Friday, July 3, 2015

The Impossibility of Renminbi Hegemony.

Most discussions on the renminbi replacing the dollar focus on how far the dollar has to fall, not on how high the renminbi has to climb. The obstacles to true renminbi hegemony are mathematic as much as they are political and economic.

As of the end of 2014, China had the largest foreign exchange reserve in the world. Part of the reason for that are China’s status as the world’s biggest exporter and the United States status as the world’s biggest external debtor. The simplest way for the renminbi to overtake the U.S. dollar as the world’s reserve currency would be for the United States to become the world’s biggest exporter and China to become the world’s biggest external debtor. Simple, but not likely. If it were to happen, we cannot be certain that most exports from the United States would be bought by holders of renminbi, nor could we be certain that China’s external debt would be in renminbi.

We can understand the likelihood of renminbi hegemony in two ways. The first would be to speculate on the renminbi rising to overtake the dollar. For this, a brief history lesson is required. The dollar did not become the world’s reserve currency because the United States made up a huge portion of world trade. China’s status as the world’s largest trading nation is one fact that many predictors of renminbi hegemony point to as a reason for the dollar’s replacement. For most of the United State’s history, it was a net exporter of goods. In that case, it should have been flooded with foreign currency, meaning dollars should have remained at home if reserve status was gained through trade. Instead, the dollar became dominant because it was the currency of choice for global debt markets. Starting with the Bretton Woods System, gold reserves could be used to issue dollar debt at multiples of the dollar’s gold price. That dollar debt could then be issued at multiples of the dollar’s foreign currency price. Not only is the U.S. dollar the currency of choice for New York City, the world’s largest financial market, it is also the currency of choice for London, Hong Kong, and Singapore debt markets. Although all three cities are vying for renminbi business, it is ridiculous to assume that they would give up on their dollar business. Dollars can be created outside America’s borders without the involvement of American institutions.

Progress has been made by the renminbi in international debt markets, but by the middle of 2015, the number of sovereign debt issues outside of China denominated in renminbi can be counted on the hand of a person with only two fingers. In October 2014, the United Kingdom became the first non-Chinese sovereign to issue renminbi-denominated debt. It issued ¥3 billion worth of three year bonds at a 2.70% yield. From a purely financial standpoint, this was an absurd move. On the same day that the three-year bond was sold for 2.70%, the yield on five-year British sovereign debt was 1.40%. The British government could have paid almost half as much in interest on British pounds borrowed for twice as long. Mongolia issued renminbi-denominated debt in June 2015, but paid about 100 basis points more than it was paying on its U.S. dollar-denominated debt. Mongolia may have given more momentum to a trend, but the last time Mongolia made an impact on the world, a well-fed horse was the most advanced weapon of war.

The second way to understand the likelihood of renminbi hegemony is the reasons the dollar would fall from grace. The rise of the renminbi is not simply a two-character story. The renminbi is not the first challenger to the U.S. dollar. In order to answer the question how the renminbi will surpass the U.S. dollar, proponents of coming renminbi hegemony must explain why others have failed. The International Monetary Fund compiles quarterly statistics on foreign exchange reserves. The figure for 2015 Q1 was US$11.4 trillion. Allocated reserves are reported broken down by currency, whereas unallocated reserves are only reported at their U.S. dollar equivalent. Of US$6.0 trillion worth of allocated reserves, U.S. dollars made up US$3.8 trillion, or 64.1%. Euros came in second place at US$1.2 trillion, or 20.7%. Japanese yen were a distant third at US$251 billion, or 4.1%. If unallocated reserves have the same composition, there were US$7.3 trillion worth of U.S. dollar-denominated foreign exchange reserves, US$2.3 trillion worth of euro-denominated foreign exchange reserves, and US$474 billion worth of yen-denominated foreign exchange reserves.

If China’s future role as the largest economy in the world will lead to renminbi hegemony, why has the euro been unable to surpass the dollar? The E.U., after all, is the world’s largest economic entity. Before the Global Financial Crisis, the euro was a likely successor to the dollar. If the European Central Bank had faced the Global Financial Crisis with higher interest rates to cleanse the financial system, that may have happened. Instead, it put internal, short-term economic considerations above long-term currency considerations. This made it no better than the Federal Reserve, but without the established brand. Fixing nominal interest rates in negative territory ended its chances of being taken seriously again. China’s status as the world’s second largest economy gives credence to the likelihood of renminbi hegemony, but Japan was the world’s second largest economy for 32 years. Today, all Japan has to show for its efforts is a huge pile of U.S. dollar-denominated foreign exchange reserves. The decision by the Bank of Japan to effectively nationalize the domestic bond market in 2015 ended the yen’s chances of being taken seriously again. As long as the U.S. dollar can keep winning the Least Ugly Contest, it will be on top of the fiat currency game.

China’s huge dollar holdings contribute to the dollar’s status as the world’s reserve currency. It is unlikely the renminbi could hold the title of world’s most common reserve currency while at the same time the country of issue holds the largest reserves of foreign currency. China could sell its dollars, but for what and to whom? If China were to sell one trillion dollars for some other asset, two issues arise. First, it would most likely have to find another foreign central bank to buy the dollars from it. In that case, the net change in the U.S. dollar’s reserve currency balance is zero. Second, if it were to buy non-currency assets with its dollars, it would still have to buy dollar-denominated assets, meaning its exposure to dollars is the same.

Realistically, the only way dollar hegemony would end is if the global fiat currency regime were to end. In that case, the renminbi is doomed, too. We cannot consider a loss for the dollar to be a win for the renminbi.

So far, the character absent from this story has been gold. The great irony of the central bank experiment is that while the entire world has accepted fiat currency, the institutions that issue fiat currency are the largest holders of gold. According to the World Gold Council, central banks held 31,977.6 metric tones of gold. At 2014 year-end prices, that was worth US$1.2 trillion. If gold were considered part of foreign exchange reserves, it would come in third, behind the U.S. dollar and the euro. If the value of gold were to increase six times over, gold would be back on top. During the last gold bull market, gold rose 662% from a low of $252.10 to a top of $1923.00, so it is not out of the realm of possibility. Unfortunately for China, it is on the short-end of the gold reserve stick. It has only invested 1.00% of its foreign exchange reserves in gold, putting it toward the very bottom of the list.

Although each move the renminbi makes in international currency markets makes headlines, we will probably never seen renminbi hegemony. How will the renminbi penetrate debt markets with higher yields than established currencies? How will the renminbi penetrate foreign exchange reserves if it exports much more than it imports? How will the renminbi survive a fiat currency shake up that would dethrone the dollar?

Thursday, July 2, 2015

Chinese Universities, the Other Local Government Financing Vehicle.

In March 2007, Jilin University, located in the north-eastern province of the same name, posted a notice on its website soliciting recommendations to resolve its debt problem. After accumulating three billion yuan of debt to build facilities to enroll 60,000 students, Jilin University was having difficulty paying up to ¥170 million in interest payments every year. The issue of university debt, and debt guarantees, became a topic of public discussion throughout 2007. Although discussion of the topic has largely disappeared, the debt has not.

During debate on this issue, very authoritative sources on the subject could not agree on the total value of debt owed by Chinese universities. People's Daily reported that total debt of public institutions of higher education had reached ¥200 billion yuan. The Economic Observer cited a People's Political Consultative Conference survey that put the number at ¥250 billion. The National People's Congress cited the 2006 Blue Book of China's Education to claim that debt levels had reached ¥500 billion. Clearly, one or two of these institutions do not understand the Chinese economy.

Any discussion on cash flow problems will have to answer the question of whether it is a spending problem or a revenue problem. According to Qifeng Zhou, the former president of Jilin University, it is a revenue problem. He was quoted as saying, "Universities have no reason to pay back their debts[.] ... The major reason for the huge debt is that the government has not invested enough in higher education[.] But public colleges are owned by the government, so the debt belongs to the government as well."

The Chinese Academy of Social Sciences Review published an article in 2009 on the university debt crisis. It explained the four ways that universities were addressing the problem.
“目前高校化解债务的方法主要有四种。第一种,地方政府出面,直接拨款给予补贴,或给予政策扶持,或牵头协调各方;第二种,以土地置换获取收益偿还贷款,这是当前中国贷款高校最普遍的做法之一,尤其是一些贷款额度较高的省份,如江苏、河南、辽宁、浙江、江西等,更是出现了全省性的土地置换风潮;第三种,以银团贷款的方式进行债务重组,江苏、河南、山东等省的高校开始与银行合作,积极探索以银团贷款方式进行债务重组的新路子,以降低高校和银行双方的风险;第四种,调整贷款结构,变短期贷款为长期贷款,变商业性贷款为政策性贷款,辽宁省与湖北省就将各自省属高校总额分别为73亿元和81亿元的短期贷款打包置换成国家开发银行的长期贷款。”
[Translation: "Currently, there are four main options universities can use to resolve their debt problems. First, local governments can directly pay subsidies, provide policy support, or lead multi-party coordination. Second, income from land exchanges can be used to repay debts. This is the most popular method used by indebted universities, especially in provinces like Jiangsu, Henan, Liaoning, Zhejiang, Jiangxi, etc., where debt levels are high. Third, debt can be restructured with syndicated loans. Universities in Jiangsu, Henan, Shandong, and other provinces have begun to cooperate with banks to actively explore new ways to reduce risks for both universities and banks by syndicating debt. Fourth, structural adjustments can be made to loans. Short-term debt can be converted into long-term debt and commercial loans can be converted into policy loans. In Liaoning and Hubei, with ¥7.3 billion and ¥8.1 billion worth of university debt, respectively, short-term debt has been repackaged into long-term debt from the National Development Bank."]
None of these options actually resolved the debt problem. Subsidies and policy support simply shifted the burden to taxpayers. Income from land exchanges only lasts so long. Syndicated debt is still risky debt if the original principle cannot be repaid. Policy loans simply shift the burden to policy bank balance sheets.

There were three options that would have actually resolved the debt problem. The first is bankruptcy. Many of the lenders to universities made lending decisions unrelated to the financial payback of the university's investments in campus construction. This would have cleared most of the debt, but caused problems for universities later on when they returned to the capital market for future lending. The second is asset sales. Many universities had huge tracks of valuable land granted to them or made redundant as institutions of higher education were merged together. This would have only reduced the overall debt load, it would not have resolved cash flow issues. Third, the universities could have been privatized. China currently does not have one single nationally-ranked private university. Many foreign educational institutions would have paid dearly to have the opportunity to obtain a license to run a fully private university in China. A private university would also be able to determine tuition rates on its own. This would bring tuition rates up to a level that would offset the university's expenses. China's overall quality of higher education would have improved due to increased competition. Unfortunately, bankruptcy or privatization were never pursued. Instead, the debt was simply extended into the future, plus interest.

Considering the lack of focus on the issue, a university bankruptcy has not been priced into the capital markets. The social implications of tens of thousands of students either having tuition increased substantially or not being able to graduate would cause risks beyond the financial markets.

Wednesday, July 1, 2015

Accounts Receivables, China's Other Credit Problem.

There are two major types of corporate debt:  Bank lending and bond issuance.  As China's economy slows and more bankruptcies are allowed, these two debt markets are receiving much more attention.  However, this attention is misplaced.

During China's experiment with the command economy, the banking system simply distributed funding from the central government to state-owned enterprises.  After Reform and Opening, this type of direct funding was transitioned to bank loans, although the precedent was set early on that non-performing loans would simply be rolled over by the state-owned banks.  This problem was never really solved.  Either the entities that could not repay loans were bailed out, or the non-performing loans themselves were rolled up into other assets, such as the four asset management companies established in the early 2000s.  Since the corporate bond market re-appeared on the Chinese mainland in the 1980s, a bond issuer had never been allowed to miss a payment until Chaori Solar defaulted on interest payments in March 2014.  A year later, Cloud Live defaulted on principle and interest.  That same month, Baoding Tianwei was the first state-owned enterprise to default on interest payments.  In May 2015, Zhuhai Zhongfu was the fourth Chinese company to default on onshore debt, but also the second private-sector company to default on principle and interest.

By the time a firm is late to repay a bank loan or defaults on a corporate bond, the root cause had already been forming for years.  A better credit instrument to judge the health of the Chinese economy is accounts receivable.  It is China's other credit problem.

The first time accounts receivable was specifically mentioned as an issue for Chinese companies was back in 2009. The Economic Observer ran an article titled “Chinese Coal Production and Sales Continue to Grow, but Company’s Accounts Receivables Increase.” It quoted the China Coal Industry Association:
今年1-11月,全国煤炭销量累计完成251736万吨,同比增加13142万吨,增长5.5%。……在产销量持续增长的同时,煤炭企业的应收账款却在增加。据中国煤炭工业协会统计,1-11月,大型煤炭企业应收账款863亿元,同比增加59亿元,增长7.4%。
[Translation: Between January and November of this year [2009], national coal sales reached 2.51 billion tons, up 0.13 billion, or 5.5%, over the same period last year. Even as production and sales increase at a steady pace, coal enterprises’ accounts receivables are on the rise. According to statistics from the Chinese Coal Industry Association, between January and November, the accounts receivables of large-scale coal enterprises increased ¥86.3 billion, up ¥5.9 billion, or 7.4%, over the same period last year.]
Despite accounts receivables growing faster than revenues, companies still funded additional projects to expand capacity. According to the same article, the coal mining industry invested in fixed assets to bring on an additional one billion tons of capacity between 2006 and November 2009, and another 300 million tons of capacity planned for the next year. The reason for the increase in capacity was a basket of economic stimulus policies increasing the demand for coal.

In 2011, accounts receivables became a noteworthy issue for another company: China Southern Railway. In the middle of 2011, it announced revenues of ¥40.1 billion, up 42.39% over the same period a year earlier. However, accounts receivables increased to ¥26.6 billion, up 138.17%. Its main customer at the time was the Ministry of Railways. The Economic Observer had this to say about the issue:
较高的应收账款及不断增长的付款周期,给中国南车带来一定的流动性压力,不过考虑到公司主要客户铁道部的信用水平极高,账款不能回收的风险极低。
[Translation: Relatively high accounts receivables and continuously increasing payment cycles put pressure on China Southern Railway’s liquidity. However, considering the fact that the company’s main customer is the Ministry of Railways, which has excellent credit, the risk of not collecting on receivables is extremely low.]
A rational person might make the observation that an entity with excellent credit should not have trouble paying its bills—or, put another way: An entity that has trouble paying its bills should not have excellent credit. Obviously, that person does not understand the Chinese economy.

According to China Daily, in October of that year, China Southern Railways and China Northern Railways were paid ¥6.0 billion and ¥4.5 billion, respectively, by the Ministry of Railways. Eventually, the Wall Street Journal reported that the Ministry of Railway’s debt became so large that the State Council had to create China Railway Corporation to take over the ¥2.66 trillion in debt owned by the ministry.

The issue of accounts receivables as a systemic issue has begun to receive limited coverage from international media since that time. In 2012, the Financial Times reported on the issue.
A Financial Times analysis revealed that 66 per cent of listed Chinese companies that have reported third-quarter results showed a year-on-year increase in such unpaid bills – called accounts receivable in accounting – as a proportion of sales, according to the S&P Capital IQ database. … Sany Heavy, the world’s ninth-largest machinery maker by sales, reported that accounts receivables were up 83 per cent year to date at the end of the third quarter, hitting Rmb21bn. … Other machinery companies reported similar problems: at Shanghai-listed First Tractor, accounts receivable rose 169 per cent from the beginning of the year. … At Zoomlion, a leading Chinese machinery maker, accounts receivable at the end of the third quarter were up 69 per cent from the beginning of the year, according to earnings released on Tuesday. … At Baosteel and Jiangxi Copper, the biggest listed producers of steel and copper, unpaid bills rose 52 per cent and 66 per cent, respectively, since the beginning of the year.
In 2013, the Wall Street Journal ran an article on the growing business of factoring, which is when companies sell their accounts receivables to banks.
China's banking regulator has instructed banks to better monitor a type of lending particularly popular with small firms as demand burgeons and banks relax their oversight standards. … Shanghai Pudong Development Bank Co. has said that it did 130 billion yuan ($21 billion) worth of factoring business in the first half of the year, up 51% from the same period last year. That is equivalent to about 8% of the new loans it made between January and June. … China Merchants Bank Co. said it earned 562 million yuan in income from its factoring business in the first half, an increase of almost 150% over a year earlier. … Bank of Communications Co. and Agricultural Bank of China Ltd. both said in their half-year earnings reports that their factoring business expanded rapidly.
In 2014, Reuters ran an article on the rising levels of accounts receivables and collection times.
A Thomson Reuters survey of data on China's more than 2,300 stock market-listed firms illustrates the impact on corporate payments, with company receivables - the accounting term for money owed by customers - on average reaching $160.49 million at the end of last year, more than double the $65.9 million average at the end of 2009. … Over the same period, the median collection time for billings crawled up from 71.4 days to 90.42 days. It was the first time China's market-listed firms averaged more than 90 days in a decade.
In addition to increased accounts receivables, there is another trend that will have systemic ramifications: Cross-ownership. Many of the companies involved in the capital goods sector own their suppliers and customers either partially or outright. Many companies are engaging in entrusted loans with owners or subsidiaries, allowing them to pay accounts receivables on time, but then have the same issues repaying the entrusted loans later down the line. According to the same Reuters article as quoted above, “Chinese companies granted a net 2.55 trillion yuan ($411 billion) in so-called entrusted loans in 2013, nearly double the 1.28 trillion yuan total in 2012.”

The current issues that affect the bank lending and corporate bond markets have formed over the last few years, many of them starting with accounts receivables. Understanding future issues that will soon impact those two markets will most likely come from understanding the accounts receivables issues of today.

Tuesday, June 30, 2015

Not Everyone is Buying the Renminbi Hype.

Earlier this month, the People's Bank of China released The Renminbi Internationalization Report 2015.  The Economic Observer ran a discussion piece (in Chinese) on this issue.  Not everyone is buying the hype.
“但如果问人民币国际化处于哪个阶段?央行报告中并未明示。不过,也许可参考2014年7月中国人民大学国际货币研究所发布的《人民币国际化报告》,文中提及2013年的RII(人民币国际化指数)为1.69。这是什么概念?尽管2013年RII的全年涨幅84%,但1.69距美元国际化指数52.96相差31倍,分别与欧元、日元、英磅的国际化指数相差18倍、2.52倍、2.54倍。答案不言而喻:人民币国际化还有很长的路要走。”
[Translation:  "At what stage are we at in the process of renminbi internationalization? The People's Bank of China's report does not elaborate. However, we can reference the Renminbi Internationalization Report issued by the International Currency Institute of Renmin University in July 2014. According to that report, the Renminbi Internationalization Index (RII) in 2013 was 1.69. What does that mean? Even though the RII increased 84% in 2013, the U.S. Dollar International Index at 52.96 was 31 times higher than the RII. The similar rating for the euro, Japanese yen, and British pound were 18, 2.52, and 2.54 times higher than the RII. The answer is self-evident: Renminbi internationalization has a very long road ahead."]
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Monday, June 29, 2015

Supply and Demand in the Chinese Stock Market.


In June, which as of this posting has not ended, yet, the China Securities Regulatory Commission published 135 prospectuses on its website, more than double the average for the last three months, and close to twice as high as the previous high point, shown above as blue columns.  That was also the same month the stock market experienced its worst two weeks since 2008, shown above as a red line.  Perhaps the stock market's appetite has finally been satisfied?

There are only two days left in June, so it is likely that June will close lower than May, the first time the stock market has lost value month-over-month in years.  However, the People's Bank of China's announcement on Saturday has not been priced in.  Has anyone written a book called Shenzhen 10,000, yet?

Sunday, June 28, 2015

2015-05 Interest Rate Trends

Both the short-term state sector and long-term private sector interest rates fell significantly in May.



The Shanghai Interbank Offer Rate (Shibor) ended May at 1.04%, down 65 basis points from April. The trailing average for May is 2.20%, meaning Shibor is currently less than half the trailing average. The lowest rate ever reached was 0.80% in March, 2009, but 1.04% is still the lowest rate since June, 2009.


The Wenzhou Comprehensive Index ended May at 18.73%, down 114 basis points from April. It is also 97 basis points below the trailing average for May, and the lowest point for the data available. On May 10th, the People's Bank of China announced that it would adjust interest rates down. The interest rate charged for loans less than one year was reduced by 25 basis points down to 5.10%. The interest rate on one-year time deposits was also decreased 25 basis points to 2.25%. Reuters quoted the central bank's justification as being:
"At the same time, the overall level of domestic prices remains low, and real interest rates are still higher than the historical average."
The "domestic prices" they are referring to must not include equities. The Wenzhou Comprehensive Index is published by the Wenzhou City Local Finance Management Bureau. Occasionally, they publish reports on trends they see in the data. In the beginning of June, reports for January through May were updated. One observation they made was that "Examining lending periods show that short-term interest rates are higher than long-term interest rates.  Market transactions are primarily focused on short- and medium-term lending."


In May, the interest rate on a one-month loan was 18.81%, but a six-month loan was only 16.21%. April showed a similar trend. Shibor is the second-most market-oriented indicator for interest rates, but it is not showing an inverted yield curve. An inverted yield curve has generally been followed by a recession in developed countries. Perhaps the Wenzhou Comprehensive Index is telling us that China is experiencing, or will experience, a recession?

Friday, June 26, 2015

Shanshui's Technical Default.

Last week, China Shanshui Cement Group Ltd. announced that it could be the next Chinese company to default on its debt obligations. In this case, the cause of the default is corporate governance, not operating health. As Bloomberg explained:
China Tianrui Group Cement Co., which holds a 28.2 percent stake in Shanshui, has proposed to install four people -- including its chairman Li Liufa and Chief Executive Li Heping -- to the cement maker’s board, according to an exchange filing Monday. Tianrui has called for a vote to oust Shanshui chairman Zhang Bin and founder Zhang Caikui, an official said last week. The removal of board members including its chairman would constitute a “change of control” event that requires the company to repurchase its outstanding bonds, Shanshui said in a filing late Friday. It won’t have enough cash to redeem $921 million of its notes, leading to a default, it said.
In this specific case, the chairmanship may not transition, or Tianrui Group could step it to cover the debt if it does. If the company is forced to pay the debt back immediately, the inability to repay the total amount would not be caused by deteriorating cash flows.

Last September, Shanshui Cement was among a group of capital goods industry companies that were downgraded by global ratings agencies. The New York Times reported:
On [September 15, 2014], S&P cut the ratings of China Shanshui Cement and Guangzhou R&F Properties by a notch, plunging them deeper into junk status. Last week, fellow rating agency Moody's downgraded steelmaker China Oriental, already wallowing in non-investment territory, also by a notch.
All of these companies “that had binged on the easy credit springing from a round of government stimulus in 2008-2009.” Considering that Shanshui and Tianrui are both in the same industry, the dynamics that are affecting Shanshui should eventually come around to negatively impact Tianrui, as well. If one company is having difficulty paying off its debt in the long term, then another company in the same industry will most likely have similar difficulties down the road.