Streetwise Professor

I have written for some time about my doubts about the sustainability of Chinese growth (driven by massive credit expansion that is delivering progressively less and less bang for the renminbi), and my concerns about the stability of the Chinese financial system, especially the shadow banking system.  So far these prognostications have not been realized, but events over the last few days relate directly to these doubts and concerns.

Specifically, China is in the grips of a full-blown liquidity crisis, with overnight repo rates approaching 30 percent, and one week rates well over 10 percent.  The Chinese yield curve has become steeply inverted, which is never a good sign.  The word “panic” is being bandied about quite freely.

News accounts make it seem that the liquidity shortage is the deliberate  policy of the People’s Bank of China.  Indeed, these accounts suggest that the PBOC is withholding liquidity from the market precisely because it too believes that credit-fueled growth is unsustainable, and that the banking and shadow banking sectors have over expanded and need to be cut down to size:

China’s interbank funding costs surged again on Thursday, with the two shortest-term rates hitting record highs, as the central bank again ignored market pressure to inject funds into the market, despite fresh evidence that the economy is slowing.

The People’s Bank of China (PBOC) told the market that it would not conduct repo business in its regular open market operations on Thursday, frustrating widespread expectations that it would use reverse repos to inject cash to ease an acute market squeeze over the last two weeks.

. . . .

“The central bank appears to be determined to force banks and other financial institutions, such as funds, brokerages and asset managers, to de-leverage,” said a trader at a major Chinese state-owned bank in Shanghai.

“That hardline stance suits the recent government policy of clamping down on non-essential businesses by financial institutions, such as shadow banking, wealth management, trust operations and even arbitrage.”

Yes, deleveraging is probably a good idea: the economy had become over leveraged as the result of previous stimulus policies that fed a credit boom. The question is: how to deleverage?  Quite often system-wide deleveraging is a chaotic process, beset with externalities.  Companies that can’t fund dump assets in fire sales, which puts pressure on other institutions holding the same or similar assets: they often join the fire sale stampede.  Institutions start hoarding credit and liquidity, which drives up rates and puts yet further pressure on financial institutions.

In other words, system-wide deleveraging often occurs through a financial panic that causes massive economic damage.  Usually central banks try to stem this process by flooding the system with liquidity.  Bizarrely, China, it appears, seems to be trying to start the process by starving the system of liquidity.  Central banking with Chinese characteristics, as it were.

One interpretation is that the PBOC has found that jawboning and other less drastic policies have failed to stem the growth in credit and shadow banking, so it feels obliged to take stern measures to curb these activities.  But this is a dangerous way to do it, and I am not sure that it is the optimal strategy in the game between the PBOC and other market participants.

Let’s say the PBOC relents and says “You’ve been warned: don’t let it happen again.”  Many market participants will infer that the PBOC’s threats are not credible, and that it will supply liquidity if the system appears on the verge of failure.  The will therefore have little incentive to curb their activities, viewing the PBOC as a paper tiger.  The economy will continue to be over leveraged.

Conversely, let’s say to demonstrate its credibility the PBOC sticks to its guns and refuses to supply liquidity: then there is a risk of a full-blown panic and crisis-and right now.

China is having an episode not unlike the one that hit world markets in August, 2007, when funding markets signaled the onset of the crisis, with the difference being-and it is a big difference-that this appears to be a crisis of choice, and one that could morph from onset to a Lehman moment in days or weeks, not months.

Perhaps the PBOC believes that the situation is so dire that a purgative crisis now is preferable to a worse one that chooses its own time to appear.  If so, it has no one else to blame.  If China’s financial system was hurtling down the road too rapidly, it was because the PBOC (and the Chinese government) had jammed down the accelerator with its credit-driven stimulus measures.  Now it is responding by jamming on the brakes.  A policy of alternating extremes seldom works out well.

There is an apocryphal belief that in Chinese the word “crisis” is represented by the characters for “danger” and “opportunity”.  (JFK is responsible for popularizing this belief.) The most charitable interpretation of the PBOC’s starving the market of liquidity is that it doesn’t view that belief as apocryphal, but as gospel.  That it is running a great danger to seize an opportunity to put the Chinese financial system on a firmer foundation.

Maybe.  But that suggests a conceit on the behalf of policymakers: it presumes that once a panic is sparked, they can control it, and the panic will make financiers more prudent in the future by putting the fear of God into them today.

That’s a very, very risky bet that has a very, very high probability of turning out very, very badly.

Rosneft is scrambling to finance its acquisition of TNK-BP.  The means it is resorting to speak volumes about the gulf between its aspirations to be a supermajor and reality, and also about the risks that lenders perceive in dealing with Russia (and perhaps Rosneft specifically).

Rosneft is raising $10 billion through an oil pre-pay deal with Vitol and Glencore.  Rosneft agreed to sell the oil forward, with deliveries starting this year, and Vitol and Glencore used those contracts as collateral for loans for $10 billion.  The money goes from the banks, through Vitol and Glencore, and then on to Rosneft which will use it to pay AAR and BP.  The use of oil to secure the Rosneft-Vitol/Glencore deal is interesting.   Rosneft cannot borrow the money on its own promise to repay: it did borrow $15 billion from banks on that basis, but individual banks were not willing to take more than $1 billion in exposure to the Russian company: that limited appetite for Rosneft credit risk (which given its asset base is driven by political and legal risk) is quite telling.

Rosneft has to use prepays-a kind of financing usually extended to less creditworthy commodity traders, producers, or processors-to get additional funds.  Big commodity houses like Vitol and Glencore frequently use prepays and offtake agreements to provide funding to smaller producers and refiners.  It’s not the way real supermajors secure credit.

Oil is particularly useful as collateral, because if Rosneft tries to renege on its commitment to the Swiss houses (as it might be tempted to do if oil prices spike well above the agreed price), it will have a difficult time selling the oil as anything it tries to sell would be subject to seizure.  It’s a lot easier to seize oil in tankers or in storage facilities in Rotterdam to collect on a debt than it would be to try to seize a refinery in Russia.

Rosneft is also going back to the China well.  It has approached CNPC for $25-$30 billion dollars, again backed by sales of oil at fixed prices.  It originally denied it was in talks with CNPC, but this appears to be a “meaning of is” thing.  It might not have been in talks right at the instant that the Reuters reporter called them last week, but today Igor Sechin is in Beijing talking to the Chinese about a deal.  That’s not the kind of thing that is stitched up over a weekend.

This is a reprise of a $25 billion loan from CNPC and the China Development Bank to Rosneft and Transneft to fund construction of a pipeline extension to China negotiated at the depths of the crisis in 2009.  As I predicted at the time, that deal soon unleashed conflict between the Chinese and the Russians over the price of the oil that the Russians sold to secure the loan, and the transportation cost. The battle raged for several years, until the Russians agreed to sell the oil at a $1.50/bbl discount to the price they charged other customers buying off the ESPO pipeline.

Again, doing a large loan secured by oil, especially with a counterparty with whom the Russians have had numerous pricing disputes (they still haven’t negotiated a price in a gas deal that was first inked in 2006), is hardly the mark of a supermajor.

I fully expect that any new deal with China will spark future price disputes.

The quite evident limits on Rosneft’s borrowing capacity will constrain its ambitions to expand production in Russia, especially in offshore projects in the Arctic.  Hence, it will be very reliant on JVs with companies like Exxon who will no doubt drive very hard bargains.

The means that Rosneft must resort to in order to finance its purchase of TNK-BP says a lot.  It can’t borrow agains the assets it is acquiring, or its other assets.  Beyond the $15 billion syndicated loan, the only thing that lenders feel comfortable lending against is the oil that Rosneft must sell.  That’s the way middling-to-marginal commodity firms get funding, not supermajors.

Last year there were concerns about a “hard landing” in China.  Those fears have dissipated with 7.8 percent growth in the fourth quarter.  Now there is widespread optimism that China’s growth will continue inexorably: the recent spike in iron ore prices (which had plunged when concerns about the Chinese economy were most acute) is a very visible sign of that.

But . . .

It appears that this rebound is the result of another dose of stimulants, notably an injection of credit.  Which (a la Michael Jackson) gives less of a lift each time it is applied.  Now it takes about 3 RMB of credit to generate a RMB of GDP growth.  Moreover, this application of stimulus has deepened the investment-dependence of the Chinese economy, and delayed its transition to a more balanced, natural system.  Furthermore, to the extent that the projects funded by this debt don’t generate sufficient returns, the borrowers will not be able to repay; this risks a solvency crisis, and of course, a liquidity crisis that can break out when lenders are solvent, but at elevated risk of becoming insolvent.

A few articles in the last few days suggest that the optimistic turn may be quite overdone, and that there are dangers lurking beneath the sea of debt.  Chinese banks are rolling over local government debt that was used to fund stimulus spending.   Chinese heavy manufacturing enterprises are becoming increasingly indebted, and are staying afloat with borrowing.  The shadow banking system is growing and mutating.

The Chinese economy is still largely centrally planned.  Not directly, but through subsidies and especially through subsidized credit.  Admittedly, my priors are that centrally planned economies are doomed to difficulty, even though they can produce spurts of measured growth.  With sufficient coercive powers, such governments can keep things going for quite a while.  But there’s a point when they can’t.  I wouldn’t be surprised if China is approaching that point.  In other words, the further injection of credit may have just deferred the hard landing . . . and made it all the harder.

I have long been a bear on China.  Prior to 2008 because of the shakiness of its banking system; post-Crisis, because of my deep skepticism about the effects of the huge stimulus program-including its impact on the banking system, or more properly, the shadow banking system.

I am not alone.  The Bank of China is warning about the country’s shadow banks:

A senior Chinese banking executive has warned against the proliferation of off-book wealth management products, comparing some to a Ponzi scheme in a rare official acknowledgement of the risks they pose to the Chinese banking system.

China must “tackle” shadow banking, particularly the short term investment vehicles known as wealth management products, Xiao Gang, the chairman of the board of Bank of China, one of the top four state-owned banks, wrote in an op-ed in the English-language China Daily on Friday.

“Unsurprisingly, although Chinese banks’ non-performing loans are at a low level of 0.9 percent, the potential risks are worse than the official data suggest,” Xiao wrote, adding that a problem could come as indebted borrowers face cash flow problems or enter default, straining the banking system.

“The music may stop when investors lose confidence and reduce their buying or withdraw from WMPs,” he said, referring to wealth management products.

He warned of a mismatch between short-term products and the longer underlying projects they fund, adding that in some cases the products are not tied to any specific project and that in others new products may be issued to pay off maturing products and avoid a liquidity squeeze.

“To some extent, this is fundamentally a Ponzi scheme.”

Xiao’s op-ed is in line with similar warnings issued by outsiders, particularly the Fitch Ratings agency whose China banking analyst Charlene Chu has long warned of a maturity mis-match and the threat to the Chinese banking system of products with various terms and interest rates.

Moreover, there is a widespread belief among investors in these products that banks are offering liquidity puts:

Although the products are technically more risky than deposits, most investors believe they are backed by the banks’ implicit guarantee and they are marketed aggressively in bank branches nationwide. Xiao acknowledged this perception posed a risk for banks’ bottom line.

“The rollover of a large share of WMPs could weigh heavily on formal banks’ reputations, because many investors firmly believe that banks won’t close down and they can always get their money back,” Xiao said.

In June, People’s Bank of China vice governor Liu Shiyu said many banks are not transparent enough about the risks wealth management products carry.

“China’s shadow banking system is complex, with a close yet opaque relationship to the regular banking system and the real economy,” Xiao concluded by saying.

“It must be tackled with care and sufficient flexibility, but it must be tackled nonetheless.”

Recall that the movement of SIVs back onto bank balance sheets was a major channel by which problems in the shadow banking sector were communicated to US banks.

These “wealth management” products grew up as a direct result of the intervention of the supposedly wise direction of the Chinese state.  It wanted to restrict bank lending that had been stoked by the 2009 stimulus, in a step-on-the-gas-whoops-step-on-the-brakes maneuver so common to attempts to “fine tune” economies.  The bank credit was basically redirected to the informal sector.

I’m sure it will work out swell.

For more background on the crazy-quilt Chinese banking sector, and all its fragility, this is a decent source.

Another reason for my bearishness is my innate skepticism-based on long experience-of state efforts to guide resource allocation.  Case in point: China has gone all out to promote investment in renewables, and has been awarded with huge losses:

hina in recent years established global dominance in renewable energy, its solar panel and wind turbine factories forcing many foreign rivals out of business and its policy makers hailed by environmentalists around the world as visionaries.

But now China’s strategy is in disarray. Though worldwide demand for solar panels and wind turbines has grown rapidly over the last five years, China’s manufacturing capacity has soared even faster, creating enormous oversupply and a ferocious price war.

The result is a looming financial disaster, not only for manufacturers but for state-owned banks that financed factories with approximately $18 billion in low-rate loans and for municipal and provincial governments that provided loan guarantees and sold manufacturers valuable land at deeply discounted prices.

China’s biggest solar panel makers are suffering losses of up to $1 for every $3 of sales this year, as panel prices have fallen by three-fourths since 2008. Even though the cost ofsolar power has fallen, it still remains triple the price of coal-generated power in China, requiring substantial subsidies through a tax imposed on industrial users of electricity to cover the higher cost of renewable energy.

The outcome has left even the architects of China’s renewable energy strategy feeling frustrated and eager to see many businesses shut down, so the most efficient companies may be salvageable financially.

Well played.  Remind me again why should we compete by throwing good dollars after bad renmibi?

(As an aside, to illustrate the absurdity of subsidy politics, Solyndra is suing Chinese solar panel makers for predatory pricing.  Predatory pricing suits are almost always meritless.)

A substantial fraction of measured Chinese growth in the recent past has been accounted for by investment.  But the relevant question is whether this investment is going to pay dividends, or whether it has been misdirected into white elephants.  The solar (and wind) experience suggests the latter.  Historical experience with politicized investment suggests the latter.  The influence of corruption and the political influence of the elite on the investment prices also suggests the latter.  I’m going with the latter.

The WSJ has a long piece on a Chinese economist who is similarly skeptical about the ability of the Chinese state to direct investment:

Mr. Zhang’s academic colleagues were all praise for the “China Model,” but in 2009 he was giving speeches entitled “Bury Keynesianism.” Then a top administrator at Peking University, where he now teaches economics, he argued that since the financial crisis was caused by easy money, it couldn’t be solved by the same. “The current economy is like a drug addict, and the prescription from the doctor is morphine, so the final result will be much worse,” he said.

. . . .

Ultimately, Beijing’s stimulus fed a false investment boom that stoked asset bubbles—then the morphine wore off while the government tightened. Officials claim the economy grew at 7.6% year-on-year between April and June this year. Skeptics think the real number is closer to 4%. (One London research house says 1%.) Meanwhile, industries dominated or favored by the state, such as steel or solar power, are idling from overcapacity. Countless sheets of copper are reportedly stacked in warehouses, blocking doorways and exemplifying Hayek’s notion of “malinvestment.”

It’s actually worse than merely Hayekian/Austrian malinvestment, IMO.  That arises from decisions made on the basis of false price signals that result from monetary stimulus.  That is surely present in China in spades.  But there is also a good deal of state-directed investment, or investment channeled to state enterprises, or investment influenced by corrupt and connected members of the elite.

A good analysis of these issues is to be found at Michael Pettis’s blog, including examples like this post.  He aims the following, trenchant questions at China bulls:

1. How much debt is there whose real cost exceeds the economic value created by the debt, which sector of the economy will pay for the excess, and what is the mechanism that will ensure the necessary wealth transfer?
2. What projects can we identify that will allow hundreds of billions of dollars, or even trillions of dollars, of investment whose wealth creation in the short and medium term will exceed the real cost of the debt, and what is the mechanism for ensuring that these investments will get made?
3. What mechanism can be implemented to increase the growth rate of household consumption?

All very good questions.  China’s recent GDP growth has really been driven by what are properly considered costs: the amount of money invested.  The relevant issue is the value produced by those investments.  Given the state domination of the process of making these investments-either directly, or via distortions of the price system through monetary stimulus and financial repression that distorts interest rates-I am dubious, in the extreme, that these investments will pay.