Dec 292013
 
 December 29, 2013  Posted by at 2:55 pm Finance Tagged with: , , ,


National Photo Co. Roller Coaster Dips, Montgomery County, Maryland 1928

There is a crisis a-brewing in China that evolves around interest rates, with interbank rates as, let’s say, the initial center piece. The underlying cause of the crisis is that both official banks and the shadow banking system seek to escape the restrictions placed on the financial system by the government and the central People’s Bank of China (PBoC), who in essence want to set all interest rates and all policies. At the very moment the regulators recently decided to let markets set some interest rates, a move intended to cool things down, money market rates went up so fast that more action by the PBoC, after an initial refusal, was deemed necessary.

The PBoC has set the interest people can get on their deposits with banks so low they’re actually losing money. Many Chinese have bought newly built empty apartments as an investment, which can’t be rented out because that would make them no longer “new”, and hence less valuable. But people are still looking for other investment opportunities. And so are the banks, who are trying to prevent a mass outflow of deposits.

One major, relatively new, option banks offer are WMPs, or Wealth Management Products. And it all gets shady right off the bat here. Banks are not allowed to lend out money directly to real estate developers and local government financing platforms (LGFPs), which therefore pay higher interest rates. Trust companies, though, are free to lend to these parties. So what do the banks do? They (co-)create trust companies, or establish business deals with them, and repackage old loans, CDO-like, into WMPs, all of which sees them move very close to, if not enter, the shady territory shadow banking operates in.

Banks conduct complex reverse repurchase transactions, or repo’s, with the trust companies, which enables the latter to lend out to real estate and local governments, at 12+%. They move this entire process through WMPs, which allows the banks to offer their clients/investors a 6% interest on deposits, and divide the remaining 6+% between themselves and the trusts. Financial innovation of the kind that would make a Chinese Alan Greenspan proud.

But, you guessed it, there is a problem here (quite a few actually). Most importantly, there is a growing liquidity risk due to the different durations of WMPs and trust loans. Two thirds of WMPs have a three months or less duration, while durations of trust loans to real estate developers or local governments are often as long as a few years. Ergo, banks have a hard time recovering funds from trust loans quickly enough to repay maturing WMPs, which leads to a lack of capital. And the PBoC eventually caved in to pressure and conducted “short-term liquidity operations” (SLOs) to make sure banks had capital. That only helped up to a point: money market rates are still quite a bit higher than before. That has a lack of “trust” and “confidence” written all over it.

The essence, and this is something I haven’t really seen being discussed at all, is that what we’re looking at is a – pretty much ordinary – power struggle. The closest I saw anyone get was Patrick Chovanec, who was quoted at BI as saying:

“The investment led growth model has made it so it’s almost like the PBoC has ceded control of monetary policy to the shadow banks.”

The current overall understanding, both in Beijing and abroad, is still that the Chinese state, the Communist Party, owns the banks and dictates all policies, both through government offices and through the central People’s Bank of China. But what the government in China is learning in crash course fashion is that the “wealthier” a nation becomes, especially if that “wealth” is realized through large increases in credit/debt created in and sloshing through its economy, the harder it is to maintain not just control over the economy, but political control in general.

The shadow banking system makes up a huge chunk of the Chinese domestic economy (JPMorgan estimated it at $5.86 trillion, or 69% of GDP, earlier this year), and nobody really knows how risky and leveraged its “capital” is. The PBoC, from its own point of view, is right to put its foot on the break in order to lower the risk inherent in the system, but if that foot comes down too heavily, the entire economic machinery might seize up. Trying to lower the risk is a risky move. That’s a Catch 22 that greatly limits the real control Beijing has over China’s financial markets.

In order to achieve the growth it has seen recently, the leadership has relied heavily on the shadow banking system, and the credit it creates through leverage, to grease the wheels of the economy. Now that it wants to rein in that system, it finds that’s very hard to do. It wants to rein it in not just for political power reasons, but also because it fears the effects the high leverage levels and high risk in the “underground economy” can have on economical and social stability. The Chinese economy as a whole would likely start showing serious cracks if growth moves below 7% per year, and without shadow banking, it appears to have gotten practically impossible to maintain that growth rate.

It looks like Beijing has embarked its economy on a 7+% growth train, but neglected to include any brakes in the design of that train. When it tries to rein in the underground economy, it risks crumbling the walls of the Forbidden City, if you permit me the poetic licence, and thereby its own power, i.e. the political control of the country by the Communist Party.

Many party leaders are undoubtedly acutely aware of how this resembles what happened in the developed world, Europe, Japan, US, where once, like in China, the state owned the banks, but where now, effectively, the banks – financial institutions-, whether they are “official” or “shadow”, own the state (though we’re good at fooling ourselves that it’s not true, an illusion that serves just about everyone on all sides of the equation). Moreover, instead of fighting that development, most of the leaders will opt to jockey for position, to wiggle and scheme all they can in order to build and improve their own personal positions in this “new” world.

It is a universal truth that when you allow money to enter into politics, money will inevitable end up purchasing, and owning, the political system. This is no different in China than it is in the west. It’s no longer about actual power anymore (that’s largely been decided), but about individual politicians’ positions in the “new world”, about who gets most outside funding.

For a while longer, some, especially at the very top, will resist the new division of powers, simply because they feel, rightly or not, that that’s the best course of action for their own particular positions. And there lies a big risk. The men at very top may have less control over the economy than they think and/or desire, but they sure still control the army, and may well feel they have the right to use that army to defend their positions. That could lead China down a long and bloody road.


I can’t resist including a lengthy quote from an email Mish posted yesterday that made me laugh, sent to him by Michael Pettis, who like Patrick Chovanec works in China and brings an equally unique perspective. Although I’m sure this was in no way Pettis’s intention, the more I read of his mail, the more I was thinking: you can just about 1 on 1 replace “China” with “The US” here; same problems, same causes. The timing is off at times, for obvious reasons, and the US has no obvious manufacturing overcapacity, sort of for the same reasons: it’s further along in the whole process, but the role played by credit and leverage surely is eerily reminiscent, to the point where it gets to be outright funny.

Lines like

“China’s astonishing growth during the past three decades is partly the result of a system that subsidized growth with hidden transfers from the household sector.” or

“Debt matters, and the only time it can be safely ignored is when debt levels are so low, and the borrower is so credible, that it creates no financial distress costs and has a negligible impact on demand.” or

“The failure of many economists to recognize that wasted investment has a cost – even as they recognize that investment has been wasted – has caused them both to misunderstand the relationship between wealth creation and GDP and to understate the future impact of this overstated GDP.”

… they make me chuckle out loud when realizing this applies to the US every bit as much as it does to China.

Pettis on Debt, Malinvestments, Hidden Losses, and China’s GDP

It is widely acknowledged that perhaps the most important reason to change the Chinese growth model is its excessive reliance on debt to generate growth. Debt has soared in recent years, to the point where many economists simply look at credit growth in the current quarter in order to determine what GDP growth over the next few quarters are likely to be.

But as China deleverages, growth in demand must drop sharply. After all, if economic growth over the past several years has been goosed by rapid credit expansion, deleveraging must have the opposite effect. It is strange that economists who acknowledge that the current growth model is overly dependent on debt have failed to understand that its reversal will have the opposite impact. If it did not, it is hard to explain why anyone would consider debt to be a problem in the first place.

If China currently has wasted significant amounts of investment spending, it is clear that much of the accompanying bad debt has not been written down correctly. Bad loans are almost non-existent in the banking system – that is they have not been recognized in the form of reserves or write-downs.

But the failure to recognize the loss does not mean that the loss does not exist. The losses implicit in the bad loans must (and will) be written down over the future, either explicitly, in which case they will result in a direct deduction to GDP growth, or implicitly, in which case they will require implicit and hidden transfers from one part of the economy or another (usually the household sector) to cover the gap between the “real” cost of capital and the nominal (subsidized) cost of capital. This transfer must reduce future growth.

The point here is that if credit is a problem in China – something no one doubts – it must be a problem because of wasted investment that has yet to be recognized, otherwise it would have resulted in negative GDP growth today. Failure to recognize the investment losses will, of course, artificially boost GDP growth today, but it must also artificially reduce GDP growth tomorrow as the recognition of those losses is simply postponed, not eliminated. The failure of many economists to recognize that wasted investment has a cost – even as they recognize that investment has been wasted – has caused them both to misunderstand the relationship between wealth creation and GDP and to understate the future impact of this overstated GDP.

Debt matters, and the only time it can be safely ignored is when debt levels are so low, and the borrower is so credible, that it creates no financial distress costs and has a negligible impact on demand. Neither condition applies in China, and so any prediction that ignores debt is likely to be hopelessly muddled. In fact I would like to propose a simple rule. Any model that predicts China’s future GDP growth must include, if it is to be valid, a variable that reflects estimates of the amount of hidden losses buried in the banks’ balance sheets. If it does not, it cannot possibly be a valid model to describe China’s economy, and its predictions are useless.

China’s astonishing growth during the past three decades is partly the result of a system that subsidized growth with hidden transfers from the household sector. These transfers are at the root of the current imbalances, and once reversed, so that China can rebalance its economy towards healthier and more sustainable sources of demand, the very processes that turbocharged growth will no longer do so.

If growth has been healthy and sustainable, there would be no need for Beijing to change its growth model – in fact it would be foolish to do so. If growth has not been healthy and sustainable, this is almost certainly because it has been artificially propped up, and if the reforms are aimed at unwinding the mechanisms that artificially propped up growth, then subsequent growth rates must be substantially lower.

Low interest rates, low wages, an undervalued currency, nearly unlimited access to credit for state-owned enterprises, a relaxed attitude to environmental degradation, and other related conditions were both the source of China’s ferocious growth as well as of China’s unprecedented economic imbalances. Reversing these conditions will rebalance the economy, but will do so while lowering growth in the obverse way that these conditions had accelerated growth.

One of the most obvious places in which to see this is in excess capacity in a wide range of businesses. It is clear that Beijing recognizes the problem of excess capacity. Here is Xinhua on the subject: “Tackling excess capacity will be one of the top tasks on China’s economic agenda in 2014, as the issue becomes a major challenge to maintaining the pace and quality of economic growth”. “The Chinese economy still faces downward pressure next year,” the Central Economic Work Conference pointed out on Friday, citing the capacity issue weighing down some sectors as one of the major challenges facing the world’s second-largest economy.

It should be obvious that building excess manufacturing capacity, like building up inventory, is a way of propping up growth numbers today at the expense of tomorrow’s growth numbers. Closing down excess manufacturing capacity must be negative for growth in the same way that building it was positive.

These three conditions, which are the automatic consequences of the reform process – deleveraging, writing down unrecognized investment losses, and reversing policies that goosed growth rates – must lead to much slower growth. In theory these conditions can be counterbalanced by an explosion in productivity unleashed by the reforms.

But this is unlikely to be the case. For the net impact of the reforms on growth to leave China’s GDP growth unchanged, or even to accelerate, the amount of productivity that must be unleashed by the reforms is implausibly, even extraordinarily, high. What is more, the positive impact on productivity must emerge almost immediately. Longer-term productivity improvements – for example those generated by education, land, and hukou reforms, or reforms to the one-child policy, or a speedier and more efficient urbanization process – do not count.

I am so convinced that the implementing of these reforms must result in slower growth – if only because it is impossible to find a single relevant case in history in which the adjustment following a growth miracle did not include an unexpectedly sharp slowdown in growth – that I would propose that we can judge the forceful implementation of the reforms inversely with GDP growth. If China is able to impose an orderly adjustment quickly, its GDP growth rate will slow substantially for several years.

GDP growth rates of 7% or more, on the other hand, will suggest that credit is still rising too quickly and that China has otherwise been unable to implement the reforms, in which case China is likely to reach debt capacity constraints more quickly. Growth of 7% for the next few years, in other words, is almost prima facie evidence that China is not adjusting.

Yeah, the taper. I hear you, loud and clear. I can’t help thinking that what connects the taper (or QE in general) and the China squeeze is, more than anything else, the role each plays in the control a financial system seizes over a society and its political system. At least, since it hasn’t been settled yet, the Chinese can still hope for a voice in the battle for that control. Not that that is necessarily something to be envious of: these battles can be very nasty. But, then so are battles to seize it back once it’s been lost.

I don’t pretend to know how the battle over credit will run, or even end, in China. Other than to say that money is power. It’s all a matter of who ends up with most. Still, I’m not sure that 2014 will be a good year for overt absolute power, that looks a bit outdated. There’s a reason why real political control in the west is exerted from behind a curtain: it works better that way. And I’ve long said that visibility doesn’t rhyme with power. With that in mind, the Communist Party may have exhausted its options. But that doesn’t mean it’s ready to give up. Absolute power is a powerful drug.

Nicole will be teaching, along with Albert Bates, Marisha Auerbach and Christopher Nesbitt, on a Permaculture Design Certificate course in Belize in 2014. The course will be the 9th annual event held at Maya Mountain Research Farm between Feb 10-22nd. Click here for details and registration.

This article addresses just one of the many issues discussed in Nicole Foss’ new video presentation, Facing the Future, co-presented with Laurence Boomert and available from the Automatic Earth Store. Get your copy now, be much better prepared for 2014, and support The Automatic Earth in the process!


Home Forums The Taper And The China Credit Power Struggle Squeeze

This topic contains 11 replies, has 6 voices, and was last updated by  steve from virginia 5 years, 8 months ago.

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  • #10082

    National Photo Co. Roller Coaster Dips, Montgomery County, Maryland 1928 There is a crisis a-brewing in China that evolves around interest rates, with
    [See the full post at: The Taper And The China Credit Power Struggle Squeeze]

    #10083

    rapier
    Participant

    Doug Noland addresses this power relationship between the banks and the central bank by always noting it is far far easier for the latter to loosen than tighten. Tighten and the banks and the financial players may just just threaten to blow the whole thing up. Leaving the central bank on the horns of a dilemma. In the end they always have to relent so they can live another day. It’s rarely understood in terms of power but that is exactly what it is.

    The world over the elites are gaining wealth from the flow of funds and asset inflation engendered by the credit bubble. While the Fed doesn’t have the slightest interest in upsetting the apple cart of the rich even if they did, like the PBOC they wouldn’t have the balls.

    #10085

    I doubt the same power relationship exists between the PBoC and Chinese banks as the ones in (formerly) rich nations. It will eventually, but for now the PBoC looks like a tool for the government, not the banks.

    #10087

    Professorlocknload
    Participant

    “The men at very top may have less control over the economy than they think and/or desire, but they sure still control the army, and may well feel they have the right to use that army to defend their positions.”

    The common denominator the world over. The MIC. It takes banks to run tanks, and tanks to secure banks. That’s why economic dislocations end in wars. As a means of redistributing real resources after the phoney ones are exposed?

    #10088

    Professorlocknload
    Participant

    “It will eventually, but for now the PBoC looks like a tool for the government, not the banks.”

    Like the Fed, the top dog in the PBoC is appointed by the top dogs in political power. It’s just that the image of the Fed is marketed as “independent,” in order to maintain plausible deny-ability on the part of pols. As you said. it keeps things behind curtains, so the buck can stop somewhere in the twilight zone when things go awry.

    Surely, in China the top dogs have their fingers in the banking pie, as well.

    #10097

    ted
    Participant

    It is always said that the U.S will be a reserve currency but what if other countries ie….Japan and China have to start bringing their money home out of the U.S market?

    #10099

    Professorlocknload
    Participant

    Ted, if trading countries don’t employ the Planners paper, with what will they trade? The Fed knows this, so is exporting it’s devaluation.

    The only thing holding it together (the dollar) at this point is the example set in Libya, Egypt, Syria, Afghanistan, Iraq etc. Trade…or else!

    #10125

    Raleigh
    Participant

    “China Local Government Debt Soars”

    “In a long-awaited report, the National Audit Office (NAO) said that China’s local government debt rose 70% from three years ago to 17.9tn yuan ($2.9tn, €2.1tn, £1.8tn). According to China’s last local debt audit, the figure stood at 10.7tn yuan as of end-2010.

    Beijing had ordered the NAO in July to submit an accurate report on government debts after available figures failed to show the exact debt situation.

    According to the NAO report, about 57% of the local debt was borrowed from commercial banks. In addition, 22% of the local debt matured before the end of this year, and about 40% will mature in the next two years.

    Meanwhile, total government debt including both central and local governments amounted to 20.7tn yuan as of June, representing 40% of the country’s gross domestic product (GDP). Including contingent liabilities, total government debt stood at 30tn yuan, equivalent to 55% of the GDP.

    “This national debt audit result could indicate that China’s local government debt almost doubled in about two-and-a-half years,” said Liu Li Gang, economist at ANZ Research.”

    https://www.ibtimes.co.uk/china-local-government-debt-soars-raising-fears-hard-landing-1430672

    #10128

    Raleigh
    Participant

    More Capitalism for the Chinese:

    “China’s role in global capitalism, despite its impressive growth figures, has been an assembly platform for foreign multi-national corporations. This system has brought wealth to a minuscule layer of Chinese capitalists while enormously profiting Western and Japanese companies, and their East Asian contractors.

    Two-thirds of China’s exports are shipped from factories wholly or partially owned by non-Chinese companies. In high-technology industries, the ratio is higher: Wholly owned non-Chinese corporations account for 68 percent of high-tech exports and, if firms partially owned by foreign companies are included, the total is 83 percent.

    And in contrast to misleading trade statistics, most of the money captured by this Chinese production is taken by Western and East Asian multi-national corporations, not by China. The world’s multi-national corporations profit immensely from China’s low wages and like the current Chinese system just as it is. […]

    The dramatic increase in Chinese manufacturing is driven by multi-national corporations from the U.S., East Asia and Western Europe. State-owned enterprises account for 25 percent of China’s industrial output, down from 75 percent in the mid-1980s.

    Exploitable workers are needed in those factories, and China’s supply of labor comes from rural wages being consistently 40 percent or less that of urban wages and that local and regional officials continually take and sell off farming land to developers, partly for their own enrichment but also to generate revenue to fund local government. According to a Reuters report, about four million farmers lose their land annually — and those farmers receive an average of $17,850 an acre from local governments, which resell it for an average of $740,000 an acre.”

    More Capitalism for the Chinese

    #10129

    Raleigh
    Participant

    Chart of the Day: How China’s Stunning $15 Trillion in New Liquidity Blew Bernanke’s QE Out of the Water

    “Much less has been said that of the roughly $2 trillion increase in US bank assets, $2.5 trillion of this has come from the Fed’s reserve injections as absent the Fed, US banks have delevered by just under half a trillion dollars in the past 5 years. Because after all, all QE really is, is an attempt to inject money into a deleveraging system and to offset the resulting deflationary effects. […]

    You read that right: in the past five years the total assets on US bank books have risen by a paltry $2.1 trillion while over the same period, Chinese bank assets have exploded by an unprecedented $15.4 trillion hitting a gargantuan CNY147 trillion or an epic $24 trillion – some two and a half times the GDP of China!

    Putting the rate of change in perspective, while the Fed was actively pumping $85 billion per month into US banks for a total of $1 trillion each year, in just the trailing 12 months ended September 30, Chinese bank assets grew by a mind-blowing $3.6 trillion! […]

    But more importantly, as with all communicating vessels, global liquidity is now in a constant state of laminar flow – out of central banks: either unadulterated as in the US, Japan, Europe and the UK, or implicit, when Chinese government-backstopped banks create nearly $4 trillion in loans every year. If one issuer of liquidity “tapers”, others have to step in. Indeed, as we suggested a few weeks ago, any possibility of a Fed taper would likely involve incremental QE by the Bank of Japan, and vice versa.

    However, the biggest workhorse behind the scenes, is neither: it is China. And if something happens to the great Chinese credit-creation dynamo, then we see no way that the rest of the world’s central banks will be able to step in with low-powered money creation, to offset the loss of China’s liquidity momentum.

    Finally, when you lose out on that purchase of a home to a Chinese buyer who bid 50% over asking sight unseen, with no intentions to ever move in, you will finally know why this is happening.”

    https://www.zerohedge.com/news/2013-11-25/chart-day-how-chinas-stunning-15-trillion-new-liquidity-blew-bernankes-qe-out-water

    Ilargi – “Moreover, instead of fighting that development, most of the leaders will opt to jockey for position, to wiggle and scheme all they can in order to build and improve their own personal positions in this “new” world.”

    Looks like they’re doing just that.

    #10130

    Raleigh
    Participant

    No Yuan for Growth

    “China’s investment binge of 2009-10 is dragging down its economy.

    While net exports contributed roughly 25 per cent of China’s GDP growth between 2001 and 2008, their contribution to GDP growth has been negative since. In other words, in the last four years, the Chinese economy has relied almost exclusively on domestic investment and consumption for growth.

    That is where the main causes of the economic slowdown lie. In the fast-growth period, China depended on three engines to power its economy: exports, investment and consumption. Exports and investment contributed roughly 60 per cent of the growth, with 40 per cent coming from consumption. But as the share of contribution to GDP growth from exports becomes negative, investment and consumption must make up the shortfall.

    China’s policymakers obviously recognised this challenge in 2008. Unfortunately, they botched their policy response. Instead of channelling resources to boost domestic consumption and the private sector, Beijing splurged roughly $2 trillion on fixed investments, most of them undertaken by local governments and state-owned enterprises. Predictably, such investments, financed largely by bank debt, were doomed to be unproductive. […]

    Little did they know that a significant portion of the Chinese stimulus went into useless projects. Local governments went on a spending spree, building shining office buildings, shopping malls, highways, bridges and power plants. Real estate developers erected pricey apartment buildings to capitalise on sky-rocketing property prices. State-owned enterprises expanded their production capacity indiscriminately.

    Today, the investment binge of 2009-2010 is dragging down economic growth through two channels. The financial leveraging in this period, during which Chinese banks issued new loans worth $3.6 trillion (about 43 per cent of the Chinese GDP in 2011), led to a massive build-up of debt accumulated by Chinese cities and corporations. […] Chinese banks have not recognised these loans as non-performing, mainly because Beijing has not pushed them to do so. However, the highly indebted local governments and corporations have become huge credit risks and, as a consequence, are finding it harder to draw new loans to survive. That is the reason why China’s shadow banking system has grown explosively in the past few years. […]

    This leads us to the second channel through which the stimulus of 2009-2010 is holding back growth. The massive investments in manufacturing capacity, which began earlier last decade but got a boost during this period, produced enormous overcapacity in many industries in China. As a result, profit margins have been squeezed, if not destroyed. Heavily indebted Chinese corporations, even when they get new credit, can only use it to service old loans, instead of producing for profit. Such “zombie companies” now dot the Chinese industrial landscape.

    Without addressing the two interconnected problems of over-leveraging and excess capacity, the Chinese economy is likely to stagnate and face its own version of a debt crisis at some point in the near future.”

    https://www.indianexpress.com/news/no-yuan-for-growth/1110852/1

    #10142

    steve from virginia
    Participant

    @ ilargi says:

    National Photo Co. Roller Coaster Dips, Montgomery County, Maryland 1928

    I rode that roller coaster back in the 1960s when Glen Echo was still an amusement park.

    It was indeed death-defying.

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