Streetwise Professor

May 29, 2015

Big Trouble in Big China?

Filed under: China,Economics,Politics — The Professor @ 2:16 pm

The Chinese stock market and the Chinese economy are perplexing. The latter seems to be slowing rather dramatically, and there is widespread belief that the growth rate is, or soon will be, far below the 7 percent level the government is touting. Nonetheless, the stock market has been skyrocketing, with some periodic selloffs as occurred yesterday.

The government is allegedly intent on transitioning from the investment- and export-driven growth model towards a more consumption-oriented one: Fixed investment as a fraction of GDP is at stratospheric levels, and consumption as a fraction of GDP is extremely low. Its ability to navigate this transition, due to the inherent difficulties of trying to manage a huge economy as well as the political economy factors that tend  to impede change, is open to serious doubt. There is always the possibility that the government will respond to any growth slowdown the way it has in the past, through massive stimulus.

Further, the strength of the Chinese banking sector is always open to question. If the government (and the central bank) are concerned about it, that would also tend to bias them towards loosening credit.

Local governments are connected to all these issues. Local governments, through so-called Local Government Funding Vehicles, fund a substantial fraction (about 20 percent) of Chinese investment. These entities have exhibited signs of financial distress, as indicted by high yields. This reflects the dodgy quality of many of the investments these vehicles funded. This is a problem for Chinese banks, which have a large exposure the LTFVs.

The Chinese government recently provided a very strong indication that it is indeed deeply concerned. It announced a set of measures that look for all the  world to be a financial shell game intended to move local government risk onto the balance sheet of the People’s Bank of China and simultaneously create credit.

As originally announced, the banks were expected to swap LGFV debt for municipal bonds carrying a lower interest rate. The banks were obviously unenthusiastic about this, and the takeup was minimal. So the PBOC made it plain that this was not voluntary: banks were expected to buy the lower interest munis. To induce them to do so, the PBOC said that it would permit the banks to post these securities as collateral at the central bank, and use the proceeds of the collateralized borrowing to extend new loans.

The exact nature of the collateralized borrowing from the PBOC is about as clear as a Beijing sunset, but it is evident that this mechanism can serve as a way of passing the muni credit risk onto the PBOC. If the munis become distressed, and the loans are de jure or de facto non-recourse, the banks default on the loans, leaving the PBOC with the bad local government debt.

It is clear that this is a bailout of the local governments. They are now borrowing at below market rates: it wouldn’t have been necessary to coerce and induce the banks to buy the local government debt if they were sold at rates reflecting the credit risk. Since the banks now appear willing to lend, they must believe that the central bank is wearing the risk, and hence paying the subsidy. In other words, the pea is under the shell labeled “PBOC.”

The command that that banks lend the proceeds from the loans from the PBOC means that the overall effect of the program will be to expand bank balance sheets and increase credit. It is both bailout and stimulus.

Putting this all together, this suggests that the Chinese authorities are deeply concerned about the financial condition of local governments and the banks, and is also deeply concerned about growth prospects. It could also indicate hesitation about transitioning away from the investment/export-driven model. All of which makes the booming Chinese stock market all the more puzzling. Unless, that is, the betting is that the government will respond to weak growth by resuming the credit stimulus and blowing asset bubbles.

None of this are signs of a healthy economy, or healthy markets. It is instead symptomatic of massive distortions and imbalances produced by years of heavy-handed policies. The imbalances must correct eventually, but the Chinese are saying not yet, lord, not yet.

But they cannot defer the reckoning forever, and the longer it is delayed, the more brutal the correction will be. But like politicians everywhere, the current Chinese government no doubt is content that the blow up occur on the next guy’s watch.


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  1. I’ve been thinking for some years now of how to effectively short China, and especially China real estate. There are leveraged inverse ETFs that look tempting. The problem is that it’s not really a efficient market — the government can and does make the numbers look whatever way they want, at least in the short and medium term. So I wait. In the long run, everything is priced correctly.

    Comment by Hal — May 29, 2015 @ 5:14 pm

  2. Thats why the best trades were always in secondary markets in countries with rules- shorting iron ore, copper, AUD/CAD, etc. Not to mention the fact that Hong Kong is a joke of a market where they can do things like suspend shares INDEFINITELY without any guidance. That’s a nice situation to be short in.

    The ultimate coup de grace trade will be shorting CNY. With capital flight increasing and offshore borrowing an increasingly critical channel, I hope this is a sooner rather than later thing.

    Comment by Nick — June 1, 2015 @ 6:14 pm

  3. How you see this as different that how the U.S. government bails out our banks, other than than the U.S. government usually waits until a catastrophic disruption of the financial markets and the Chinese government seems to be trying to manage individual credits through non-recourse loans?

    I understand the issue with local government debt, but lacking an efficient tax structure either at the municipal level that provides for direct funding, or at the federal level that disburses funds to municipalities (or a hybrid system such as in the U.S.), there had to be some structure for municipal governments to raise revenue. I don’t agree with the decision to allow them to become real estate speculators, but when the decision was made, Beijing obviously chose to ignore my sage insight.

    The can be no denying the U.S. government both manipulates the economy and directly subsidized bad banking practices. The fed’s historic practice of purposely manipulating the yield curve to help recapitalize banks has clear effects on the overall economy. Waiting for a catastrophic disruption of the banking system has enormous social and economic costs. The Chinese are choosing to handle the problem its policies created in a manner different than the way the U.S. government has historically chosen. The bailout of Chinese local governments is a bailout of speculators who made misguided decisions. How is this anything but just an alternative approach to the same sort of mess that the U.S. government has been bailing out here since 2008?

    Comment by Charles — June 5, 2015 @ 8:36 am

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