China’s Downturn Will Force SOE Reform 

The standard analysis about China falls into three baskets. The first is the collapse or decline theory, with very negative views from investors like Jim Chanos and Kyle Bass against more benign economists who see China massaging the downturn. Others are hopeful that recent policy statements will lead to reform of the state sector and rejuvenate corporate activity, increase profits, reduce debt, and steer China toward growth. A third theory sees China rebalancing the economy toward consumption, as a result of lower fixed asset investment and a rising middle class.

I don’t think any of these capture the features that we are likely to see in the coming two to three years. Instead, I see China splitting into two camps – the wealthier cities, protecting their state firms, against the more impoverished smaller cities and remoter provinces, whose state firms will gradually run out of money. A collapsing property bubble will exacerbate this split.   Continue reading →

Gao Xiqing

I am frequently asked what data points to monitor to gage the likelihood of a hard landing, or at the least a credit crisis that alters the trajectory of China’s economy. There is no easy answer. Two years ago, many investors thought rapidly rising interbank rates were a strong negative indicator for China’s economy. But the interbank market is a relatively small tool utilized by the PBOC; the rates were useful merely because they are accessible on the Bloomberg Terminal. So what measures can we examine?

1) Tier 3-4 Property Data. The smaller cities in China have GDP more closely tied to property than the larger ones and their governments are heavily reliant on land/property sales for revenue (anywhere from 30% – 80%). Plus, these cities account for as much as 60% of property construction. If there’s going to be a property crash, this is where it will start. However, the official data is heavily skewed to the top four cities which are financially and economically much stronger than other parts of China.

There are three main sources of reasonable property data: Soufun CREIS; E House, and the official National Bureau of Statistics (NBS). They all have their methodological problems and focus on national data as opposed to tiers. Soufun uses a smaller subset than NBS, but NBS relies on state developers only and excludes most private developers. E House is slightly more complete. The bigger problem is what constitutes a sale and how is it reported. There is no advantage for property developers to report bad news. For example, they can avoid reporting price declines by keeping prices flat and providing extra square footage to the buyer — a balcony, for example. Still, the larger, 100 city sets would include some Tier 3-4 cities.

2) Land Sales. Land sales constitute more than one-third of local government revenue. This is a good leading indicator — are prices, supply, rising or falling? A Beijing decision in January 2016 to limit the sale of land in areas with a property glut may cloud this data as governments will attempt to hide their sales. But cash-strapped local governments are unlikely to let this edict reduce land sales, which are hard to hide, in any case. Land sales are reported on a regular basis by the Ministry of Land and released by the local press.

3) Listed Companies. Most of the big Hong Kong listed developers have correctly concentrated their investments in the top cities. However, a few have ventured further afield — and are likely to suffer the consequences because the property overbuild is more acute in regions where governments need revenue and the hoped-for middle class has yet to materialize. One to keep tabs on is Agile Property (3383). As of 1H 2015, Agile had a 38.58M sqm land bank in 41 cities and districts, including more remote and economically weaker areas like Hainan, western China including Xian and Chongqing, and remoter areas of Yunnan Province. Agile’s ASP fell 13% in 2014 and 2.6% in 1H 2015. They are listed so their data is public.

4) Non-bank Lending. This is the most difficult to track as it is a moving target due to constant category readjustment by the banks, who are taking advantage of regulatory arbitrage. Much of bank flows since occur outside of the official restrictions of the CBRC and PBOC. They can be an indicator of underlying ‘political’ demand for capital. To fight existing or future asset bubbles, the China Banking Regulatory Commission (CBRC) got clever in 2011 by inventing something called “Total Social Financing” to include Shadow Banking on top of ordinary bank loans. They threw in Entrusted Loans, Equity Financing of non-financial companies, Undiscounted Banker Acceptances and other flows. In response, the banks dreamed up new categories of lending not included in TSF, which allowed them to expand their balance sheet without running afoul of CBRC guidelines or forcing them to say where the money was going. This Augmented TSF includes Claims on the Non-financial economy, Non-loan Claims on the Non-financial economy, and other factors. It is a better indicator of total credit in the system than TSF alone, and an indicator of credit demand and declining effectiveness of fiscal stimulus.

5) Defaults. Unfortunately, there is no real database for defaults and the press is forced to keep quiet about these. The only exception are corporate bonds, which are a small part of total capital flows. In addition, defaults frequently are avoided through recapitalizations or mergers. However, near defaults are almost as interesting as actual defaults and are an indicator of the size of the problem and how Beijing expects to resolve it. One recent example is the recapitalization by China Cinda AMC to the tune of Rmb18 billion of a golf course owned by Goldin Properties. The four Asset Management Companies — the so-called “bad banks” are the plumber’s wrench of the financial system, swooping in to plug leaks, backed by the overflowing pool of capital from the state banks. But to recapitalized a loss-making polo club suggests political connections dictate who is bailed out — not economics. This is important to note as defaults increase.

Just keep in mind — there is no simple number on the Bloomberg Terminal from China that will tell the full story.

Serious Firepower
China surprised the markets Monday by cutting the Required Reserve Ratio by 0.5 ppt, injecting Rmb 700 billion into the market. This was a desperate measure. There are several reasons why the PBOC chose to do this now.

1) Short Term Injections Too Expensive. The PBOC had been relying on Short and Medium Term loans to the banks. They cost 0.6 to 1 ppt more than ordinary reserve deposits. The banks already are suffering from margin squeeze and rising NPLs. They can’t afford further reductions in profits.

2) Zombie Loans. Total system debt tops 300% of GDP. Many loans are to “Zombie” companies for which the government and various political actors would be too embarrassed to allow to fail. Rolling over even a portion of these loans requires massive liquidity — hence the RRR cut.

3) Capital Flight Pressure Eased? Capital flight continues to create monetary shortages domestically. With China’s forex dropping about $100 billion per month, the liquidity shortage is becoming acute.

4) Biggest Available Pool of Capital. This is the most important argument. The leadership already has used up the available pools of capital. These include: a) The stock market (an abject failure); b) Policy bank injections (about Rmb3 trillion); c) Local Bond Swap (3.2 trillion which only partly replaced debt and thus was stimulative, apart from also reducing interest costs for local governments; d) Insurance Firms (Rmb1 trillion mainly invested in local government projects and real estate).

5) Replace Bank Investments. The banks already have put an estimated Rmb8 trillion into investment products, in addition to loans. These are highly stimulative as they are direct purchases of corporate financial instruments. The banks can’t do too much more of this as they weaken the balance sheet.

Currency Devaluation is the Next Step
The banks have more than Rmb 20 trillion locked into the PBOC in reserves; what political leader can resist a cash pool this large? That’s why Zhou Xiaochuan at the PBOC and the State Council are tapping this pool of capital. But the reserves won’t last forever. As capital continues to leave the country, the PBOC will have to lower RRR several times. As political economist Victor Shih has noted, ” However with average monthly outflows,measured by banks fx sales, at 65 bln rmb, the rrr cut counteracted 1.5 months in high power money drainage.

At some point, probably when the RRR approaches global levels of 10% to 13% (lower than the existing 17% in China), the bank will have to face the music and do another significant devaluation of the currency. There’s no way around that.