Two people look towards high-rise buildings in Kowloon, Hong Kong, in a file photo. The Hong Kong Monetary Authority and Beijing have agreed to launch a cross-border bond connect, granting foreign investors access to the Chinese onshore bond market. (Antony Dickson/AFP/Getty Images)Two people look towards high-rise buildings in Kowloon, Hong Kong, in a file photo. The Hong Kong Monetary Authority and Beijing have agreed to launch a cross-border bond connect, granting foreign investors access to the Chinese onshore bond market. (Antony Dickson/AFP/Getty Images)

Beijing and Hong Kong have approved a new cross-border bond trading program, called bond connect, hoping to attract a new wave of foreign investors to buy Chinese onshore bonds.

The platform is similar in theory but differs in execution to the existing stock connect between Hong Kong and the mainland, which allows foreign investors to purchase mainland stocks. The bond connect will link Hong Kong to Shenzhen’s bond markets and is expected to go live on July 1, the 20th anniversary of Hong Kong’s handover to China.

Beijing hopes the bond connect will legitimize its bond market on the global stage and help diversify bearers of onshore default risk. But immediate success is unlikely, given the existing lukewarm reception of the similar stock connect program and overall investor skepticism of Chinese credit.

Expanding Access

China is the world’s third largest bond market following the United States and Japan, but is largely closed off from foreign investors. It first opened the onshore bond market to foreign investors in February 2016. Under this arrangement, foreign asset managers wishing to purchase such bonds must register locally in mainland China.

The bond connect will officially eliminate that requirement, as firms in Hong Kong will have the ability to purchase onshore bonds at will, without a mainland license.

In a joint statement May 16, the People’s Bank of China (PBoC) and Hong Kong Monetary Authority (HKMA) said that “Northbound trading will commence first in the initial phase, i.e. overseas investors from Hong Kong and other countries and areas (overseas investors) to invest in the China Interbank Bond Market.” The opposite southbound trading, or mainland investors investing in Hong Kong bonds, will commence in the second phase at a later date.

Oppenheimer_bonds1

China is the world’s No. 3 bond market (Source: Oppenheimer Funds)

In theory, bond connect will no doubt expand the market for Chinese onshore bonds and bring in a new wave of investors. “The major advantages of the Bond Connect compared to the existing China Interbank Bond Market scheme are the speed of gaining the access and the fewer onshore account set up needed,” Gregory Suen, investment director of fixed income at HSBC Global Asset Management, told industry publication Fund Selector Asia.

Today, prior to the bond connect, about 473 foreign investment firms are active within China’s onshore bond market with investments totaling 800 billion yuan ($117 billion), according to PBoC estimates. However, the true number of foreign firms holding Chinese debt is less than the official figures, as about 200 of the 473 are investors from the Chinese territory of Hong Kong, which Beijing deems foreign.

To cater to the anticipated trade flow, the Hong Kong Exchanges and Clearing and China Foreign Exchange Trade System formed a joint venture on June 7 called the Bond Connect Company to offer trading and support services to market participants of the bond connect.

‘Not a Case of Build It and They Will Come’

Beijing hopes demand for bond connect from foreign institutional investors will exceed the lackluster enthusiasm investors currently have for the Hong Kong-Shenzhen stock connection, where trading activity remains tepid.

But that’s far from a certainty.

The Hong Kong-Shenzhen stock connect has been open for six months, but logistical and demand issues remain. Clearing and settlement differences between Shenzhen and Hong Kong regulators have caused a sizable portion of trades to fail in recent months, according to a South China Morning Post report. In addition, foreign demand for Shenzhen stocks so far hasn’t met Beijing’s expectations, with the technology-heavy Shenzhen issuers viewed as perhaps too risky for foreign investors.

It’s difficult to see bonds faring better. Despite Beijing’s opening up the domestic bond market to foreign investors last February—with no approval necessary as long as the investor has a local registered entity—foreign ownership of China’s bond market remains tiny.

At the end of 2016, foreign holdings of onshore bonds are only 1.3 percent of total market value, according to estimates from the Financial Times

That means investors don’t believe the investment returns on Chinese bonds are enough to justify the heightened default risk of owning Chinese debt, which has fueled much of China’s recent economic growth and today sits at almost 260 percent of GDP, according to ratings agency Moody’s Investors Service.  

Looking past macro issues, individual bonds are also notoriously hard to evaluate for foreign investors.

The industry standard global credit rating agencies of Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings are barred from operating in China. Chinese bonds are instead rated by domestic ratings agencies, which are viewed by foreign investors with distrust for granting overly generous credit ratings. In other words, it’s difficult to assess the credit-worthiness of Chinese issuers because information on bonds is unreliable.

Oppenheimer_bonds2

Investors believe Chinese domestic credit rating agencies have tendencies to give out overly generous ratings to bond issuers (Oppenheimer Funds).

“For foreign investors, it’s not a case of build it and they will come,” concluded Rachel Ziemba, Managing Director at Roubini Global Economics, on CNBC. “They want to understand, they want to be paid for the risks they are taking on. In an environment where interest rates are rising in China, where the property market is flattening out a bit, that question mark about more information and drivers is going to be very important.”

The new U.S.-China trade deal signed during Chinese Communist Party leader Xi Jinping’s visit with U.S. President Donald Trump in April outlined a path for the U.S. credit rating agencies to begin operations in China later this year.

To foreign investors, that’s a step in the right direction, while also introducing new challenges. Foreign credit agencies will operate under supervision of Chinese securities regulators. During times of economic duress, can they remain independent and objective?

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Customers and real estate agents look at several building models at a real estate exhibition in Jiashan, Zhejiang province, in a file photo. (AFP/AFP/Getty Images)Customers and real estate agents look at several building models at a real estate exhibition in Jiashan, Zhejiang province, in a file photo. (AFP/AFP/Getty Images)

When China’s richest man and its most successful real estate developer calls the country’s overheating property market “the biggest bubble in history,” it’s probably not a good sign.

But that’s exactly what Wang Jianlin, billionaire owner of Dalian Wanda Group and Communist Party insider, said in an interview with CNN last week. “The government has come up with all sorts of measures—limiting purchase or credit—but none have worked,” he told CNN.

Average new housing prices across China increased 1.3 percent in August from July, according to state data, which was the 17th consecutive monthly jump. September was also the biggest one month increase since early 2011.

The Shanghai Composite Index has declined 15 percent since Jan. 1. If the trend continues, 2016 would be the biggest drop in five years. But volume on the exchange is also down—to the lowest level in two years—signaling that investors are pouring their money elsewhere after the scare of last year’s market crash.

In 2016, China’s property sector has been the biggest beneficiary.

At a macro level, Chinese retail investors are akin to children at a soccer match; they’ll simply swarm to where the action is. And over the last several years, the action mostly seesawed between equities and real estate, with an occasional interest in commodities.

Real estate is the hot market right now, to the point where experts—inside and outside China—are sounding the alarm.  

Ma Jun, chief economist at the People’s Bank of China’s research arm, recently called the property market a bubble in an interview earlier this month with Yicai.com.

People’s Daily, the Chinese Communist regime’s mouthpiece, published an editorial last week expressing deep concern about the frothing property market. “Looking at the current average price [of real estate] and personal income in Shenzhen, it would take an average person more than 1,200 months—that is, 100 years—of not eating or drinking to afford a 90 square-meter house,” wrote investor Tang Jun, regarding the unaffordability of Shenzhen real estate.

“China has become an economic power, but the real estate market is a landmine, and the most frightening is that no one knows when it will detonate.”

Dangerous Business Model

Low interest rates mean that even cash-strapped developers can leverage up by way of the relatively cheap onshore bond market. And property developers have been aggressive, putting little thought into their land purchases.

Economists at Deutsche Bank AG pointed out that a “clear sign of a bubble” rests in the fact that land auction prices have become so inflated that the business models of new developments only make economic sense if property prices keep rising at today’s pace.

It’s a line of thinking prevalent amongst investors before the U.S. mortgage crisis a decade ago, where lenders disregarded risks of default or foreclosure by assuming the ever-rising housing prices would cover any losses.

Deutsche_Bank_ChinaHousing

Price sensitivity of recent land auctions in top 10 Chinese cities. (Deutsche Bank)

After studying recent land auction prices at ten major cities, Deutsche Bank analysts believe that if real estate prices remain flat from today, half of current developments would lose money. Zhang Ziwei, Deutsche’s chief China economist, thinks a severe correction could arrive in 2018.

Regime Ambivalence

But the Chinese Communist regime has been halfhearted, at best, when trying to tame the market.

Local and regional governments instituted tightening measures at the transactional level such as capping prices, limiting the number of properties per household, and restricting non-local buyers from purchasing by closely examining residence (“hukou”) records.

Localities have taken different approaches. Shanghai, for example, decided to suspend land auctions. Other cities, such as Guangzhou, chose to cap prices. The tactics largely backfired as determined buyers found other channels to secure real estate.

The issue is that authorities have been reluctant to address a main cause of rising housing prices—easy money.

Much of the easy credit has been tied up in the real estate market. State data showed that in August, 71 percent of new bank loans went to household mortgages, instead of to the small to medium-sized businesses whom Beijing hopes would drive the economy.

Authorities have been reluctant to address a main cause of rising housing prices—easy money.

But it’s too simple to lay the blame on rate and regulatory policy nationally—China is increasingly a country with two divergent economies.

Much of the talk regarding a real estate bubble is in regards to Tier-1/Tier-2 cities and China’s coastal regions where real estate is perceived as safer, relative to other onshore investments.

Elsewhere in China, there is excess inventory and the housing market is mired in a years-long slump. This is especially true in Northern and Northeastern China where the economy—reliant upon coal and steel industries—has been in decline.

After years of overbuilding, provinces of Inner Mongolia, Liaoning, and Jilin all have supply-to-sales ratios of more than four years, according to London-based Lombard Street Research. That means it would take more than four years to sell the number of available homes, at current rate, assuming no new properties would be built. That same metric in the United States is 4.6 months as of August, according to data from the St. Louis Fed.

LSR_ChinaProvinces

China real estate supply-to-sales ratios by province. (Lombard Street Research)

“Provinces with severe overbuilding (with an excess supply-to-sales ratio of more than three years) accounted for 20% of total residential investment over the past five years,” wrote Michelle Lam of Lombard in a research note.

“Housing construction in those provinces has already shrunk over the last two years and will continue to contract for another couple of years, acting as a significant drag on overall residential investment growth.”

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September 27, 2016

People work at an offshore oil engineering platform in Qingdao, China, July 1, 2016.  According to the independent China Beige Book survey, the economy has stabilized, but this improvement comes at a price.
(STR/AFP/Getty Images)People work at an offshore oil engineering platform in Qingdao, China, July 1, 2016.  According to the independent China Beige Book survey, the economy has stabilized, but this improvement comes at a price.
(STR/AFP/Getty Images)

Nobody believes the official Chinese economic data, but people still have to use it in their analysis because there aren’t many good alternatives. 

The official data for 2016 tells us real estate in China is bubbly, credit is growing by leaps and bounds, manufacturing activity is bouncing back, and State Owned Enterprises (SOEs) are investing like there is no tomorrow, while their private counterparties are slamming their wallets shut.

In the meantime, profits at most companies are hurting. Struggling to repay their massive debts, some of them have even folded and gone out of business.

So if the official data is unreliable, what is really going on? Fortunately, we have the China Beige Book (CBB) to tell us what’s happening on the ground—and this quarter’s findings largely back the official narrative.

On the Ground Data Backs Up Stimulus Theory

CBB collects data from thousands of Chinese firms every quarter including some in-depth interviews with local executives and bankers. Although the CBB does not give definitive growth numbers, it logs how many companies increased their revenues or how many laid off workers, for example.

Most importantly, the CBB report for the third quarter of 2016 backs up the claim the Chinese regime resorted to old-school stimulus to keep employment from collapsing, thus pouring cold water over the hopes of a rebalancing to a consumer and services economy. 

“The growth engines this quarter were exclusively ‘old economy’—manufacturing, property, and commodities. The ‘new economy’—services, transportation, and especially retail—saw weaker results,” the reports states.

(China Beige Book)

(China Beige Book)

In sync with the official manufacturing indicators, the China Beige Book reports revenue increases at 53 percent of manufacturing companies, a full 9 percentage points higher than last quarter.

The property sector is red-hot according to official data with double-digit price and sales increases. Accordingly, CBB reports 52 percent of companies increased their revenues, 4 percentage points more than last quarter.

More Debt

Both manufacturing and property rebounded because of an increase in debt and infrastructure investment, mostly for home mortgages as well as investment by SOEs. 

“The number of firms taking loans leapt off the floor we’ve seen for the past three quarters to its highest level in three years,” CBB states. 

According to official data, bank loans grew 13 percent in August compared to a year earlier and the CBB reports 27 percent of companies increased their borrowing, a full 10 percentage points more than the quarter before. 

“If sales and prices continue to rise in the fourth quarter, it will be due to yet more leveraging,” CBB says about real estate. According to People’s Bank of China (PBOC) data, household loans made up 71 percent of new bank loans in August. 

(Capital Economics)

(Capital Economics)

The report also confirms that SOEs invested the most with 60 percent of them increasing their capital expenditure, up 16 percentage points from the second quarter.

“Impatient for stronger growth, Chinese policymakers were likely to shelve their
rebalancing goal, and ‘double-down’ on investment-led growth,” Fathom Consulting stated in a recent report on China. The numbers on the ground confirm this assessment.

Conversely, smaller private companies did not invest much at all. The smallest companies increased investment in 34 percent of the cases, compared to 44 percent the quarter before.

“While we still see bank borrowing … as the most important driver for infrastructure in the near to mid-term, we expect its sustainable growth to hinge upon more private capital involvement,” the investment bank Goldman Sachs writes in a report.  

Price to Pay

This centrally planned strategy comes at a price, however. “CBB data show profits and cash flow deteriorated, casting a pall over recorded increases in borrowing and investment,” the report states with only 45 percent of companies reporting an increase in profits, compared to 47 percent last quarter. CBB also points out that cash flow deteriorated across the board, explaining the rise in company defaults this year.  

The main reason for this renewed stimulus, according to the CBB, is the Chinese regime’s fear of unemployment, which started to show up in CBB data in the second quarter. The official unemployment rate is infamously unreliable because it has been staying at 4 percent for the last ten years. 

So after this quarter’s offensive in investment, 38 percent of companies said they hired more people in the third quarter. “Hiring was again strong and it is fair to say this is the single most important issue for the central government,” CBB states.

But buying a bit of growth and employment with a bit of credit is an old trick? What about the much-touted rebalancing and reform?

“A more service-oriented economy will give rise to higher share of labor income in GDP, but a more redistributive fiscal policy is necessary to bring down income inequality, and provide more equal opportunities to both urban and rural households,” the International Monetary Fund (IMF) wrote in a recent report.

Alas, the CBB data on the ground does not confirm this is happening at all. If anything, the third quarter was a step back. 

“Services, transport, and especially retail saw profits hit hard on-quarter,” CBB states. Only 53 percent of services companies reported an increase in earnings, compared to 57 percent in the last quarter. 

 

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Pedestrians walk past the People's Bank of China on July 8, 2015. The central bank on Sept. 23 approved interbank trading of credit default swaps. (Greg Baker/AFP/Getty Images)Pedestrians walk past the People's Bank of China on July 8, 2015. The central bank on Sept. 23 approved interbank trading of credit default swaps. (Greg Baker/AFP/Getty Images)

China has a debt problem, and it’s desperate enough to employ drastic—and dangerous means—to counter it.

Chinese regulators on Sept. 23 approved trading of a complex financial derivative called credit default swaps (CDS) that provides investors insurance against defaults. The move signals that Beijing may finally allow more delinquencies and even bankruptcies of state-owned enterprises.

But such swaps are a dangerous double-edged sword. The CDS market expanded in the United States before the global financial crisis. Their widespread use in speculation, lack of transparency and regulation, and complexity exacerbated the effects of the crisis and contributed directly to the collapse and bailout of insurer AIG in 2008.

PBOC outlined rules of engagement for usage of CDS after weeks of consulting with banks and brokerage firms across China. The regulator had considered approving the swaps in 2010, but as bond defaults were relatively unheard of before 2014, the market had little appetite in trading CDS.

Default swaps have been in existence in the West since its creation by J.P. Morgan in the mid-1990s. At its core, CDS allows a party to buy or sell (write) insurance that pays if a company fails to repay interest or principal. Similar to an insurance contract, the party buying the swap pays premiums, while the party selling the swap receives the premiums. In the event of default or other credit event the seller must compensate the buyer by an amount specified in the CDS contract, usually the difference between price at time of contract and the ending price.

Beijing has never been comfortable in allowing companies, especially state-owned enterprises (SOEs), to default on their bonds. This isn’t to protect investors per se; any company defaulting on its debt is effectively barred from raising new debts, thus preventing access to crucial working capital as many SOEs are effectively insolvent otherwise.

Local and regional governments—which rely on SOEs to provide jobs, tax revenues, and local economic growth figures—often step in to help struggling firms repay bonds. But since last year, local governments’ ability to help has been diminished due to slowing economic growth and weakening real estate prices.

More Defaults Ahead

So how does China plan to use CDS’s to help its debt problem? First, swaps lessen the pressure for Chinese authorities to act as initial backstop on bond defaults, as investors using CDS to hedge their bonds would, in theory, be protected.

Secondly, the allowance of CDS’s gives banks and brokerages a way to hedge their portfolio of loans and non-performing loans. “To have CDS is a very good thing because, so far, there are no meaningful hedging tools in the domestic market. The market has high demand for such instruments,” Liu Dongliang, an analyst at China Merchants Bank, told Bloomberg last week.

China_default

(The Epoch Times)

Analysts also believe the decision is a sign that the Chinese Communist regime may allow more bond defaults. That’s the main raison d’être. After all, if authorities don’t believe the rate of bond defaults would increase, there wouldn’t be a need to introduce such insurance contracts.

And there’s increasing evidence to support that conclusion. Nine months after Guangxi Nonferrous Metals Group defaulted on its bonds, the provincial court on Sept. 12 allowed the metals company to go bankrupt and liquidate. It’s a momentous decision—the company became the first Chinese SOE allowed to liquidate after defaulting on bonds.

So far, there are no meaningful hedging tools in the domestic market.

— Liu Dongliang, China Merchants Bank

More companies similar to Guangxi Nonferrous Metals—lower tier companies in remote regions and supported by local governments—are expected to default. “It is very important to recognize that not all SOEs are equal in their likelihood of receiving support,” said Ivan Chung, Moody’s Associate Managing Director.

“If you look forward three to five years, it seems more and more probable that local government entities will need to increasingly stand on their own and the likelihood of substantial government support will gradually recede for those not providing a public goods or service linked to national priorities as their sole or predominant purpose,” Chung said.

Passing the Credit Hot Potato

The Chinese financial sector has reason to applaud a liquid CDS market. But there is a big question left unanswered: who will write the swaps and in turn, assume risk of default?

Will they be the banks, the state-directed asset management companies, or perhaps the insurance companies who have an unenviable mandate to protect the pensions of millions of Chinese workers? Beijing talks a lot about “sharing” the risk of default—is it simply looking to shift the risk of default from various levels of government to the banking and the insurance sectors?

There are a host of other challenges to work through. What will the legal framework around swaps look like for China? The International Swaps and Derivatives Association (ISDA) has simplified most of the language and terms around “plain vanilla” CDS contracts in Western markets. Western investors in China would likely demand more clarification on enforcement and settlement of swaps.

Pricing volatility could be another landmine for CDS investors and regulators. The spread, or price the protection buyer must pay over the notional value of the referenced bond, will be extremely hard to determine for Chinese swaps. The likelihood of local or regional governments to step in and prevent defaults is unpredictable, and such possibilities could result in wild price swings. 

Creation of a New Problem?

Credit default swaps also introduce undesirable consequences, which led Warren Buffett to describe such instruments as “financial weapons of mass destruction.” Many of these effects exacerbated the 2007-2008 global financial crisis.

Swaps can easily be used by speculators to bet on defaults, due to the relatively small outlay necessary to make a wager. A party who does not own a particular bond can bet on its default by entering into a naked CDS, as long as there’s a taker on the other side of the contract. Buying a naked CDS is akin to taking out life insurance on one’s ailing neighbor—it creates unnecessary moral hazard to inflict further damage on an already tenuous SOE bond market.

China must think about how to regulate its CDS market. If left unchecked, naked swaps would compound shocks to the financial market in the event of mass defaults. A naked CDS holder need not own the referenced bond. So if a bond defaults, the losses are not just limited to the holders of the bond itself, but potentially thousands of other banks, insurance companies, and other investors who may have written swaps on the same bond.

CDS’s can also distort the market and hide true concentrations of risk from regulators. Leading up to the financial crisis, AIG’s Financial Products unit underwrote default swaps on more than $440 billion worth of asset-backed securities. When such securities defaulted en masse, the insurance giant was suddenly saddled with liabilities it could not pay, ultimately bringing about its collapse and $180 billion in government bailouts.

On top of managing credit risk, investors also must monitor counterparty risk to determine whether the seller of the CDS (counterparty) is able to pay up in the event of a default. In AIG’s case, it was not, and thousands of investors who previously thought their risks were completely hedged suffered a rude awakening when AIG collapsed.

Swaps can spread around the risk of default, but they add another layer of complexity for investors and a mountain of problems for regulators.

As Beijing readies a new way to deal with its debt crisis, it may have inadvertently sowed the seeds of a future crisis.

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Chinese yuan notes at a branch of the Industrial and Commercial Bank of China (ICBC), on March 14, 2011 in Huaibei, China. The Chinese government is now spending up to 15 percent of GDP on fiscal stimulus. (ChinaFotoPress/Getty Images)Chinese yuan notes at a branch of the Industrial and Commercial Bank of China (ICBC), on March 14, 2011 in Huaibei, China. The Chinese government is now spending up to 15 percent of GDP on fiscal stimulus. (ChinaFotoPress/Getty Images)

For years the world has marveled at China’s foreign exchange reserves ($4 trillion at their peak in 2014) and low government debt, 21 percent of GDP at the end of 2015.

This is about to change, however, as fiscal spending was up 15.1 percent in the first half of 2016 to counter a slowing economy and achieve the official GDP growth target.

“China’s growth rebound in the first half of this year has been strongly supported by an active fiscal policy that has significantly front-loaded on-budget spending and fostered strong growth in off-budget investment in infrastructure,” Goldman Sachs writes in a note to clients.

 

China's debt distribution (Macquarie)

China’s debt distribution (Macquarie)

The government says the deficit on this year’s budget is only about 3 percent of GDP. Some central bankers want to boost it to 5 percent because they think monetary policy alone won’t be able to hold the economy together.

If they are trying to resist a debt-induced slowdown with more debt and by wasting room on the central government’s balance sheet, I’m afraid China is heading for a fate worse than Japan.

— Worth Wray, STA Wealth Management

Also, people are starting to look at Chinese government debt differently. According to Goldman Sachs estimates, China’s total fiscal deficit is approaching 15 percent rather than 3 or 5 percent.

“We try to ‘augment’ the official fiscal policy measures by incorporating off-budget quasi-fiscal policy to obtain a comprehensive picture of the stance of China’s fiscal authority,” Goldman Sachs writes.

China's total fiscal deficit according to Goldman Sachs calculations (Goldman Sachs)

China’s total fiscal deficit according to Goldman Sachs calculations (Goldman Sachs)

To get to the 15 percent, Goldman looks at infrastructure spending in total, which is driven by the central government, State Owned Enterprises (SOE), or local governments. SOEs are in debt to the tune of 101 percent of GDP and local governments through their off balance sheet finance vehicles have about 40 percent of GDP. 

“Specifically, we sum up the fixed asset investment in sectors such as transport, storage, and postal service, and water conservancy, environment and utility management. We assume most of the spending in these sectors is heavily state-driven,” the bank writes, noting that the analysis is not complete but provides a good proxy.

 

The recent burst in investment was carried out by Chinese State Owned Enterprises (Capital Economics)

The recent burst in investment was carried out by Chinese State Owned Enterprises (Capital Economics)

The theory holds up when looking at charts of fixed asset investment by the state sector, which zoomed ahead at the beginning of the year, but has recently pulled back.

Public Private Partnerships

Because investment by private companies has turned negative, the regime is trying to continue fiscal stimulus and get the private sector involved through so-called public-private partnerships (PPP).

According to Xinhua, China wants to fund 9,285 projects worth $1.6 trillion in infrastructure projects such as transportation or public facilities like sports stadiums. According to the National Development and Reform Commission (NDRC), $151 billion of these projects have been signed at the end of July 2016.

SOEs are also central to the issue of over-capacity.

—  Goldman Sachs

Investment bank Morgan Stanley doesn’t think the initiatives will succeed, however. 

“We expect PPP to have limited impact on China’s investment growth, considering the small size of PPP projects in execution, still low private participation, and weaker [credit] growth,” Morgan Stanley writes in a note.

So it looks like SOEs will have to do the heavy lifting again, despite mounting bankruptcies and abysmal returns on investment. 

“SOEs are also central to the issue of over-capacity. According to an official survey, the average capacity utilization ratio in the manufacturing sector was 66.6 percent in 2015, declining by 4.4 percentage points compared to 2014. Most of the sectors facing over-capacity issues are dominated by SOEs, such as steel and coal,” writes Goldman.

Worth Wray, the chief strategist at STA Wealth Management thinks short-term motives could be behind the burst in spending this year.

“If this is about buying time, until after the G20 meeting in September, after the yuan’s inclusion in the International Monetary Fund (IMF) reserve currency basket in October, and after the U.S. presidential election in November. Then I can understand why massive fiscal and credit stimulus in 2016 could make sense.”

Long-term, however, this strategy won’t be sustainable, according to Wray: “If they are trying to resist a debt-induced slowdown with more debt and by wasting room on the central government’s balance sheet, I’m afraid China is heading for a fate worse than Japan.”

So will the spending spree continue? Goldman says yes—the government wants to hit its official GDP target for 2016.

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Workers distribute packs at S.F. Express in Shenzhen, China, on Nov. 11, 2013. Private companies in China have stopped to invest in further expansion in 2016. (ChinaFotoPress/ChinaFotoPress via Getty Images)Workers distribute packs at S.F. Express in Shenzhen, China, on Nov. 11, 2013. Private companies in China have stopped to invest in further expansion in 2016. (ChinaFotoPress/ChinaFotoPress via Getty Images)

Previously the engine of relatively efficient growth, it looks like the private sector has given up in China. Investment by private companies went negative in June and decreased another 0.6 percent in July. That’s right, negative growth month over month, something completely unfathomable during the boom years of above 20 percent growth just a few years ago.

“We believe private [investment] slowdown is more structural this time, dragged by weaker investment return and falling business confidence amid limited reforms and deregulation. Strong State Owned Enterprise (SOE) investment is unlikely to fully offset the weakness, instead, it could create more excess capacity and deteriorate capital returns,” the investment bank Morgan Stanley writes in a note.

For the first half of 2016, private investment is only up 2.4 percent over the year. This is worrying because the private sector is responsible for most of China’s real economic development and relatively efficient capital allocation. 

The government will try to coopt the private sector into spending through monetary and fiscal policies.

— Viktor Shvets, global strategist, Macquarie Securities

To balance the decline in private investment, the state used SOEs as countercylical fiscal policy instruments. SOE’s share of investment in fixed assets rose 23.5 percent compared to the first half of 2015. Because of inefficient investments from years prior, overcapacity, and mounting defaults, Morgan Stanley thinks this is ill advised. 

 

(Morgan Stanley)

(Morgan Stanley)

Morgan Stanley notes that private companies are avoiding sectors such as mining and steel, which are plagued by overcapacity. But they also cannot invest in the service sector as they please because of high entry barriers and too much regulation.

Private investment outside of manufacturing—read services—declined 1.1 percent in the first half of 2016 over the year, compared to 15 percent growth in 2015. SOEs, on the other hand, boosted investment in services 39.6 percent.

So much for a successful rebalancing to services, which has been considered a linchpin of the effort to reform the Chinese economy. It’s happening, but at the behest of the state.

 

 

(Morgan Stanley)

(Morgan Stanley)

Overall, there just aren’t enough good investment opportunities around and the borrowing costs for private firms are as high as 15 percent, much higher than the return on assets. Unlike their state-owned counterparts, private companies actually try to be profitable—and they don’t see profits in China’s slowing economy.

In addition, the lack of progress in the much-touted reform agenda hurts business confidence and financial visibility. Zhang Qiurong, who owns a specialty paper business told the Wall Street Journal: “The economic outlook is really grim. You have to survive, that comes first.”

Mr. Zhang’s feelings are reflected in the China Economic Policy Uncertainty Index, which has been increasing steadily in 2016, almost reaching the record levels of uncertainty seen during the last handover of Communist Party leadership in 2012.

The economic outlook is really grim. You have to survive, that comes first.

— Zhang Qiurong

The result of the uncertainty? Companies are stashing money at the bank and just won’t spend and invest it. 

“Despite loads of liquidity pumped into the market, enterprises would rather bank the money in current accounts in the absence of good investment options, which is in line with record low private investment data,” Sheng Songcheng, head of statistics and analysis at the People’s Bank of China said earlier this year. Cash and short-term deposits at banks grew 25.4 percent in July.

To counter concerns of crashing private investment in China, the regime promptly announced private-public partnership (PPP) investment programs worth $1.6 trillion and spanning 9,285 projects, first reported by Xinhua on Aug. 15.

“The government will try to coopt the private sector into spending through monetary and fiscal policies,” says Viktor Shvets, global strategist at Macquarie securities.

The problem is that this strategy is unlikely to work. 

“The impact of PPP on China’s investment growth is likely to be limited, considering the small share of PPP projects in execution (less than 0.5% of total [investment]), the still low participation ratio by private investors … International experience shows that private financing of public investment entails large fiscal risks in the absence of a good legal and institutional setup,” writes Morgan Stanley. And a good legal and institutional set-up is not what China is known for.

If the PPP and short-term monetary and fiscal stimulus won’t work, China actually has to deliver on reforms to get the private sector to spend again. 

 

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A Chinese steel worker walks past steel rods at a plant on April 6, 2016 in Tangshan, Hebei province, China. (Kevin Frayer/Getty Images)A Chinese steel worker walks past steel rods at a plant on April 6, 2016 in Tangshan, Hebei province, China. (Kevin Frayer/Getty Images)

One year after the mini-devaluation of the Chinese currency, China is getting desperate about its corporate debt situation and is directives to evergreen loans. According to an Aug. 8 Caixin report, the banking regulator is now telling banks to get rid of bad bank debt by swapping it for equity.

Local media Caixin reports that the China Banking Regulatory Commission (CBRC) issued a directive to encourage government owned so-called Asset Management Companies (AMC) to buy bad loans from banks. This exercise worked well during the last banking bail-out at the beginning of the millennium and China has prepared itself for another round since 2012, when local governments started to set up 27 new AMCs. 

Instead of keeping a loan that a company can’t repay and writing it down, the bank would get an equity stake in the company. Because banks aren’t allowed to hold equity in companies, they would sell the equity stake to an AMC at a price the bank can afford without hurting bank equity too much. AMCs would get the money from local or the central government or the central bank. 

The directive says that firms in the troubled steel and coal sectors will be the first to try the arrangement. However, only companies should be supported which have made efforts to cut overcapacity and improve profitability and whose problems are temporary, similar to another directive by the CBRC and first reported by Chinese National Business Daily about rolling over defaulted loans. 

(Société Générale)

(Société Générale)

“A Notice About How the Creditor Committees at Banks and Financial Institutes Should Do Their Jobs” tells banks to “act together and not ‘randomly stop giving or pulling loans.’ These institutes should either provide new loans after taking back the old ones or provide a loan extension, to ‘fully help companies to solve their problems,’” the National Business Daily writes.  

The recent leaks in relatively quick succession may be proof of hedge fund manager Kyle Bass’s concern of “the Chinese corporate bond market freezing up,” as he said in an interview with RealVisionTV in June. “We are seeing the Chinese machine literally break down.

“In the West, the speculation is always about the Lehman moment in China. That is a Western fantasy. Chinese politicians know what’s coming up and have a plan to manage the bad loans,” Horst Loechel, an economics professor at the Frankfurt School of Management told the Wharton Business School. Evergreening and debt for equity swaps seem to be that plan.

Kyle Bass estimates bad loans in Chinese banks could lose up to $3 trillion in bank capital if all loans were properly written down. 

In transactions from 2015, where banks sold defaulted loans to AMCs in Zhejiang province, they only received 32 percent of their original value, down from 43 percent in 2014 according to a regional AMC manager quoted by Caixin.  

The announcement comes in the wake of seven government-owned coal miners in Shanxi being allowed to extend maturities on existing debt, according to state mouthpiece Xinhua, a shipbuilder failing to make a payment on a $60 million one-year bond on Aug. 8 according to Bloomberg, and a developer defaulting on a $380 million offshore bond in Hong Kong, according to the Wall Street Journal. 

For good measure, the National Association of Financial Market Institutional Investors (NAMFII), an organization backed by the central bank, has enquired with major banks and brokers to see whether it would be possible to roll out a credit default swap market in China, according to the Wall Street Journal. Credit default swaps are insurance contracts on bond defaults, precisely what China needs right now.

According to the report, the regulator responsible for the $8.5 billion corporate bond market with soaring defaults, is drafting rules to make Chinese CDS compliant with international practices. The Journal reports that the regulator will soon ask the People’s Bank of China (PBOC) for approval.

After 39 defaults this year totalling $3.8 billion, it is about time. 

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A worker of an Industrial and Commercial Bank of China Ltd (ICBC) branch counts money as she serves a customer on  September 24, 2014. (JOHANNES EISELE/AFP/Getty Images)A worker of an Industrial and Commercial Bank of China Ltd (ICBC) branch counts money as she serves a customer on  September 24, 2014. (JOHANNES EISELE/AFP/Getty Images)

On the surface, China is talking the reform talk. But is it also walking the walk? There are many examples to demonstrate it isn’t. The most recent one is a directive from the China Banking Regulatory Commission (CBRC) to not cut off lending to troubled companies and evergreening bad loans. This first reported by The Chinese National Business Daily on Aug. 4.

“A Notice About How the Creditor Committees at Banks and Financial Institutes Should Do Their Jobs” tells banks to “act together and not ‘randomly stop giving or pulling loans.’ These institutes should either provide new loans after taking back the old ones or provide a loan extension, to ‘fully help companies to solve their problems,’” the National Business Daily writes. 

“It’s big news. A couple of weeks ago they were threatening Liaoning Province to cut off all lending to them if they didn’t tighten loan standards,” said Christopher Balding, a professor of economics at Peking University in Shenzen. “This is a pretty significant turn-around for them to do and it indicates how significant the problem is.”

To say it so publicly or bluntly is amazing

— Christopher Balding, professor, Peking University

The official reform narrative is espoused in this Xinhua piece which claims China has to reform because there is no Plan B. “Supply-side structural reform is also advancing as the country moves to address issues like industrial overcapacity, a large inventory of unsold homes and unprofitable ‘zombie companies.’” Clearly resolving the bad debt of zombie companies is not high on the priority list.

Goldman Sachs complained in a recent note to clients that companies can default on payments and often nothing happens. The investment bank notes that companies like Sichuan Coal default on payments of interest and principal for weeks or months and then maybe pay creditors later. The company in question defaulted on 1 billion yuan ($150 million) worth of commercial paper in June but made full payments later during the summer, a somewhat arbitrary process.  

Another case is Dongbei Special Steel, which missed at least five payments on $6 billion of debt since the beginning of the year, but has done nothing to resolve the problem. This is why creditors wrote an angry letter to the local government to help resolve the issue.

Going forward, we do expect this trend to continue.

—  Goldman Sachs

According to Goldman Sachs, Dongbei was the reason Liaoning Province came under pressure:

“A bondholders meeting took place … with bondholders requesting that the [regulators] halt fundraising by the Liaoning provincial government and the enterprises in Liaoning province, and that institutional investors should stop purchasing bonds issued by the Liaoning government and the enterprises in Liaoning province. According to news reports, this demand stems from disappointment in progress by the provincial government in resolving Dongbei Special Steel’s debt problems, with a lack of information and no clear resolution plan.”

“Going forward, we do expect this trend to continue, with more defaults given our expectation of slower growth in the second half, and continued uncertainties on how these defaults are resolved.”

With the blessing of the regulator, Goldman’s prediction is probably correct. The investment bank notes that 11 out of 18 high-profile defaults have not been resolved since the first official default of a Chinese company by Chaori Solar in 2014.   

(Goldman Sachs)

(Click to enlarge. Source: Goldman Sachs)

Christopher Balding thinks the directive shows how serious the debt situation has gotten. “This does indicate that there is a relatively significant pressure on the system and people aren’t making their payments. ‘Look, don’t rock the boat and push people into default.’ To say it so publicly or bluntly is amazing.”

The notice did include a modifier stating that the companies to be supported “must have a good outlook in terms of either their products or services and have restructuring values,” and that the “the development of the companies should be in line with the macro-economic policy, industrial policy and financial supporting policy of the country.” How serious banks will take this modifier is open to debate. 

Overall bankruptcies in China have surged 52.5 percent in the first quarter of 2016 compared to a year earlier with 1028 cases being reported by the Supreme People’s Court. Most cases that are resolved involve small companies with few employees. The small firms are liquidated rather than restructured, according to the Financial Times. As we have seen there is another measure applied to larger companies, much to the dismay of Goldman Sachs:

“A clearer debt resolution process … would help to pave the way for more defaults, which in our view are needed if policymakers are to deliver on structural reforms.” If they want to deliver.  

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A man reads a newspaper report that China's central bank announced it will devalue China's tightly controlled currency on Aug. 11, 2015 following a slump in trade, triggering the yuan's biggest one-day decline in a decade. (AP Photo/Andy Wong)A man reads a newspaper report that China's central bank announced it will devalue China's tightly controlled currency on Aug. 11, 2015 following a slump in trade, triggering the yuan's biggest one-day decline in a decade. (AP Photo/Andy Wong)

The more debt the merrier, the saying goes, at least until the party stops and the hangover starts. This is true for the debt situation inside China, as well as for international lending to China. 

According to the Bank for International Settlements (BIS), total cross-border bank lending to China decreased $63 billion to $698 billion at the end of the first quarter of 2016. Over the year, this measure is down 27 percent. 

“Since hitting its all-time high at the end of September 2014, cross-border bank credit to China has contracted by a cumulative $367 billion (–33 percent), with interbank and inter-office activity leading the decline,” the BIS writes in a recent report. 

The total stock of outstanding cross-border bank credit was $27.5 trillion at the end of March 2016. 

This is important because that money is not coming back. Once the loan or debt is paid off, it vanishes and can’t be used to fuel other financial or economic transactions. It is part of the reason why many economies in the world are teetering on the edge of a recession with only bank lending to Western governments balancing out the emerging market credit decline.  

The reduction in bank lending is part of the capital that is flowing out of China by the hundreds of billions, $676 billion in 2015 alone.

International Institute of Finance (IIF)

International Institute of Finance (IIF)

Banks in Hong Kong decreased their China exposure by 4.5 percentage points from 32.8 percent of assets at the end of 2014 to 27.3 percent at the end of 2015, according to rating agency Fitch, the first decrease in a decade.  

International banks are wary of a slowing Chinese economy and a rise in corporate defaults.  

According to rating agency Standard and Poor’s (S&P), China’s credit quality is “deteriorating more quickly than at any time since 2009,” it states in a recent report. S&P downgraded three companies for every company upgraded in the first half of 2016.

Chinese corporates will “come under increasing strain as economic growth slows, industrial overcapacity crimps profitability and cash flow, and an elevated appetite for expansion weakens leverage.”

Claims of international banks of different countries in U.S. dollar trillion (left) and U.S. dollar billion (right) (Bank for International Settlements (BIS))

Claims of international banks of different countries in U.S. dollar trillion (left) and U.S. dollar billion (right) (Bank for International Settlements (BIS))

And international banks don’t want to wait for that to happen. Neither do they want to wait for a sharp devaluation of the Chinese currency. 

“A sharp depreciation of the yuan, which would be the consequence if the [foreign currency] reserves would have to be used to safeguard systematically important entities that do have foreign currency debt. This would be the consequence of a failure to act, a recession and, in the worst case, a financial crisis. Again, something that’s survivable; not the end of the world, but very costly and politically destabilizing,” said Citigroup chief economist Willem Buiter. 

Hugh Hendry, principal at the hedge fund Eclectica is more pessimistic:

“Tomorrow we wake up and China has devalued 20 percent, the world is over. The world is over. The euro breaks up. Everything hits a wall. There’s no euro in that scenario. The U.S. economy, I mean everything hits a wall,” he told RealVisionTV earlier this year.

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Local Chinese residents walk on a flooded street in heavy rain in Wuhan, central China, on July 6 2016. (Wang He/Getty Images)Local Chinese residents walk on a flooded street in heavy rain in Wuhan, central China, on July 6 2016. (Wang He/Getty Images)

Chinese president Xi Jinping seldom comments directly on the economy. Instead, he lets his premier Li Keqiang do the talking. Or Xi speaks through one of the regime’s mouthpieces like People’s Daily or Xinhua.

On July 21—only one week after China published unexciting GDP figures—it was Xinhua who came out with a commentary on how important reform is for China and that there is no alternative to short-term pain and long-term gain.

“China must push through reform, for there is no plan B,” the mouthpiece states.

The article is just a Xinhua commentary and didn’t cite an “authoritative person” like the People’s Daily usually does, but given the amount of control Xi personally exerts over the media, it probably had his blessing. 

Piecemeal solutions no longer work.

—  Xinhua

The article espouses the reform narrative we have heard previously: market reform, sustainable growth model, innovation, consumer spending, supply-side structural reform, cutting red tape etc. So we can assume that Xi and his premier still stand behind the reform agenda.

“What is called for is not temporary fixes: My government has resisted the temptations of quantitative easing and competitive currency devaluation. Instead, we choose structural reform,” Xinhua quotes premier Li Keqiang. 

Reality Check

The problem, as it is the case so many times with Chinese media and utterances from the Communist Party, is that the claims don’t reflect reality.

With respect to temporary fixes, China just created a record amount of credit in the first quarter, amounting to $712 billion in new loans. These loans did not go into the private sector as Li claims but broadly speaking boosted investment by state enterprises.

Chinese ship-builders, for example, reported a surge in orders by volume of 44.7 percent from January to June this year compared to last year. Private investment on the other hand only grew 3.9 percent in the second quarter of 2016, whereas total investment rose 9.6 percent.

“State Owned Enterprises (SOE) continue to invest in the overcapacity industries, which suffer from slower growth in production,” writes the investment bank Natixis in a note.

However, judging from the Xinhua piece and others before, the regime clearly recognizes the problems: “Problems facing China’s economy, including a troubled property sector, industrial overcapacity, rising debt levels and the lack of new growth engines, are all connected with each other and piecemeal solutions no longer work. The only way to restore vitality to the economy is to push through reforms.” They aren’t happening.

Instead, central bank officials are calling for fiscal deficits of up to 5 percent to support the economy and they admit traditional monetary stimulus is not working anymore. 

“Despite loads of liquidity pumped into the market, enterprises would rather bank the money in current accounts in the absence of good investment options, which is in line with record low private investment data,” Sheng Songcheng, head of statistics and analysis at the People’s Bank of China (PBOC) said recently.

You can have a good old financial crisis without having the 1997–1998 Asian foreign debt issue.

— Willem Buiter, Citigroup

Willem Buiter, the chief economist of Citigroup says China needs to recapitalize the banks and go through a round of central bank financed deficits to clear up past excesses. He thinks China won’t avoid a financial crisis otherwise:

“Unless they are willing to go for Chinese helicopter money, fiscal stimulus targeted mainly at consumption not at investment. Yes, some capital expenditure like social housing, affordable housing, yes, even some infrastructure. But organization supporting infrastructure, not high-speed trains in Tibet. It has to be funded by the central government, the only entity with deep pockets, and it has to be monetized by the People’s Bank of China.”

Debt Semantics

Speaking about debt and a financial crisis, naturally, Xinhua has a differing view: “Most of China’s debts are domestic, and its debt levels are within control and lower than other major economies. A moderate deficit level (2.4 percent in 2015 and a target of 3 percent for 2016), large household savings and massive foreign exchange reserves strengthen the country’s ability to endure risk.”

Forget about the fact that central bank officials are already calling for a 5 percent deficit, Standard and Poors just released a report warning about China’s dangerously high debt levels. “The downside risks are material, especially if Chinese authorities lose their grip on rebalancing the economy,” it states. 

china debt

Foreign exchange reserves have decreased from $4 trillion in 2014 to $3.2 trillion now. Hedge fund managers like Kyle Bass of Hayman Capital think the crisis threshold is at around $2.5 trillion. 

“They are so far ahead of the world’s excesses in prior crises, we are facing the largest macro imbalance in world history,” he told RealVisionTV.  

Willem Buiter says the debate of external versus internal debt is largely meaningless: “You can have a good old financial crisis without having the 1997–1998 Asian foreign debt issue.” 

Both Kyle Bass and Buiter see a further devaluation of the Chinese currency as highly likely. “The Chinese government wants a devaluation, they just want it on their terms. In the next two years, this is happening,” says Bass.  

One thing Xinhua gets right: The days of double-digit growth are over. “To be sure, China’s economy cannot, and should not, repeat its past growth record. It may be on a bumpy journey, but will maintain a slower, but stable growth.” Which is the best the country can hope for. 

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A woman counts Chinese yuan bills worth thousands of dollars in Vancouver, Canada, on Oct. 27, 2015. (Benjamin Chasteen/Epoch Times)A woman counts Chinese yuan bills worth thousands of dollars in Vancouver, Canada, on Oct. 27, 2015. (Benjamin Chasteen/Epoch Times)

The chief economist of Citigroup is not your average economist. Yes, Willem Buiter studied plenty of economic theory at Yale and Cambridge but then he says funny things like the New York State Driving Test was his “greatest educational achievement.”

He is also very outspoken for someone who works for one of the biggest banks in the world. He thinks Citigroup “must have decided that it was better to have somebody who tells the truth occasionally than to have somebody who tells what people want to hear.”

Epoch Times spoke to Mr. Buiter about a possible financial crisis in China, a devaluation of the currency and potential solutions. [Skip to 19:00 in the video]

They are going to have a financial crisis.

— Willem Buiter, Citigroup

Epoch Times: What are China’s problems?

Willem Buiter: China has three problems. It has a madly over-leveraged corporate sector, banking sector, and shadow banking sector that really need restructuring and consolidation. It has massive excess capacity in many of the crucial industries, so it has a cyclical problem.

And then it needs to rebalance: From export growth to domestic demand that goes from investment growth to consumption; from physical goods growth to services; from I can’t breathe to green; and a growing role for the private sector. This simply isn’t happening at the moment.

Citigroup Chief Economist Willem Buiter at an interview with Epoch Times in New York on July 6, 2016. (Epoch Times)

Citigroup Chief Economist Willem Buiter at an interview with Epoch Times in New York on July 6, 2016. (Epoch Times)

Growth has stopped falling at the moment, though it is significantly lower than what it was, but only by unsustainable stimulus measures.

This is credit growth that adds to the excessive leverage. Investment in sectors where there is already excess capacity, basically building up a bigger and harder landing by postponing the necessary adjustments.

The rebalancing has been put on hold because this requires active and innovative policy making. With the anti-corruption campaign still in full swing, in its fourth year now and if anything intensifying, all senior civil servants in the ministry or the party are unwilling to stick their necks out and do something untried and new. The stuff that is required both in terms of financial stability management, in terms of stabilization policy, the right kind of fiscal stimulus and in terms of rebalancing.

Epoch Times: What can be done?

Mr. Buiter: We need to increase the role of the private sector to cut back on state-owned enterprises. What is happening? We’re growing state-owned enterprises because that is the path of least resistance because we know how to do that.

So then China is in a holding pattern, and I think it won’t change until there is a long-run rebalancing, until the political issues that are reflected in the anti-corruption campaign are settled, it won’t be supported by the right fiscal policies.

Unless they are willing to go for Chinese helicopter money, fiscal stimulus targeted mainly at consumption not at investment. Yes, some capital expenditure like social housing, affordable housing, yes, even some infrastructure.

But organization supporting infrastructure, not high-speed trains in Tibet. It has to be funded by the central government, the only entity with deep pockets and it has to be monetized by the People Bank of China.

That is what the country needs and at the moment it is incapable politically—not technically—of reaching that kind of resolution. I think it is unlikely that they will be able to achieve that without at least a cyclical downturn of some severity. How deep depends on how quickly they respond when things start visibly going pear shaped.

Workers go about their chores at a construction site for new shops in Beijing on November 28, 2011.  (Goh Chai Hin/AFP/Getty Images)

Workers go about their chores at a construction site for new shops in Beijing on November 28, 2011. (Goh Chai Hin/AFP/Getty Images)

Epoch Times: What’s your estimate of Chinese GDP growth at this moment?

Mr. Buiter: Somewhere below 4 percent. The official figure is still around 7 percent, but those data are made in the statistical kitchen.

Epoch Times: So if growth is 4 percent and interest rates are 8 percent, doesn’t this create problems?

Mr. Buiter: Real interest rates are high in China. Especially for what I call honest, private borrowers. The relationship of the interest rate to the growth rate drives the debt to GDP dynamics. The so-called snowball effect is adverse when the interest rate exceeds the growth rate and that is probably the case now.

So there’s a problem there. They are solvable. That’s nothing beyond the ken of man. The wheel doesn’t have to be reinvented but having the tools and being politically able to use them and willing to use them are different things. China has the tools but not yet the willingness and ability to use them in the way that is necessary to avoid a hard landing.

Financial Crisis

Epoch Times: So we are talking about a somewhat similar problem than in Europe. We would have to write down a lot about of bad debt. We recapitalize the banks and then stimulate the consumer to get inflation?

Mr. Buiter: In Europe of course, we should really fund the capital expenditure. Investment rates are notoriously low in Europe. China has the opposite problem. They need to boost consumption. So there’s an obvious win-win situation that we could have.

Debt restructuring, haircuts if necessary and then a well-targeted fiscal stimulus funded ultimately through the European Central Bank (ECB), people’s helicopter money. China will be aiming at consumption. The composition is different because China invests too much.

You can have a good old financial crisis without having the 1997-1998 Asian foreign debt issue, which China does not have.

— Willem Buiter, Citigroup

Epoch Times: What if China doesn’t address the problem?

Mr. Buiter: They are going to have a financial crisis. It can be handled because 95 percent of the bad debt is yuan-denominated, but you have to be willing to do it, you have to be proactive.

The United States didn’t have a foreign currency denominated debt problem when it had the great financial crisis. Banks fell over. These were all dollar denominated liabilities. You can have a good old financial crisis without having the 1997-1998 Asian foreign debt issue, which China does not have.

So a financial crisis is a risk. Then, of course, a sharp depreciation of the yuan which would be the consequence if the reserves would have to be used to safeguard systematically important entities that do have foreign currency debt. This would be the consequence of a failure to act, a recession and, in the worst case, a financial crisis. Again, something that’s survivable; not the end of the world, but very costly and politically destabilizing.

The official figure is still around 7 percent, but those data are made in the statistical kitchen.

— Willem Buiter, Citigroup

Devaluation

Epoch Times: But the currency would have to go down.

Mr. Buiter: I cannot see the yuan following the dollar over the next year, let alone two years, no. I do think that at the moment, the market is no longer afraid of an eminent sharp depreciation. So capital outflows driven  by expectations of a sharp depreciation have ceased. But they could be back like that, especially if there are more kerfuffles in Europe, another flare up. Maybe the banking crisis, and as a result further upward pressure on the dollar and other safe-haven currencies.

And the Chinese currency is being dragged along? I don’t think so. They will have to decouple. So that is a channel which for external reasons, the yuan peg might become hard to manage.

Epoch Times: How do you see the rest of the year?

Mr. Buiter: Continued subdued growth. China is flirting with the loss of faith in its ability to manage its currency and flirting with a sharp slowdown in activity. Europe and the rest of the industrial world, assuming that the Brexit negotiations remain orderly, not too hostile and growing more slowly than it did last year but not dramatically more slowly.

If Brexit becomes a dog fight between the 27 and the U.K. If Brexit becomes contagious, through general elections in the Netherlands in March next year, in France, Germany. If the Italian referendum in October or November this year goes against the government and fear of emulation of the British example takes over, then there could be a further, deeper slowdown in activity.

The United States again should putter around roughly the same way as last year. So mediocre growth at best with mainly downside risks. A few emerging markets—Russia, Brazil—will do better this year than they did last year simply because it’s impossible to do worse.

The wheel doesn’t have to be reinvented but having the tools and being politically able to use them and willing to use them are different things. 

— Willem Buiter, Citigroup

The specific shocks, home-made mainly in Brazil, partly external like oil prices in Russia and sanctions. These things are no longer slowing them to the same extent. So some recovery is possible.

It’s going to be a secular stagnation world, unless we provide the combined monetary fiscal stimulus and the longer term, supply side, enhancing measures to promote growth, higher capital expenditure, better education and training including vocational training, sensible deregulation, less disincentivizing taxation and all that.

All these things are necessary to keep potential output at a level that allows fulfilling our ambitions, but even the miserable level of the growth rate of potential output won’t be achieved unless we have additional stimulus.

 Epoch Times: So no way for stocks to go up another ten percent from here?

 Mr. Buiter: Everything is possible but I think the fundamentals say no.

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A woman counts Chinese yuan bills. (Benjamin Chasteen/Epoch Times)A woman counts Chinese yuan bills. (Benjamin Chasteen/Epoch Times)

He was right about subprime, right about gold, and early in his call for a Japanese crisis. Is Texan investor Kyle Bass too early in his call for a China banking crisis and currency devaluation within the next two years?

“It’s a foregone conclusion but we don’t know about the timing, it feels like it’s happening as we speak,” he told Grant Williams of RealVisionTV in an interview. Bass had first stated his pessimistic view of China in late 2015 when the currency was under pressure and the country was bleeding capital to the tune of $100 billion per month.

Since February of this year and so-called Shanghai Accord or the G20 finance ministers, outflows have abated, although the currency has declined to a multi-year low of 6.66 per U.S. dollar.

There are so many perfect parallels to the U.S. mortgage credit system or the European banking system and the Chinese banking system.

— Kyle Bass, Hayman Capital
The exchange rate of the Chinese yuan versus the U.S. dollar over a year (Bloomberg)

The exchange rate of the Chinese yuan versus the U.S. dollar over a year (Bloomberg)

So why does Bass think the situation in China is intensifying? Everybody knows China has too much debt, especially corporate debt. As a result, the country’s total debt to GDP ratio is higher than 250 percent according to a range of different estimates. This is not much higher than Japan’s government debt ratio of 245 percent of GDP, so why focus on China now?

“The Chinese corporate bond market is freezing up. Since April 11th the Chinese corporate bond markets had 150 cancellations out of 210 announced deals,” says Bass. And indeed, the Chinese corporate bond market, which has helped keep unsustainable corporate debt afloat and also backs trillions in repackaged loans called Wealth Management Products (WMP) is in trouble in 2016.

Source: McKinsey

Source: McKinsey

According to Bloomberg, Chinese companies raised 1.85 trillion yuan ($280 billion) of onshore bonds between April and July this year, 30 percent less compared to the three preceding months.

Bankruptcies are also on the rise. Although corporate defaults are still in the low double digits, Chinese courts handled 1028 bankruptcy cases in the first quarter of 2016, up 52.5 percent compared to a year earlier.

“There are so many perfect parallels to the U.S. mortgage credit system or the European banking system and the Chinese banking system. There are things that go on in those systems that show you there are problems,” says Bass, emphasizing the acuteness of these problems. “We see it starting now.”

While there are clear parallels to what happened in the United States in 2008 and Europe in 2010, Bass says that China’s problems are a magnitude larger. “They have asset liability mismatches in wealth management products that are more than 10 percent of their system. Our mismatches were 2.5 percent of the system and you know what they did,” he says. 

According to Bass, the bad loans will first hit the banking system and then lead to a sharp devaluation of the Chinese yuan. 

“How they deal with this, it’s not armageddon. They are going to recap the banks, the are going to expand the People’s Bank of China’s (PBOC)  balance sheet, they are going to slash the reserve requirement, they are going to drop their deposit rate to zero, they are going tot do everything the United States did in our crisis,” he said.

Devaluation

All of these policy measures would lead to a depreciating currency all other things being equal. But China’s currency is already under pressure as mostly Chinese citizens are taking their money out of the country because they don’t trust the banking system any longer. Bass estimates that bad loans could lead to losses of up to $3 trillion or 30 percent of GDP. Chinese citizens’ savings are backing these loans and they don’t want to wait around to find out whether Bass’s number is correct or not.  “In China, the credit excesses are already built in,” says Bass. 

They are going to do what’s best for China. And what’s best for China is to materially devalue their currency.

— Kyle Bass, Hayman Capital

Goldman Sachs estimated that net capital outflows from China in the first quarter of 2016 were around $123 billion according to a report, 70 percent of which came from Chinese citizens funneling money out of the country. They do this in spite of harsher capital controls in 2016 and use either illicit methods like smuggling or legal ones like buying up Vancouver and New York real estate.

According to Bass, there is no way out for the regime, which is trying to manage the devaluation as much as it can. “The Chinese government wants a devaluation, they just want it on their terms.”

Reuters had previously reported that the Chinese central bank would not mind seeing the currency slip to 6.80 against the dollar, a target it will likely overshoot if things don’t change materially.  

Bass also shines light on why the regime would not be opposed to devaluing the currency, albeit measuredly. He says one of president Xi Jinping’s closest aides, vice premier Wang Yang, thinks the Japanese made a mistake by not devaluing in the mid-1980s, right when they were blowing up their own credit bubble. 

“Wang has said that he thinks Japan’s critical error was agreeing to the Plaza Accord. Japan decided to be submissive to the United States once again, to sacrifice their economic growth for that of the United States,” as the dollar devalued and the Japanese yen strengthened, the United States finally emerged out of a decade of stagflation. what happened to Japan at the beginning of the 1990s was less flattering. According to Bass, however, this time will be different: “They are going to do what’s best for China. And what’s best for China is to materially devalue their currency.”

After the devaluation and the recapitalization of the banking system, however, it’s time to buy again: “If you have any money left, it will be the best time in the world to invest. It will be the greatest time ever to invest in Asia.”

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Chinese workers prepare stuffed toys at a factory in  Zhejiang, China, September 17, 2015  (Kevin Frayer/Getty Images)Chinese workers prepare stuffed toys at a factory in  Zhejiang, China, September 17, 2015  (Kevin Frayer/Getty Images)

 

Any kind of improvement will have to start somewhere. For the Chinese economy, the starting point is the second quarter of 2016, at least according to the data experts at China Beige Book (CBB).

Every quarter they survey thousands of Chinese companies and ask them whether their revenues went up, whether they are hiring or not and what they think of the future.

The results are a much better representation than official data, which often follows CBB’s lead a quarter or two later.  

Transport construction followed its worst performance ever in Q1 with its largest improvement ever.

—  China Beige Book

So after a pretty bad first quarter, CBB says most indicators improved in the second quarter, although activity is roughly flat over the year. In most cases, less than 50 percent of survey respondents report an improvement in sales, hiring, capital expenditure, or bank lending.

So the results hardly represent a booming economy, but are much better than the below 40 economy from the first quarter.

“The rebound constitutes a performance roughly echoing that of a year ago—profits and capex were moderately better than the second quarter of 2015, revenue and wage growth were similar, and output, new domestic orders, receivables, and payables all weakened over the past year,” CBB states in an advance release of its report

The problem: The report for the second quarter of 2015 looked similar, only for things to get worse later.

But let’s focus on the improvements first, which in most cases confirm official data throughout the second quarter.

Fiscal Stimulus

After the central government made it clear it would turn on the spigots of fiscal stimulus and targeted a 3 percent deficit for 2016, it followed through.

According to CBB, one of the prime targets for fiscal spending is the transportation sector, which is largely controlled by the government directly or State Owned Enterprises (SOE).

“Transport construction followed its worst performance ever in Q1 with its largest improvement ever, a reversal which is difficult to explain except by citing (effective) government action,” states the report.

So revenues improved at 59 percent of the transportation construction companies surveyed, which is 43 percentage points higher than in the first quarter.

New data from our 3,000-firm survey is still more optimistic, showing Q2 capex recovering sharply from first-quarter weakness.

—  China Beige Book

Transportation revenue in general improved at 57 percent of the firms and most companies (63) forecast higher revenues in the next six months. Also of note, 51 percent of steel companies reported higher revenues, possibly connected to the increase in transportation construction.

Another favorite for government stimulus is real estate, it also improved. Half of the firms reported increases in revenues this quarter, an improvement of 23 percentage points. It’s interesting to note that the best performers came from the less loved Tier 3 cities.

This fits the narrative of the official data which reported vast price increases and volume increases. Residential real estate construction lagged at 43 percent, hardly surprising with 18 million of unsold units still on the market.

(Capital Economics)

(Capital Economics)

Services Up

The service sector also showed some real gains, a feat many have been waiting for in the China rebalancing story. Revenues for service sector firms increased in 57 percent of the cases, a boost which is likely disconnected from government stimulus and fits the rebalancing story from manufacturing to services.

“This is a difficult performance to replicate, but it’s exactly what services must do in order for overall growth to be maintained as excess manufacturing capacity is addressed, states the report.”

Media, restaurants, healthcare, and IT all did well.

The Below 50 Economy

The rest of the economy is the below 50 economy. Better than last quarter, but less than half of firms are making serious headways. Capital expenditure, manufacturing, retail, commodities, and residential real estate construction all fall into that category, broadly echoing official data.

CBB notes that private investment has not decoupled from public sector investment and should see a rebound soon. Most official data shows a big drop in private investment whereas state investment is rising.  

“New data from our 3,000-firm survey is still more optimistic, showing Q2 capex recovering sharply from first-quarter weakness,” states the report. “Private firms led the way in Q2.”

Despite the overall positive report, some dark spots still remain. Only 37 percent of companies are hiring more people, especially private firms. The labor market remains right, especially unskilled labor supply only improved at 29 percent of companies, confirming official data that migrant workers are not leaving the countryside anymore.

(Capital Economics)

(Capital Economics)

Coal companies did particularly bad in the commodities sector, with only 33 percent of companies showing an improvement. Exports for the whole of the manufacturing sector improved at only 34 percent of companies.  

Bank lending to companies is also not happening, despite China’s record credit binge in the first quarter. Borrowing increased at only 17 percent of the companies, as application for loans increased at 37 percent and availability of loans increased at 33 percent. Almost a fifth of all loan application is rejected, according to the bankers responding to the survey.

Almost a fifth of all loan application is rejected, according to the bankers responding to the survey.

Because firms are not demanding new loans, interest rates also dropped across the board (bank, bonds, and shadow loans) and remain near record lows, one reason why the yuan was under constant pressure in Q2.

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Germany's Chancellor Angela Merkel, right, and China's Premier Li Keqiang review an honor guard during a welcome ceremony at the Great Hall of the People in Beijing, Monday, June 13, 2016. (AP Photo/Andy Wong)Germany's Chancellor Angela Merkel, right, and China's Premier Li Keqiang review an honor guard during a welcome ceremony at the Great Hall of the People in Beijing, Monday, June 13, 2016. (AP Photo/Andy Wong)

No matter the outcome, there will be certainty about whether Britain will remain within the European Union or exit the European superstate on June 23.

There is uncertainty about what happens if Britain chooses to exit and some risks, but many financial analysts think there is a bigger problem hiding in plain sight, one which will take longer to solve, with less clear-cut outcomes.

“We believe China’s ongoing stealth devaluation of the renminbi is far more important for the global economy,” writes Albert Edwards of investment bank Société Générale. He is talking about the drop in the Chinese yuan against a basket of currencies especially since the beginning of the year, while the yuan remained more or less stable against the dollar.

The yuan is down 10 percent against this basket since last August, the first time the Chinese central bank sharply lowered its fixed exchange rate, surprising markets at the time.

Global excess capacity in the steel industry leads to trade problems historically.

— Lewis Alexander, Nomura

“China is now exporting its deflation, and my goodness it has a lot of deflation to export. In the Ice Age world, countries need to devalue to avoid deflation,” writes Edwards.

Deflation means lower prices for goods and services. If the yuan exchange rate falls against the euro and the Japanese yen, manufacturers in Germany and Japan have to compete with precisely that: lower prices from Chinese exporters.

The U.S. chief economist of investment bank Nomura says overcapacity in the steel industry is part of the problem leading to lower prices worldwide as well as a series of competitive devaluations.

(Société Générale)

(Société Générale)

“Global excess capacity in the steel industry leads to trade problems historically. This is something we are all going to have to manage,” he said at a meeting of the Council on Foreign Relations (CfR) on June 21.  “China is opening up financially which is making itself vulnerable to market dynamics.”

China has announced and carried through a series of reforms which removed certain barriers to trade and the flow of capital in order to gain access to the International Monetary Fund’s (IMF) basket of reserve currencies.

I think that China, financially speaking, is the world’s biggest problem.

— James Grant, Grant’s Interest Rate Observer

James Grant, editor in chief of Grant’s Interest Rate Observer agrees with Edwards in that China poses the biggest risk to the financial system.

“I think that China, financially speaking, is the world’s biggest problem. One day we will all wake up and hear or read that there has been a collapse in the Wealth Management Products (WMP) in the Chinese shadow banking and banking system,” he said the CfR meeting.

Wealth Management Products are pools of bank loans sold to retail investors which have a higher yield than deposits but also have higher risks because banks usually don’t report what exactly is inside these products. Grant says this financial product is close to a Ponzi scheme because maturing WMPs are being redeemed by the issuance of new WMPs.

Emma Dinsmore, co-founder and CEO of r-squared macro, hopes China will be able to reform its economy before it’s too late: “Ultimately the only way to work out the access capacity is to grow the consumer base and accept lower growth in the short term. Moving down the course is very challenging for China,” she said at the CfR meeting. “Either way, they will export more disinflation.”

Exporting more disinflation means having a lower currency, buying growth from the rest of the world, which is struggling to spur growth itself.

“What is going on in China to that end is very worrying,” said Grant.

Follow Valentin on Twitter: @vxschmid

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After market crises, it sometimes takes a while for the real picture to emerge, the reasons why Western stocks followed the Chinese currency down at the end of 2015.
So it is only now that we learn how much money international banks withdrew from China in the fourth quarter of 2015 and how this unwind of lending caused a liquidity squeeze, thanks to minute data aggregation from the Bank of International Settlements (BIS).
“The $114 billion decline in cross-border lending to China was the second quarterly drop in a row, and it pushed the annual growth rate down to –25 percent,” the BIS states in its quarterly review published this June.
The trend of lending to China has clearly turned. (BIS)
In other words, global bank lending to China crashed by one full quarter. No wonder the currency weakened and liquidity in global financial markets decreased throughout the year as volatility peaked right around the first Fed rate hike in December. In total, cross-border banking liquidity decreased by $651 billion to $26.4 trillion.
These $26 trillion in cross-border claims could be anything related from trade finance to derivative contracts which cross two banking jurisdiction. For example, a U.S. bank lending money to a Chinese company in the form of a loan or a bond. It also includes interbank lending. Once the loans are paid back, this credit money goes out of existence, thereby decreasing overall system liquidity.
Total bank lending to China is now down $304 billion, or 27 percent from a high of $756 reached in September of 2014, which also coincides with the peak of Chinese foreign exchange reserves of $4 trillion (now $3.2 trillion).
This repayment of debt to foreign banks is only part of the $676 billion which left China in 2015 according to the International Institute of Finance (IIF). The rest has been mostly Chinese households and companies moving their money abroad and Chinese companies repaying debt to non-bank creditors.
The $800 billion decline in foreign exchange reserves over two years resulted from the People’s Bank of China’s (PBOC) intervention in the currency markets to keep the yuan stable against the U.S. dollar.
(Capital Economics)
Global Contagion
The BIS report also details how closely Chinese banks are tied into the global financial system.
Chinese banks, after paying back much of their international liabilities in 2015 are still lending $529 billion U.S. dollars to the international financial system. According to the BIS, they have a $300 billion surplus (more assets than liabilities) and are funding these assets with dollars obtained from mainland companies and households.
The BIS cautions that shocks can come not only from debtors like the Asian Tigers in the late 1990s but also from creditors as well:
“As the Great Financial Crisis of 2007–09 demonstrated, it is as important to monitor potential shocks emanating from creditors as those from borrowers. Furthermore, the existing  international banking statistics underestimate the overall increase in the indebtedness of those countries relatively more reliant on credit from China.”
(BIS)
At this moment, Chinese citizens and companies are still trying to get their money out of the country and are happy to do so with the help of Chinese banks. If that situation changes and Chinese players want to hold their dollars outright or need to service debt obligations in yuan because of a falling economy, this liquidity could very quickly disappear from the global financial system.

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