Sunday, July 26, 2015

2015-06 Relative Interest Rate Trends

Both the short-term state sector and long-term private sector interest rates rose in June.

The Shanghai Interbank Offer Rate (Shibor) ended June at 1.25%, up 22 basis points from May. The trailing average for June is 2.82%.  Not only did June's rate continue May's trend of being less than half the trailing average, but June's gap between actual and trailing average was 156 basis points, the highest in 2015.

The Wenzhou Comprehensive Index ended June at 19.92%, the highest rate since November, 2014.  The rate was 114 basis points higher than May's close.  The trailing average for June is 20.07%, meaning there was a 15 basis point gap between June's actual and the trailing average.  This is the smallest gap for 2015.

The Wenzhou Comprehensive Index still shows an inverted yield curve.  In June, he rate for one-month lending was 18.13%, but the rate for one-year lending was 15.45%.

On June 28, the People's Bank of China decreased reserve requirement, benchmark lending, and benchmark deposit rates.  The benchmark lending rate decreased from 5.10% to 4.85%.  The benchmark deposit rate for one-year time deposits decreased from 2.25% to 2.00%.  All other maturities were also decreased by 25 basis points.

Three concerning trends continued in June.  First, although both the Shibor and Wenzhou Comprehensive rates increase, the cost of financing for the private sector increased more than the state-sector.  Second, the private sector yield curve continues to be inverted, indicating the private economy is in a recession.  Third, the central bank continues its irresponsible policy of monetary easing.

Saturday, July 25, 2015

Flashback: "Hayek, Once China's Poison, Is Now Its Prophet."

Hayek, Once China's Poison, Is Now Its Prophet: Andy Mukherjee By Andy Mukherjee - July 26, 2004 15:53 EDT July 27 (Bloomberg) -- If economist Friedrich Hayek were alive today, he would scoff at Beijing's awkward -- and failing -- attempts to check runaway economic growth as yet more evidence that all central planning was ultimately a ``pretense to knowledge.''

In a way, Hayek, the 20th century's leading critic of statism, may have given his verdict, some 60 years ago, on whether China's Premier Wen Jiabao (or any other state planner, for that matter) can have enough ``man-on-the-spot'' information to be able to cool excess investments in some industries without freezing up the whole economy.

``If we can agree,'' argued Hayek in a 1945 essay, ``that the economic problem of society is one of rapid adaptation to changes, it would follow that the ultimate decisions must be left to the people who're familiar with the (changed) circumstances.''

``We cannot expect,'' reasoned the Austrian-born British economist, ``that this (economic) problem will be solved by first communicating all this knowledge to a central board which, after integrating all knowledge, issues its orders.''

And that's just what's frustrating the task of policy making in China. Although wedded to capitalist ideals now, China remains a planned society where the state allocates resources. While a market economy can curb overheating by raising interest rates -- a ``pricing'' signal to businesses to reconsider investments -- Beijing is trying to ``plan'' a correction by telling bankers whom they shouldn't lend to.

Credit Crunch

So far, the script hasn't played to planners' satisfaction.

Eddie Wong, the Hong Kong-based chief strategist at ABN Amro Asia Ltd., explained in a note to clients last Friday how Beijing's instructions to banks to curb credit are backfiring.

Since working capital loans are renewed in three months to 12 months and the duration of fixed-asset credit is between three years and five years, ``when the banks are asked to tighten,'' says Wong, ``the easier way is to stop rolling over working capital loans as they'll mature faster, although this is not what the central bank wants them to do, and more importantly, it is not what the economy needs.''

In fact, China's strategy of choking credit to real estate firms and makers of cement, steel and aluminum, is turning out to be an all-round clampdown on credit, even causing airlines to curtail new aircraft orders, according to David Hale, president and chief economist at Hale Advisors LLC.

``They want to slow things down selectively,'' Hale said last week. ``But because their system is so clumsy and so authoritarian, what they produced in the last eight weeks is an across-the-board credit crunch.''

``Pretense to Knowledge''

Hayek, who opposed British economist John Maynard Keynes's view that state intervention was often the key to keep an economy at full employment, was never in any doubt about what works better -- ``pricing'' or ``planning.''

A market-based pricing system is superior because of ``the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action,'' he argued.

Hayek's works were banned in Mao Zedong's China.

``Full of poison,'' is how a Chinese introduction described his 1944 book ``Road to Serfdom,'' which was made available to high-ranking communist cadre to acquaint them with the ``enemy's'' thinking, according to William McGurn in the 2000 book ``China's Future: Constructive Partner or Emerging Threat?''

The ban has since been lifted, and Hayek is a respected name among Chinese scholars now, according to Kate Zhou, a professor of political science at the University of Hawaii at Manoa. ``Even some government officials,'' Zhou writes on the Web site of the Mackinac Center for Public Policy, ``have put some of Hayek's writings on their work desks for decoration.''

Blunt Weapons

Earlier this month, China reported second-quarter economic growth of 9.6 percent, slower than 9.8 percent in three months to March 31. Growth in fixed-asset investment eased to 29 percent in June, from 35 percent in the previous month, raising expectations that government measures to slow the economy were succeeding.

However, ``preoccupation with statistical aggregates,'' as Hayek so presciently warned, is counterproductive because the knowledge that oils the wheels of an economy is ``of the kind which by its nature cannot enter into statistics and therefore cannot be conveyed to any central authority.''

Commodity prices, which contain Hayek's ``man-on-the-spot'' information, don't suggest a slowdown is near. The London Metal Index, which combines prices of copper, aluminum, lead, tin, zinc and nickel, closed at 1684.6 on Friday, 9 percent higher than its May 17 low. Since June 30 last year, the index has risen 47 percent, primarily because of strong metal demand in China.

Asia's second-biggest economy is still growing at a ``torrid and unsustainable rate,'' Morgan Stanley Chief Economist Stephen Roach said.

Hayek Vindicated

Hayek was vindicated when the Berlin Wall fell in 1989, three years before his death at age 92. The Nobel Prize-winning philosopher's prophecy is now catching up with China, which is undergoing what ABN Amro's Wong calls a ``policy vicious cycle.''

``When the government tightens,'' says Wong, ``the economy will die; when the economy is about to die, the government will loosen; when the government loosens, it will lose control.''

State planning, especially when it involves state-sponsored investment booms and busts, can be every bit as messy as Hayek said it would be.

Monday, July 20, 2015

Chinese Monetary Printing and Re-Nationalizations Sending Gold Prices ... Down?

"Dollar in demand, gold dives to five-year low."
Wayne Cole, July 19, 2015, Reuters

The U.S dollar held broad gains in Asia on Monday as investors looked ahead to higher interest rates from the Federal Reserve, while gold slumped to five-year lows as a lack of global inflation left little to hedge against.

The precious metal XAU= ran into a wave of selling in Asia that drove it down 3.9 percent to $1,089.80 an ounce, having already suffered its worst weekly performance since March last week. ...

There was better news from China where home prices rose for a second month in a row in June, suggesting government efforts to boost the struggling property sector have started to gain traction.

China stocks seem to have pulled out of their recent nosedive amid a barrage of measures from regulators and buying by brokerages and mutual funds.
The reasons given for a drop in the price of gold are the Chinese central bank's monetary easing policies to prop up the housing market and the central government's decision to re-nationalize much of the equity market.  It is time to buy gold.  The time to buy a hedge against inflation is precisely the time the rest of the world thinks there is "little to hedge against."

Sunday, July 19, 2015

2015-06 Relative Price Trends

Consumer prices increased 1.4% year-over-year in May, whereas purchasing prices fell 5.6% over the same period. This marks China’s 43nd month of economic contraction.

As usual, commentators quoted by the mainstream financial media maintain their sentiment that up is down, and left should be further to the right.  Mr. Li-Gang Liu, chief China economist at Australia & New Zealand Banking Group, was quoted by Bloomberg as saying "As deflation risk remains elevated and market sentiment deteriorated sharply amid the stock market slump, China’s monetary and fiscal policies will have to become more supportive."

What could be more supportive than cutting interest rates and reserve requirements four times since November, halting all initial public offerings, organizing the largest re-nationalization of Chinese industry since 2009, and posting online that the People's Bank of China will provide "ample liquidity" to the stock market
“Consumer prices signal stronger demand,” said Zhu Qibing, an analyst at China Minzu Securities Co. “But the figure is still lingering at a low level. The central bank doesn’t need to worry about inflation for now.”

That’s a relief for the People’s Bank of China, which has joined other government bodies in the effort to halt a month-long slide in stocks that threatens to derail signs of economic stabilization. ...

“The People’s Bank of China has already ratcheted up its easing efforts,” Bloomberg’s Chief Asia Economist Tom Orlik wrote in a note. “With market turbulence reinforcing the argument for further easing, we continue to expect a further rate cut by the end of the year.”
 In just that one article, the author implied that a three year bull market with triple digits represents "economic stabilization", whereas a "month-long slide in stocks" threatens stability.  At the same time, another Bloomberg employee is quoted as saying this is all "market turbulence".  How about we first understand the causes of the tremendous run-up in Chinese equities, as well as the causes of the sharp downfall, before we begin proscribing policy responses?

Wednesday, July 15, 2015

Tsinghua Unigroup Offers to Buy Micron Technologies.

On Monday night, Tsinghua University's investment arm, Tsinghua Unigroup Ltd., made a $21 billion bid for Micron Technology Inc., the world's fifth largest chip maker.  If the deal goes through, it would be the largest outward investment on record, surpassing Cnooc Ltd.'s purchase in 2012 of Nexen Energy for $17.4 billion.

Personal computer sales are down considerably over the past year, and Micron technology has been made considerably cheaper because of it.  Its stock price ended December 31, 2014 at $35.01, but ended June 2015 down 46.1% to $18.84.  Tsinghua Unigroup offered $21 per share.

The deal seems to be driven by Beijing's industrial policy, as opposed to commercial considerations.  According to Bloomberg:
If completed, a deal by state-owned Tsinghua Unigroup would be the largest overseas takeover by a China-based company and comes as the nation that accounts for more than half of global semiconductor sales seeks to wean itself from technology developed overseas. The government has budgeted as much as 1 trillion yuan ($161 billion) for spending on the chip industry over the next five to 10 years, consulting firm McKinsey & Co. estimates.
It's unclear what Tsinghua Unigroup would bring to the table.  It has limited technology or management expertise to bring to the table.  China's technology sector is suffering the same pressures as the rest of the world, so One Billion Customers is not as attractive as it otherwise would be. If U.S. regulators allow the deal to go through, market share seems likely to transition towards Samsung Electronics Co. and SK Hynix Inc.

Tuesday, July 14, 2015

China Auto-Makers Find Out the Answer to the Question: "What Could Go Wrong?"

The mainstream media is beginning to write about China in a more desperate tone.  A recent USA Today article on auto sales in China is an excellent example.
For the last 20 years, China has been the auto industry's promised land. A population of 1.4 billion, a growing middle class and projections that sales would continue to soar created a "what could go wrong?" attitude.
The China Association of Automobile Manufactures reduced the sales forecast for 2015 from 7% to 3%.  The year is half over, how can they already be off by half?  General Motors, the second largest auto-maker in China after Volkswagen, is discounting models by up to 20%, yet growth for the first half of the year was only 4.4%.

Not only is the auto industry having a demand problem, it is having a supply problem.  The China auto market is a classic example of mal-investment supplying artificial demand.  According to the same article, "Manufacturers have been engaged in a massive race to boost production that has outpaced demand and dented profits." Car markers built 270,000 more cars in 2014 than they sold, the widest gap since 2007.  General Motors sold 246,066 vehicles in June in its largest market.  On top of deep discounts to drive current demand, car makers will have to reduce production to burn off inventory.  That is bad news for commodities and wages.

Monday, July 13, 2015

New Money Creation in the New Year.

For monthly economic indicators, the Chinese New Year can pose problems for comparisons over a twelve month period.  For example, in 2012, Chinese New Year was on January 23rd, but it was on February 11th in 2013.  The growth rate of a certain indicator may be understated by comparing January 2012 to January 2013, but overstated when comparing February 2012 to February 2013.  Chinese New Year in 2014 fell on January 31st, so economic activity related to the new year would have been spit between both January and February, further complicating accurate comparisons over a twelve month period.

Usually, the best way to compare the two is to measure the month containing Chinese New Year with the previous year's month for Chinese New Year, although this cannot mitigate the issues with Chinese New Year impacting the end of January and the beginning of February.  In that case, the only accurate comparison is between Q1 of one year and Q1 of the next year.

China's currency in circulation (M0) is an example of an indicator that is impacted significantly by the timing of the Chinese New Year.  January 2015's value decreased by -17.58% over the previous 12 months, but February 2015's value increased 16.97% over the previous 12 months.  This information is not very useful.

One trend that is noticeable is that the Chinese New Year spike in 2015 was lower than the spike in 2014.  In the data available, this only happened back in 2002.  However, that decrease was only -1.72%, and there was an abnormally large increase in bank reserves to make up for it.  The drop in 2015 was -4.69%, and with no abnormal increase in bank reserves.

Now that May's numbers have been released, we can see annual growth figures that are not impacted by the Chinese New Year.

M0 in May grew at its lowest rate ever for the available data in comparable months.  Previously, the growth rate had never dropped below 6.00%, but now it already down to 1.77%.

M1 in May grew at its second lowest rate for the available data in comparable months.  Perhaps this is the new normal?

M2 growth in May continued its downward trend.  Similar to M0, it is now at its lowest rate for the available data in comparable months.

Despite cutting interest rates and reserve requirements, the Chinese money supply seems to be losing steam.  Could the Year of the Goat be the year the credit addict experiences withdrawals?

Sunday, July 12, 2015

2015-06 Stock Market Valuation

The Shenzhen Composite ended June at 0.34 gold ounces. Although it was down from May’s close of 0.38 ounces, June’s close is still the second highest price paid for the index in the series. The price-to-earnings ratio was 54.28, considerably lower than May’s 61.41 times, but still high. Although the index lost 10.64% over the last month, it is still up 152% over the last year. The gold price fell faster than the price-to-earnings ratio, meaning earnings stayed mostly flat from last month.

The big story in June was the drop in tech company valuations. According to Bloomberg:
"A rally in Chinese technology companies is reversing at the fastest pace in at least a year on concern valuations are too high relative to earnings growth. … The CSI 300 Information Technology Index has plunged 19 percent from its June 2 record, almost twice the 12 percent loss by the broader gauge. Even after the declines, the hi-tech measure trades at 74 times earnings, versus 31 times for the Nasdaq Composite Index in the U.S. The Chinese gauge sank 6.3 percent by the close Thursday, while the Shanghai Composite Index declined 3.5 percent. … Beijing Shiji Information Technology Co. has lost 31 percent since June 2, wiping out around $3.5 billion of value. The stock still trades at more than 100 times earnings. Leshi Internet Information & Technology (Beijing) Co. has plunged 28 percent in the period, paring its gain this year to 251 percent."
The run-up in Chinese equities is beginning to impact overseas equity markets as well. After initial public offerings by Chinese companies in the U.S. hit a record high in 2014 of $29 billion, 2015 has seen a reversal of the trend. In June alone, $22.6 billion worth of deals were agreed on to take Chinese companies listed in the U.S. private again so that they can be re-listed in China at higher valuations.[1] The risk for Chinese companies is that if they borrowed money to take U.S.-listed companies private and then are unable to list in China, or list at expected valuations, they will be in much worse situations than if they had remained listed in the U.S.

Saturday, July 11, 2015

China's Stock Market Losses Now Exceed Worst Month of 2008.

On June 12, 2015, China's total market capitalization hit ¥78.3 trillion.  Four weeks later, on July 10, the total had fallen to ¥51.2 trillion.  At an exchange rate of ¥6.2 to the U.S. dollar, that ¥27.1 trillion drop equates to $4.3 trillion in losses.

Back in January 2014, the financial press began to wonder if the impending default of the Credit Equals Gold No. 1 wealth management product, issued by the bank ICBC, would be China's "Lehman Moment."  The bailout of that financial product came and went, so the China Bears looked elsewhere.

The next glimmer of hopelessness came in March.  That was the month Chaori Solar became the first Chinese company to default on a domestic bond.  Instead of a Lehman Moment, Joseph Sternberg at the Wall Street Journal, argued that it was actually a Bear Stearns Moment with Chinese Characteristics.
The Bank of America economists who articulated the analogy describe the original Bear moment of 2007 as the time "when the market started to seriously reassess subprime debt risk." Put another way, the write-downs at the two hedge funds spurred market participants to rethink whether their assumptions about market conditions for housing and debt were still correct, and to start adjusting their behavior. ... What is happening as a result of Chaori's default is something different: Market participants are wondering whether their assumptions about government behavior have been correct. It's an important distinction.
The Chaori Solar default, as well as defaults for three other companies, came and went.  China's financial markets only seemed to gather momentum.

Finally, relief for the China Bears came.  Ben Bernanke, former Chairman of the Federal Reserve, made a statement during the World Business Forum in Hong Kong this June that "A Lehman Moment" is not likely.  That was less than two weeks before the peak.  His record on foreseeing economic catastrophes is Keynesian level, at best.

The United State's market capitalization before the Panic of '08 peaked out at $16.1 trillion in April 2007.  Lehman Brothers filed for bankruptcy on September 15, 2008.  At the end of September 2008, market capitalization stood at $13.5 trillion, down $2.6 trillion from the peak.  By the end of October, market capitalization had fallen another $3.2 trillion to $10.3 trillion, surpassing the value of all losses up to that point.  October was the month Alan Greenspan declared financial markets were experiencing "a once-in-a-century credit tsunami".

At $3.2 trillion, the worst month of the Panic of '08 was still only 75% of the losses that China's market capitalization just experienced.  China's market capitalization today is also much lower than the United State's was in 2008.  Could we be experiencing a once-in-a-China-Century credit tsunami?

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Thursday, July 9, 2015

The End of Chinese Economic Exceptionalism.

The Washington Post ran an article yesterday that touched on an issue relating to the founding of this blog.  The article was titled "China’s Market Crash Dents Nation’s Aura of Invincibility".  It dealt with the disconnect between ideology and reality within and outside of China.
“It is remarkable to us how analysts and investors around the world who deeply believe in the laws of economics and free markets have tacitly bought into the idea of Chinese exceptionalism,” wrote Anne Stevenson-Yang, director of J Capital Research.
On the one hand, we have commentators outside of China that support the free market, yet they believe the Chinese model of heavy-handed state-ownership will lead China to surpass the West.  They denounce the actions of the Federal Reserve, a central bank with the second best record of maintaining purchasing power and the most transparent central bank, but at the same time put tremendous faith in the People's Bank of China's ability to replace the dollar.  They believe in the spontaneous order, but advise we all teach our children Mandarin Chinese, a language that is a government invention and enforced by the state.
The authorities responded first by easing monetary policy, suggesting pension funds would invest more, cutting trading fees and even relaxing rules of using borrowed money to speculate in the markets. Opinion leaders took to social media to demand that investors buy shares “for the nation.” Elderly women burst into trading halls to sing patriotic songs.
On the other hand, we have nostalgic communists within China that somehow make the stretch to measure the success of socialism with Chinese characteristics in terms of market capitalization, corporate bond values, and export levels.  They speak up for the workers, but credit China's cheap labor for its success in the globalized economy.  They oppose monopolies, but support merging state-owned enterprises to compete in overseas markets.  They oppose foreign influence in China, but study Marxism.

We must look to Martin Jacques for intellectual honesty, but reverse his opinions to come to the proper conclusions.

Tuesday, July 7, 2015

The New Normal Equity Bubble and Policy Spirits

Ever since the Chinese economy entered a “new normal” of lower real economic growth, the Chinese stock market has appreciated rapidly. Considering the speed, value, and valuation of the equities in question, this episode can clearly be defined as a bubble. Most commentators have tried to explain this phenomenon as either the result of a declining real estate market diverting funds, the real economy decreasing needs for lending, rampant speculation, or a combination of all four factors. Although this could be considered another case of animal spirits by irrational participants in the market, a more accurate diagnosis would be to understand these events as reactions to official policy, i.e. policy spirits, not animal spirits.

The first culprits are wealth management products. They are a financial product that allowed banks to offer higher interest rate alternatives to customers while facilitating loans to higher risk clients. Savers got higher returns, borrowers got more capital, and banks got more fees, but with no risk for the banks, or so they thought.

On January 31, 2014, the Credit Equals Gold No. 1 wealth management product was due to mature. The wealth product had invested in a coal miner and was issued by the Industrial and Commercial Bank of China. The coal miner went bankrupt, so the planned interest and principle payment could not be honored. Before that point, no wealth management product had been allowed to default on principle. This policy is known as “gāngxìng duìfùi” in Chinese, or “rigid redemption” in English. Days before the wealth management was due to default, a mysterious third-party stepped in to cover the losses and recoup investor’s three billion yuan investment.[1]

In April 2014, the China Banking Regulatory Commission issued Document #2014/99, titled “Guidelines on Regulating Risks of Trust Companies”. The most important section was:
[Translation: "The shareholders of trust companies should include in their trust company charters a promise or agreement that when the trust company experiences liquidity risks, shareholders should provide support. If capital is eroded because of operating losses, the amount should be fully deducted from net capital, the scope of business should be reduced, or shareholders should promptly replenish capital."]
Now that stakeholder equity was at stake, trust companies had less incentive to offer wealth management products. Although wealth management products are still being issued, the number of available wealth products is decreasing. According to the Economic Observer, in 2015 Q1, banks issued 17,289 wealth management products, but 20,059 wealth management products came do, so the net amount of outstanding wealth management products decreased, at least in product offering terms. These funds had to seek yield in other investment classes.

In contrast with rigid redemption on financial products issued by trust companies, official policy towards bank closers has moved closer to market mechanisms of risk, profit, and loss. Since commercial banking was re-established in Mainland China since the 1980s, no bank has ever been allowed to fail. The largest banks in China are all state-owned, so there was an additional guarantee for those banks’ liabilities. In May 2015, the State Council established deposit insurance for all deposits with balances of ¥500,000 and under, our third culprit. It is not uncommon for a Chinese person in an area with low access to big state-owned banks to have more than ¥500,000 in a bank account. Now that official policy is to allow these banks to fail, depositors with more than ¥500,000 must find other investments. If originally a person had one million yuan in a small rural bank, the full amount was risk-free. Now, only half of it is risk free, the other half could be lost entirely, so any other asset class becomes attractive. This is one of the reasons we could be seeing such an increase in person-to-person lending, with much of it ending up in the stock market.

The third policy change that has caused animal spirits in the stock market has been the People’s Bank of China’s policy of reducing interest rates and reserve requirements. In Chinese, this policy is known as “shuāng jiàng”, or “doubling down” in English. Over the last six months, the People’s Bank of China has decreased interest rates and reserve requirements three times, each. At the beginning of the year, the reserve requirement ratio stood at 20.0%, but as of the end of June was at 18.0%. The targeted lending rate decreased from 5.60% at the start of the year to 4.85% at the end of June. This encourages banks to lend more of the deposits they have. At the same time, depositors are encouraged to seek out yield in other investments, such as the stock market.

Hopefully, when this artificial credit boom comes to an end, the central bank will be seen as the culprit, not the savior.

Monday, July 6, 2015

Quote of the Day: Leap Forward Campaigns.

Yi, Gang.  Money, Banking, and Financial Markets in China.  Westview Press.  1994.  Page 204.
The leaders of China often have incentives to overheat its economy with a so-called "leap forward" campaign. Perhaps they always want to show the socialist system is superior to the capitalist system and the ultimate way to show that is to prove that its economy is developed more rapidly in the socialist system. Once a leap forward campaign fever creates famine and shortage and drives the economy to the brink of bankruptcy, the government has to adjust to the direction of obeying economic laws, such as providing material incentives and respecting the invisible hand, etc. After the economy has recovered from the disaster, the government is ready to start another great leap forward campaign. This kind of movement happened several times in the 40 years of the People's Republic under different slogans, most notoriously in 1958 (the Great Leap Forward), in 1978 (Four Modernizations), and in early 1980s (Quadrupling the Total Output by the Year 2000) and perhaps in 1988 under some new slogans. Although China has repeatedly suffered the ill-effects of investment fever, this problem is still haunting its economy, because the incentives for such fever remain. One thing that is worth mentioning is that before the economic reform, only one economic agent, namely the central government, was capable of overheating the economy, given its tight control over local governments and firms. After decentralizing reform, local governments and numerous firms have also been infected by this investment fever disease. The economic reason behind this is simple. Facing a soft budget constraint, its is rational for a firm--or a local government--to invest more when it has the authority to do so. The relationship between the interest of the investing agent and the result of the investment is asymmetric. It enjoys the success of the investment (in terms of gaining power, material rewards, and promotions, etc.), but does not bear fully the cost of a failure. It is often said by Chinese government officials to excuse a failed investment that "this is the tuition we have to pay to learn".

Sunday, July 5, 2015

2015-06 Relative Equity Trends

In June, both the consumer goods and materials sectors lost momentum.  The materials sector, represented by CHIM, grew only 23.14% over the last 12 months, compared with 46.83% in May.  The value of the portfolio dropped 13% over the month.  The consumer goods sector, represented by CHIQ, grew almost exactly zero percent over the last twelve months, closing June at $14.40.

On the consumer goods side, ecommerce and the food and beverage industries led the news. Alibaba and were added to CHIQ holdings. The Financial Times published an article on’s rising popularity in China. Companies that make money in the long run talk about profit margin expansion. Companies that lose money in the long run talk about anything but profit margin expansion, such as revenues, market share, popularity, facility expansion, and service. In the 700 word article by the Financial Times, discussion of profit margins only took up 19 words: “’s net loss widened to Rmb710.2m in the first quarter, up from Rmb454.3m in the fourth quarter of 2014.”[1]

In the food and beverage industry, multiple state-owned enterprise mergers or reorganizations were announced. China Resources Enterprise Ltd. will sell its money-losing retail venture with Tesco Plc. to its parent company for HK$30 billion. This will allow the dividend to be raised from HK$12.30 to HK$11.50. The parent company announced it will also acquire up to 20% of the Hong Kong-listed company, up from 10% currently.[2] Bright Dairy & Food Co., China’s third-largest milk producer by market value, announced that it will buy China Modern Dairy, a cattle-breeding operation that owns 35,000 cows, from Shanghai Dairy Group, which is owned by the same parent company as Bright Dairy. Prior to that, Bright Dairy had also announced that it will purchase Israeli Tnuva Foods from its parent company, and merge with edible oil maker Shanghai Liangyou Group, which is also controlled by the Shanghai municipal government.[3]

On the materials side, there is one bright spot in the over-capacity story: China Hongqiao Group. China exported 410,000 tonnes of aluminum and aluminum products in May, a 21% increase compared to the previous year.[4] Despite the impressive growth in volume, prices have declined. China Hongqiao Groups biggest domestic rival, Aluminum Corporation of China, posted a ¥16.2 billion net loss in 2014 due to poor cost competitiveness and lower prices. Despite that, China Hongqiao has managed to make a net profit of ¥5.3 billion in 2014, and expects to see expanded profit margins in the first half of 2015.[5] The company is able to do this by passing on lower energy costs into the price of its finished goods.

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.
[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:
[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:
[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.