Monday, August 24, 2015

Public Comments for Future Review, 2015-08-24

"It's totally premature to speak of a crisis in China," [Carlo Cottarelli, an IMF executive director representing countries such as Italy and Greece on its board] told a press conference. 
He reiterated an IMF forecast for a 6.8 percent expansion in the Chinese economy this year, below the 7.4 percent growth achieved in 2014.[1]

Sunday, August 23, 2015

2015-07 Interest Rate Trends

In July, the state-sector and private-sector interest rates showed divergent trends, for the benefit of the private sector.

The Shanghai Interbank Offer Rate (Shibor) ended July at 1.47%, which was a 43 basis point increase from May.  However, that is still 108 basis points lower than the trailing average for July.  The cost of financing for state-owned banks is increasing, despite the amount of new money that is being created by the central bank.

By comparison, the Wenzhou Private Finance Index ended July at 18.08%, the lowest rate in the series.  It may be that as private lending is liberalized more financial capital is being allocated to the private sector.  Or, it may be that financial repression by the central bank and the collapse in equities and real estate prices has led an unsustainable amount of funds seeking yield into riskier assets.  Probably both.

Sunday, August 16, 2015

2015-07 Relative Price Trends

Consumer prices in China increased 1.6% in July from a year earlier.  Purchaser prices declined -6.1% over the same period.  Two divergent trends are occurring for China's structure of production.

The rate of increase in consumer prices is accelerating.  The rate of increase hit a most recent low point of 0.80% in January, 2015.  Since then, the growth rate has mostly been accelerating, especially over the last three months.  In May, the rate was 1.20%, but has gained twenty basis points every month since then.

The rate of decrease in purchaser prices is also accelerating.  The extent of the decline in July was the largest since October, 2009.  Even though the central bank is pumping money into the economy to increase overall economic activity, the only effect it seems to be having is to make life more expensive for everyday people.

It will be interesting to see how the recent devaluation affects these prices.  China does not import many consumer goods, so the devaluation will not affect the Consumer Price Index much.  China does import most of the world's commodities, so they devaluation should be directly reflected in the Purchaser Price Index.

Friday, August 14, 2015

Investment in Overcapacity, Consumption of Depleted Resources.

China Daily quoted Tianyong Guo, head of the Chinese Banking Industry Research Center at the Central University of Finance and Economics in Beijing, as saying: “A great amount of capital has enteredthe equity market and squeezed capital for investment and consumption, resulting in insufficient investment in the real economy and a contraction in demand.”

The authors’ observation was: “[T]raditional sectors such as steel, cement and power industries are struggling with difficulties such as overcapacity, rising costs, and depleted natural resources.”

If the pillars of the Chinese real economy (i.e. steel, cement, and power generation) are experiencing overcapacity, why invest in more capacity? If natural resources are being depleted, why should demand expand further?

Another question to ask is what is driving costs higher? According to the front-page article on the Business Section of the China Daily on July 28th, interest payments of industrial companies dropped 6.2% after three cuts in benchmark interest rates. Commodity prices have also been falling consistently. The only other major cost would be labor. Are industrial companies expanding their workforces to offset layoffs in other sectors of the economy? Is the Chinese labor market worse that it appears?

Thursday, August 13, 2015

Yanghangese: China’s Fedspeak.

On July 29, 2015, China Daily reported on the statement made by the People’s Bank of China the day before. The statement claimed that the central bank would “continue a ‘prudent’ monetary policy in thesecond half [of 2015] while maintaining proper liquidity to stabilize financial market expectations, reducefinancing costs, and keep a stable currency exchange rate.”  Many of the adjectives used in the statements are great leaps of faith in the institution of central banking.

Fedspeak is an English word for the intentional wording of Federal Reserve statements in a manner that could cause different market participants to come to completely different conclusions on the direction offuture policy. The word for central bank in Mandarin is zhōngyāng yínháng, often shortened to Yāngháng when referring specifically to the People’s Bank of China. Given the habit of ending Asian languages or dialects (Japanese, Cantonese, etc.) with the suffix –ese, the Chinese equivalent of Fedspeak would be Yanghangese.

In the statement quoted above, one person’s understanding of the words “prudent”, “proper”, and “stability” are quite different than the intended meaning of those words in the context of Yanghangese. In Yanghangese, the definition of a “prudent” monetary policy is the same monetary policy that initiatedthe largest single-country stock market bubble in history. This policy will be continued, despite the consequences. Similarly, the Yanghangese meaning of “proper” liquidity means whatever amount of liquidity is needed to re-inflate the stock market to its previous high and continue the upward trend in equity prices for at least the next 5,000 years of Chinese civilization. The central bank has facilitated greater inflation in the domestic money supply and pushed interest rates lower against the general trend of higher interest rates in the developing world. Maintaining the exchange rate at about ¥6.2 against the dollar has led to a dramatic decrease in foreign exchange reserves as capital leaves the country. As foreign exchange reserves decrease, more capital will leave the country in anticipation of a greater devaluation than otherwise would have occurred. This will become a self-fulfilling prophecy, but in Yanghangese this arrangement will lead to the maintenance of a “stable” exchange rate.

A proper translation of Yanghangese based on the central bank’s announcement should lead us to expect imprudent monetary policy that will deliver excessive liquidity and higher volatility in the exchange rate value of the renminbi.

Tuesday, August 11, 2015

Yuan Devaluation Causes Offshore Financing Costs to Spike.

The yuan devaluation on August 10, 2015 was the largest single-day devaluation since 1994.  According to the Wall Street Journal, the daily fix was increased from 6.1162 on Monday to 6.2298 on Tuesday, representing a 1.9% devaluation.[1]  What does that mean for China's offshore debt market?

According to Bloomberg, China's corporations have $529 billion worth of offshore debt.[2]  On Monday, that was worth ¥3,235 billion.  On Tuesday, that was worth ¥3,295 billion, representing a ¥60 billion increase in principle.

According to another Wall Street Journal article, the average interest rate for offshore Chinese debt is higher than 8.00%.[3]  At 8.00%, the $529 billion debt burden would require $42.32 billion in interest payments every year.  On Monday, those interest payments were worth ¥258 billion, but by Tuesday had increased to ¥263 billion.  Overnight, the cost of offshore financing for Chinese companies increased by five billion yuan.  Each news article indicates that Chinese companies have not hedged against currency fluctuations.

Sunday, August 9, 2015

2015-07 Stock Market Valuation

In July, the gold price of the Shenzhen Composite fell for a second straight month.  It is now back to where it was in April, but still up 112% over the previous twelve months.  The closing price for July was 0.31 gold ounces, down 0.03 ounces from June.

Up until very recently, all of the factors related to viewing the value of the Chinese stock market in this way were falling into line to inflate the index.  Most importantly, the valuation of Chinese equities was increasing.  After ending 2014 at 34.05 times earnings, the price-to-earnings ratio peaked out on a month end basis at 61.41.  Second, the U.S. dollar price of gold has been declining for four years.  Lastly, the exchange rate with the U.S. dollar has remained stable.

In the coming months, the cashflows of Chinese equities will be further discounted, gold will resume its bull market, and the renminbi will devalue significantly.

Saturday, August 8, 2015

Tourism, Stock Connections, and Renminbi Outflows in 2015.

The impressive appreciation in the renminbi since 2006, despite the rapid increase in the domestic money supply, was justified because of China’s rapidly increasing foreign exchange reserves. Since the renminbi was pegged to the dollar in 1994, the only time China’s foreign exchange reserves decreases over an extended period of time was during the Asian Financial Crisis to bail out the Hong Kong Monetary Authority. Beginning this year (2015), China’s foreign exchange reserves have began to consistently decline.

The South China Morning Post printed two articles discussing trends that will ensure this trend continues. A declining foreign exchange reserve will make it more difficult for the Chinese monetary authorities to maintain the current exchange rate against the dollar.

On August 7, 2015, the South China Morning Post reported:
“Outbound travel, which mainland airlines see as the fastest growth driver this year, is set to outnumber inbound visits to China for the first time in 2015.”
The good news for Chinese is that their increased wealth allows them to travel overseas for business and leisure. The bad news for the Chinese monetary authorities is that as more Chinese visit other countries, more renminbi will be exchanged for foreign currency to be consumed overseas. This will cause a decrease in the amount of physical foreign currency cash in China.

On August 8, 2015, the South China Morning Post reported:
“Average daily turnover of international investors trading Shanghai stocks via the stock connect scheme between Hong Kong and Shanghai has dropped to 8.92 billion yuan (HK$11.12 billion), down 21.47 per cent from the level in June. In July, daily sell orders averaged 113.9 billion against 82.4 billion of buy orders.”
The stock connect scheme currently only applies to Shanghai listed stocks, but will likely be extended to Shenzhen. There are three primary issues that make Hong Kong equities much more attractive than Mainland equities. First, the number of delisted stocks has significantly lowered the number ot tradable equities. According to the same article, after a peak of 900 delisted shares in July, there are still 311 delisted shares in Shenzhen, alone. Second, even after significant declines in price, many of the stocks listed in Shenzhen are still trading 100 times earnings per share. Third, even foreign companies have been impacted by the restrictions on normal market functions. Citadel Securities, a unit of a U.S. hedge fund, announced on Monday (August 3, 2015) that one of its China accounts had been barred from trading during the crackdown on “malicious short selling.” All of these issues will drive more foreign and Chinese capital out of the Chinese capital market and into foreign capital markets, which will facilitate more declines in the foreign exchange reserve.

Thursday, August 6, 2015

Healthy Capital Markets and Doubled Profits.

After the sharp decline in Chinese stock market indexes beginning in mid-June, the Chinese monetary authorities have attempted to bring stability back to the market.  Was the trend the stock market showed before the crash really stability?  Perhaps an overvalued stock market creates just as much damage in the economy as a sharp decline in prices.  The China Business Journal on August 3, 2015 reported on one aspect of how equity prices before the crash distorted financial decisions and the proper functioning of the capital market.
“数据表示,截至6月末,保险公司资金运用余额为103684.49亿元,较年初增长11.11%。其中固定收益类投资中,银行存款和债券合计62322.83亿元,占资金运用余额的比例为60.11%,较年初下降5.17个百分点,同比下降11.19个百分点;权益类投资中,股票和证券投资基金合计15386.11亿元,占比14.84%,较年初上升3.78个百分点,同比上升5.48个百分点。”["According to data for the end of June, insurance companies’ held ¥10.3 trillion worth of working capital, an increase of 11.11% from the beginning of the year. Of that, fixed assets, bank deposits, and bonds accounted for ¥6.2 trillion, or 60.11% of the total, which is a decrease of 5.17 basis points from the beginning of the year and 11.19 basis points from the same period last year. Among equity investments, stocks and securities accounted for ¥1.5 trillion, or 14.84% of the total, an increase of 3.78 basis points from the beginning of the year and 5.48 basis points from the same period last year."]
The same article states that in the first half of 2015, insurance companies made ¥229 billion in profit. That would imply that the stock investments made by insurance companies only need to fall by 15% to wipe out the entire industry’s profits. Maybe insurance companies’ profits should go back to being derived from the insurance business, not stock market speculation.

Wednesday, August 5, 2015

Comment: "When the Real Economy Becomes the Starting Point for Decision Making."

Below the fold of the Economic Observer’s August 3, 2015 edition, an editorial was published with the title “When the Real Economy Becomes the Starting Point for Decision Making” to discuss the Politburo’s meeting on July 30th. The editorial advocated focusing on the need for exceptional entrepreneurs and enterprises to carry the Chinese economy forward and the standard of living of the Chinese people upward. Although the spirit of the editorial is basically correct, one premise was wrong.
“…监管者的使命是建立公平透明的规则,让真正优秀的企业脱颖而出,维护良好的交易秩序,打击内幕交易和坐庄行为,舍此之外,市场并无更多诉求。” [“The duty of the regulators is to establish just and transparent rules so that truly exceptional enterprises can stand out. They should maintain orderly exchanges by prohibiting insider trading. Outside of this, the market requests no more from them.”]
Over the last thirty years of reform, much of the debate and policy measures were focused on how to make China’s vast state-owned resources more efficient. State-owned enterprise reform led to unemployment, but the opportunities produced by private sector growth created a net increase in employment opportunities at higher wages. Even though some people got different pieces of pie, everyone’s piece of the pie got bigger.

Ever since the Great Ease Forward in 2008, artificial credit creation created mal-investments in both the private and state-owned sector. The debate now should not be on allowing exceptional enterprises to succeed on their own, but instead on how to liquidate the mal-investments and bankrupt enterprises so that their assets can be re-organized. This will be a much more painful process, so it is unlikely we will see anything but more of the same.

Tuesday, August 4, 2015

Stability and Gunpowder.

Up until recently, the renminbi was considered more attractive than other currencies, especially the U.S. dollar. The assets that could be bought with renminbi also held allure. This sentiment seems to be changing. An example of this is an article that appeared in the August 3, 2015 edition of the Economics Observer.
过去数周,内地股市的波动令不少投资者惊心动魄。香港市场同样出现波动,可是同样出现波动,可是上市企业的基本面其实并无出现大变。当政府宣布一连串稳定A股市场的措施,包括延迟A股的IPO、上市公司的主要股东不得在一段时间内减持,推动内地大型券商投资蓝筹股,鼓励上市公司、管理层及员工回购公司股份,市场相对稳定下来。 [Over the last few weeks, the volatility in the Mainland stock market has frightened quite a few investors. The Hong Kong market has experienced similar movements, but the basic composition of listed companies has not changed. When the Chinese government announced a series of measures to stabilize the A-share stock market, such as delaying IPOs for A-shares, prohibiting the major shareholders of listed companies from reducing their holdings for a period of time, pushing large brokerages to invest in blue chip companies, and encouraging listed companies, management, and staff to buy back their own company shares, relative stability returned to the market.]
All economic assumptions and theories on human action rely on the principle of ceteris paribus. For some action or event to have a direct and expected impact on some other variable, all other factors must remain equal. This rule seems to always change when government intervention is being evaluated. In the case of the Chinese stock market, the market began to fall in mid-June. The authorities introduced the measured above to stop the decline. Once stock prices stopped plummeting, and on some days even rose, the authorities celebrated their achievement in bringing stability to the market. However, we should not evaluate the effects of a policy as the policy is being implemented. If the measures and guarantees were removed, prices would plummet further. Therefore, we cannot evaluate market stability until the level of government intervention returns to its previous level.

A counterpart to stability is certainty. Government intervention in the market is adding uncertainty, which means the same measures that were meant to maintain stability are precisely the reason more instability will exist in the future.
目前,内地仍然拥有不少刺激经济及股市的弹药,特别对于国际投资者来讲,他们更希望见到内地实体经济及金融市场的基本框架能持续完善,改革道路持续,长线而言将会利好当地股票发展。短期而言,对有兴趣投资中国概念的国际投资者,由于估值较低,企业管治环境较为成熟,港股的确显得更具魅力。 [Currently, the Mainland still has a sizeable amount of gunpowder left to stimulate the economy and the stock market. International investors would rather see continued improvement in the basic foundation of the real economy and financial markets, as well as continued progress on the road to reform. This will benefit the development of Mainland equities over the long term. In the short term, international investors interested in investing in China are more attracted to Hong Kong equities because of their lower valuations and more mature corporate governance.]
After the policies of the People’s Bank of China caused an explosion of misallocated capital, corporate debt, and equity overvaluations, we primarily should be concerned that it still has any gunpowder left.

There are two factors that will aggravate the People’s Bank of China current policies. First, further monetary inflation will decrease the value of the renminbi on foreign exchange markets. It is unlikely that the next domestic credit bubble could attract as much foreign capital as the Great Ease Forward did in 2008, which means any marginal increase in short-term economic activity would be erased by currency devaluation.

Second, the artificial credit created by the People’s Bank of China and the factional reserve state-owned banking system will further delay the necessary adjustments in the real economy. The underlying assets and the cash flows derived from them will be less attractive in the global economy. In the example given above by the author, Hong Kong equities are more attractive than Mainland equities. Not only does a more international renminbi need to compete with foreign currencies, it must compete with the underlying assets that can be purchased with those currencies. In this case, capital employed as Mainland equities denominated in renminbi will be liquidated and then converted into Hong Kong dollars to be re-employed as Hong Kong equities. Thus, as the Chinese stock market goes, so goes the renminbi.

Sunday, August 2, 2015

2015-07 Relative Equity Performance

In July, CHIQ's 12 month performance declined further into negative territory at -9.26%.  CHIQ follows the consumer goods industry in China.  CHIM, an exchange traded fund that tracks the materials sector, also fell from its price reached last July.  It fell -5.96% over the last twelve months.

This is the first time since November, 2014 that both sectors have been in negative territory.  CHIM experienced its largest decline since May, 2014.