Waiting for China's Somprasong Land.

While doing a follow up on the Kaisa default, I came across a Financial Times article titled "Corporate China Goes on a Borrowing Binge", with the sub-line "Despite Some Alarming Numbers, Fears of a Debt Crisis have Dimished".  I couldn't help but feel a sense of déjà vu.

The alarming numbers that the article is referring to is the fact that Chinese corporations have issued $42 billion between the start of 2015 and the end of May, which is the highest year-to-date amount on record.  The total outstanding value of corporate debt is also 11 times higher than it was in January, 2007.

The sense of déjà vu I felt came from the way the business press talked about Thailand in the 1990s.  Below there are two quotes from newspaper articles, one discussing China in 2015 and one discussing Thailand in 1998, after the crash.

"Seven of the top 10 Asian borrowers in the US dollar high-yield market with bonds outstanding are Chinese property developers with low credit ratings. Combined, the group has raised almost $20bn in that market alone."  (Sender, Henry.  "Corporate China Goes on a Borrowing Binge."  June 9, 2015.  Financial Times.)

"The Thai economy was the global capital markets' flavor of the decade, a much favored venue for international investors in search of high returns. But by fixing the baht's exchange rate, the Government encouraged Thais to accumulate debts in foreign currencies. Worse, by fixing the rate in terms of dollars, exports became less competitive as the dollar soared."  (Passell, Peter.  "The Precocious Thai Economy Receives Its Comeuppance."  August 14, 1997.  The New York Times.)

Interestingly, both articles took the time to critique capitalism of some sort.

"This puts an ironic twist on the conventional tale of global capitalism undermined by speculation and short-term thinking. Narcotic-like inflows of capital may have lulled Thailand into complacency. But it was the reluctance of the private market to act that allowed the Thais to dig themselves so deep a hole."  (Passell, Peter.  "The Precocious Thai Economy Receives Its Comeuppance."  August 14, 1997.  The New York Times.)

"For investors in search of high returns, the lure of the Asian high-yield market remains strong despite some of the troubling fundamentals. Their belief in capitalism with Chinese characteristics is an impressive thing."  (Sender, Henry.  "Corporate China Goes on a Borrowing Binge."  June 9, 2015.  Financial Times.)

2015-05 Book Review

Book Review:  Privatizing China, by Carl Walter & Fraser Howie

When a book is written by insiders that shatters existing myths about a certain subject, it is worth reading.  Privatizing China is such a book.  It combines statistical data and analysis into a very enjoyable read on the subject.

Although the book is titled Privatizing China, the authors make it very clear from the beginning:  “In China, the market is operated by the state, regulated by the state, legislated by the state, and raises funds for the benefit of the state by selling shares in enterprises owned by the state” (p. 4).  The authors discuss both the financial and political implications of reforms.

The narrative on China’s financial market is that Chinese savers are fueling China’s market capitalization to be the largest in Asia, if not the world.  As of the book’s publication, official market capitalization figures put China second only to Japan in Asia.  The author’s point out that “if, however, market capitalization is calculated using the prices prevalent in the mergers and acquisitions market in China, China’s markets are only as large as Malaysia’s.  Big difference” (p. 16).  Overvalued tradable shares are being used to value non-tradable shares, thus inflating market capitalization.

The other myth that the authors deconstruct is that of widespread stockownership amongst the general public.  The authors show with data from multiple sources that reports of stock ownership by private citizens are either double counting, counting inactive accounts, or counting fraudulent accounts.  Instead of being an investment opportunity for the middle class, the Chinese stock market is mostly made of large insiders that have vast influence over the market.

One contradiction with this reasoning appears in another part of the text.  The authors claim that the reason A-shares are overvalued is because the average household has very little other investment opportunities.  The authors compare this situation with investors that can buy H-Shares, who have access to almost any kind of investment in different markets (p. 178-179).  If individual investors barely make a dent in the A-Shares market, why would it matter if they have limited alternatives?  Because Chinese individual investors have limited options, it seems as though they should be over-represented in the stock market.

Privatizing China was written by insiders, but tells a different story than the usual narrative.  It backs up statistics with outstanding analysis.  If the book is still available new, buy it new.

2015-05 Stock Market Valuation

The Shenzhen Composite ended May at 0.38 gold ounces, up 179.77% since May, 2014.  The index was trading at a price-to-earnings ratio of 61.41.

The May close of 0.38 gold ounces was the highest price paid in the data series.  The price-to-earnings ratio has yet to catch up to the series high point of 72.97 times in September, 2007.  To repeat that, the gold price would have to increase to 0.45 gold ounces without any increase in earnings.  The price-to-earnings ratio increased faster than the gold price, meaning May's appreciation was driven entirely by higher valuations, not underlying earnings growth.

May's big news story was the decline of Hanergy, Inc.  Although not part of the Shenzhen Composite, Hanergy, Inc. is another example of questionable valuations of Chinese companies.  According to Bloomberg, "Hanergy Thin Film’s market value had at one point risen to more than HK$300 billion. That’s larger than Sony and almost seven times the size of First Solar Inc., the biggest U.S. solar company."  Considering the majority of sales the company books are to its parent, Hanergy Inc. will most likely turn into China's Enron.

The other conversation that began to happen in the mainstream was the amount of margin debt individual investors have access to.  According to Bloomberg:

"About 29 million new stock accounts have opened this year through May 22, almost as many as in the previous four years combined, according to the China Securities Depository & Clearing Corp. Margin debt on the Shanghai exchange has soared more than 10-fold in the past two years to a record 1.35 trillion yuan ($220 billion) on Thursday."

The People's Bank of China has pushed down Shibor and the yield on time deposits, which is pushing money out of savings and investment into stock market speculation.  Eventually, the correction will destroy more wealth than it artificially created.

2015-05 Relative Equity Trends

Both the Chinese materials sector and consumer sector continued their upward movements from last month, with both sectors seeing double digit growth. The materials sector represented by CHIM appreciated 46.23% over the twelve months ending in May. The consumer sector represented by CHIQ appreciated 13.12% over the same time period.

Fosun continued its acquisition binge in May as it offered to buy the remain shares in Ironshore Insurance for US$1.8 billion. Before that deal, it had already made $6.0 billion in acquisitions since the beginning of 2014.[1] Two issues stand out for these deals. The first is that until the Ironshore deal, most of these acquisitions had been financed with debt. The Ironshore deal will mostly be funded by issuing more shares in Hong Kong. Second, even though Fosun is considered part of the materials sector, all of its recent high-profile acquisitions have been focused on consumer spending. Its recent deals or offers have included Portugal’s Caixa Geral de Depositos SA, Italy’s Raffaele Caruso SpA, America’s Meadowbrook Insurance Group Inc., and France’s Club Mediterranee SA.[2] China’s largest private sector company is selling overvalued equities in China to invest outside of China in less-cyclical businesses than it traditionally has dealt with. Perhaps others should take note.

The other business deal of note was the US$298 million that Fujian-based Zijin Mining Group paid for 49.5% of Canada-based Barrick Gold’s Porgera gold mine in Papua New Guinea. Barrick’s statement on the transaction described the reasons for going forward with the deal: “Substantial synergies and value may be realised by bringing to Barrick the expertise and relationships that Zijin offers, including low-cost capital from Chinese institutions, leading Chinese engineering and construction skills, and Chinese machinery.”[3] Does Barrick really need outside help with engineering, construction, or machinery? The first reason, “low-cost capital from Chinese institutions”, was the main driver. The People’s Bank of China’s interest rate manipulation is now creating mal-investments outside of China.

2015-04 Interest Rate Trends

In April 2015, the short-term state sector and long-term private sector showed divergent trends.

The overnight Shanghai Interbank Offer Rate (Shibor) ended April at 1.69%, significantly lower than the 3.18% seen at the end of March. The trailing average rate for April is 2.07%, which means the short-term interest rate is now significantly below the trailing average.

The Wenzhou Comprehensive Index ended April at 19.75%, which is 75 basis points higher than March’s close. The trailing average rate for April is 20.18%, so the current rate is still lower. The spread between the current month end value and the trailing average value has narrowed, however, from March’s 93 basis points to April’s 31 basis points.

Some significant events happened in April to drive these movements. The top three institutions for private lending all reported higher non-performing loans, mostly driven by loans to small private businesses. According to a recent Bloomberg article:

China Minsheng Banking Corp., the nation’s first private lender, has retreated from its small and micro lending business after bad loans from the segment surged about 140 percent in 2014 from a year earlier. […] China Merchants Bank Co.’s bad debts from micro lending more than doubled last year, while China Citic Bank Corp. said its increase in nonperforming loans was mainly due to a “significant” increase in credit risk of private SMEs and sole proprietorships engaged in manufacturing and trade.

Additionally, China’s first private bank began operations at the end of March. According to a recent Global Times article:

Wenzhou Minshang Bank, one of China’s first five pilot private banks, started operations on Thursday, a move which analysts said will help finance the country’s cash-starved small businesses and spur reforms in the financial system. […] The bank completed its first credit business on Thursday, offering a credit loan with 300,000 yuan ($48,285) to Jiangda Electronic Co, a Wenzhou-based electronics and aluminum foil producer.

It is possible that as the small and medium sized businesses with higher credit quality are brought into the formal banking system, the informal credit system is left only to lend to firms with lower credit quality, thus pushing up the risk premium.

2015-04 Relative Price Trends

Consumer prices increased 1.5% year-over-year in April, whereas purchasing prices fell 5.5% over the same period. This marks China’s 41^st month of economic contraction.

Once again, the financial media is asking all the wrong questions to come to the wrong conclusions. Chinese policy maker’s consumer price inflation target for 2015 is three percent. The wisdom of this target is not questioned. Because the current rate of consumer price inflation is half the government’s target, commentators are calling for more monetary stimulus. According to a recent Bloomberg article:

China’s consumer prices in April rose at half the pace the government is targeting for 2015, suggesting the central bank may need to add to its recent monetary easing to spur a pickup in domestic demand.

The wisdom of closing this gap is not questioned. The same Bloomberg article goes on to state that the People’s Bank of China has already reduced interest rates and required deposit reserve rates twice in the last six months. No reason is given for why this did not have the desired effects, nor is there any explanation of how it will help in the future.

Now that China’s consumer price index has been at or below 2.00% for nine months, even government economists are beginning to sense that China is the new Japan.   According to a recent Reuters article:

Wary about following in the footsteps of Japan, where a decade-long fall in consumer prices has hurt the economy, Chinese officials have warned about the danger of deflation, saying a cooldown in inflation to under 1 percent would raise red flags.

However, the current problem is not that declining consumer prices threaten the economy; the previous over-investment in capacity threatened the stability of the economy. Declining consumer prices are the answer to excess capacity, not the cause.

2015-04 Stock Market Valuation

The Shenzhen Composite ended April at 0.29 gold ounces, up 0.03 ounces from March and up 126% from April of last year.  The index was trading at an average price-to-earnings ratio of 49.67.

April’s close, 0.29 gold ounces, was as high as the price paid in August 2007, the peak of the previous bull market in equities.  There has now been 28 months of year-over-year positive price increases, the longest length of time for the data available.

The month-over-month increase in the gold price of the Shenzhen Composite was 9.75%, but the price to earnings ratio only increased 9.64%, meaning the appreciation in stock prices was entirely driven by higher valuations.