Squeezing liquidity, forming reforms
Weakening global growth, Fed tapering, Chinese squeeze: sounds like the perfect recipe for a market disaster in the making, a vociferous storm reigning global. The Xi-Li leadership steps up to the plate and makes a move that can reshape the credit and manufacturing driven growth model into a domestic consumption based, financially more savvy market. This should be good news long term but causes uncertainty and headwinds short term.
Credit control in China's case is a problematic one, as the view from Nomura shows: "liquidity tightening can be very damaging to a highly leveraged economy. In particular, many local government financing vehicles rely on new debt issuance to pay the interest on their outstanding debt because they are operating-cash-flow negative. As liquidity tightens, financing costs rise, which may make it difficult to sustain operations."
Divergence since 2009
By creating a chart comparing the U.S. and China, it can be seen that there has been a great divergence between the two countries' markets. The difference becomes striking after the shaded band (the 2009 crisis) and the approaches the two governments took thereafter; Fed lowering interest rates, China boosting investments ($600B stimulus), U.S. printing money and relying on consumption (70% of GDP) while China relying on growth driven by manufacturing and big ticket investments (railroads, ports, airports, urbanization). The main issue is the efficiency of the markets: the U.S. rebalanced, while trust in China's stock markets wavered.
The current SHIBOR (Shanghai inter-bank offering rate) jump (over 6% in July, as it was around 3% June) due to the PBOC liquidity decrease shows that the financial system in China over-reacts market news and the stock market is not always controlled purely by market forces. Banks are the main investing sources in real-estate or infrastructure and lending to each other has been the cause of growth and development in recent years.
According to Ashmore Group's economist Jan Dehn, there is no systematic risk in China from an investor's point of view. This SHIBOR scare can be regarded as a step for the new leadership to take a long-term view and make the domestic financial markets ready to expand and internationalize, reign in shadow banking and put back more trust into the financial system. Or it shows the misguided steps the leadership tries to take. In any case, the Party is more actively guiding the developments of the financial market; good news long term.
As the below chart shows, China's central bank needs to be more careful with addressing the market as credit and credibility go hand-in-hand. Not long ago there were rumors that Bank of China is insolvent, and the bank deferred transactions for half an hour due to a fund shortage. Such rumors and mistrust in a still opaque market can wreak havoc quickly.
(Source: Wall Street Journal)
What the last leadership neglected (rampant shadow banking) the current leadership sees as vital to address. The time of easy money is moving into a new phase, and it should be positive news for foreign investors long-term:
- Some argue that the 2009 massive stimulus created more harm than good, making loans and spinoff products more widespread in the Chinese economy. The shadow banking side that evolved from such easy money is an after-effect that is getting out of hand.
- Squeeze is a crackdown on the shadow banking's illegal bond trading and the widespread WMPs (wealth management products) that have mushroomed between small-banks. As JP Morgan explains, it's the small-banks that are in need of cash and are affected more from the liquidity decrease. However medium and bigger banks in China have also started using these higher yield short term bonds causing possible threat to the savings accounts of the masses, leaching into the mainstream.
- As banks used these WMPs to get higher yields and sales commissions, some of these investments leaked back into the deposit-taking citizens' accounts; the real systematic risk lies in the regular savings being affected, the lifeblood of the economy that could cause social tension. Social tension is the last thing the Party needs.
- In China, interbank lending is about 20%, not so widespread and relied upon as in the U.S. If things turn sour, the Authorities can always inject capital as the State has the upper hand (in most parts of the economy still). Excessive money printing has not been an option in China yet (unlike the Fed) as the Party is very cautious of inflation and closely manages the renminbi.
- Since 2009 Chinese domestic debt has been growing rapidly. The shadow banking rates and products started reciprocating from smaller to larger banks, in a way starting to create a massive Ponzi-scheme. According to Forbes total non-loan credit hit $5.6 trillion in 2012, with nearly $2 trillion of that credit extended by opaque non-bank financial institutions in the countryside.
- Easy money may be over, and this is bad news for companies that relied on 8%+ yearly growth. Companies like China-based Sany Heavy Industry (GM:SNYYF) and Peoria, IL-based, Caterpillar (CAT) that have banked on the exploding growth of China's construction industry. Companies that supply energy, oil and commodities will be negatively impacted by a slower China as well.
- Risk infuses into local-government debt that can directly affect the population. In China land is owned by the Party, local-governments sell land as debt to real-estate developers, invest in pet projects (malls, gold courses ... etc.) seeking higher yields; these so-called LGFVs (local government financing vehicles - similar to US CDOs and mortgage-backed securities) have mushroomed.
- According to a Chinese banking regulator, the total outstanding loans to these financing vehicles rose to 9.59 trillion yuan ($1.56 trillion) in the first quarter ended March 31. Yang Kaisheng, president of ICBC, the country's biggest lender by assets (and now ranking 1st in the world by tier 1 capital), put the local debt figure at closer to Rmb10.75 trillion ($1.7 trillion), or just shy of 30% of Chinese GDP. Total LGFV debt is approaching levels of China's FX reserves. Quite an alarming figure.
- Similar to LGFVs, small and regional banks will suffer from the credit crunch and ones with weak deposit rates and capital will get wiped out; a cleansing of the market in the long-term.
Long-term view: where to invest
China's economy is strong on the outside but is brittle on the inside with a closed-off financial system and cheap bank lending. It can be argued that the current liquidity squeeze is an initial step to curb bad-loans, and will involve more steps similar to the 1999 and 2004/05 bank bailouts.
Companies that cater to the Chinese domestic consumer market can benefit, especially domestic companies in industries which are always needed and are not too cyclical, such as e-commerce (Alibaba), food & beverages (Wahaha) and reliable banking (big four banks). In China, the smaller banks will suffer from the credit crunch, but the strong big banks are to stand, even though their stocks fell by an average 12% last month in Hong Kong.
E-tailing is growing at a rapid pace as Chinese are big internet users and like to bargain hunt online. Companies such as Alibaba, Suning, Vancl, 51Buy.com, Sina (SINA) will continue to have an edge. As I explained in my last article, Alibaba is of special focus, as it is gaining ground in online payments (Alipay) and differentiated e-commerce (TMall), while readying itself for an international IPO.
Slowing growth should provide shorting opportunities in ETFs banking on overall economic growth. iShares China Large-cap (FXI) , iShares MSCI China (MCHI), SPDR S&P China ETF (GXC) and Guggenheim Invest China Small Cap ETF (HAO) just to name a few. The same downward trend is applicable to the big four banks, but after the current liquidity media storm eases, banking on these banks long term is an option.
If the Party continues to make headwinds and reform the markets, creates a more open-stock market and financing methods and risk and liquidity management for banks, it can stir up growth domestically long term: stock market investments, savings deposits, consumption will grow. China will be the world's biggest consumer market more stable, more U.S.-like, led by consumption.
More market oriented interest rates will create a possible convergence in the long-term between the U.S. and China's economic structures. The current issues are an indicator of how much reform is needed.