A worker checks the production in the packaging section of the newly opened Lego factory in Jiaxing, Zhejiang Province, China, on Nov. 24, 2016. (JOHANNES EISELE/AFP/Getty Images)A worker checks the production in the packaging section of the newly opened Lego factory in Jiaxing, Zhejiang Province, China, on Nov. 24, 2016. (JOHANNES EISELE/AFP/Getty Images)

The Chinese economy is strange in many ways. Not only is it a hybrid between private capital and state control, but very few people directly invest in the mainland — and yet everybody is interested in how the second largest economy in the world is going to develop.

That’s because Chinese demand determines the prices of world commodities, and the operations of multinational companies in China impact earnings. When the yuan falls, markets across the world get jittery.

China watchers accept the fact that official Chinese data is severely flawed, and often simply fabricated, yet they still use it to analyze the Chinese economy and markets because there are few alternatives.

One alternative, however, is the China Beige Book International (CBB), a research service that interviews thousands of companies and hundreds of bankers on the ground in China each quarter. They collect data and perform in-depth interviews with Chinese executives.

Leland Miller, president of China Beige Book International.

Leland Miller, president of China Beige Book International.

Leland Miller, the founder of CBB, spoke with The Epoch Times about which investors and companies are interested in China, the latest developments in the currency, U.S.-China relations, overcapacity problems, and the One Belt One Road Initiative.  

The Epoch Times: Who are the investors and companies interested in China and your services?

Leland Miller: There’s people who play the share roulette or people who have a specific company in mind. We see a lot of this in the retail space and they want to get more information from us. They invest in something where they think there is this untapped market either in China or as China goes abroad.

You’ve got macro firms who may not care about the day-to-day in China but want to make sure they understand the dynamics of China demand, of China credit, of China currency, so that they don’t get caught out.

Commodities are in incredibly high demand. We spend a lot of our time dealing with commodities firms now because we have all this data that’s not typically available. Things like net capacity, and a lot of firms have said, “Well, we have no way of checking government numbers…. If they say they’re cutting capacity, we have to believe them.” Well, we don’t believe them, we do it ourselves and what we found is that the opposite is happening across commodities, across time.

So you have all these different types of firms, but I think there is one uniting factor: whether they’re doing China micro, they’re doing China macro, or some niche element of the economy. If they don’t get China right, there are going to be repercussions in their portfolio.

So even people now who have absolutely nothing to do with China are clients of ours because as they keep abreast of what’s going on, they need to understand this and not get knocked from the side off their feet when they weren’t expecting it.

An increasing share of our clients are people who just want to understand China at the 30,000-feet level. Our early clients are people who want to understand at the 30-feet level. And we have everything in between, but also the corporates. The corporates have a very different mind-set: they need to know different things than, say, a hedge fund or other asset manager, who is simply trying to find a good trade.

The Epoch Times: How do you see the Chinese currency developing?

Mr. Miller: They took a very risky strategy on the currency dating back to last fall, and it worked. But it didn’t have to work and it may not have worked, and I think it’s worth looking back at this chronology because this could have been a very different year had some of this not worked out. Back in September 2016, the Chinese started to understand that there was a very real chance that the Federal Reserve (Fed) was going to hike in December, and they needed to prepare the currency and prepare themselves for a rate hike.

They started doing that and they weakened the currency. And then when President Trump was elected, they said, “Okay, well, we got to do this even more. We have to weaken right up until he gets elected so that we can come back and say we’re going to strengthen it once he gets elected.” Now it’s a very cynical strategy that happened to work, but what’s interesting is that there was an enormous amount of commentary late in 2016, early 2017, about how — and we see this all the time — now that China is pegged to a basket, it’s not pegged to the dollar, and that the Chinese have made this move.

That is just not correct. They had not switched, there has not been this back-and-forth. The yuan is essentially pegged to the dollar. The seven handle on this, the seven yuan to the dollar is extremely important for a lot of reasons, most importantly the politics around this, the politics with Congress, the politics with Trump, the politics with the Chinese leadership.

And the idea of them creeping closer and closer to 7 was a real major problem. They understood that this was a politically charged number and they got real close to it and they timed it well and they backed off it, and it had been strengthening ever since which has been supported by the fact that the dollar has been in a weakening trend.

But the interesting thing here is they figured out, “We’re going to give Trump little rationale for letting him say we are a currency manipulator. But right up until that point, we’re going to keep weakening, and we’re going to hope that nothing bad happens.”

Shockingly, they got up to 6.9 — it was approaching a danger point where I think markets would have started caring, and they backed off at the right time. So they have had the 2017 best case scenario, they haven’t had these interruptions, they haven’t had a super strong dollar that a lot of people thought was going to happen six months ago.

So the yuan is not on the top of people’s worry list right now but it’s just a matter of time before they have to deal with these dynamics again, unless the dollar is in a long term weakening trend.

The Epoch Times: How do you see U.S.-China relations in the future?

Mr. Miller: The administration understood that China’s a radioactive word if you use it politically, so we’re going to fight back on China, we’re going to save American workers from the tyranny of Chinese goods. That was the calling card for a while. And then of course President Xi and President Trump met at Mar-a-Lago and had this beautiful chat and everything turned around.

President Trump was convinced to give the Chinese some amount of time to fix the trade problem and fix North Korea and a whole bunch of other things. A lot of really smart China watchers have been saying recently that the President is angry that the Chinese have not done what he wanted them to do on the trade side of North Korea and he’s flipped and you’re about to see the repercussions.

I would actually push back against that. I think that what you’re seeing right now is a gradual dissatisfaction with this. But the real tea leaf here will be the South China Sea. The U.S. position in the South China Sea has just been invisible for the most part. I mean, they talk about a few spy ops but they have been mostly invisible for the past six, seven months.

And when the President, the White House, the administration makes this turn and decides: “Alright, China is not going to help us out, we now need a stick and we need a big stick,” you’re going to start seeing developments in the South China Sea. The fact that there has been some push back on trade, the fact that we’re talking a little bit about steel, it’s totally misunderstood.

The steel measures being talked about are not anti-China, although they’ll be sold as that. So I think we need to stop jumping the gun on the idea that the president has turned hostile on China. This hasn’t happened. Do we think it will happen? Yes. I think it’s a 2018 thing. But I don’t think that there has been a major shift in policy.

Chinese blacksmiths at a steel furnace in Nuanquan, China, on Feb. 23, 2015. A booming property sector and monetary stimulus provided support for battered steel companies in 2017. (PHOTO BY GETTY IMAGES)

Chinese blacksmiths at a steel furnace in Nuanquan, China, on Feb. 23, 2015. A booming property sector and monetary stimulus provided support for battered steel companies in 2017. (PHOTO BY GETTY IMAGES)

The Epoch Times: Are the Chinese really tackling the overcapacity problem?

Mr. Miller: There are two stories here. The first is what our data is saying and the second is the mistake I think a lot of investors make in seeing commodities as monolithic in China.

People usually think that they’re either going to cut capacity across the board or they’re not going to cut capacity at all. So what we have been seeing is not cutting capacity. When prices have gone up, a lot of investors said, “Look, the Chinese government is making good on their pledges to cut capacity. Look at prices are going up, imports are going up.” Anecdotally, that suggests they’re cutting capacity.

Now, they are cutting gross capacity, but total capacity added has gone up every quarter and it’s gone up in almost every sub-sector every quarter. They are adding capacity, and this is very intuitive if you think about it. There are all these industries who used to laugh about the economic reports we used to get from these firms quarter after quarter after quarter of higher inventories, worse revenue, no profits, more capacity — it was just a joke.

Now all of a sudden they’re getting this good economic scenario and they are not about to cut back. It makes sense that they’re not cutting back, but the narrative on this is that the Chinese government is hard at work cutting capacity, and it’s totally a mistaken narrative. Now, we tracked this very closely across coal, aluminium, steel, and copper, and there is a very clear dynamic there and it’s been clear for the last year plus. They are not cutting net capacity.

Now the other issue here is the differences between sub-sectors. When you look at coal and when you look at steel, there’s a different long term concern about the two of them. With all these Chinese commodities, there’s potential overcapacity issues, but coal kills people and coal turns people’s lungs black.

China Beige Book International (CBB) is an independent research firm that collects data from thousands of Chinese firms every quarter, including in-depth interviews with local executives. Although the CBB does not give definitive growth numbers, it logs how many companies increased their revenues, how many laid off workers, and many more datapoints.

China Beige Book International (CBB) is an independent research firm that collects data from thousands of Chinese firms every quarter, including in-depth interviews with local executives. Although the CBB does not give definitive growth numbers, it logs how many companies increased their revenues, how many laid off workers, and many more datapoints.

And so the idea that the Chinese can continue to crank out coal the same way they can crank out steel, with the same repercussions, it’s not there. So over time I think we will see a pullback on the coal side. It’s an open question as to whether we’ll see it in steel and aluminum; a lot of this might be affected by the trade actions coming out of the United States, but right now the major story here is that investors are guessing.

They’re guessing based on prices and they’re getting this wrong more often than not. They don’t understand the degree to which these sub-sectors are cutting back. In fact, they increasing capacity, they’re bringing more capacity online. They take the old ones and take them offline or the ones that aren’t being used, but they’ll activate others or they’ll build others or they’ll upgrade others. So the overall dynamic is that more capacity is being brought online but then make a very big show of what they take offline or what they blow up.

They used to put TNT into giant iron plants and blow them up to show that the government was doing something. This is the equivalent of this in 2017. But net net, they’re not cutting back right now. They’re trying to take advantage of a good market for their goods and so this is going to shock people. It’s already surprised people; that’s why you see these enormous 5 percent, 8 percent moves in a day on these commodity markets. But it’s going to shock people more going forward when they understand the totality of what has happened over the past year.

The Epoch Times: What are your thoughts on the One Belt One Road (OBOR) initiative?

Mr. Miller: What is the real goal for this? The goal is to exert Chinese influence abroad, it’s to recycle surpluses in goods and services abroad to some degree because of oversupply. It will accomplish certain things but is it a worthwhile project? Is it going to do what everyone thinks it’s going to do? No, of course not.

But there are things being done. It is a project large in scope, it will attract headlines for many years, but at the end of the day is this a game changer for China? No. Have the Chinese ever in any context found a sustainable ability to get returns, to get an actual return on their investment? No. And they’re going into a situation where they’re irritating a lot of these states who think that they were going to be able to use their own labor, but the Chinese are using Chinese firms who are doing quite well so far, and having them do the labor.

There are political problems that brings up. They also have a different situation right now than they did three years ago when you talk about the Forex reserves in the capital accounts. So the idea that they had too much and had to figure out ways of dumping Chinese capital in other places, that problem has reversed itself. Now we are not at any kind of problematic point at around $3 trillion, people have the opposite concerns. I think that if this were not a President Xi initiative that he has attached his name to, this would have been deescalated far more dramatically.

They’re going to have to build it up, it still plays a role, it’s still worth watching, but the idea that this is a real game changer similar to the Asian Infrastructure and Investment Bank which was a political upheaval about a year ago, two years ago, whenever it was, these are not game changers. These are Chinese inefficiencies at work abroad.

Interview edited for brevity and clarity

Twitter: @vxschmid

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June 27, 2017

A customer selects vegetables at a supermarket in Hangzhou, in eastern China's Zhejiang province on March 10, 2016. (STR/AFP/Getty Images)A customer selects vegetables at a supermarket in Hangzhou, in eastern China's Zhejiang province on March 10, 2016. (STR/AFP/Getty Images)

After severe jitters in 2015 and 2016, the Chinese economy and its foreign exchange rate have been mostly stable in 2017. Except for volatility in interest rates and the stock market, everything seems fine ahead of the important Party Congress to be held this fall. At the congress, the regime will confirm the next Party leadership.

Of course, official figures, like the 6.9 percent annualized GDP growth rate released for the first quarter of 2017, are unreliable and merely a rough indicator of where the journey is going.

To provide a more accurate read on China’s economy, Leland Miller and his team at China Beige Book International (CBB) interview thousands of companies and hundreds of bankers on the ground in China each quarter. They collect data and perform in-depth interviews with Chinese executives. 

The CBB’s recent report confirms the eerie stability of the Chinese economy.

“So far, 2017 has played out as a best-case scenario. … The remarkable absence of both domestic and foreign shocks has created the stable environment corporates need to outperform most expectations, including ours,” states a preview to the full Q2 2017 report.

The retail, services, and manufacturing sectors all showed an increase in activity. Hiring was also better than in an already good first quarter. This is important for the Chinese regime, as unemployed workers are unhappy workers who often express their unhappiness in mass protests.

According to the official unemployment rate, this is hardly ever a concern, as it has been hovering between 3.97 percent and 4.3 percent for the last decade. However, when the real economy dipped in 2016, the China Labour Bulletin logged a total of 1,378 strikes and protests in the second half of last year.

Extend and Pretend

However, despite the overall positive response from the firms surveyed by CBB, there are a few traditionally Chinese “extend and pretend” caveats to the rosy picture.

For example, every sector reported record inventories, which is positive for production and jobs, but not for sales. If the stocked products aren’t sold shortly, it will hit the companies’ bottom line.

“The same companies who report solid results on most indicators also continue to show cash flow in the red—corporate health has not yet responded to better growth,” states the CBB preview.

Then there is the credit market, a source of worry for China watchers since the end of last year. China’s bank borrowing rates have been creeping up from 3 percent to almost 4.5 percent since late 2016, and CBB notes that this is now affecting the bank’s corporate customers.

“In Q1 … credit tightening was limited to interbank markets. In Q2, it hit firms: Bond yields and rates at shadow banks touched the highest levels in the history of our survey, and bank rates their highest since 2014,” states the report.

According to CBB, however, overall borrowing was relatively stable, despite higher costs and the fact that corporate bond issuance collapsed in 2017. Why? Because firms believe in the ability of the regime to keep things stable beyond 2017.

As the report puts it, “while borrowing did see a mild drop for the third straight quarter, companies’ six-month revenue expectations remain robust in every sector save property. Companies assume deleveraging is transient, likely because they are skeptical the Party will allow economic pain in 2017.”

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March 28, 2017

Workers at a construction site of a residential skyscraper in Shanghai on Nov. 29, 2016. (JOHANNES EISELE/AFP/Getty Images)Workers at a construction site of a residential skyscraper in Shanghai on Nov. 29, 2016. (JOHANNES EISELE/AFP/Getty Images)

Given the notorious unreliability of official Chinese economic data, analysts risk getting it wrong when relying solely on figures the government puts out. Is the China growth story, and a rebalance from manufacturing to consumption, actually happening? Or is the question of enormous debt, with semi-bankrupt state-owned enterprises and widespread overcapacity, still the overriding concern?

To shed light on these murky issues, Leland Miller and his team at the China Beige Book (CBB) interview thousands of companies and hundreds of bankers on the ground in China each quarter to get an accurate gauge of how the economy is doing.

CBB collects quantitative data and conducts in-depth interviews with local executives. It often comes up with data that are completely opposite to the official narrative—but not always, as its survey for the first quarter of 2017 shows.

“China Beige Book’s new first quarter results show an economy certainly stronger than a year ago and performing comparably to last quarter. But core problems remain, and some of them are getting worse,” the CBB Early Look Brief states.

First, the good news. In order to maintain social stability, the Chinese Communist Party needs to maintain high employment at all costs. And it did in the first quarter.

“Nationally, jobs and wage growth were unchanged from last quarter, but the party may not be resting easy about the desired stability,” the brief states.

What’s keeping central planners up at night is the fact that only State Owned Enterprises (SOE) are hiring, at the directive of the government, while private enterprises have slashed hiring, according to CBB.

“Job growth slowed at private firms, leaving state enterprises to drive employment. Moreover, workforce expansion was concentrated in old economy sectors.”

No Rebalancing

This is another problem, given how Chinese officials have hyped up the term “rebalancing” over the last decade. The term covers a range of policies intended to shift economic focus from heavy industry and exports into consumption and services.

“It’s about cutting power, it’s a self-imposed revolution,” said Premier Li Keqiang in his first speech after being appointed in 2013.  “It will be very painful and even feel like cutting one’s wrist.”

A picture shows the headquarters of the People's Bank of China (PBC or PBOC), the Chinese central bank, in Beijing on August 7, 2011. Standard & Poor's US debt downgrade was a wake-up call for the world, a commentary in a top Chinese state newspaper said on August 7, adding that Asian exporters faced special risks. China is the largest foreign holder of US Treasuries. AFP PHOTO / MARK RALSTON (Photo credit should read MARK RALSTON/AFP/Getty Images)

The headquarters of the People’s Bank of China, the Chinese central bank, in Beijing in this file photo. (Mark Ralston/AFP/Getty Images)

Over the last couple of years of CBB coverage, this rebalancing has failed to materialize on the ground, although officials keep talking about it.

The latest quarter was no exception. One important proxy for the ascent of the Chinese consumer, for instance, is retail sales.

In 2017, even official retail sales growth dipped below 10 percent for the first time in years. Although this is a number that developed markets could only dream about, it has been trending down, not up, as it should under a rebalancing scenario.

And CBB data suggests the retail sector may in effect be even weaker. As the brief says: “Our more extensive results show much more than easing sales. Profits, investment, cash flow, and hiring all weakened as compared to [the last quarter of 2016]. Price and wage growth were also slower. Retailers borrowed less despite sharply lower rates, indicating lack of confidence.”

Another indicator is the services industry. China wants to move away from making widgets and melting steel to provide high-level domestic services like finance and software-based solutions. This approach would be better for the industrially-poisoned Chinese environment too.

Such hopes remain “premature,” states CBB. Manufacturing did better than services in all respects, from sales to profits, as well as investment and borrowing.

No Cuts

Another major element of rebalancing is the cutting of excess industrial capacity, especially in coal and steel. These would all be market-based reforms, where semi-bankrupt companies stop producing, wasting resources, and depressing prices.

Officially, China said it met its 2015 target of cutting 45 million metric tons of iron and steel capacity as well as 250 million metric tons of coal capacity.

Not so according to the CBB report. “China Beige Book data show net capacity has risen in every sub-sector for each of the last four quarters.” This means that China did shut down some plants, but that more new ones were built at the same time.

According to research firm Capital Economics, the accounting doesn’t add up. “If companies are actually reducing their production capacity, then one should expect that a portion of their workforce is no longer needed and will be laid off,” they write in a recent report. However, total employment in what it labels “overcapacity sectors” has only fallen by 5 percent, significantly less than would support the official numbers.

The CBB data on the ground also contradicts the official monetary tightening narrative. The People’s Bank of China (PBOC) has raised different interest rates it charges banks slightly this year, leading to a spike in interbank lending rates. China watchers subsequently concluded liquidity was tighter everywhere. 

According to the CBB, however, the tightening has only fed through to the property sector, which it believes may have peaked. For everybody else, borrowing conditions remain flush: “It hasn’t happened yet, not on the street. The price of capital fell across the board this quarter, at banks, at shadow financials, and in the bond market.”

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In a file photo, miners push carts containing coal at a mine in Qianwei county, Sichuan. (Liu Jin/AFP/Getty Images)In a file photo, miners push carts containing coal at a mine in Qianwei county, Sichuan. (Liu Jin/AFP/Getty Images)

A rebound in global coal prices became one of the biggest stories in commodities during the second half of 2016. A more than 90 percent increase since mid-year in the benchmark Australian thermal coal prices has lifted stocks of international coal producers.

But don’t tell that to Chinese coal producers. The recent rally in coal prices hasn’t reversed the fortunes of many Chinese coal producers still wallowing in overleveraged balance sheets, high debt burden, and weak demand.

Recent bond market travails of these companies signal more defaults may lie ahead for Chinese onshore issuers as trillions of yuan in bonds become due in 2017.

Sichuan Coal Default

State-owned Sichuan Coal Industry Group missed a bond payment on Dec. 25. A total of 1 billion yuan ($150 million) in principal plus interest were due.

It was the second default for the coal company this year. Sichuan Coal also missed an interest payment in June but that default was ultimately resolved after the Sichuan government stepped in. Bond investors were paid at the end of July with loans from state-owned Sichuan Provincial Investment Group and a consortium of local and national banks.

ATC_Coal

Australian thermal coal prices during last twelve months (Indexmundi.com)

Other Chinese state-owned enterprises (SOEs) are experiencing similar liquidity issues. China’s biggest lender—the Industrial and Commercial Bank of China—on Dec. 30 agreed to invest in Taiyuan Iron & Steel Group, Datong Coal Mine Group, and Yangquan Coal Industry Group via debt-to-equity swaps. Such swaps have been a key tool of Beijing to reduce leverage amongst SOEs by exchanging debt for equity. The swaps instantly eliminate debt and reduce leverage ratios at the cash-strapped firms.

Steel, coal, and other heavy industries have languished on weak global and domestic demand. Beijing also launched a program to shut underperforming mines and plants and reduce its coal producing capacity. China’s Shanxi Province in the northeast is its biggest coal-producing area, accounting for more than 25 percent of the country’s coal production last year.

Trillions of Yuan Becoming Due

Historically, bond defaults have been unheard of in China. But in 2016, 55 corporate defaults were recorded, more than double the number for 2015. And 2017 will likely see even more defaults.

More than 5.5 trillion yuan ($800 billion) in bonds will mature in 2017, or 1.8 trillion yuan more than 2016, according to China Chengxin International Credit Rating Group. That’s a significant amount of cash Chinese companies must come up with during the next year.

Sichuan Coal’s default—assuming the local government declines to extend another bailout—could signal that Chinese Communist authorities are willing to allow more bond defaults going forward. In truth, analysts have expected massive bond defaults for years, while Beijing has been selective in choosing which SOEs to bail out. Regardless, the number of such bailouts has decreased, underscoring authorities’ increasing comfort level with letting companies fail. With the significant amount of bonds due in 2017, a spike in bond defaults will likely result.

Furthering the challenge facing Chinese companies is the economic backdrop, which doesn’t look friendly for the Chinese bond market.

China’s rickety financial system is built entirely on overleveraging with cheap debt.

Like the rest of the global bond market, Chinese bonds have already been under pressure from the U.S. Federal Reserve’s plans of raising short-term interest rates. This has raised yields across the globe. China’s 10-year government bond yield settled at 3.07 percent on Dec. 30, slightly lower than mid-month but far higher than the 2.8 percent range at the beginning of 2016 (bond yields and prices move in opposite directions).

Faced with increased risk of capital flight, China may elect to guide its own rates higher. But in such a scenario, raising new debt would become prohibitively more expensive during a time when many Chinese companies are facing liquidity problems amidst slowing economic growth. The central bank’s actions would further squeeze Chinese borrowers in need of new debt to roll over existing debt.

China’s rickety financial system is built entirely on overleveraging with cheap debt. It is especially susceptible to rate hikes and without the type of economic growth required to withstand such rate increases.

With so much debt becoming due and armed with few options to raise new capital, 2017 could spell disaster for cash-strapped Chinese companies.

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Workers sort parts at an electronics company in Tengzhou, in China’s eastern Shandong province on Feb 1, 2016.  While revenues and profits have grown, companies are squeezed for cash. (STR/AFP/Getty Images)Workers sort parts at an electronics company in Tengzhou, in China’s eastern Shandong province on Feb 1, 2016.  While revenues and profits have grown, companies are squeezed for cash. (STR/AFP/Getty Images)

Chinese regime leader Xi Jinping is rocking so many boats on the political front that he wants to make sure the economy and financial markets remain stable in 2017. He even said he prefers stability over meeting the regime’s GDP growth target. 

The past year was a partial victory, as the regime managed to contain massive capital outflows, labor market stress, and stock market crashes by using the usual tactic of pushing hundreds of billions of dollars into the economy through the state banking system. But underneath the surface, risk in financial markets keeps building. 

Xi recently admitted at a secret meeting that China may not meet its target for GDP growth if doing so creates too much risk, according to a Bloomberg report. As long as the economy and employment remain stable, growth can slip below the 6.5 percent target.

“Investors may obsess over GDP, but the Party can demand any GDP figures it wants. What matters to Beijing is joblessness. If net hiring looks good, the government has little reason to act, even if other indicators show results which disturb markets,” states a report by research firm China Beige Book (CBB).

CBB has made a name for itself by providing accurate on-the-ground data for China’s economy, as official figures are often unreliable. The researchers interview thousands of companies and hundreds of bankers in China each quarter to get an accurate gauge of the themes in the Chinese economy.

The latest report reflects the narrative of the Chinese regime as well as Western analysts: The economy has stabilized thanks to stimulus, and the labor market is also stable.

Revenues in retail, the service sector, manufacturing, transportation, real estate, and the commodity sector increased at more than 50 percent of the companies surveyed in the fourth quarter of 2016, a good indicator of solid GDP growth. Overall profits increased as witnessed by 47 percent of companies and 43 percent of firms hiring more workers. 

Keeping workers happy is the most important objective for policymakers, as an article by regime mouthpiece Xinhua in August stated: “China did not fabricate its unemployment data, and it can keep it stable despite redundancy pressures … Unemployment reflects the performance of an economy and influences policy.”

However, stability in China is a double-edged sword for Western investors. If things are good, more stimulus is probably not forthcoming. “If net hiring looks good, the government has little reason to act, even if other indicators show results which disturb markets. In the fourth quarter, net hiring looked very good, leaving no reason for stimulus in early 2017,” states the CBB report. 

Financial Pressure

This gain in growth and hiring came at a price, however. Profits and revenues at firms are rising, but the cash doesn’t show up at the firms—a potential signal of financial stress. “Cash flow pain persisted, with the year-on-year results rather eye-catching,” states the report.

Much of the cash flow from a company’s operations is determined not only by how much the company sells but also, much more importantly, by how much of that money it receives and when. If a company is still waiting for payment, the money is booked under a category called “receivables.” This category got bigger in 22 percent of the companies CBB surveyed and decreased in only 15 percent of the firms in the survey.

Likewise, if some businesses have to wait for money, they are going to delay payments to their suppliers (“payables”). The payable category got bigger in 26 percent of companies and decreased in only 17 percent—some of the worst readings in CBB’s history.

A survey by Bloomberg earlier this year showed that it takes 83 days for the average Chinese firm to get paid, almost double the time it takes in other emerging markets. As for paying out, Chinese companies are even slower. Euler Hermes, a company that specializes in trade credit insurance, shows that Chinese companies took 88 days on average to pay their obligations in 2015. 

Another drain on cash is a rise in inventory. The companies spend money to produce goods but don’t sell them for the time being. Inventories got bigger at 39 percent of the firms in the fourth quarter, the largest increase on record for the CBB survey. 

The long delays in settling bills could be a sign that payments for interest and debt—another negative for cash flow—are overwhelming companies. If these payments become too large, the companies have to squeeze operational cash flow to keep on going or borrow even more to make their immediate payments.  

“Cash flow could explain why firm borrowing in the third and fourth quarters hit the highest levels CBB has reported since mid-2013. Firms may not be borrowing to fund expansion, but rather to cover shortfalls,” states the report. 

 If firms can’t borrow more or squeeze their suppliers, they will go bankrupt. According to research by Goldman Sachs surveying companies in China, four have defaulted on $3 billion worth of bonds since the middle of November. These defaults are a break with the record in the previous five months from June to October, when only three of the companies surveyed didn’t meet their payments. Given that China’s companies are drowning in debt, this squeeze on cash flow does not bode well for stability in 2017.

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Pedestrians walk past the People's Bank of China, the central bank of China, in Beijing July 8, 2015. (Greg Baker/AFP/Getty Images)Pedestrians walk past the People's Bank of China, the central bank of China, in Beijing July 8, 2015. (Greg Baker/AFP/Getty Images)

The U.S. Federal Reserve is poised to raise benchmark interest rates as soon as this week, which may bring wide-ranging impacts to China’s own economy and monetary policy.

The Chinese economy serving as backdrop has shown signs of slight improvement in recent weeks. October trade data was positive, according to state statistics, with both imports and exports increasing in dollar terms compared to a year ago.

Exports were flat (at 0.1 percent) but up considering recent strengthening of the dollar. Imports surged—up 6.7 percent—on higher inflows of commodities such as oil, copper, and coal.

Deflationary pressures also eased somewhat. China’s producer’s price index (PPI)—a measure of price of factory inputs—rose in November as prices of coal, steel, and crude oil all jumped. Consumer inflation also picked up more than forecast, and should continue to rise given the increase in PPI.

An expected series of U.S. rate hikes—December’s 25 basis points should only be the beginning—will continue to boost the dollar and exacerbate existing capital outflows which Beijing is trying hard to restrict. And with continued positive inflation figures domestically, People’s Bank of China (PBoC) could be pressured to tighten its own rates policy in the near future.

No End to Capital Outflows

A stronger dollar makes U.S. investments more attractive to the Chinese, considering recent depreciation of the yuan.

This could prompt Chinese investors and companies to continue searching for loopholes around capital controls put in place by Beijing to limit cash outflows. China has already spent a big portion of its foreign exchange reserves to manage a depreciating yuan. Any continued strengthening of the dollar will put even more burden on Beijing to burn through its remaining reserves.

PBoC’s reported foreign exchange reserves dropped $69 billion in November, a decline of 2 percent from October and the biggest monthly slide since January. China’s foreign reserves have largely been declining since August 2015 as the PBoC has sold dollars, and as the dollar’s relatively strength versus basket of other currencies increased.

Along with selling the dollar, Beijing is aggressively cracking down on cash leaving the country from companies and individuals. Consumers already face a $50,000 annual conversion limit. For companies, authorities recently barred foreign acquisitions of $10 billion or more, and instituted a new program where each transfer of greater than $5 million must be reviewed and approved by regulators.

BBG

(Source: Bloomberg)

A widening gap between onshore and offshore yuan prices points to further yuan depreciation—and possible outflows—ahead. Hong Kong-traded CNH (offshore) yuan fell 0.84 percent versus the dollar in the last week (ending Dec. 8) while CNY (onshore) dropped 0.41 percent. Analysts generally view the CNH to be an accurate predictor of future dollar to yuan direction as it is not restricted by Chinese regulators.

Tightening Rates and Chinese Corporates

With cash expected to continue to flow out of China, Beijing may have little choice but to tighten its own monetary policy.

If authorities choose to go down this route, corporate loan defaults could accelerate and some companies may find it difficult to service their debts and stay solvent.

To put it in context, China’s total debts stand at over 250 percent of the country’s GDP. Fitch Ratings sounded the alarm last week after it estimated that some 15 to 21 percent of all loans in China’s banking system are non-performing. Those figures have been widely suspected, but regardless it’s a staggering amount compared to official average statistics of less than 2 percent at the nation’s biggest lenders.

SHIBOR

(Source: Shibor.org)

After an initial flurry of corporate defaults early this year, few companies have been allowed to falter since. Instead of a massive wave of defaults like some analysts predicted, Beijing avoided such action by turning to more creative measures. Facing a slew of redemptions at maturity this year, state-owned companies employed other avenues to assuage the problem by using debt-to-equity swaps, and if the companies are still viable, issuing new bonds or using shorter-term financing to roll over long-term debt.

Until now, easy credit has made issuing new bonds cheap and easy. China financial data firm Wind Info estimates domestic bond offerings are up 44 percent year-to-date compared to 2015. But outside of the largest issuers, small to medium sized companies are increasing turning to short-term financing such as issuing commercial papers wealth-management products.

But these solutions are the most susceptible to interest rate fluctuations. If Chinese interest rates continue to rise, these strategies will no longer be viable.

The 3-month SHIBOR (Shanghai Interbank Offered Rate) has increased 12 percent in the last 60-day period to 313 basis points. Such increases in short-term interest rates may squeeze corporate financing activities and cause defaults at already cash-strapped companies.

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Chinese retirees walk on the street in Beijing Oct. 16, 2014. (Kevin Frayer/Getty Images)Chinese retirees walk on the street in Beijing Oct. 16, 2014. (Kevin Frayer/Getty Images)

To boost returns and support a growing population of aging pensioners, China is embarking on a plan to centralize management of pension funds and divert more money into riskier asset classes.

The blueprint calls for transferring portions of local and regional pension funds to the centrally managed National Social Security Fund (NSSF), which is based in Beijing and has broader mandates to invest in riskier assets such as stocks, stock funds, and private equity.

The expansion of the NSSF and deployment of money into the stock market serves a dual purpose for the Chinese communist regime. In theory, investing in the stock market should generate greater returns and boost the size of the fund to cover growing pension commitments. This is something the local and regional funds couldn’t previously accomplish due to their investment restrictions and the low interest rate environment.

In addition, funneling more institutional money into China’s equity markets could reduce stock market volatility by decreasing influence of fickle retail investors. The more stable fund flow from pension funds should stabilize markets which has suffered from sudden retail investor inflow and outflows in the last two years.

Beijing began outlining a transfer of assets to the NSSF since last June, in the midst of Shanghai’s stock market bubble and subsequent crash. Guangdong Province was the first to transfer assets to the NSSF, and other provinces are following suit. As of December 2015, the NSSF managed 1.9 trillion yuan ($276 billion) of assets.

High Reward, Higher Risk

Currently, local and provincial pension funds are restricted to investing in safer asset classes such as bank debt and government bonds to preserve capital. But due to low interest rates, such investments have generated such meager returns that many pension funds find themselves unable to cover retirement payouts at a time when more state employees are approaching retirement.

The NSSF has no such restrictions and can invest up to 40 percent in stocks. At the end of 2015, 46 percent of NSSF’s assets were direct investments into companies, while the remainder were managed assets and investments, including stocks. According to the National Council for Social Security Fund which administers the NSSF, its assets appreciated 15.2 percent in 2015 and 8.8 percent inception-to-date.

Those are good returns, assume the figures are believable. But investment returns and monetary policy are often fleeting. Within a different set of circumstances—a higher interest rate environment, for example—the fixed-income heavy local and provincial pension funds could beat the returns of the riskier NSSF.

What this asset transfer from provincial funds to the NSSF means is that going forward, the fortunes of all Chinese state retirees now rest upon investment managers in Beijing.

The problem isn’t the disparate investment strategies between funds—competent investment managers can disagree on asset allocation philosophy. Pensioners should be concerned that the interests of NSSF investment managers in Beijing may not always align with those of the retirees.

Exposure to Non-Performing Loans

The NSSF already appears to be doubling down on its risky bets by dipping into increasingly more toxic asset classes that could partially be motivated by political pressures.

The four massive state-owned asset management companies—set up to buy piles of non-performing loans (NPLs) from Chinese banks—are in the midst of raising new capital from a combination of IPOs and strategic investments from insurance companies and pension funds.

The NSSF will invest in at least two of these “bank banks,” as they’re commonly referred to—China Great Wall Asset Management and China Orient Asset Management. Both are also seeking IPOs early next year.

The bad banks were set up by China in 1999 to resolve the nation’s NPL problems resulting from years of bank loans to mismanaged state-owned enterprises (SOEs). The bad banks bought NPLs from state banks, freeing the latter’s balance sheets so they could keep lending to SOEs.

These bad banks essentially act as clearinghouses for China’s bad-debt problem. Beijing is able to shift such devalued—and sometimes worthless—assets away from the banks’ balance sheets, swapped out for either cash or bonds issued by the bad banks. That’s how the country’s big banks can claim sub-2 percent bad-loan ratios.

Initially, bad banks were given ten-year loans to finance the asset purchases and were supposed to go away after winding down the NPLs in ten years. But China’s debt-fueled economy has been generating so many NPLs that these bad banks are here to stay and need capital infusions to keep buying more NPLs.

And that’s where Beijing wants the NSSF and other retail investors to step in. Need more evidence that the interests of Beijing are going to increasingly influence management of pension assets? China’s recently deposed Finance Minister Lou Jiwei was appointed as the new chairman of NSSF, according to financial magazine Caixin.

Early Retirement and Social Unrest

At the same time, some Chinese provinces are instituting early retirement plans to push workers off active state payrolls. At least seven provinces—mostly in the Northeast—announced the plans, in part to comply with Beijing’s directive last year to reduce steel and mining capacity.

Similar to the 1990s policy enacted by then-Prime Minister Zhu Rongji, these early retirees don’t count toward official unemployment statistics and their pension benefits are deferred. China’s official retirement age for state employees is 60 for men and either 55 or 50 for women depending on position. Early retirement plans generally accelerate those rules by five years. They get a reduced monthly stipend during the five years, but must wait until the formal retirement age to enjoy pension benefits.

This alone has generated a spate of small but growing protests in the nation’s rust belt. If NSSF’s returns falter and the fund has trouble meeting its liability payments in the future, Beijing’s problems could quickly exacerbate.

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A Bank of China branch in the City of London May 13, 2016. Bank of China is one of a number of Chinese banks looking to expand their presence abroad. (Dan Kitwood/Getty Images)A Bank of China branch in the City of London May 13, 2016. Bank of China is one of a number of Chinese banks looking to expand their presence abroad. (Dan Kitwood/Getty Images)

In an effort to curb runaway real estate prices, major banks in Australia—a popular destination for Chinese real estate investors—have stopped lending to foreign property buyers without domestic income.

Enter Bank of China, China Construction Bank, and the Industrial and Commercial Bank of China. Chinese purchases of Australian real estate barely skipped a beat, as local branches of Chinese banks have stepped in to fill the gap.

Chinese banks are following their corporate and retail clients by expanding abroad, bucking a global banking industry trend of retrenching.

However, compliance and regulatory obstacles could slow their ambitions. And despite recent gains, their overall global footprint is unlikely to challenge current market leaders in the near future.

According to data from China’s Ministry of Commerce, China’s outward direct investment (ODI) rose to $103 billion between January and July 2016, a 61.8 percent increase from the same period last year.

The United States and Germany were the most popular destinations for Chinese foreign investment, driven by major corporate mergers and acquisitions.

Chinese domestic banks are attempting to ride this wave. At the end of 2015, more than 20 Chinese banking organizations had set up 1,300 locations across 59 countries and territories, according to data from Bank of China.

“Chinese banks’ overseas loans increased by more than $600 billion since 2010 to reach near $1 trillion at the end of 2015, and are likely to grow further with the government’s support for companies’ ‘go global’ policies,” wrote the IMF in an August report “China’s Growing Influence on Asian Financial Markets.”

China_Banks_Deploy

China outward direct investment (ODI). (Source: IMF)

China Construction Bank, its second-largest bank by assets, is looking to expand its footprint from 24 to 40 countries and increase foreign contribution of pretax profit from 1.7 percent as of 2015 to 5 percent by 2020, according to its Chairman in a recent speech in Hong Kong.

Among its peers, Bank of China has the biggest foreign operation, contributing to 23 percent of its pretax profit last year.

Bucking a Trend

Chinese banks are pivoting abroad while established global banks are scaling back.

Ten years ago, New York-based Citigroup Inc. had a retail presence spanning 50 countries from Tokyo to Madrid serving almost 270 million people globally. But profit and regulatory pressures have caused the bank to close or divest operations in more than half of those locations, including Turkey, Guatemala, and Japan.

The retrenching at Citi, HSBC, and other global banks has been quick and dramatic. The goal is to get leaner by focusing on the most profitable customers such as high-net-worth individuals and multinational corporations.

That has also been a goal of Chinese banks—as wealthy consumers and both private and state-owned companies look for foreign assets, the banks have been there to lend.

There’s also a political component to the expansion. China’s state-directed “One Belt, One Road” initiative have forced Chinese banks to enter emerging markets in the Middle East and West Asia where the banks otherwise wouldn’t venture. That’s a major reason the “big five” Chinese banks have been ahead of smaller banks in expanding abroad.

Regulatory Push Back

Chinese banks’ activities are coming under increasing scrutiny, especially in Australia where they’ve exported the hyper lending that fueled China’s real estate bubble.

Chinese banks have financed the majority of recent Chinese purchases of property and corporations in Australia. Loans originated by Australian branches of Chinese banks increased at four times the rate of growth for loans originated nationally during the first quarter of 2016, according to Australian government data. This has prompted regulators to warn that such rapid expansion by foreign lenders could become a systemic threat to the Australia’s financial system.

“One is duty bound to observe that there is a history of foreign players expanding aggressively in the upswing only to have to retreat quickly when more difficult times come,” Reserve Bank of Australia Governor Glenn Stevens said in a speech in Sydney in March. Stevens did not single out China specifically.

Lack of controls adhering to the more stringent foreign regulatory framework is another common risk facing Chinese banks with overseas aspirations. The U.S. Federal Reserve last month ordered the New York branch of the Agricultural Bank of China to improve its anti-money-laundering (AML) infrastructure after examiners found “significant deficiencies” in its AML controls.

While the Fed did not specify what the violations were, the regulator said on Sept. 29 that it had found major flaws in risk management — monitoring and combating illicit banking transactions — at the bank’s local branch.

Agricultural Bank of China is the latest example of Chinese bank having difficulties with U.S. AML and know-your-client rules. The Fed gave similar warnings last year to Bank of China and China Construction Bank regarding AML procedures.

And there’s reason for the heightened scrutiny. Global Financial Integrity, a Washington-based financial industry watchdog, estimated that between 2004 and 2013 China was the world’s biggest source of illicit monetary outflows, according to Reuters. China accounted for about 28 percent of the $4.9 trillion in illicit funds moving from the world’s ten biggest economies.

China’s “Big Five” banks are approaching 10 trillion yuan in combined overseas assets.

Minding the Gap

Despite the challenges, China’s “Big Five” banks are approaching 10 trillion yuan ($1.5 trillion) in combined overseas assets for the first time.

But they still lag behind their global peers in many respects and have inadequate business models. “The over reliance on interest income [at Chinese banks] as a profit model most definitely requires change,” according to a joint PwC-Renmin University study on internationalization of banks.

Currently, Chinese banks provide a financial support network for Chinese businesses and nationals in overseas markets, especially as Chinese companies need to transfer cash to make acquisitions abroad or invest in local R&D.

The banks generally focus on commercial and merchant banking, and do not offer a full product suite including asset management or investment banking like their international peers. As more countries and organizations use the yuan to settle payments, Chinese banks’ overseas influence and product portfolio could grow.

That’s the easy part. But Chinese banks lack the single most important element for any bank’s success: trust.

Major Chinese banks answer to the Chinese Communist Party, not its customers. Their systems and processes are often archaic. For political reasons, state-owned lenders eschew global industry-leading software for homegrown systems. Risk management and corporate governance is often lax.

For Chinese banks, the business framework for global expansion is in place. The trust? Not so much.

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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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World leaders have gathered in Brisbane, Australia, for the annual G20 Summit. (Andrew Taylor/G20 Australia via Getty Images)World leaders have gathered in Brisbane, Australia, for the annual G20 Summit. (Andrew Taylor/G20 Australia via Getty Images)

News Analysis

Inclusive growth, green energy, more trade, and a move away from financial crisis management to long-term planning—those are the official goals of the 2016 G-20 meeting in Hangzhou, China.

And wouldn’t it be great if the leaders of the world’s biggest economies could just flip a switch when they meet Sept. 4–5, forget about the huge economic issues, and focus on a prosperous future?

“China’s leadership steered the debate to facilitate the G-20 to move from short-term financial crisis management to a long-term development perspective,” U.N. Secretary-General Ban Ki-moon told Chinese reporters in New York on Aug. 26, according to state-run news outlet Xinhua.

But reality doesn’t work like that and huge frictions already lie beneath the surface, especially concerning the host. Aside from a very messy geopolitical situation in the South China Sea, the Middle Kingdom faces an economic crisis at home.

Neither the West nor China knows how to deal with China’s overcapacity and debt problems without ruining world trade and globalization altogether, let alone promoting inclusive growth and green energy.

“China is angry with almost everyone at the moment,” a Beijing-based Western diplomat told The Fiscal Times. “It’s a minefield for China.”

Global Effect

Despite China’s relatively closed financial system, the economic growth of many countries, like Brazil and Australia, depends on China’s huge consumption of commodities. Other countries, like the United States, are not vitally dependent on Chinese inflows of capital but have gotten used to trading Treasury bonds and New York real estate for cheap Chinese goods.

Ideally, the West would encourage China in its official quest to reform and rebalance its economy from manufacturing exports and investment in infrastructure to a more service- and consumption-driven economy.

The United States’ and most of Europe’s trade deficit with China would be reduced. The Chinese consumer would have more income to consume at home, importing Western goods and services instead of commodities.

There is no world after the tomorrow where China devalues by 20 percent.

— Hugh Hendry, principal portfolio manager, Eclectica Asset Management

“The necessary structural reforms would make it the largest consumer market in the world. Every other economy would benefit,” independent economist Andy Xie wrote in the South China Morning Post.

Chinese leaders and state media have repeatedly stressed they are behind this goal. “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 quoted Premier Li Keqiang, who said the country has no Plan B.

Regime leader Xi Jinping again stressed the importance of reform in a meeting of the Central Leading Group for Deepening Overall Reform. “The country should focus more on economic system reforms and improve fundamental mechanisms that support these overhauls,” Xinhua wrote about a statement released by the group.

However, China has not entirely followed through with the reforms, which will cause short-term turmoil, and local governments are not prepared to handle worker unrest. Up to 6 million people will lose their jobs because of the regime’s rebalancing program, and the official unemployment rate could reach 12.9 percent, according to a report by the research firm Fathom Consulting.

For example, Hebei Province was supposed to close down 18.4 million tons of steel-producing capacity in 2016. By the end of July, it had only closed down 1.9 million tons, according to Goldman Sachs.

(Goldman Sachs)

Hebei province was supposed to close down 18.4 million tons of annual steel-production capacity and only managed to close down 1.9 million tons by the end of July. (Goldman Sachs)

The economies of Australia, Brazil, Russia, and South Africa—all major commodity exporters—are slowing because Chinese imports have collapsed, falling 14.2 percent in 2015 alone, according to the World Trade Organization. In 2015, world merchandise imports crashed 12.4 percent, while world merchandise exports crashed 13.5 percent.

Australian exports and imports (World Trade Organization)

Australian exports and imports. (World Trade Organization)

This collapse in world trade happened before China even started to implement its goals of reducing overcapacity, liberalizing the capital account, and floating its currency.

Instead, it has been buying time by pushing credit in the economy and spending it on infrastructure investment through state-owned companies and local governments, while private companies have thrown in the towel.

(Morgan Stanley)

(Morgan Stanley)

Debt Problem

China has also told banks not to push delinquent companies into default but instead to make their loans evergreen or swap debt for equity.

The real question the West and China should be asking is how much pain they can endure in the short term to reach the Chinese reform goals and achieve a rebalancing toward a consumer economy.

“To avoid a financial crisis that would be bad for China and the world, the government needs to tighten budget constraints, allow some firms to go bankrupt, recognize the losses in the financial system, and recapitalize banks as needed. … History shows it makes more sense to help the affected workers and communities rather than to try to keep alive firms that have no prospect of succeeding,” the Brookings Institution stated in a paper on the subject.

However, the proposed remedies, which in the long run would be good for China and the world, cannot happen without upsetting the global financial system in the short term.

Billionaire investor Jim Rogers pinpointed the main issue in an interview with Real Vision TV: “I would certainly like to see more market forces everywhere, including in China. If that happens, you’ll probably see more fluctuations in the value of the currency.”

What sounds innocent, however, will be even more detrimental to world trade and the global financial system. If China wants to realize the losses it accumulated through 15 years of capital misallocation, it will have to recapitalize the banks to the tune of $3 trillion.

It’s impossible to do this without heavy intervention from the central bank of the kind Li Keqiang wanted to avoid. On the other side, Chinese savers will try to move even more money abroad to protect the purchasing power of their currency.

In 2015 alone, China lost $676 billion in capital outflows, mostly because residents and companies wanted to diversify their savings, the majority of which are tied up in the Chinese banking system.

If China were to restructure corporate debt and recapitalize banks on a massive scale, the currency would devalue by at least 20 percent, according to most experts.

Trade Collapse

Because China is such a large player, exporting and importing $4 trillion of goods and services in 2015, a 20 percent devaluation of the Chinese currency would destroy the current pricing mechanism for importers and exporters across the world—a mutually assured destruction scenario.

“The world is over. The euro breaks up; there’s just no euro in that scenario. Everything hits the wall. There is no world after the tomorrow where China devalues by 20 percent. Their share of world trade has never been higher. … You would destroy global manufacturing,” Hugh Hendry, principal portfolio manager at Eclectica Asset Management, told Real Vision TV. 

Global trade for the developed economies is already in recession (World Trade Organization)

Global trade for the developed economies is already in recession. (World Trade Organization)

For China itself, a net importer of food supplies, a devaluation would make necessities even more expensive for the vast majority of the population, adding a layer of social unrest on top of the unemployment pressures.

So China is damned if they do and damned if they don’t. Even the West won’t favor a quick and painful devaluation scenario and isn’t in the best shape to offer many alternatives.

The other option, possibly discussed behind closed doors at the G-20, is a Japan scenario. China won’t realize bad debts, will keep zombie companies alive, and will prevent money from moving abroad, defaulting on its ambitious reform agenda.

“In lieu of a quick adjustment, a ‘gradual adjustment approach’ would leave us with the outcome of an extended period of excess capacity, disinflationary pressures, and declining nominal growth and returns in the economy,” investment bank Morgan Stanley stated in a note.  

China, the West, and Japan share the same problem of excess debt and no expedient way to get rid of it. By not naming the real issues at hand and choosing feel-good topics instead, the G-20 has already admitted defeat in finding a solution to the problem.  

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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 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.  

Follow Valentin on Twitter: @vxschmid

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International Monetary Fund Managing Director Christine Lagarde speaks at the 40th anniversary of the IMFC meeting at the IMF Headquarters in Washington, April 20, 2013. (Stephen Jaffe/IMF via Getty Images)International Monetary Fund Managing Director Christine Lagarde speaks at the 40th anniversary of the IMFC meeting at the IMF Headquarters in Washington, April 20, 2013. (Stephen Jaffe/IMF via Getty Images)

When Bloomberg reported late last year that China founded a working group to explore the use of the supranational Special Drawing Rights (SDR) currency, nobody took heed. 

Now in August of 2016, we are very close to the first SDR issuance of the private sector since the 1980s.

Opinion pieces in the media and speculation by informed sources prepared us for the launch of an instrument most people don’t know about earlier in 2016. Then the International Monetary Fund (IMF) itself published a paper discussing the use of private sector SDRs in July and a Chinese central bank official confirmed an international development organization would soon issue SDR bonds in China, according to Chinese media Caixin.

Caixin now confirmed which organization exactly will issue the bonds and when: The World Bank and the China Development Bank will issue private sector or “M” SDR in August.

The so-called SDR are an IMF construct of actual currencies, right now the euro, yen, dollar, and pound. It made news last year when the Chinese renminbi was also admitted, although it won’t formally be part of the basket until October 1st of this year.

How much? Nikkei Asian Review reports the volume will be between $300 and $800 million and some Japanese banks are interested in taking up a stake. According to Nikkei some other Chinese banks are also planning to issue SDR bonds. One of them could be the Industrial and Commercial Bank of China (ICBC) according to Chinese website Yicai.com.

The IMF experimented with these M-SDRs in the 1970s and 1980s when banks had SDR 5-7 billion in deposits and companies had issued SDR 563 million in bonds. A paltry amount, but the concept worked in practice. 

The G20 finance ministers confirmed they will push this issue, despite private sector reluctance to use these instruments. In their communiqué released after their meeting in China on July 24:  

“We support examination of the broader use of the SDR, such as broader publication of accounts and statistics in the SDR and the potential issuance of SDR-denominated bonds, as a way to enhance resilience [of the financial system].”

They are following the advice of governor of the People’s Bank of China (PBOC),  Zhou Xiaochuan, although a bit late. Already in 2009 he called for nothing less than a new world reserve currency.

“Special consideration should be given to giving the SDR a greater role. The SDR has the features and potential to act as a super-sovereign reserve currency,” wrote Zhou. 

Seven years later, it looks like he wasn’t joking. 

Follow Valentin on Twitter: @vxschmid

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