Trying to figure out what is going on with the Chinese economy is a first-order issue. Superficially, everything looks great; growth is right on official targets, and is at levels that the world would envy even during boom times. In spite of that–no, because of that, among other things–there are many reasons for disquiet.
A report that Chinese state-owned companies will be allowed to walk away from loss-making commodity derivative trades provoked anger and dismay among investment bankers on Monday as they feared it may set a damaging precedent.
The State-owned Assets Supervision and Administration Commission, the regulator and nominal shareholder for state-owned enterprises (SOEs), told six foreign banks that SOEs reserved the right to default on contracts, Caijing magazine quoted an unnamed industry source as saying in an article published on Saturday.
While the details of the report could not be confirmed, it was Monday’s hot topic in financial circles from Shanghai to Singapore as commodity marketers feared that companies holding underwater price hedges could simply renege on the deals, costing banks millions of dollars in profit.
This could be a very big deal. A major default on derivatives by huge Chinese SOEs would hurt the banks on the other side of the deal, but more importantly, raise huge questions about the reliability of Chinese SOEs as counterparties not just on derivatives, but on other transactions as well.
But this is all very inscrutable (stereotypically?) as one of the companies allegedly involved denied it sent any letter. From Bloomberg (no link yet):
China Eastern Airlines Corp., which had $916 million of unrealized losses last year on wrong-way bets on fuel prices, denied a Reuters report that it sent a letter to banks about its futures contracts.
Air China Ltd. and China COSCO Holdings Co. also sent letters to banks about futures contracts, Reuters reported today, citing an unidentified Singapore-based banking executive who had heard of the letters. Companies owned by China’s central government may terminate derivative contracts with six foreign banks that provide over-the-counter commodity hedging services,Beijing-based Caijing Magazine reported earlier on Aug. 29.
“No, we didn’t” write letters to banks about futurescontracts, China Eastern Board Secretary Luo Zhuping said byphone today without elaborating. Air China spokeswoman Rao Xinyu declined to comment. China COSCO spokeswoman Yang Ling didn’t immediately answer calls to her office today seeking comment.
Now, both stories could be true. Note that Reuters reports that the threat came from State Assets Supervision and Administration Commission, which oversees companies like China Eastern. The Reuters story does not claim that the companies wrote the letters on their own behalf: it claims instead that SASAC wrote the letters in its role of regulator of these companies. So, the Reuters story could be true AND China Eastern’s denial could be true too.
But this raises the question of why would such a course be contemplated, let alone threatened. One interpretation is that these companies are in financial trouble, and the government doesn’t want to spend its money making western banks whole. Another interpretation is that the government wants to clamp down on speculation in general, and derivatives speculation in particular, by Chinese companies, and figures that raising doubts about the reliability of Chinese companies as counterparties is a very effective way to do that: It may be very hard to crack down on trading by Chinese companies directly, but if they have nobody to trade with because no banker in his right mind would take the risk of giving away a free default option, the “problem” is “solved.” Although this may seem to be limited to Chinese SOEs, it will no doubt have the effect of raising doubts about the reliability of all Chinese counterparties, thereby making it costlier for them to trade, and perhaps shutting them out of the market altogether.
There is some hint of this in the Reuters article:
The warning from SASAC follows a series of measures from Beijing this year to crack down on the sale of derivative products by foreign banks to Chinese enterprises, principally big consumers, who bought protection against higher prices last year only to watch the market collapse — leaving them with losses.
There may also be an old school-new school battle going on:
SASAC took over the job of overseeing SOEs’ derivatives trading from the securities regulator in February after several Chinese firms reported huge losses from derivatives.
I would wager that SASAC is dominated by old school industrial types and party types who are not in the least financially sophisticated, and who are probably not all too down with the idea of derivatives anyways, thinking that they smack of speculation, even if they are used for hedging. (I’ve taught at some Chinese SOEs, and the level of finance knowledge is pretty thin even among higher level execs–or should I say especially among such types. I imagine that goes exponentially for the SASAC.)
But, if my conjecture that this is an effort to tamp down speculative trading, it would fit in with a good deal of other stories coming out of China that it is struggling mightily with its efforts to stimulate the economy. These efforts are leading to manifest distortions, and reports suggest that the authorities are operating in a very ad hoc way to try to control the distorting effects of the stimulus. Like a financial sorcerer’s apprentice, China has unleashed a massively power monetary, fiscal, and credit stimulus, but cannot control it.
The Chinese stimulus is immense, as I’ve written before. The fiscal stimulus is on the order of 15 percent of GDP. Chinese banks have created huge amounts of credit:
In the first half of 2009, bank credits increased Rmb7,300bn, above the official target for the full year. Credit growth was surprisingly high, and the same was true of the broad money supply, M2, which grew at a record rate relative to GDP. As a result, the inter-bank money market has been inundated with liquidity.
But these efforts have led to the growth of bubbles in real estate and the stock market. The government is trying to tamp down on the flow of funds into these areas, and it is evidently having some effect: the Shanghai stock index was down 23 percent in August, far and away the worst performer among major world markets. Moreover, the market is extremely sensitive to signs that the government is tightening credit.
Moreover, there is other evidence that the deluge of spending has led to severe dislocations in the allocation of resources. Some amazing figures from the same FT article just quoted, by Chinese economist (and former central banker) Yu Yongding:
To maintain decent growth and avoid massive unemployment, the Chinese government was left with no option but to replace flagging external demand by domestic demand. But in the short run it is difficult to stimulate domestic consumption; investment demand became the only alternative. As a result of the stimulus package, the growth rate of fixed asset investment hit 36 per cent year-on-year in the first half of 2009, and China’s investment rate may have surpassed 50 per cent of GDP.
The government knows very well that the economy has been suffering from overcapacity. This is why government-financed investment in the stimulus package is concentrated in infrastructure, rather than new factories. However, there are still problems with an investment-centred expansionary fiscal policy. Due to the hasty and under-supervised implementation, waste in infrastructure construction is ubiquitous, and the prospective returns of this big push into infrastructure are less than promising.
Investing 50 percent of GDP, a nearly 50 percent increase from an already huge 36 percent of GDP, means that it is almost certain that many of the projects are hastily conceived, and ill conceived to boot. I think that Yongdong is a master of understatement when he opines that “the prospective returns of this big push into infrastructure are less than promising.” That is the gravamen of the analysis I gave on BNN (Canadian Business Television) earlier in the month.
And indeed, there is evidence that the government is trying to get control of the brooms its fiscal and monetary spells have brought to life. Not so much in infrastructure, but in other parts of the economy:
China’s cabinet said it’s studying curbs on overcapacity in industries including steel and cement as policy makers seek to rein in investment growth fueled by a record credit expansion this year.
The government will also increase “guidance” over parts of the coal, glass and power industries, the State Council said on its Web site today. Controls on stock and bond sales by companies in targeted sectors will be strengthened, it said.
China is aiming to prevent excessive investment in the world’s biggest user of steel and cement without imposing restrictions that may endanger an economic recovery. The nation’s benchmark stock index has dropped 15 percent from its Aug. 4 high on concern banks may tighten credit after extending a record $1.1 trillion of loans in the first six months.
There is a very Austrian lesson in this Chinese story. The government may be able to manipulate aggregates, but its attempts to do so can aggravate resource misallocations. In the Austrian story, these misallocations eventually come back to haunt: eventually they result in a contraction that is necessary to force resources out of bloated sectors and into more productive uses. The Chinese government apparently recognizes this, and is attempt to fall back to its comfort zone–state directed allocations of resources. But that just raises another problem the Austrians were quite familiar with: the Knowledge Problem. How can the central planner know where resources should go? Answer: He can’t.
I don’t think this will turn out well. There’s no Big Sorcerer to sweep in and undo Apprentice Sorcerer’s mischief. The Apprentice learned, it’s easy to unleash the magic, but it’s very hard to direct it. In the Chinese case, it’s easy to go on a spending binge, but it’s hard to ensure that the money is spent well. It may result (especially given the idiosyncrasies of Chinese income accounting) in high rates of measured growth, but this growth is likely to be chimerical, and even destructive in the long run as resources spent today may prove very unproductive months from now when the world economy begins to turn around and the stimulus-driven investments are ill-suited to serve the resulting demand.
In other words, China may represent history’s biggest free cash flow problem. (A reference to the finance literature that suggests that companies with free cash flow tend to fritter it away on unproductive investments).
The effects of this will spill over far beyond China, most notably in the commodity sector. China has been on a commodity import splurge, but apparently that is another thing that is already slowing down, and likely to slow down even further soon. And that is already having an effect on the canary in the commodity coal mine: shipping rates. From another Bloomberg story:
Just as global trade starts to recover, the shipping market is crashing for the second time in a year as China reduces raw-material imports and record numbers of new vessels set sail.
The rate for leasing capesize ships, boats three times the size of the Statue of Liberty, will drop about 50 percent from the current price of $37,865 a day to as low as $18,000 before the end of the year, according to the median in a Bloomberg survey of six analysts and fund managers. Forward freight agreements traded by brokers show the fourth-quarter average price will be 7 percent lower.
Shipping rates, which already fell 59 percent from this year’s high, are retreating as the Organization for Economic Cooperation and Development predicts a 16 percent drop in world trade for all of 2009. China’s State Council called for curbs on steel and cement production last week.
. . . .
From their low of $2,316 in December, rates rebounded to $93,197 in June as China imported record amounts of everything from coal to iron ore, used to make steel. Almost two in every five tons of steel are made in China, according to the Brussels- based World Steel Association. The nation consumes the same proportion of the world’s coal, BP Plc estimates.
Rates are poised to keep falling, the survey shows. China’s State Council, the nation’s cabinet, said it’s studying curbs on overcapacity in industries including steel and cement. The government will provide more “guidance” over parts of the coal, glass and power sectors, the group said in a statement.
Imports of refined copper fell 23 percent in July from the previous month. Coal shipments shrank 13 percent, customs data show. Iron-ore purchases will likely average about 16 percent less in the remainder of the year than in the first seven months, according to Will Fray, an analyst at Maritime Strategies International Ltd. in London.
“China could very easily turn the taps off,” Fray said. “Rates will keep sliding.”
The commodity import channel is the primary mechanism connecting the Chinese stimulus to the rest of the world. It’s hard to explain the robustness of commodity prices in recent months (which has redounded to the benefit of Australia–and Russia) on the basis of conditions in OECD countries. The EU, US, and especially Japan have hardly done well during that period, with the first maybe experiencing an anemic recovery, the second bottoming out at best, and the third still imploding. The most likely explanation is that this is the direct consequence of the Chinese stimulus, and the related policy of accumulating strategic inventories of everything from aluminum to iron ore to oil to zinc.
But all of the foregoing suggests that this is coming to an end, if it hasn’t come to an end already. And that’s why very peculiar stories like the one about a threatened default on derivatives trades may just be shadows of larger, looming developments.