China's Third Plenum has come and gone and the market reaction has been cautiously positive, as shown by the chart of the Shanghai Composite and the Hang Seng Index, with the grey area shown as the post-Plenum period.
Unraveling the financial repression bubble
I had expected the reforms unveiled at the Plenum was supposed to be a story of short-term pain for long-term gain.
The State's control of the banking system had led to artificially low interest rates for the household sector and resulted in financial repression in the following form. The ordinary Zhangs in China's household had few avenues for excess savings. If he put it into the banking system, he got negative real interest rates (financial repression). The stock market is tiny and amounts to little more than a casino; there was no bond market to speak of; and there were limited ways of taking money out of the country. Meanwhile, the state owned banks lent to the SOEs at below market rates, because of the banks' cheap funding, and the SOEs, having also benefited from fixed prices and little or no competition, made out like bandits - as did the Party insiders running these enterprises. The household sector channeled its savings to the only place it could - property. In effect, financial repression led to an enormous property and credit bubble in China.
The bubble was exacerbated by the USD peg. Consider the following news from the FT. State controlled China Development Bank recently issued a bond with a yield of 5.5%:
CDB, the policy bank whose credit profile is as good as the government of China itself, was forced last week to cut a proposed Rmb24bn ($3.9bn) deal by 60 per cent to Rmb10bn and pay a yield of more than 5.5 per cent.
“Chinese 10-year Treasury bond yields are at a six-year high and are up about 100 basis points versus a year ago,” said one senior bond banker in Beijing. “CDB’s yields have widened by a bit more than 100 basis points and other corporate bonds are seeing yields rise by 150-200 basis points.”
The article went on to state that these yields were not competitive with wealth management products with 8-9% yields:
[A] big problem for Chinese issuers right now is the tougher competition from alternative fixed income investments, such as wealth management and trust products, which offer yields of 8 or 9 per cent and are guaranteed by the issuing banks.
5.5% yields in a sovereign guaranteed instrument and 8-9% yield for "junk" paper in a currency pegged to the USD? What would you do?
This yield differential was an open invitation for a carry trade. While outsiders in the West have limited means to execute that trade, Chinese companies with offshore subsidiaries can use transfer pricing to shift funds either onshore (to Mainland China in RMB) or offshore (in USD and other currencies), depending on return differentials. In addition to the excesses that I mentioned before spawned by the practice of financial repression, the USD peg no doubt created a carry trade - borrow in USD and invest it in RMB denominated assets.
The authorities understand these problems. They also understand that the country's growth path had become overly reliant on export-led and infrastructure-led growth. The reforms announced by the Third Plenum are intended to re-focus growth and unwind some of these excesses.
Who are the losers?
There are no free lunches and there is a cost to this policy. Growth has to slow and there will be losers and winners under the new policy. The way I see it, there are two distinct sets of losers under the latest round of reforms:
- Local governments: Local governments had been highly dependent on the sale of land to developers for funding. The latest reforms shifted the power over land use from local authorities to residents (as per Nomura via FT Alpahville):
We expect this reform to have small to moderate positive impact on the economy, depending on the implementation. Many of reform measures in this area actually had been proposed in the third plenary session of the 17th CCP Congress in 2008, but there has been no meaningful progress thus far. Local governments are not keen to implement these measures as they heavily rely on land sales for financing local projects and daily operations.
- Farmland. Reiterates the confirmation of rural land rights and developing modern agriculture with larger-scale farms, while strictly maintaining farmland purpose. We believe this, if implemented successfully, will improve productivity in agriculture and rural areasw, but the implementation is likely to be very slow.
- Rural residential land. Carefully and properly promotes collateralisation, guarantee, and transfer of rural properties to increase farmers’ asset revenue through a few pilot regions, as well, as it establishes the rural property market. The tone here is very cautious. Also, there is, expectedly, no mention of transactions between rural and urban citizens/property developers on rural residential land. This requires revising “Land Management Law” and resolving the problem of many rural properties with limited property rights – i.e., where properties were built on rural residential land but purchased by non-local residents.
- Rural construction land for commercial use. Allows rural construction land for commercial use to be transferrable and rentable and establishes an integrated market for construction land for commercial use. This part of land – mainly occupied by township and village enterprises (TVEs) – consists of a very small portion of rural land, and has been in land market for trading with certain restrictions for some time already. As such, this is not a significant measure.
- Rural land expropriation system. Reduces the scope of taking over land from farmers by local governments and standardises the land expropriation procedure. Usually, farmers are under-compensated for their expropriated land, while local governments can benefit significantly from land sales. If this measure can be implemented, it will reduce local government land sales revenue significantly, so we expect local governments will resist such reform as usual.
- State owned enterprises: The latest reforms reduces their monopolistic power, deprives them of their cheap funding through financial reform and deprives them of retained earnings by forcing them to remit more dividends to the State by 2020.
All of these steps are positive steps to re-balancing China growth path. If the plan is executed properly, then there should be some short-term pain as existing structures get torn down and better market and political structures get created.
Pick your poison
Given the recent market reaction, where's the pain?
If the market is rallying, then what it's telling me is that there is no short-term pain. In that case, the imbalances build and the whole thing comes down in a Crash some time in the future. In fact, that's what Andy Xie recently wrote in an article called No sugarcoating it: A hard landing is likely. He had believed that a soft landing was possible, but he changed his mind:
I believed for a long time that China would have a soft landing. When its economy began to descend in 2012, fear of a hard landing permeated financial markets for several months. My view on a soft landing was based on the dominance of bank loans in credit creation. The country's banks are government-owned. When property developers face a liquidity crunch, the banks are likely to reschedule their loans. A hard landing is a consequence of the snowball effect from creditors liquidating delinquent borrowers. When there is a big bubble funded by debt, as is usually the case, its bursting would lead to a hard landing if the credit agreements are stuck to. Hence, a soft landing is usually due to either an inability or unwillingness of creditors to enforce debt contracts. Japan, for example, was in such a situation in the 1990s.
That's because the carry trade has spawned an enormous bubble, which I described above:
The carry trade is the most important and speculative force in international capital flows. Interest rates are different in different currencies and the across spectrum of credit quality. When the interest rate is higher in one currency than in another, it usually reflects a higher inflation rate in the former, which would lead to its depreciation against the latter. The interest rate difference reflects the inflation difference and the former's depreciation. Similarly, when two bonds have different interest rates, the difference reflects their different bankruptcy probability. Because currency depreciation and corporate bankruptcy happen infrequently, many investors or speculators cannot resist the temptation of arbitraging interest rate differences.
This force has come to China lately and in force, especially after the Fed defied market expectations and declined to taper its US$ 85 billion monthly QE in September. The money has shown up as foreign exchange reserves, prompting the rise of shadow bank financing and land kings lately in big cities.
When the Fed starts to unwind its QE program, that's when Xie thinks that it all comes crashing down on us:
China's shadow banking system has become the main source of financing for the ongoing speculation. Nearly half of the credit growth this year can be classified as that. As such financing is usually short term, the speculative game depends on rollover confidence, as the underlying assets need years to become liquid. The confidence depends on faith in land prices surging for years to come. Such confidence is on thin ice to begin with because it is only working in big cities currently, and small and medium-sized cities are all facing difficulties. Any psychological shock could trigger rollover failures.
When the Fed does unwind its QE, China's shadow banking system will likely face a severe liquidity squeeze. Janet Yellen, the new Fed chairwoman, has expressed her disregard for asset bubbles and determination to push on until either the unemployment rate falls below the Fed's target or inflation breaches the Fed's limit. It is likely that either or both could be breached in 2014. It may mean the end of China's decade-long property bubble.
Andy Xie's China hard landing scenario depends on how the Fed navigates its QE exit (see Zen and the Art of the Fed Taper). Can the Fed manage to taper and maintain a narrow risk premium through its communication policy?
Regardless, I am puzzled by the market's reaction to the details of the reforms from the Third Plenum. If Chinese sensitive markets fall, then that's good long-term news as pain is being felt by existing players as the economy restructures. If it doesn't fall, then the market doesn't believe that listed companies are likely to feel much pain. In that case, we could be setting ourselves up for a crash down the road, possibly triggered by a Fed taper as postulated by Andy Xie.
Pick your poison.
Disclaimer: Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”
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