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.

2015-04 Book Review

Book Review: Money and Monetary Policy in China, 1845-1895, by Frank H. H. King

It seems as though every book written on money in modern China cites Frank H. H. King’s Money and Monetary Policy in China, so it is worthwhile to go back directly to the source. Readers should be prepared for a very dry, academic book with a level of detail that will test their determination towards the subject.

The title of the book should have been Monies and Monetary Policies in China, meaning the plural as opposed to the singular form. Professor King rightfully notes that “the phrase ‘Chinese economy’ may be misleading,” (p. 20) and “the Chinese monetary system was, in reality, several systems with many common features” (p. 43). Chinese monetary uniformity during that time is wishful thinking started by foreign traders in China, who despised the transaction costs involved with interregional trade, and carried on by contemporary scholars, who have come to the realization that without it their work on early Chinese currency is either one system inaccurately applied to the whole country or an analysis that is so specific to a single region that it is hopelessly irrelevant.

Professor King’s attention to detail in regards to weight, composition, and fineness in currencies issued throughout the country is helpful to scholars on the subject as reference material, but does not make for leisurely reading. In some cases, Chinese monetary units or institutions are referred by a romanized version of their Chinese name. Unfortunately, Wade-Giles Romanization, the system used in the book, is no longer in use. Anyone that learned Chinese on the Mainland after 1958 or outside of China after the 1970s is stuck constantly flipping to the glossary in the back.

Considerable attention is given to the issue of foreigners and foreign money in China. Professor King wrote: “It is in the treaty ports, however, that the problems and developments of most significance in the economic history of China take place […]” (p. 164). The reader is left wondering why the author decided to wait to discuss issues that in his view were most significant problems and developments until well into the second half of the book. The author’s view on the significance of foreign involvement is contradicted by his belief in the introduction that “up to 1895, the accumulated impact of trade, war, diplomacy, missionary activity, and constant foreign pleading for modernization had achieved very little, particularly if Japan be used as the measure” (p. 12). Although foreign coins, banknotes, and banking institutions were models of modernization, none were necessary for a country that was mainly based on barter and an immobile population.

The book has been out of print since it came out in 1965, so readers are limited to used copies. Hopefully a revised addition with Wade-Giles substituted for Hanyu Pinyin becomes available. If that happens, read it.

2015-04 Relative Equity Trends

In April, both the materials section and the consumer goods sections saw tremendous gains as both sectors were lifted by higher equity valuations.  The materials sector appreciated 48.63% since a year ago, which was higher than the 9.89% appreciation saw in the consumer goods sector.  This trend would indicate that the economic expansion that began in June, 2014 is continuing.

The big news in April was the fact that PetroChina saw the lowest profit margin in history.  According to Bloomberg, “Net income at China’s biggest oil and gas producer fell 82 percent to 6.15 billion yuan ($991 million) from 34.2 billion yuan a year ago[.]”[1]  Despite that, “Exxon’s capitalization was $352.6 billion through [April 8, 2015], compared with PetroChina’s $352.8 billion as of 1:36 p.m. on Thursday in Shanghai. The Chinese company’s A shares surged about 61 percent the past year, versus Exxon’s 14 percent drop.”[2]  PetroChina is now more valuable than Exxon Mobil.

In the future, we will look back on this event as a prime example of resource mis-allocation and animal spirits driven entirely by reckless central banks.

2015-03 Interest Rate Trends

In March 2015, both the short-term state-sector and long-term private-sector interest rates decreased. The overnight Shanghai Interbank Offer Rate (Shibor) ended March at 3.18%, a lower rate than the 3.44% seen in February. However, the spread between March’s rate and the trailing average for March was 108 basis points, slightly higher than the gap seen in February. Even though the rate dropped month-over-month, it is still high for March.

The Wenzhou Comprehensive Index ended March at 19.00%. That is 74 basis points lower than February’s close. The spread between March’s number and the trailing average was -93 basis points, which is higher than the rate seen in February.

Both rates are dropping, but the long-term private sector rate is dropping faster than the short-term state-sector rate. The convergence trend seems to be continuing.