(Source: Congressional Research Service)
President Xi Jinping's strategic objective, of gaining greater political and economic control of China at the 2017 Communist Party Congress, is facing significant challenges. The immediate economic challenge is presented by the risk of a bursting of the credit bubble that has sustained economic growth since the PBoC loosened monetary policy aggressively last year. The equity market has already crashed, so the expected economic slowdown traditionally portended by this event could arrive just in time for the Congress.
(Source: Financial Times)
The current speculative economic momentum in the Chinese economy is meeting significant challenges. The recently bursting commodity bubble may be joined by a deflating credit bubble. Whilst foreign observers concentrate on these deflating bubbles, they may miss the bigger picture; in which President Xi Jinping attempts to maintain political and economic momentum until the 19th Party Congress in 2017.
Looking at this picture one is reminded of how Chinese policy makers kept the bubble inflated until the 2008 Olympic Games after which things rapidly collapsed. A similar strategy may be deployed by President Xi, running into 2017, especially as America will have a new President to compare and contrast him with.
The speculative rise in Chinese real estate prices continues unabated. In the latest twist to the story, the lower tier cities are converging on tier 1 in terms of prices gains; despite the large unoccupied inventory of houses in these locations. Houses are being bought to speculate with rather than to live in.
(Source: Financial Times)
China's unsustainable debt mountain remains Click to enlargea source of discussion and analysis. There is clearly a case of diminishing returns on economic stimulus. Analysis shows that the majority of the debt recently taken on since 2015 by companies and municipalities has been used to refinance debts accrued immediately after the monetary stimulus in 2008/09. China's recent monetary stimulus has therefore not been used for investment in growth; but rather has been used for refinancing debt incurred since 2008 that subsequent economic growth has been unable to finance. The conclusion to be drawn is that China is kicking the debt can down the road, whilst at the same time making the can larger. This implies that the first stimulus failed; so that China is now throwing good money after bad.
The latest news that Chinese wealth managers are increasingly investing in each other, rather than opportunities in the real economy, puts the debt mountain into current context. The concentration of risk in the shadow financial economy is an obvious red flag, which signals the "financialization" of the Chinese economy has reached a new phase.
As was observed in America, before the Credit Crunch, the financial sector has become the largest component of economic growth. Moody's estimates that shadow banking grew by 30% last year; and may now be as large as 80% of GDP . Opportunities for investment in the real economy are falling as the economy slows.
There is also the suspicion that the economic slowdown is a symptom of the secular aging process. China has rapidly grown as an industrial economy, its post-industrial maturity has been even more swift. Consequently, financial prospectus promises of return are driving investment flows rather than the underlying trend in economic growth. This situation is unsustainable.
(Source: Financial Times)
The "financialization" of China's economy, discussed in the last report, can be placed into the context of the debt refinancing and the kicking of an enlarged debt can down the road. More worryingly, unlike traditional experiences with monetary stimulus, economic growth has not been pulled forward from the future into the present. China's GDP has therefore stagnated. The refinancing has thus enabled the existence of spare industrial capacity that is uneconomical in commercial terms and underutilised in global terms. To sustain this idle capacity, China risks trade wars by dumping its output on global markets. The deflationary consequences of this spare capacity, continues to undermine all attempts at reflation and economic stimulus by global central banks. China is the world's problem.
The destruction of economic value and risks of trade wars, highlight the perverse outcomes of the moral hazard that China is using to retain a semblance of coherence within its population. Moral hazard is a political necessity under the Communist Party system. The tightening of control over the system by President Xi signals that economic reform on the scale envisioned by China's trade partners will not occur. China's considerable foreign reserves surplus and concentration of control of them in Xi's hands can perpetuate the system for a considerable period of time. China's ability to remain solvent may outlast its trade partners' abilities to create inflation and economic growth.
A glaring example of the moral hazard dilemma was thrown up recently by the case of the China City Construction Holding Group Company. Although the company was sold to private equity by the Housing Ministry, it has recently asked the PBoC for an explicit guarantee on its bonds which are under yield credit stress. Without some kind of implicit or explicit guarantee, the company will struggle to fund itself.
Despite the headline grabbing speculative increases in house prices, there are signs that the debt financed rise in hard asset prices may soon come to a swift pause or even end. The wheels have come off the refinancing of China's great wall of maturing debt. The inability to refinance will identify the economic Zombies immediately. Premier Li has vowed to let them fail, as he reforms the economy, therefore his conviction will now be tested.
Faced with this insurmountable refinancing wall and the prospect of not being guaranteed by the State, Chinese companies are capitulating with great hilarity in some cases. The excuses for non-payment of interest and maturing debt have become juvenile. One company said it can't pay because it can't find the company seal to authorize payment. Another one said that the executives in charge of the company cannot be contacted. Some companies are also changing ownership in the hope that the new owners will be forced to pay down debt. The situation is literally can't pay won't pay. The government is now increasingly being looked at to pick up the tab for unpaid debts.
Since government guarantees are hard to come by, it is far more likely that the government wishes to enforce its bad debt conversion into bad equity plan. The nation's banks therefore become the custodians of lost shareholder value; and will then need to be bailed out by the PBoC. China's latest rolling bailout has started as a bail in of the banks and other private creditors. The banks may get bailed out but the private creditors will lose everything. This process matches very carefully the script of President Xi Jinping. In his view the private sector lenders who have done well out of China's growth story must now pay their dues to those who have been left behind by the growth miracle. Wealth is therefore being transferred to the Zombie companies and their hapless employees, to serve Xi's vision of the greater good.
The prospect of runs on companies, to force the PBoC to declare its guaranteed support or not, is now a viable prospect for traders. The state of tension has been raised by the lack of equity market liquidity and the flash crashes and then recoveries, which now seem to be a normal occurrence in the market.
Interestingly, the PBoC already appears to be passing the buck onto the capital markets regulators. The regulators then pass the blame onto the investment banks who have raised the capital for the distressed borrowers. The China Securities Regulatory Commission is now opining that many investment banks failed to adequately disclose the weak financial positions of companies that they were raising capital for. It therefore appears that the PBoC or the government will not be providing blanket guarantees after all, but may selectively guarantee those that they are instructed to by the President.
Restructuring through privatization of state controlled entities is therefore dead. No private investor will invest unless there is an explicit state guarantee. The mere assumption of a guarantee or the presence of Party nomenklatura on the board is no longer good enough. The role of private capital in the economy now has a huge question mark over it. This supports the President's portrayal of private capital rather than Premier Li Keqiang's. Private capital wants to bet on the sure thing of a government guarantee. It is therefore not a true risk taker, but is in fact a free rider. President Xi will exploit this fundamental flaw in private capital in China; and divert it towards the sure things that he wishes to get done.
Premier Li Keqiang's plan for economic reform and restructuring along globally accepted lines is in ribbons. Private capital is being shredded, making it very difficult for Premier Li to sell his economic reform story. If private capital still has a risk budget for China, after the current phase of bail ins, it will only wish to bet on the sure things. Whilst Xi Jinping's vision of state capitalism is not exactly a sure thing, his selected winners will at least be around for long enough to potentially honour future obligations and liabilities. Rational private capital will however exit China rather than face these terms.
Despite this hurdle to restructuring, Premier Li continued to extemporize about how it will occur. In his view excess capacity will be removed, whilst at the same time those losing their jobs will not become unemployed. It is difficult to reconcile his two assertions, other than to assume that the unemployed will just be reclassified as something less onerous in name.
Continuing to say what he thinks that foreign investors want to hear, Premier Li then stated that intellectual property will be protected; even when it is in conflict with established industries in China. Whilst this is what foreign investors wish to hear, they would probably prefer to hear it from President Xi Jinping rather than the ostracized Premier.
The position of the PBoC is also ambiguous. Ostensibly it continues to support the reform process. Chief Economist Ma Jun recently opined that the short term pain, from deleveraging and cutting over-capacity, was worth the long term gain. This position however strongly conflicts with the recently observed monetary expansion from the PBoC that has enabled the deleveraging and over-capacity to continue. The PBoC is not therefore a rational actor.
Premier Li's untenable position was then weakened even further when his replacement was leaked for general circulation. The austere teetotalling Anglophobe Wang Qishan is rumored to be replacing Li. Mr Wang currently heads China's equivalent of the Spanish Inquisition, named the Central Commission for Discipline Inspection. His strong Party credentials and distrust of foreigners do not augur well for the reforms envisaged by the global community. The latest regional governor promotions, including one of Wang's proteges, further cemented President Xi's grip on the Party apparatus before the Communist Party National Congress showdown with Premier Li next year.
The campaign against Premier Li is now understood to be unfolding under the cover of an anti-corruption crackdown. Inquisitor General Wang recently stated that a new set of rules will be created to prevent ideological degenerates from infiltrating the higher echelons of the Party; in what he called an "institutionalized cage". Premier Li and his cadre may soon find themselves imprisoned in said cage.
The recently announced economic stimulus for the rustbelt in China's north-east, will provide greater insight into where the money goes and how great the moral hazard is. Zhou Jinping, the director of the office in charge of transforming the north-east's economy, at the National Development and Reform Commission (NDRC), recently announced that $250 billion will be spent on projects in this region over the next three years. Specific details of the projects were not issued, however he did say that:
... the people's livelihood needs more support" and also that "the north-east has contributed a lot to China in terms of coal, oil and human resources, so Beijing needs to help with pensions and a sustainable environment among other areas.
The rustbelt continues to stumble along with the mixed messages that it is receiving. On the one hand it hears of support. On the other hand it hears of mothballing of spare capacity. Then there is the signal from the markets. The recent spike in iron ore and steel prices has prompted the switching back on of the spare capacity which was due to be mothballed. There is now talk of consolidation in the steel industry, but this is not coming with the reduction in capacity.
Through the apparent chaos the discernible strategy of the creation of scale producers, who can undercut their global competitors seems to be playing out. The noise of the apparently conflicting policies of rationalization versus support for the rustbelt, can therefore be seen as complementing each other to produce scaled up national champions.
The Ministry of Transport also announced an Rmb5 trillion planned transport infrastructure investment over the next three years. The response to this announcement was tepid and even suspicious. Infrastructure spending has served China well in the past; when it was growing rapidly to remove bottlenecks in the economy and to magnify growth. In recent years as growth has slowed this type of investment has resulted in white elephants, industrial overcapacity, economic distortions and even more debt. There is a feeling that these negative externalities rather than economic growth will result from this latest announcement of transport infrastructure investment.
The political challenge to President Xi's 2017 strategy can be views as domestic and international.
On the domestic front, Premier Li Keqiang is the greatest challenge.In the last report, the battle between President Xi Jinping and Premier Li Keqiang was observed to have gone public. Premier Li sees the way to save China's economic growth problem through painful structural reform. President Xi understands that the social and hence political cost to the Communist Party, from real structural reform will be immense. Premier Li sees China's solution as a global one. President Xi acknowledges this, but also fears that the loss of central authority and control to a global master would end the Party's effective control of the country.
This existential threat has caused a strong response from President Xi. The directive to save the Party has taken precedence over saving the economy. The Party will however lose its legitimacy if it can no longer deliver economic growth and employment. The President therefore has a difficult balancing act of saving the Party; but not at any cost to the nation from which the Party ultimately devolves its power.
President Xi has therefore adopted a policy taken from Sun Tzu of being everywhere and also mirroring his foes. By being everywhere he appears to be in control; and by mirroring his enemies he takes away their own initiatives. A test of Party loyalty now seems to be latest tool for dividing those who back the President from those who support the Premier and his reforms.
Party members have been asked to hand-copy the Party's constitution, whilst those who fail to pay their membership dues will be fined. Presumably prizes will be awarded for those who can recite it! Having thus ostracized the disloyal, who have benefited from monetary stimulus, President Xi then went on to disarm Premier Li by taking away his weapon of structural reform. In a more candid interview than the preceding "authoritative person" edict, in which he appeared as a ghost-writer, President Xi articulated clearly what structural reform is not. He explained that it is not the same as Western supply-side structural reform.
Xi's version of structural reform will remove red-tape, lower taxes and stimulate innovation. President Xi has therefore effectively taken the subject of structural reform out of the hands of Premier Li and directly associated the term with himself and the Communist Party. There is only one definition of structural reform in China; and it now belongs to the Communist Party.
The removal of red-tape is code for the removal of those and their processes which do not fit his definition of structural reform. The previous bureaucracy will now be replaced with a new one that directly reports to Xi. Red-tape refers to people and policies which do not have Xi's blessing.
The lowering of taxes is a fiscal stimulus rather than a monetary stimulus. It is also a massive gift to the recipients of said tax cuts to buy their loyalty. The Communist Party is now the source of pecuniary gifts, rather than the PBoC's monetary stimulus. Capitalism in the form of borrowing to generate wealth has been replaced by the division of economic benefit by Communist Party decision. The Party can therefore target the recipients of the gift depending upon whom it wishes to retain the loyalty and control of. The PBoC's monetary gift has been seen to be too dangerous in bubble terms; and too focused on a specific sector of the polity who like to speculate.
Innovation stimulation is code for protecting China's value added industries, in order for them to compete globally and in the domestic market.
If Premier Li does not get with the new reform programme he will have to go. Furthermore, if Premier Li brings the kind of supply side policies that the Neoliberal globalist movement ascribes to, he will also have to go. Premier Li shows no signs of surrender and appears to be pressing on with his own restructuring offensive. He responded to the overt threat from the "authoritative person" by saying that he had avoided a "strong stimulus"; thus refuting the claims that the stimulus has been unsustainable.
Li then defended his own interpretation of structural reform. Li said his government had been focused on structural reforms in recent years to address the slowdown in growth. From Li's responses it is now clear that he is actually trying to defend his reputation and credibility for competently handling the economy. It is also clear that he is going to be blamed for any failure to date, which may then lead to his removal.
As the rustbelt was being saved by President Xi, Premier Li was to be seen in contrast making the case for further structural economic reform that will just undermine the attempts to save it. He also used his reform initiative as a direct weapon in his battle with the President. His cryptic remark that "We should be clearly aware that the government is still engaged in things that it should not be" should be viewed as a direct challenge to President Xi's influence. His advice to government officials at all levels to keep in mind the bigger picture and restrain their own power for the sake of society and market dynamics, shows that his definition of economic reform is the banner under which he marches.
The second political challenge to President Xi's 2017 strategy is international. Currently, a large game of bluff is being played by China with its trade partners. Developed nation policy makers believe that a slowdown in China will tip the global economy back into recession. Tolerance of China's kicking the debt can down the road is based on fear. This tolerance however comes at the real economic cost to the developed nations, of undermining their own economies with China's deflationary idle spare capacity. Rather than basing policy emotionally on fear, developed nation policy makers will be forced to rationally assess the costs and benefits of passively accommodating China's economic policies.
There are signs that America is becoming more emboldened to challenge China. America is supposedly worried about China unloading its masses of US Treasury holdings. Recent actions suggest that it may now think otherwise. America recently challenged China's anti-dumping tariffs on American poultry. A 500+% levy has been imposed on Chinese steel imports by the US Commerce Department, for alleged dumping. This levy is largely symbolic since it only pertains to a relatively small volume of cold-rolled steel imports. The implications are clearly more political than economic\therefore.
America is also leading moves to block China's attempts to be recognised as a market economy. Failure to get market economy status would then allow anti-dumping tariffs to be placed upon it by its developed nation trade partners. The situation was succinctly characterized by Lourenco Goncalves the CEO of Cliffs Natural Resources, who said that: "This is war. This is not trade. China is waging economic war. We ought to recognise that and act accordingly," to reporters recently on the sidelines of a US steel industry association meeting. The European Union (NYSEARCA:EU) is also antipathetic towards handing market economy status (NYSEARCA:MES) to China.
Treasury Secretary Lew signaled that America's intention is to strike at the centre of gravity of President Xi's strategy to protect the ranks of his grass roots support in the industrial heartlands. Going forward, America will push for deeper industrial capacity cuts from China. This will directly undermine Xi's strategy of creating scale industries that can compete aggressively on price in global markets. It will also create masses of unemployed who will then undermine his political grip. Secretary Lew also called for greater transparency from China in relation to its economic policy intentions and capabilities going forwards. Clarity does not seem to be something that President Xi Jinping excels at providing, so it is hard to see this request being met with alacrity.
The bottom line is that China must go much further in reforming its economy to prevent state-led distortions having a global impact. America and the EU are therefore aligned with Premier Li Keqiang rather than President Xi Jinping. It is highly likely that the President will exploit this foreign interest to undermine the position of Premier Li further. In doing so he will push China into greater isolation and tension with its trade partners.
Secretary Lew also said that he is looking forward to more accurate data from China to go with the greater transparency. This kind of data is still considered a national security issue by the higher echelons of the Chinese policy making elite. There is a growing suspicion that the unemployment rate is being deliberately underreported for political reasons. Fathom consulting estimates that the true unemployment rate may be three times the officially reported value. The estimate is consistent with idle industrial capacity that awaits full capacity cutting. This would perhaps explain why the Chinese stimulus response has been so aggressive. Unfortunately however, this response still appears to have failed to arrest the general economic decline.
Goldman, traditionally positioned in the vanguard of Sino-American relations, has swiftly joined the new spirit of accurate Chinese data releasing. According to Goldman's new indicator, Chinese debt is actually much larger than reported…. unsustainably so. By implication therefore, the economic growth that has been predicated upon it is at risk.
China has tried to adopt a holding conciliatory posture to deal with its current problems with America. Zhu Guangyao the designated point man in the strategic dialogue with America, signalled that China would like to have "institutional arrangements" in place to manage the relationship and coordinate respective national agendas. China may be hoping that by engaging in dialogue that it will have the opportunity to procrastinate whilst pursuing its own objectives.
President Xi tried to frame the strategic dialogue, between the two nations, by opining that dispute is normal and does not imply conflict. He urged for dialogue to achieve greater understanding over time. The sense of conflict was heightened by Finance Minister Lu Jiwei's angry rejection of America's overcapacity assertions as "hype". Reading through Xi's conciliatory words, it is clear that he requires time.
First he needs time to consolidate his grip on power, then he needs more time to address the fallout from the economic slowdown and transformation from manufacturing to service economy. In return for being given time therefore he must provide greater American access to economic opportunity in China; and also provide regional security guarantees to his neighbors. The real discussion is therefore over how much time he is given in return for reciprocation with America. Given that he is focused on 2017, he is pressed for time; so America can exploit this window of opportunity.
PBoC Deputy Governor Yi Gang tried to bluff his way through the risk of Taper Tantrum fallout in China from the anticipated rise in US interest rates. According to him such a tightening will be bullish for China because it will signal that American demand is strong. Said strong demand has yet to show up in China's economic data yet; and the threat of trade sanctions further undermines its potential. Deputy Governor Yi was presumably trying to block the negotiating threat of the Fed's alleged tightening in the strategic dialogue.
From behind the conciliatory façade, China then tried to leverage itself into a stronger position. The Chinese seemed well prepared for America's aggressive negotiating tactics. After Secretary Lew stated that American business was feeling discriminated against, the Chinese swiftly respond with disarming alacrity.
America was granted a $38 billion Renminbi Qualified Foreign Institutional Investment (RQFII) quota. Ostensibly this will give America access to growth opportunities in China, whilst also taking its economy another further step closer to liberalization by a full opening of the capital account. Drilling through the positively spun Chinese headlines, it is clear that China wishes to attract foreign direct investment to stabilize its currency and reverse capital flight.
In addition, this new qualified investment scheme quota gives the Chinese the opportunity to demand recognition as a market economy; and thus avoid punitive tariffs on their exports. As always, the Chinese offer was therefore double edged; with the leading Chinese edge cutting deeper in China's favor. In response to the RQFII proposal therefore, America will no doubt demandeven greater transparency and accuracy of reporting in order to enable the investment. The game of cat and mouse continues.
America has however now moved beyond the talking stage; and is actively pursuing legal redress to its economic issues through formal petitions at the WTO. Since America is also going into Presidential elections, there is also no way that President Obama will sign up to any agreement that would be binding on his successor. Treasury Under Secretary Nathan Sheets made it clear that America is focusing on China's strategic centre of gravity, which is national security itself. Chinese national security strategy and policy, uses economic policy as a weapon. China has amassed a massive trade surplus in consequence, by promoting exports and suppressing foreign imports.
America is now leading an assault on this national security strategy of China's. As Under Secretary Sheets put it:
We need to see discreet progress on issues like transparency, reliable rule of law. The national security review that they have stands in the way of investment, so increased openness to investment... This plays an increasingly key role in our discussions with our Chinese counterparts." The American and Chinese national security agendas are essentially in conflict; so that the unfolding trade war has a more specific context.
Whilst feigning open handedness, China understands that practically speaking there is no opportunity for any "institutional arrangement" with America in the immediate future. The posturing is therefore for window dressing purposes, rather than for serious political consideration. Since President Xi Jinping has also effectively taken control of the economic and political executive, the strategic dialogues are rendered meaningless. What is now required is the kind of diplomacy enacted by Kissinger and Nixon, with direct dialogue between the US and Chinese President rather than their minions.
As G7 heads of state met , to follow up on the lack of progress that their finance ministers had earlier made, China was about the only theme on which they had a consensus. Even before the meeting starting, the word "Steel" was being used by the leaders as code for China and its industrial overcapacity threat to the developed nations. The heads of state then went even further beyond their national boundaries; by indirectly censuring Chinese expansionist maritime policy in waters that the G7 has no legal claim to.
There are also signs that the currency markets are going to be the next scene in which the evolving dynamic between China and America is played out. As reported in a previous article, China's tactic of pegging the Yuan to a weakening Dollar earlier this year has bought it some breathing space. The currency markets are now throwing off mixed signals about the US Dollar's continued weakening. The US Dollar is now strengthening based on the conviction that the FOMC will resume tightening. Unilateral Yuan weakening, at a time when there is political strife and collapsing equity and commodity bubbles, could quite easily get out of hand again. Capital flight could become a problem once more. Presumably the Chinese hope that Janet Yellen will blink again, when she feels the capital market volatility emanating out of China, and ease off the tightening again. It's a reasonable bet to make!
Recently however, the FOMC has shown itself to be of a little sterner stuff; and may well press ahead with the tightening albeit a token gesture in light of the weakening global economic picture. On the contrary, the Fed is sending out smoke signals that the economic stability achieved by China in Q1 this year, will now allow the FOMC to continue with its tightening schedule. As the Yuan has not depreciated significantly, the Fed has got the green light to go and risk the capital flight from China that it creates.
China has immediately reacted by going on capital flight watch. The insurance regulator recently clamped down on the issuance of products which act as collateral for schemes which shift Dollars out of the country. The authorities also clamped down on offshore Dollar bond issuance.
There has also been talk of expanding the number of reserve currencies in the IMF's SDR basket. Recently speaking, at the High-Level Conference on the International Monetary System in Zurich, Bill Dudley opined that the more currencies there are in the reserve basket the more stable that the financial system will be in times of crisis. This is the kind of portfolio diversification analysis that proves not to be the case in practice, when trouble occurs and all risk becomes correlated.
The Bank for International Settlements (NASDAQ:BIS) put the matter into specific context. Ending the dominance of the US Dollar in the SDR basket will not be enough to bring stability to the financial markets in the BIS's view. China should be in no doubt, that there will be no safety for it in the IMF SDR basket; which it is currently trying broaden the use of globally in order to undermine American hegemony. China has been advised to think again, if it really thinks that it can sell or even threaten to sell its US Treasuries.
An insider's perspective of how America strategically views China was providing in a guide for the perplexed to China's Communist Party's 13th strategy blueprint. The fact that this guide was provided by a Neocon Vulcan signals that this perspective comes from the heart of the national security doctrine strategists. Robert Zoellick's guide for the perplexed can be summed up in his OpEd for the FinancialTimes as:
"The 13th five-year plan reflects Mr Xi's consolidation of power and party revitalisation. The strategy appears to be to strengthen China Inc rather than to transform it. Meanwhile, centralised power will probably conflict with decentralised markets and local innovation right up until the 19th party congress in late 2017, when the president and a new standing committee of the politburo will need to reassess the drive to create a new growth model. The Soviet Union managed only 13 plans, so the party's real aim is to make sure China reaches number 14."
President Xi's priority is to consolidate his power and revitalise Communist Party doctrine. This puts him in direct conflict with the reformists and also the Neoliberal globalist's agenda. His current focus is on strengthening his grip at the 19th Party Congress in 2017. Currently therefore, everything China does is tactically focused on the Party Congress in 2017 rather than current developments in the global economy. This current versus future perspective disconnect is a source of risk not only for China but also the global economy.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.