistakes. Indeed, regulators are clearly aware of the problems and have already been working to ensure that the banks hold sufficient collateral for loans made to infrastructure investment platforms backed by local governments, a group of borrowers deemed most worrisome.

Still, it could be a stretch to put a numerical probability on something as uncertain as the timing of a financial crisis in China, especially if it’s based on a one-size-fits-all model applied to diverse economies across the globe.

The Fitch model says four conditions have to align before it’s time to sound the alarm. Real private-sector credit growth must exceed 15% a year, sustained over two years. Property prices need to grow more than 5% a year and the real effective exchange rate (that’s a measure of the currency on a trade-weighted basis, adjusted for the effects of inflation) must appreciate by more than 4% a year over the same two-year period. And finally, equity prices need to gain more than 17% a year over the preceding two year period. China has fulfilled the credit and property-price conditions for most of the decade, but a stock market bubble in 2006-2007 and strong yuan appreciation pushed it over in 2008.

China’s government is far from omnipotent, but it does have significant ability to mitigate or delay a crisis—not least because the state is ultimately the owner of both the banks and most of the big borrowers they lend to. And given that the once-a-decade transition in China’s leadership, which begins in the autumn of next year and runs through early 2013, there will be a serious political imperative to paper over problems in the economy. It could be a while yet before the big cracks start showing in the banking system.

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Soros speaks: "China must fix the global currency crisis"

Whilst George Soros and the US are happy to hammer the Chinese over the overvalued RMB I am pleased to see that Wen Jiaboa is finally coming out and explaining the true implications of a revaluation policy.

This is important and should not be underestimated.

Wen's argument is that:

..."forcing Beijing to revalue its currency would lead to a "disaster for the world"".

Why? Because of the increased changes of social unrest of course. In this blog this is something I have been writing about for months if not years. This factor has been key to China's exchange rate policy all along. His warning is correct:

"Many of our exporting companies would have to close down, migrant workers would have to return to their villages".

"If China saw social and economic turbulence, then it would be a disaster for the world".

This issue needs close attention.

So let us now look what George has to say:

"China must fix the global currency crisis"[FT]

The prevailing exchange rate system is lopsided. China has essentially pegged its currency to the dollar while most other currencies fluctuate more or less freely. China has a two-tier system in which the capital account is strictly controlled; most other currencies don’t distinguish between current and capital accounts. This makes the Chinese currency chronically undervalued and assures China of a persistent large trade surplus.

Most importantly, this arrangement allows the Chinese government to skim off a significant slice from the value of Chinese exports without interfering with the incentives that make people work so hard and make their labor so productive. It has the same effect as taxation but it works much better.

This has been the secret of China’s success. It gives China the upper hand in its dealings with other countries because the government has discretion over the use of the surplus. And it protected China from the financial crisis, which shook the developed world to its core. For China the crisis was an extraneous event that was experienced mainly as a temporary decline in exports.

It is no exaggeration to say that since the financial crisis, China has been in the driver’s seat. Its currency moves have had a decisive influence on exchange rates. Earlier this year when the euro got into trouble, China adopted a wait-and-see policy. Its absence as a buyer contributed to the euro’s decline. When the euro hit 120 against the dollar China stepped in to preserve the euro as an international currency. Chinese buying reversed the euro’s decline.

I would ask again that readers refer to my previous post on what China can actually do with its surplus. Surplus' are not always good.

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Rural earnings in China and the financial crisis

Apologies once again for a lack of recent posts. This management game takes up a lot of my previous blogging time.

It is very interesting to get some figures on the impact of the financial crisis on employment in China. I will be following this up shortly with a link to the current "currency" debate taking place in the national press.

The bottom line is that China is now coming out to explain it's position - something it should have done a while ago (see next post).

The numbers are large and the recovery impressive. 49 million laid off and over 1/2 rehired within a short space of time.

Interesting reading.

The Impact of the Global Financial Crisis on Off-Farm Employment and Earnings in Rural China

Jikun Huang
Chinese Academy of Sciences (CAS)

Huayong Zhi
affiliation not provided to SSRN

Zhurong Huang
affiliation not provided to SSRN

Scott Rozelle
Stanford University - Freeman Spogli Institute of International Studies

John Giles
World Bank

October 1, 2010

World Bank Policy Research Working Paper No. 5439

Abstract:
This paper examines the effect of the financial crisis on off-farm employment of China's rural labor force. Using a national representative data set collected from across China, the paper finds that there was a substantial impact. By April 2009 off-farm employment reached 6.8 percent of the rural labor force. Monthly earnings also declined. However, while it is estimated that 49 million were laid-off between October 2008 and April 2009, half of them were re-hired in off-farm work by April 2009. By August 2009, less than 2 percent of the rural labor force was unemployed due to the crisis. The robust recovery appears to have helped avoid instability.

Keywords: Labor Markets, Labor Policies, Work & Working Conditions, Tertiary Education, Crops & Crop Management Systems

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IMF global stability report

At least the IMF agree with me that there is potentially a lot of left in the finanical crisis. The Global Stability report is a worthwhile read.

IMF Sees Financial Risks Still Elevated [IMF]

Let me begin with our overall assessment of global financial stability. The IMF has just released its new Global Financial Stability Report. We find that risks to stability have eased somewhat. The policy stimulus enacted at the height of the crisis has provided substantial support to financial institutions and markets, and has underpinned the global recovery. This has helped to improve a broad range of risk indicators and financial conditions.

And yet risks remain elevated: global financial stability has not been secured, as the recovery is still fragile, and the repair of consumer and financial balance sheets is still ongoing. Furthermore, there are concerns over rising sovereign risks related to the buildup of public debt that need to be carefully monitored and addressed.

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Manipulation or revovery

Interesting article in China Briefing about the China recovery. H/T: blog comment.

There is nothing new here but the concerns are real and mirror my own. Things are not always what they seem in China.

China’s Exports More to do with Manipulation than Recovery [Chin Briefing]

The news that China’s exports increased by 17.7 percent in December year-on year is impressive. So too, the statistic that China has now overtaken Germany as the world’s largest exporter. In turn, this has lead to commentary about the position of the RMB against other globally traded currencies such as the Euro and the U.S. dollar. However, in announcing that China has overtaken Germany, analysts have been jumping the gun – Germany has yet to release its own export figures for December. As in the news that in 2009 China overtook the United States as the world’s largest vehicle market make for interesting headlines, there is the matter of sustainability. Are these positions sustainable? Let’s examine both of these situations.

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China’s export boom
Also overlooked in the export equation when it comes to China figures is the matter of manipulation of taxes to encourage exports. Again, this is not a sustainable situation in the longer term. China needs tax revenues to pay for the extraordinary cost of continuing its development. Yet here is where the real truth lies: China’s export boom has come largely as a result of the huge incentives given by China’s export rebate program, speeding up repayments of VAT and widening the quantity of products that could be reclaimed. China has enhanced this by extending claim deadlines widened VAT scope to assist with R&D, extended VAT refunds to overseas contractors, abolished VAT altogether in certain construction situations, and increased refund rates.

The argument, when looking at China’s growth, is how much of this is truly sustainable. Massive fiscal handouts for vehicle and property purchases, a stock market that appears fed by loose cash rather than underlying fundamentals from its companies, and exports driven by massive tax incentives is going to be a tough act for China to keep up.

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Economic CRASH in China coming soon

As an economist one never likes to dwell on "good news" stories. The previous post on the 56% exporting rebound gave the wrong impression.

There remain a number of issues with the Chinese growth miracle that simply do not add up. The stockmarket and house prices are significantly overvalued.

At least James Chanos has got China's card marked. Good coverage from the New York Times. In this case he may lose his money - he must make sure not to underestimate the Chinese governments ability to plough on regardless.

I am sure China is cooking the books and house prices are out of the range of the vast majority of hard working Chinese. He is right to raise the "crash" possibility.

Contrarian Investor Sees Economic Crash in China [New York Times]

SHANGHAI — James S. Chanos built one of the largest fortunes on Wall Street by foreseeing the collapse of Enron and other highflying companies whose stories were too good to be true.

James Chanos made his hedge fund fortune predicting problems at companies and shorting their stock.

Now Mr. Chanos is betting against China, and is promoting his view that the China miracle has blinded investors to the risks in that economy.

Now Mr. Chanos, a wealthy hedge fund investor, is working to bust the myth of the biggest conglomerate of all: China Inc.

As most of the world bets on China to help lift the global economy out of recession, Mr. Chanos is warning that China’s hyperstimulated economy is headed for a crash, rather than the sustained boom that most economists predict. Its surging real estate sector, buoyed by a flood of speculative capital, looks like “Dubai times 1,000 — or worse,” he frets. He even suspects that Beijing is cooking its books, faking, among other things, its eye-popping growth rates of more than 8 percent.

“Bubbles are best identified by credit excesses, not valuation excesses,” he said in a recent appearance on CNBC. “And there’s no bigger credit excess than in China.” He is planning a speech later this month at the University of Oxford to drive home his point.

As America’s pre-eminent short-seller — he bets big money that companies’ strategies will fail — Mr. Chanos’s narrative runs counter to the prevailing wisdom on China. Most economists and governments expect Chinese growth momentum to continue this year, buoyed by what remains of a $586 billion government stimulus program that began last year, meant to lift exports and consumption among Chinese consumers.

Still, betting against China will not be easy. Because foreigners are restricted from investing in stocks listed inside China, Mr. Chanos has said he is searching for other ways to make his bets, including focusing on construction- and infrastructure-related companies that sell cement, coal, steel and iron ore.

Mr. Chanos, 51, whose hedge fund, Kynikos Associates, based in New York, has $6 billion under management, is hardly the only skeptic on China. But he is certainly the most prominent and vocal.

For all his record of prescience — in addition to predicting Enron’s demise, he also spotted the looming problems of Tyco International, the Boston Market restaurant chain and, more recently, home builders and some of the world’s biggest banks — his detractors say that he knows little or nothing about China or its economy and that his bearish calls should be ignored.

“I find it interesting that people who couldn’t spell China 10 years ago are now experts on China,” said Jim Rogers, who co-founded the Quantum Fund with George Soros and now lives in Singapore. “China is not in a bubble.”

Colleagues acknowledge that Mr. Chanos began studying China’s economy in earnest only last summer and sent out e-mail messages seeking expert opinion.

But he is tagging along with the bears, who see mounting evidence that China’s stimulus package and aggressive bank lending are creating artificial demand, raising the risk of a wave of nonperforming loans.

“In China, he seems to see the excesses, to the third and fourth power, that he’s been tilting against all these decades,” said Jim Grant, a longtime friend and the editor of Grant’s Interest Rate Observer, who is also bearish on China. “He homes in on the excesses of the markets and profits from them. That’s been his stock and trade.”

Mr. Chanos declined to be interviewed, citing his continuing research on China. But he has already been spreading the view that the China miracle is blinding investors to the risk that the country is producing far too much.

“The Chinese,” he warned in an interview in November with Politico.com, “are in danger of producing huge quantities of goods and products that they will be unable to sell.”

In December, he appeared on CNBC to discuss how he had already begun taking short positions, hoping to profit from a China collapse.

In recent months, a growing number of analysts, and some Chinese officials, have also warned that asset bubbles might emerge in China.

The nation’s huge stimulus program and record bank lending, estimated to have doubled last year from 2008, pumped billions of dollars into the economy, reigniting growth.

But many analysts now say that money, along with huge foreign inflows of “speculative capital,” has been funneled into the stock and real estate markets.

A result, they say, has been soaring prices and a resumption of the building boom that was under way in early 2008 — one that Mr. Chanos and others have called wasteful and overdone.

“It’s going to be a bust,” said Gordon G. Chang, whose book, “The Coming Collapse of China” (Random House), warned in 2001 of such a crash.

Friends and colleagues say Mr. Chanos is comfortable betting against the crowd — even if that crowd includes the likes of Warren E. Buffett and Wilbur L. Ross Jr., two other towering figures of the investment world.

../

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Is china pumping up another asset bubble?

In fact you could argue that the property bubble in China never really went away but it is inflating again and this spells danger.

Andy Xie at China Digital Times rants. This is a rant and is a rather simple analysis of a complex picture but there is an element of truth in his words. It may take a lot longer that the 4th quarter of 2009 to deflate however.

Andy Xie: “Crazy Again” [China Digital Times] H/T TDWatkins

Chinese stock and property markets have bubbled up again. It was fueled by bank lending and inflation fear. I think that Chinese stocks and properties are 50-100% overvalued. The odds are that both will adjust in the fourth quarter. However, both might flare up again sometime next year. Fluctuating within a long bubble could be the dominant trend for the foreseeable future. The bursting will happen when the US dollar becomes strong again. The catalyst could be serious inflation that forces the Fed to raise interest rate.

Chinese asset markets have become a giant Ponzi scheme. The prices are supported by appreciation expectation. As more people and liquidity are sucked in, the resulting surging prices validate the expectation, which prompts more people to join the party. This sort of bubble ends when there isn’t enough liquidity to feed the beast.

[...] In summary, the market frenzy now won’t last long. The correction may happen in the fourth quarter. There could be another wave of frenzy next year as China can still release more liquidity. When the dollar recovers, possibly in 2012, China’s property and stock market could experience collapses like during the Asian Financial Crisis.

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Is China spawning systematic financial risks?

Yes say local commentators. I agree.

The China recovery is built on sand - where has the money all gone when trade is still falling, profits are falling and output is falling.

Asset bubbles are forming as we speak. Sell China.

Risks Emerge as Bank Loans Hit Overdrive [Caijing.com.cn]

Record bank lending in China is spawning systematic financial risks that may lead to a credit crisis.

New lending in the January-May period totaled 5.84 trillion yuan, 3.72 trillion yuan more than during the same period last year. That's an unprecedented pace for new loans, as lending levels never even reached 5 trillion yuan for an entire year between 2001 and '08.

This huge influx of borrowing, aimed at stimulating China's sluggish economy, is leading to overcapacity.

Most scholars believe China's recovery is solid and strong, but economic statistics suggest otherwise. Industrial enterprise profits and trade volume have fallen remarkably.

Between January and May, industrial enterprises with annual revenues of more than 5 million yuan booked a combined decline in profits of 22.9 percent year-on-year. Profits for big state-owned enterprises declined 41.5 percent year-on-year.

Meanwhile, China's trade volume fell between January and May by 24.7 percent year-on-year, with imports off 21.8 percent and exports down 28 percent.

Those numbers show that the world market for made-in-China products is shrinking. If China's production-driven growth model continues, the country soon may face a predicament that combines "low interest rates, high capacity and finally low growth" – a scenario that's plagued Japan since the early 1990s.

The global economy is now caught in a vicious cycle: The world expects China to lead a recovery, while China is relying on the international market to absorb its products.

And if excessive lending is a power keg, an interest rate hike will be the fuse that sets it off. Indeed, a credit crisis would ensue if China's central bank raises its interest rate.

Interest rate increases were the immediate causes of the 1988 U.S. credit crisis, implosion of Japan's economic bubble in the 1990s, and the 2007 subprime credit crisis.

China's central bank will be reluctant to raise the interest rate, however, so overcapacity in the real economy will continue.

Due to a lack of investment opportunities in the real economy, speculative investment appears to be a reasonable alternative. That leads to high prices on the stock and real estate markets. Meanwhile, low bank interest rates encourage people to transfer cash from savings deposits to asset markets.

In May 2009, total bank deposits increased by a mere 188.6 billion yuan – down 47.8 billion yuan from the same period last year.

If enterprises and individuals use bank loans and deposits to engage in high-risk speculation, assets bubbles can be expected. Commercial banks would then reduce lending to avoid high credit risks, and market interest rates would rise, puncturing asset bubbles and ruining a financial system pillar.

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Debt sale flounders

China's stimulus plan is large. I just don't like the size of it. Nor it appears does the market.

The plan has already caused a bubble in the stockmarket in my opinion.

China Fails to Attract Enough Buyers in Bill Sales [Bloomberg]

July 10 (Bloomberg) -- China failed to attract enough bidders in a government debt sale for a second time this week on speculation record bank lending will spark inflation in the world’s third-largest economy.

The Ministry of Finance sold 25.1 billion yuan ($3.7 billion) in bills of the 35 billion yuan it had sought, according to statements on the Web site of Chinabond, the nation’s biggest debt-clearing house. The government fell short of its target in a bond sale for the first time in almost six years on July 8.

The auction’s failure reflects concern that Premier Wen Jiabao’s 4 trillion yuan stimulus package will cause bubbles in stock and housing markets, forcing the central bank to tighten monetary policy. The People’s Bank of China this week pushed up money-market rates and drained cash from banks, the biggest investors in the nation’s $2.2 trillion debt market.

“The central bank’s open-market operations suggest concerns that the rapid surge in new bank lending in the first half of this year could fuel inflation,” said Tommy Xie, an economist at Oversea-Chinese Banking Corp. in Singapore. “Some people speculate the central bank will raise interest rates this year but I don’t think they can as global growth slows.”

Rising Yields

The Ministry sold 12.48 billion yuan of 91-day bills at 1.15 percent, compared with 0.84 percent at the last such auction on June 19. It issued 12.65 billion yuan of 273-day bills at 1.25 percent, up from 0.88 percent at a previous sale on June 5.

The People’s Bank of China yesterday resumed one-year bill sales after an eight-month pause, signaling a shift from an “extremely loose” policy, Goldman Sachs Group Inc. said.

Chinese banks extended 1.53 trillion yuan of new loans in June, more than double the amount in May, the central bank said on July 8. Housing sales surged 45.3 percent in the first five months of this year, the National Development and Reform Commission said today.

The Shanghai Composite Index has jumped more than 80 percent from last year’s Nov. 4 low. Guilin Sanjin Pharmaceutical Co. and Zhejiang Wanma Cable Co., the first two companies allowed to go public in China since September, were suspended in Shenzhen trading after surging on their stock market debut today.

More IPOs

“More initial public offerings will come, which will further tighten liquidity,” said Shi Lei, an analyst in Beijing at Bank of China Ltd., the nation’s third-largest lender. “Investors are quite bearish on short-term bonds.”

The yield on the 2.29 percent treasury note due April 2014 surged five basis points to 2.53 percent, and the price of the security dropped 0.20 per 100 yuan face amount to 98.95, according to the Interbank Bond Market. A basis point is 0.01 percentage point.

“We doubt their aim was to cause distress in the government’s deficit financing effort,” Christian Carrillo, a bond strategist at Deutsche Bank AG in Singapore wrote in a research report today. “It appears the signaling aim of the PBOC has gone wrong especially given our understanding is that top level governors are very uncertain about the economic recovery.”

Rate Outlook

China’s bond market swelled in size by 16 percent in the year-ended March 31, paced by corporate bond sales, according to the Asian Development Bank. Demand has been waning in recent weeks. Before this week’s failed one-year auction, a sale of five-year government securities on July 3 drew bids for 1.42 times the debt on offer, compared with a 1.65 bid-to-cover ratio in a sale of 10-year notes on June 17.

Investments by China will help developing economies regain their growth momentum in the second half of this year, pulling the global economy out of the worst recession in six decades, the International Monetary Fund said on July 8. The IMF forecasts China’s expansion will accelerate to 8.5 percent next year from 7.5 percent in 2009.

Policy makers will probably refrain from raising interest rates as the government aims for 8 percent economic growth this year to create jobs and maintain social stability, according to a Bloomberg survey of economists. China’s consumer prices dropped 1.4 percent in May from a year earlier, after falling 1.5 percent in April, according to the statistics bureau.

The benchmark one-year lending rate will stay at 5.31 percent and the deposit rate at 2.25 percent this year, according to the median estimate of 15 economists surveyed by Bloomberg News.

China’s exports fell for an eighth month, dropping 21.4 percent in June from a year earlier, the state-run Xinhua News Agency reported today, citing customs data.

“Despite the lack of success in selling the intended amount of bills, it is unlikely that the government would switch its tactics to hiking interest rates,” said Sherman Chan, an economist with Moody’s Economy.com in Sydney. “They are trying to mop up excess liquidity without raising rates.”

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Chinese lending - a recovery built of sand

China is new to the capitalism game and I have been concerned for some time about the size of the stimulus plan. One problem is that the spike in lending is resulting in more risk being taken.

The Chinese recovery may well be built on sand and stimulus packages. This leaves me uneasy. The problem (as it was in the previous stockmarket bubble) is the lack of alternative investment homes for all the cash that is still sloshing around.

Risks Emerge as Bank Loans Hit Overdrive [Caijing.com.cn]

(Caijing.com.cn) Record bank lending in China is spawning systematic financial risks that may lead to a credit crisis.

New lending in the January-May period totaled 5.84 trillion yuan, 3.72 trillion yuan more than during the same period last year. That's an unprecedented pace for new loans, as lending levels never even reached 5 trillion yuan for an entire year between 2001 and '08.

This huge influx of borrowing, aimed at stimulating China's sluggish economy, is leading to overcapacity.

Most scholars believe China's recovery is solid and strong, but economic statistics suggest otherwise. Industrial enterprise profits and trade volume have fallen remarkably.

Between January and May, industrial enterprises with annual revenues of more than 5 million yuan booked a combined decline in profits of 22.9 percent year-on-year. Profits for big state-owned enterprises declined 41.5 percent year-on-year.

Meanwhile, China's trade volume fell between January and May by 24.7 percent year-on-year, with imports off 21.8 percent and exports down 28 percent.

Those numbers show that the world market for made-in-China products is shrinking. If China's production-driven growth model continues, the country soon may face a predicament that combines "low interest rates, high capacity and finally low growth" – a scenario that's plagued Japan since the early 1990s.

The global economy is now caught in a vicious cycle: The world expects China to lead a recovery, while China is relying on the international market to absorb its products.

And if excessive lending is a power keg, an interest rate hike will be the fuse that sets it off. Indeed, a credit crisis would ensue if China's central bank raises its interest rate.

Interest rate increases were the immediate causes of the 1988 U.S. credit crisis, implosion of Japan's economic bubble in the 1990s, and the 2007 subprime credit crisis.

China's central bank will be reluctant to raise the interest rate, however, so overcapacity in the real economy will continue.

Due to a lack of investment opportunities in the real economy, speculative investment appears to be a reasonable alternative. That leads to high prices on the stock and real estate markets. Meanwhile, low bank interest rates encourage people to transfer cash from savings deposits to asset markets.

In May 2009, total bank deposits increased by a mere 188.6 billion yuan – down 47.8 billion yuan from the same period last year.

If enterprises and individuals use bank loans and deposits to engage in high-risk speculation, assets bubbles can be expected. Commercial banks would then reduce lending to avoid high credit risks, and market interest rates would rise, puncturing asset bubbles and ruining a financial system pillar.

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Chinese company results - does anyone believe the numbers?

I am glad it not just me. This Chinese stock market rose and then fell and is beginning to climb again.

First, it should never have risen so high (we have previously covered why it did so).

Second, it should have fallen further (and may still do so).

Third, the recent rally will not last.

My personal worries again relate to what Chinese companies are reporting. I have had my doubts and this links in with my view that I simply do not believe the data that these companies are reporting.

It was reassuring therefore to see that the Economist has picked up on this and about time.

The issue of Chinese subsidies is very important. This is the mother of all stimulus packages and it is clearly helping companies survive but to what cost and to what end?

It is tempting to take a large short position on China at the moment.

Red flags [Economist]

CHINA’S stockmarket has been one of the best performing in the world this year, and the country’s firms have so far steered through the global financial crisis better than many of their global peers. Partly they may have been buoyed by robust business conditions in China. But two recent studies, which raise serious questions about the credibility of China’s corporate earnings, suggest that companies may also have had an artificial boost.

The less damning of the two is issued under the auspices of the Hong Kong Monetary Authority and written by Giovanni Ferri, of Italy’s University of Bari, and Li-Gang Liu of BBVA, a bank. It argues that the profits of China’s large state-owned companies are entirely a product of subsidised financing by state banks, which lets them borrow much more cheaply than private or foreign firms (see chart).

To reach that conclusion the authors sifted through government data from 1999-2005. Mr Liu believes that such subsidies may have even increased since last summer, because the big state-owned enterprises have been the main beneficiaries of China’s economic stimulus. In the short term the subsidies will have boosted profits, not least compared with the firms’ credit-starved private peers. But in the longer term Mr Liu believes that the political component of the loans will mean capital is being allocated inefficiently, raising the prospect of future losses.

At least the academics are convinced that the profits are genuine, even if they are subsidised. But an exhaustive working paper by TJ Wong and Danqing Young, of the Chinese University of Hong Kong, and Xianjie He, of Shanghai University of Finance and Economics, reaches a more alarming conclusion. It suggests investors have little faith in the numbers.

To measure this they looked at Chinese firms before and after the country broke with its accounting traditions in 2007, adopting something akin to international accounting standards, which base valuations on market prices. They then dissected earnings in three ways. First, they compared how shifts in earnings correlated with shifts in share prices under the old accounting system and the new. An improvement in accounting practices should have meant a closer correlation between earnings and the performance of the share price. Not only did this not happen—there were some signs that things got worse.

Nor were there correlations between the share price and the shift in reported value of investment instruments, goodwill and the impairment of assets—all typically critical to an investor’s analysis. Lastly, the academics examined a nuance in the new standards that allowed Chinese firms to book profits by restructuring debt that was owed to affiliated companies. Before the change in accounting standards, this kind of debt restructuring was rare. Afterwards, it was common: more than 200 companies, or over 15% of those in the study, did it in 2007. This resulted in clear gains to earnings but no impact on share prices. So is there anything in the company reports that investors do consider to be meaningful? That, says Mr Wong, is the subject of the next study.

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"Dollar Trap" snaps shut

One of the most intriguing political games being played out at the moment is the ongoing "death grip" between China and US over China's massive (and growing) holdings of US paper.

Both countries stand to suffer massive losses if either country deviates off the current, unsustainable path. How China and the US can get out of this is not clear to me but the only answer I can see if for there be a slow unwinding of positions over 5 to 10 years. Speculators will not make this easy.

I happen to believe the dollar will come under increasing pressure and opens up some interesting futures trading opportunities although there are other good FEX deals out there at the moment (on which more another day).

Stick the following title into google to read the whole story.

China Stuck in "dollar" trap [FT]

"China's official foreign exchange manager is still buying record amounts of US government bonds, in spite of Beijing's increasingly vocal fear of a dollar collapse".

The article goes on to say that China has little choice but to keep buying US paper. It is in a dollar trap. The massive volumes involved means that Chinese buying of any other currency would distort the market. Likewise, selling dollars would cause a collapse in the dollar.

I suspect Chinese outbound FDI will increase with less emphasis on US paper but this will be a long process. Look what happened to Japan when it went down this route in the early 90s.

China is overextending itself and its expertise.

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"Manchurian Paradox" - Can China see the wood for the trees?

Thanks to a comment on this blog directing me to an article by Stephen Roach who is the chairman of Morgan Stanley Asia.

It raises some interesting points. This is a long article. Highlights only below.

I agree entirely - I do not think that China sees the danger it is getting itself into. They are simply too optimistic. Having not experienced how ugly capitalism can get they are walking into a whole pile of trouble.

It is reassuring to read that I am not the only one who is calling that the emperor has no clothes.

Manchurian Paradox [The National Interest Online]

THE CHINESE word for crisis, weiji, includes elements of both danger and opportunity. This symbolic meaning has taken on especially great significance in recent years. The emergence of modern China as a global economic power can, in fact, be dated to the nation’s willingness to seize critical moments of adversity. That was very much the case during the Asian financial crisis of 1997–98, which marked a critical turning point in the ascendance of China as a major economic power. And it could also be the case today.

But there is an important catch: unlike earlier crises, it is not altogether clear that China senses the gravity of the current danger. That leaves it caught in something much closer to denial—making it difficult to seize the opportunity that peril can provide.

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There is nothing wrong with China’s gathering sense of self-confidence and its concomitant contribution to the global debate. In fact, it is to be encouraged. China has earned its place at the table. For a nation steeped in five thousand years of inward-looking experience, China is looking outward as never before. The world can only benefit from this sea change. But that underscores the biggest danger of all—the risk that China takes its newfound external dependence too far and ignores the lasting and serious pitfalls of a postcrisis world. If it fails to rebalance its unbalanced economy, China’s power play could be surprisingly fleeting.

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China survives recession without a scratch?

A couple of rather remarkable stories suggesting China has suffered relatively little in the current recession and that it survived without a scratch?

How do they define scratch - millions losing their job and high levels of poverty?

China: What world recession? [Salon]

Back when the Asian financial crisis ravaged the world, China surprised nearly everyone by bulldozing through the downturn while suffering hardly a scratch. Could it be possible that the Middle Kingdom is about to repeat that amazing feat, in the face of a much, much worse economic crisis?

Goldman Sachs appears to think so. Last week, Goldman upgraded its estimate of Chinese GDP growth in 2009 from 6 percent to 8.3 percent. Even more astoundingly, the investment bank forecast that GDP growth in 2010 would be back to a robust 10.9 percent.

This article is way off the mark, not least because the recession is far from over. We may even by some way off the bottom. At least William Buiter has been correctly included for balance.

Next we have:

China cashes in on crisis [Asia Times]

The global financial crisis is proving a boon for a resurgent China, which is poised to exert ever greater influence in Southeast Asia.

While drawing neighboring countries back into China's economic orbit has been part of Beijing's strategy for restoring what it sees as the country's rightful place on the global stage, recent months of recession have furnished Beijing with new opportunities to further its leadership ambitions in the region.

This article is closer to the action. China has large surpluses and it has used them fairly well in the recent stimulus package. I am not sure I mean "well". China has spent a lot of money. Other Asian countries have not. There is every possibility that China will be more powerful in the region at the end of all this.

Where the end is, nobody knows.

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Financial news operations banned in China

I hope this does not mean China finance related blogs will be banned as well - opps I forget - China Economics Blog has been banned shortly after its inception although I lose track whether "blogger" blogs are banned or not these days.

China bans foreign financial news operations [FT]

China raised the spectre of renewed international trade friction over market access for foreign financial information providers as the government said such businesses must not engage in news gathering in China.

The surprise ban on this business area is seen by industry executives as backtracking on an agreement China reached with the US, the EU and Canada in November last year on allowing companies like Bloomberg, Dow Jones and Thomson Reuters to distribute information to financial and corporate clients.

The November deal adopted a loose definition of financial information, including news rather than limiting such information to data such as stock market indices and exchange rates.

It was reached after the US, the EU and Canada lodged a complaint against China at the World Trade Organisation earlier last year over Beijing’s move to make Xinhua, its official news agency and a competitor for the foreign providers in the financial information business, its de facto regulator.

In regulations published on the cabinet’s website on Thursday, the government said foreign financial information providers would be allowed to set up businesses in China and would be regulated by the State Council Information Office. But the rules also said: “foreign financial information providers set up in China ... must not undertake news gathering activities".

The industry had seen the memorandum of understanding signed late last year as a victory of advocates of opening over protectionism.

But on Thursday, people close to the situation said they had the impression that forces intending to protect Xinhua had intervened in the last minute. “There will have to be communication and clarification,” one source said.

Industry executives praised the rules in general as a breakthrough giving foreign players a clear legally-defined role for the first time.

“Thomson Reuters has developed an excellent relationship with SCIO over many years and looks forward to working with them on the successful implementation of the new measures to ensure that financial markets in China are as well informed as their counterparts outside China,” said Henry Manisty, global head of government and regulatory affairs at Thomson Reuters.

Dow Jones and Bloomberg were not immediately available for comment.

China has required foreign news agencies to distribute to media clients only through Xinhua for more than 50 years. This will not change, and the foreign players do not challenge this arrangement for their news agency business which helps the Chinese government ensure news does not reach the public uncensored.

The companies’ financial information services business had been relatively unrestricted until 2006, when China took the controversial step of ordering distribution through an agent wholly-owned by Xinhua.

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"Blue Ocean Strategy" and China

Some comments from blog readers are interesting. One such comment linked to a comment from a NY Wang on "Blue Ocean Strategy".

Sometimes it is useful for economists to look at the anecdotal evidence.

This article is interesting from two perspectives. First, the rapid rate of job losses amongst financial traders in Hong Kong and secondly, the use of the term "blue ocean strategy".

I must admit to not being fully aware of what this strategy actually is.

Here is a definition for those equally perplexed.

What is a BLUE OCEAN STRATEGY? The authors explain it by comparing it to a red ocean strategy (traditional strategic thinking):
1. DO NOT compete in existing market space. INSTEAD you should create uncontested market space.
2. DO NOT beat the competition. INSTEAD you should make the competition irrelevant.
3. DO NOT exploit existing demand. INSTEAD you should create and capture new demand.
4. DO NOT make the value/cost trade-off. INSTEAD you should break the value/cost trade-off.
5. DO NOT align the whole system of a company's activities with its strategic choice of differentiation or low cost. INSTEAD you should align the whole system of a company's activities in pursuit of both differentiation and low cost.

So how does NY Wang link this to China?

China: Banking Jobs for Blue Ocean Strategists?

If you are a "Blue Ocean Strategy" person, should you try to find a banking job in the Greater China region?

The obvious answer is yes. The power of China can be felt in the G20. Everyone seems to be waiting for China's $2 trillion foreign exchange reserves. The Asian Development Bank pegs China’s GDP growth at 7%*. Some economists predict that China will enjoy 8% GDP growth in 2009**.

However, I sent 10 emails to friends working in investment banks in Hong Kong last December. 5 out of these 10 emails bounced back. Yes, you are right. That is the worst sign you can imagine during a worsening market. Then I visited Hong Kong by myself to check out what was happening. Guess what? Among the 5 people whose email boxes worked fine two weeks before I left, two lost their jobs the same week that I visited them.

That does not sound right. The Chinese market seems to be booming. Investment banks are supposed to expand in the most promising markets. They should be hiring instead of firing people. What is the reason behind this?

During the downturn, investment banks tend to protect their roots first. They are not only protecting their headquarters in the States and Europe but also protecting their people. Accordingly, they are trying to cut costs by "re-engineering" the "outskirt" regions such as Hong Kong.

They are losing their market share in the Greater China region, one of the sexiest markets of the future, whilst some investment banks such as Nomura, CICC, CITIC are gaining market shares. But if your head dies - you die. It makes sense to protect your head first (US/Europe) instead of your hands (HK).

In the long-term, emerging markets will still be great places to go. However, in the short-term, if you would like to be an investment banker, most hiring is still in the developed markets.

What do I believe that blue-ocean strategists should do? Watch this space …

If everything now clear?

Sometimes it si easier to be an economist. All this business school speak is just common sense dressed up with catchy phrases that only a small group of other "management speakers" actually understand.

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Stimulus crackdown - what is really going on in China?

A series of articles in the Times on Friday touch on a number of points that I have been concerned about for a while.

Nowadays all newspapers seem hell bent on talking about the "green shoots" of recovery. The cynic in me wonders whether these are placed stories with the press and government attempting to talk us out of recession via the usual "confidence is key" mantra.

I happen to believe things have a lot further to fall yet before we bottom out. All the "macro" models are churning out 2010 recovery stories but remember, these models are based on hundreds on assumptions and imputed numbers. However, in the new world they are guessing even more than they previously did. Ignore.

To this end, the Times has a good article on Friday that gets closer to the truth and also shows how the stimulus package in China, whilst big, is potentially built on sand and is building larger problems for the future.

The fact that the Chinese regulators recognise the problem is good news.

The other issue that this article touches on is whether we can believe Chinese data. I have posted on this before and it is the case that some data is more trustworthy that others.

What is interesting here is to compare oil demand against the GDP figures. See the end of the article.

Chinese regulator may crack down on banks to prevent $585bn stimulus fuelling speculation [Times]

China’s financial regulator may be poised to crack down on bank lending practices to try to prevent money from the Government’s $585 billion (£392 billion) stimulus package being used to fuel stock and property speculation.

Expectation of such a move comes as the Government yesterday revealed that China’s economy expanded at only 6.1 per cent in the first quarter of this year – the most anaemic phase of growth since quarterly records began more than 15 years ago.

A sharp fall in exports, rising unemployment and the closure of tens of thousands of factories were behind the drop in GDP growth, although several analysts said that the figures could indicate the low-water mark for what is now the world’s third-biggest economy, behind the US and Japan.

Wensheng Peng, Barclays Capital’s chief of China research, said: “We are seeing a significant rebound in the underlying momentum of growth.”

He added that a huge 88 per cent rise in newly started projects over the January-to-March quarter was a leading indicator that private spending may now increase much further.

The Government’s numbers nevertheless showed that, for the second consecutive quarter, growth in China has remained well below 8 per cent – a level identified by many observers as the “danger line” for Beijing as it tries to calm unrest among tens of millions of newly unemployed migrant workers.

The poor GDP figures were accompanied by other readings from the economy suggesting that the path to recovery may already be clearing and that Beijing may yet make good on its pledge that China will be the first leading economy to recover from the global downturn.

Andy Rothman, chief China economist for CLSA, the broker, said that there were especially encouraging signs on employment, with the proportion of companies reporting staff cuts falling to 10 per cent for March, from 14 per cent for February. Mr Rothman, in a note to investors, said: “The peak period of layoffs – primarily migrant workers in export processing and construction – has passed.”

Driving the optimism of some analysts is the sense that Beijing’s immense stimulus plan may be starting to work its intended magic.

Qu Hongbin, an economist for HSBC, said that the November stimulus package had begun to take effect sooner than many had expected and that economic growth would be lifted back above the critical 8 per cent mark in the second half of this year.

The package, which involved expansive promises of infrastructure projects, cuts in export taxes and ordering the banks to open the lending taps wide, has already had a dramatic effect on Shanghai-listed stocks.

The index has soared to an eight-month high, although that may now have triggered alarms in Beijing, where there are rising fears that the flood of liquidity may have side-effects. Analysts said yesterday that the cascade of state money could itself produce asset bubbles and other risks. Wang Tao, of UBS, said that careful policy steps were needed to reduce the risk of “massive resource misallocation, asset bubbles and damage to the banking system”.

China’s banks, it was revealed this week, lent more between January and March than they did in all of 2007. Spending on real estate development was also on the rise in the first quarter, growing by 4.1 per cent and up substantially from the 1 per cent gain logged between January and February.

Others said yesterday that the signs of recovery were only tentative, and that significant risks remain as the global economy struggles to right itself.

Although China is in much better shape than many other countries – particularly in Asia – the rapid fall in its growth rates provided more bearish observers with evidence of the nation’s vulnerability to the global economy and to the spending slump by American and European consumers.

One closely watched gauge of the Chinese economy, given many analysts’ scepticism over the accuracy of official statistics, is power consumption; the numbers cannot be manipulated as easily as official data and power consumption closely tracks the true pace of industrial activity. In the first ten days of April, Chinese media said yesterday, the decline in electricity consumption accelerated – a possible sign that deeper cuts in industrial production and further factory closures may be around the corner.

On a national level, power running through the grids was down 3.57 per cent compared with the same period a year earlier, a considerably larger drop than the average 2.0 per cent decline throughout March.

Some analysts use power data as an early indicator of economic activity, and have cautioned against viewing the improvement in the employment picture in March as a sign that demand has started to recover.

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The Chinese credit crunch

Coface, one of the world’s biggest credit insurers, make a good point in today's FT.

Whilst the world seems to have paused for breath on the way to global meltdown the cracks are beginning to show before the next step down.

With the massive fall in exports, the inability of Chinese companies to pay suppliers was always going to happen. Only now are we getting the details.

So what are the implications? My belief is that credit management in China has been very poor in the past and that these bad decisions could lead to a chain reaction of failure across the supply chain.

This is not a time to be buying Chinese stocks.

Fears rise on China groups’ payments [FT]

A rapid deterioration in the ability of Chinese companies to honour payments to their suppliers as a result of the economic crisis is significantly increasing the risk of doing business in China, according to Coface, one of the world’s biggest credit insurers.

Xavier Farcot, who heads the French insurer’s underwriting and claims business in China, said the cost of insuring against customers defaulting on payments in domestic trade had risen by 30 per cent since the financial crisis, even for the best customers who have not made any claims previously.

“It is a reflection of the change in the overall risk environment [of selling to Chinese buyers],” said Mr Farcot.

Chinese companies, particularly in the export-oriented technology and electronics manufacturing sectors, faced a liquidity crunch at the end of last year as China’s exports plummeted. Many of them were also unable to access bank loans to tide them over the tough times, especially if they were small to medium-sized private businesses, said Mr Farcot.

Even though Chinese banks, unlike their western counterparts, have ample liquidity, “they are accustomed to lending to large state-owned enterprises rather than small companies who often do not have large resources or equity”, he said.

This cash crunch forced many Chinese companies to turn to their suppliers for credit, thus forcing the pain up the supply chain.

Nearly 90 per cent of Chinese suppliers are extending credit to their domestic customers on more than half of their sales, compared to just 70 per cent a year ago, according to Coface’s annual survey of the country’s corporate credit management practices.

This was bad credit management, said Mr Farcot. “Now is not the time to extend credit, it is time to restrict it,” he said. Most Chinese suppliers, however, have never experienced such a downturn.

“A lot of these companies never had to deal with the problem of not getting paid, because sales had always been increasing,” he said, “There’s not enough financial resource, not enough management.”

As well as customers demanding longer payment terms, the vast majority of Chinese suppliers said they had increasing problems with overdue payments last year. A quarter of them said accounts that were overdue by more than half a year now made up more than 2 per cent of their sales, which “is usually the threshold above which you start running into problems”, Mr Farcot said.

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What happened to the Chinese lost billions?

Interesting article discussing the Chinese lost billions. I admit to being in favour of Chinese diversification given the over reliance on US paper which offered historically low returns.

Given the worries over the safety of US owned paper and the poor returns this was probably the correct move but the wrong investments were chosen. I am not sure China can be blamed too much for calling this wrong. Very few called in right after all.

What China should not have been doing was making huge upside bets on global equities. Whoever sanctioned this move was clearly caught up in the belief that markets only go up and has cost China dearly. Heads must have (quite literally) been rolling over at the State Administration of Foreign Exchange.

China lost billions in diversification drive [FT]

China has lost tens of billions of dollars of its foreign exchange reserves through a poorly timed diversification into global equities just before world markets collapsed last year.

The State Administration of Foreign Exchange, the opaque manager of nearly $2,000bn (€1,547bn, £1,429bn) of reserves, started making huge bets on global stocks early in 2007 and continued this strategy at least until the collapse of the US mortgage finance providers Freddie Mac and Fannie Mae in July 2008, according to analysts and people familiar with Safe’s operations.

By that point Safe had moved well over 15 per cent of the country’s $1,800bn reserves into riskier assets, including equities and corporate bonds, according to people familiar with its strategy.

Safe never discloses its holdings except to the top Chinese leadership so it is impossible to know exactly how much it has lost from diversifying before markets crashed.

But judging from the subsequent fall in global stock prices and a conservative estimate that Safe held about $160bn worth of overseas equities, Chinese losses on those investments would exceed $80bn, or more than 50 per cent, according to Brad Setser, an economist at the Council on Foreign Relations in New York.

Total holdings of US equities by all Chinese entities reached $100bn by the end of June last year, more than triple the total of Chinese holdings in June 2007, according to an annual survey published by the US Treasury.

‘It appears Safe began diversifying into equities early in 2007 and, rather than being deterred by the subprime crisis, it continued to buy’
Brad Setser, economist, Council on Foreign Relations

In mid-2006, Chinese holdings of US equities totalled just $4bn. Chinese investors are mostly barred from investing abroad and Safe is the only entity with the resources and the authority to make such large-scale offshore portfolio investments.

“Safe has built up one of the largest US equity portfolios of any foreign government entity investing abroad, including the major sovereign wealth funds,” Mr Setser said.

“It appears Safe began diversifying into equities early in 2007 and, rather than being deterred by the subprime crisis, it continued to buy.”

China’s leadership has not commented on the equity losses but Wen Jiabao, prime minister, expressed concern about the value of China’s large holdings of US assets on Friday and warned the US to take measures to guarantee its “good credit”.

Safe uses a Hong Kong subsidiary when investing in offshore equities in the US and other countries, including the UK, where this subsidiary took small stakes last year in dozens of UK companies including Rio Tinto, Royal Dutch Shell, BP, Barclays, Tesco and RBS.

As part of its diversification in early 2008, Safe also gave some money to private equity firms such as TPG and to hedge funds on a managed account basis.

This gave the Chinese government ultimate approval for how its money was invested, according to people who have worked with Safe.

The large shift into global equities appears to have started at around the time that Beijing approved the establishment of China Investment Corporation, the country’s official sovereign wealth fund, which has been widely criticised in China for incurring paper losses of around $4bn on high-profile investments in Morgan Stanley and Blackstone.

The bulk of Safe’s holdings remain in US Treasury bills and much of the loss on its riskier assets will be offset by gains on long-term bills, according to Mr Setser.

“They are a lot more cautious and risk-averse now and have basically returned to buying government bonds,” said someone who works with Safe.

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