Thursday, June 20, 2013

Painful Reform is Under Way?

Chinese Economy - Reform will be Painful and is under Way?

This report is a continuation of the last report written on 15th June. The previous report was fairly optimistic, that the move to change the 30 year old Chinese Model had begun. But the latest signs (several current reports are analysed below) including a drop in manufacturing activity and extremely high short-term interbank interest rates. These early signs seem to indicate that industrial activity is bound to contract and this could bring pain to millions employed in the industrial sector. But perhaps the managers of the Chinese economy have prepared for this moment. The Social Security net and medical insurance has been expanded to almost the entire population. Free school education (9 years) and unemployment insurance are measures which will considerably alleviate this pain and keep the consumption going. It is obvious that the Chinese leadership will be monitoring the economy and taking appropriate steps to manage this transition successfully. On the one hand the world will be watching whether the thoughtful Chinese leadership come out with a more improved way of handling this Austerity phase. On the other hand, the resoluteness of the Chinese leadership will be tested if the pain becomes deeper. Most economies have to make such painful adjustments when they are in a corner and at the mercy of the global financial institutions. The plus point is that the Chinese have deliberately decided on this painful move when the economy is not in a corner and China has ample financial resources to adjust and modify its decisions as and when required and not be forced into doing anything by compulsion. Till only last week many western reports were pointing Xi Jinping out to be an old-school Maoist who will not bite the reform bullet and take the country leftward. The current initial trends if confirmed indicate on the contrary that Xi Jinping could be in the Zhu Rongji mould (SOE privatisation and retrenchment) of taking tough neo-liberal economic decisions. And like Zhu Rongji he seems to be backing up his touch decisions  with social welfare measures to alleviate the people's pains. 

All of the fascinating news coming out of China seems to be revealing that big changes are under implementation. Although these changes have the potential to shake China up, successfully implemented they will leave China much stronger. This will not be easy and could  lead to lot of pain and turmoil in China. But as of now, China despite having the financial capacity to postpone the problem has decided to tackle the Systemic structural problems of over-investment and over-reliance on exports  and shift to a consumption based economic system. Let us now go straight to the four news reports which have come out today (19-20th June), which seem to indicate that at this point the Chinese leadership is committing itself to strong steps to changing the China Model. These reports also provide some details of how the Chinese leadership's decision to slow down investment is having effect. 

The following is from a Bloomberg Report  of 20th June 2013. Please click here -
China’s seven-day repurchase rate, a gauge of interbank funding availability, touched 12 percent today (while the overnight rate had touched nearly 30%!!), the highest in data going back to May 2006, as the central bank refrained from using reverse-repurchase agreements to inject cash into the financial system. The Finance Ministry separately added 40 billion yuan ($6.5 billion) via an auction of six-month deposits. “If market rates remain at such high levels, the only scenario for the Chinese economy is a hard landing,” said Xu Gao, chief economist with Everbright Securities Co. in Beijing. “That possibility is growing now -- it seems the leadership is deliberately taking a wait-and-see stance to see how low China growth can be.”

So what was a surmise when the previous report (of 15th June) was written now seems to be getting confirmed - that the government is deliberately laying off from injecting cash to desperate corporates. A period of low growth and belt tightening seems to be upon the Chinese economy unless the desired take-off of the consumption sector occurs. The China Model is under stress and it is unsure how whether it will be able to come through successfully out of this current round of problems.

The second report in Businessweek of 19th June says (Please click here) -
The seven-day repurchase rate, rose to the highest since at least 2006 today because slowing economic growth, drying up of foreign funds because Fed has intimated a rise in US interest rates; a crackdown on illegal capital inflows and efforts to rein in shadow banking have contributed to increased borrowing costs.

The State Council meeting yesterday “dashed hopes for any immediate rescue efforts by the central bank to ease the credit crunch,” such as reserve-ratio or interest-rate cuts, Tang Jianwei, a Shanghai-based economist at Bank of Communications Co., said by telephone today. “Between stabilizing economic growth and adjusting the growth model, China’s top policy makers have clearly made the decision to focus on the latter.”
“Beijing’s new approach is to focus on reform, rather than stimulus,” said Qu Hongbin, HSBC Holdings Plc’s Hong Kong-based chief China economist. “In the last three months, we have seen enough evidence that the current generation of leadership is really determined to push forward reform.”

What could be the nature of this reform? China must push forward interest-rate liberalization, encourage corporate overseas investment (OFDI), boost bond issuance and support those seeking to buy their first homes, according to the statement. Bank lending for projects in industries with overcapacity must be banned, the State Council said. This has already been confirmed when Suntech the leading edge solar technology firm was allowed to default on a $500 million loan. China's solar technology industry and even their iron, steel, aluminium industries are having huge over-capacity.

The evidence available to us seems to indicate that the Chinese economy seems is on the road to painful reform and restructuring.

The third report is from The Telegraph (19 June 2013). Please click here.
This again goes into the details and guesses that the People's Bank of China (PBOC) is deliberately holding bank the liquidity and teaching the banks a lesson for indulging in Shadow banking and making things risky. It also expects that when large payments are due next month it will release the liquidity.
One needs to keep in mind that the problem of shadow banking has escalated tremendously only in the last five years when China was responding to the Global Financial Crisis and trying to maintain its growth rate. All the fiscal stimulus could manage just a 7-9% growth rate over the last five years. This government had been ignoring the dubious semi-legal methods which were generating this increased liquidity. But this is becoming increasingly difficult as the quality of investments gets sacrificed when higher investment becomes an end in itself.

The fourth report also from The Telegraph (20 June 2013). Please click here.
This points out how the Manufacturing Activity Index "Purchasing Manager's Index" calculated by HSBC shows a drop to 48.3. Below 50 is considered a contraction. Goldman Sachs says that the HSBC index is tilted in favor of exports and the actual PMI calculated by the government should come in better. It says that "downside risks" are increasing - meaning the possibility of growth slowdown increases. But Goldman Sachs still sticks to its Q2 growth rate forecast of 7.8%. This is strange because Goldman Sachs is considered to be one of the most reliable analysts around and when if are sticking to their original forecast, probably things are not as unstable as one is made to believe by some of the strident reporting. However there seems to be a warning for the Chinese government to go a little slow with its tough reform policy to squeeze liquidity. It just might happen that in the short term reform might end up hurting deeper than expected and trigger a deeper slowdown instead of stabilising it. The Dangers of extensive Austerity are already being discussed in Europe and just might become applicable to China in the coming days.

One of the good coverages of the entire crisis phase is Simon Rabinovitch's coverage in Financial Times of June 21, 2013. Please click here.
He notes that the seven-day bond repurchase rate, which is a key gauge of liquidity, had gone up to a remarkable 10.8 percent a year. He concludes that in China where the state controls the banking system and the credit situation and which is micro-managed  "these financial strains are definitely of the government’s own making." He finds that the small liquidity crisis can cascade and become the cause of a collapse of the arger financial system. But what he fails to mention is that governments taking aggressive steps to rein in renegade banks. That does not seem to happen in the West. Banks even when they collapse are pampered with State funds and the taxpayers have to bear the burden. As regards the power dynamics  between the State and Big Business and Big Banks, the China state still wields greater power and has the edge. It can take decisions which pain the banks for improving the banking system in order to protect the larger interests of the people and society. While in the West the pain has to be borne by the people and society in order to protect the banks. This itself is a stark indicator of the clear distinctness of the China Model - capitalist though it is. Or one can call it Financial Regulation with Chinese characteristics.

Arthur Kroreber one of the most important and respected watchers of the Chinese economy has commented in The Atlantic on 22nd June. He estimates that China will get through this crisis period. But a bigger crisis seems to be building up in the long run. Please click here.

And here is the article which convinces me finally that China was an excellent story but currently it is facing a really huge challenge. Stephen Roach of Morgan Stanley is an experienced hand and has been bullish on China for a long time and his bullishness has been justified as China has weathered each storm. But now in  January end 2013, he has argued (please click here to read "China's Last Soft Landing") that China is facing an uncertain situation and without rebalancing and reforms the possibility of a hard landing is quite real. While says that China has managed a Soft Landing in the 2nd half of 2012, the future options are getting limited. He says “Without rebalancing and reforms, the days of the automatic Chinese soft landing may be over. I have been an optimist about China for 15 years. I still am. But the clock is ticking.” He feels that some of the reform which Chinese authorities must address are - developing services industries, funding the social safety net and altering the hukou-based residential-registration system.
After January he has written in March end that China is finally Walking the walk. After talking for more than 6 years since 2006, he says that, China has finally started taking the actions required for transitioning to a New Model. Please Click here to read China on the Move.

In his latest piece of April 27, "Long Live China's Growth Slowdown", he says that a services and consumption based economy has the advantage of being able to provide higher level of employment per unit of GDP and so employment can be retained at lower growth rates. Even a China which grows at say 6.5% after it has begun transitioning to services should be able to provide similar levels of employment and will not slip towards instability. He says that  China's skeptics have a tendency to exaggerate problems especially the recent one of Shadow banking and an impending credit bubble which gets further exaggerated when combined with longstanding concerns of  China descending into a dreaded “middle-income trap” scenario. This is a growth slowdown which fast growing emerging economies have to face after they reach a certain size of GDP. Please click here.

While he says that it is a possibility. He is confident that, "it is unlikely to occur if China can carry out the services-led pro-consumption rebalancing that remains the core strategic initiative of its current (12th) Five-Year Plan. Invariably, the middle-income trap afflicts those emerging economies that cling to early-stage development models for too long."

June 25, 2013, Nobel Prize winner Robert Engle who teaches finance at NYU has commented on the currently credit-squeezed increasingly risky Chinese economy today. Please click here to read the article in the China Economic Review. He feels that this is a deliberate policy of the govt of reducing credit availability and punish highly leveraged firms - which have high debt and low revenue generation to return it. They will avoid lending to risky private players and stick with safe well-performing State Oriented Enterprises. This he says will be bad for the ambitious and greedy entrepreneurs and so will be bad for the economy.
He says that over-greedy entrepreneurs create risks in the economy by taking so much leverage with the capital that’s available, that they and the banking system exposed when it goes away. He feels that there is a negative feature of State backed guarantees to the state financial system. Banks, SOEs, municipal governments which are effectively guaranteed by the government, the tend to take on more risks as they feel they are safe. As a result the true risks inside the system are not known and could be higher. But one must maintain a perspective and keep in mind that many well-known economists have bet against China over the last 2 decades based on their ideas of classical western economics and ended up burning their fingers.

David Keohane of Financial Times explains that the big State-owned banks will be the least affected. Joint stock banks will be next and the small banks which have high exposure to wealth management products are the most likely to be affected. Please click here. Isabella Kaminski of FT analyzes in detail the role of the PBoC in this crisis phase. Please click here. Kate Mackenzie of FT explains that during normal times an opaque Banking and Media system does a good job of suppressing minor rumors and keeps the financial stable. However, in the case of major crisis, such opaque systems can in fact be more dangerous as investors and customers will believe the worst nightmare rumours which will trigger instability. That is just another theory which will be verified over the coming weeks. Please click here.

One will also find out whether China has acted proactively and implemented reform long before a crisis erupted. But it is clear that they have carefully chosen a reform path which hits the irresponsible bankers who created the crisis with their illegal Wealth Management Products. A path much different from the Western model which protected the banks and punished the people. So we could possibly be witnessing here the robust features of Banking with Chinese characteristics. A banking system where large and powerful banks do not dictate policies to the State but can also be held accountable. If this risky gamble of the PBoC succeeds it could stabilize the Chinese economy for a long period of growth and also add to the attractiveness of the Chinese Model for its proactiveness and for holding the rich and powerful to account.

In the meantime it would also be appropriate to mention that all large Western banks and financial companies like Goldman Sachs, HSBC etc have revised downward there China growth forecasts over Jun 23-25. Most have revised 2013 forecasts down from 7.8 to 7.4% and 2014 forecasts from 8.4 to 8.1%.

A good brief review of Wealth Management Products can also be found here. The Economist has naturally  been investigating these unusual happenings in the Chinese banking system. Links are provided here to a series of useful articles on these topics. The Economist examines the recent spike in Chinese short-term interest rates here and here . The Economist analyzes wealth management products here and it explores why the yuan has been strengthening lately here.

A highly readable explanation of Shadow Banking and its implications, has been published in The Atlantic on June 28, 2013, "Shadow Banking Threatens China's Economy—but What Is It, Exactly?" by Ryan Perkins. Please click here to access.

The Telegraph of UK has come out with a provocatively titled "China may not overtake America this century after all". The confidence is undeniable but then the media always has a tendency to go overboard to make its point. He says that both on Innovation and Demographics , the US outscores China over the long term. Plus the US banking system has been restored and is much more stable than the Chinese banking system currently. He quotes Richard Haas who has said that the US is firmly on topic and that this will be another US century. He ends by saying that nothing is foreordained and has to be worked for. Is he implying  that China is in decline or can it return. Read here.
Read here.

George Mangus of The Globalist has also written in May 2013 that the Chinese growth story can no longer be extrapolated based on its past performance. China has entered a risky new phas. Read here.

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