Belt-Up For The Next Chinese Roller Coaster Ride

by: Adam Whitehead


Foreign businesses are adapting to the new executive power structure in China.

The Chinese government is tentatively pressing ahead with limited economic reform in the face of rising unemployment.

Chinese policy makers allege that they have engineered a soft landing from which the next Belt and Road phase of economic expansion can take off.

China is shifting its domestic credit bubble to its Belt and Road partners’ economies to grow out of its own debt problem and mitigate its exposure to America.

China is going global as the developed world goes Populist.

Against a stage backdrop of a new commitment to free trade, China recently embarked on a new phase of economic expansion subtly different from the previous one. The new phase will mitigate domestic economic bubble risk by transferring it to the regional trade partners who will be driving the expansion. This new phase requires a change in the team to execute it and the team to manage it.

(Source: Bloomberg)

In recognition that the power structure is changing within China, western businesses are changing their modus operandi. The Conference Board, which comprises 1,200 companies, is now in the process of studying how to change the way that its members operate in order to optimally interface with the new command and control hierarchy that President Xi Jinping has created.

Symbolic of this change in the power structure is the new status of Premier Li Keqiang. His role and hence the reformist trend that he has represented has now changed, as reforms have been sacrificed for national solidarity. This prioritization of solidarity, especially in light of the new hostilities from Washington, requires the Premier to join ranks with his former enemies in a united show of strength. Premier Li may therefore find himself re-elected, even if he is effectively a minister without a real portfolio, when his terms shortly ends. Despite the continued consolidation of power by President Xi Jinping, rumors continue to circulate that all is not well in the Chinese corridors of power. An exiled Chinese businessman named Miles Kwok recently revealed that President Xi has ordered an investigation into his own corruption Czar Wang Qishan. These claims remain un-corroborated by evidence and Mr Kwok threatens greater revelations in due course.

As the recent G20 meeting approached and Treasury Secretary Mnuchin prepared to deal with the putative currency manipulators, China was taking no precautions to be wrong footed. In consequence the PBOC followed the FOMC's latest rate hike with a tightening of its own, just to be sure that the Yuan did not weaken against the US Dollar and give Secretary Mnuchin the opportunity to label China as a currency manipulator. The G20 meeting came and went without incident, illustrating the softening of the position of the Trump administration towards China. This is being interpreted by some as a sign that the Goldman Sachs contingent within the White House is emerging as victorious over the Populist faction.

(Source: Bloomberg)

There is also a domestic economic policy reason for the PBoC to shadow the Fed. As the new Chinese economic growth target has been lowered, riskier asset prices have yet to discount this reality; leading to a more violent discounting of these fundamentals later. A bubble still persists in the property sector, which Ning Jizhe, vice chairman at National Development and Reform Commission (NDRC) recently alluded to as justification for continuing with more cooling measures. Riskier borrowers are increasingly relying on the shadow banking market, whilst bona fide banks are probing to see where the PBoC's real tolerance to support them if they get into difficulty lies.

The PBoC therefore sent a strong signal that it has no tolerance for shadow banking at these levels of asset prices, by tightening money market rates and withdrawing interbank liquidity to levels that triggered interbank lending defaults. The PBoC also has no tolerance for the outsourcing of shadow banking to foreign financial institutions, who then recycle this with increased leverage and resulting market volatility. The practice involves Chinese banks "entrusting" their own funds to external asset managers. Said asset managers act as shadow banking conduits for the funds to then return to the Chinese capital markets with increased leverage and price risk, as they chase capital gains to deliver the returns promised on the underlying shadow banking products. Regulation preventing this "entrusting" is now taking effect, with the resultant collapse of the pyramid structure of asset price support that it has created. The impact of the policy maker clampdown is clearly being felt. According to data compilers PY Standard and Use Trust, the number of wealth-management products issued by Chinese banks slumped 39 percent in April from the previous month, while trust firms distributed 35 percent fewer products.

(Source: Bloomberg)

The tightening of credit and related regulation has had a significant impact on risk assets thus far. The latest estimate of this impact sees at least $453 billion erased from the value of Chinese stocks and bonds since mid-April, $21 billion of cancelled debt sales and a knee jerk response from the People's Bank of China to inject $48 billion into jittery money markets. Sales of shadow banking products by lenders and trust companies have plunged by more than 30 percent this year, whilst domestic real estate transactions have slowed and metals prices have sunk. This contraction has got some observers speculating about how much tolerance there is at the policy maker level for its continuation and when it will end. Consensus is growing that policy makers will start to think about ending the contraction if and when the Shanghai stock index hits 3000. Some observers are starting to evaluate and discount the probability that the deleveraging in China could spill-over into global markets as it did in 2015. Thus far contagion has been contained, but this may not persist especially as the Fed makes progress on normalizing and the ECB move towards the normalization start-line. Despite the warning signals coming from capital markets, some observers are still predicting worse to come as the authorities continue to suppress and expunge leverage from the financial system.

(Source: Bloomberg)

The general tightening of operating conditions for shadow banks and the ongoing structural economic reform process away from the traditional industrial base now seems to be flashing some warning signals to policy makers. The PBoC is signaling that it is aware of the rising hysteria and wishes observers to relax and think positive thoughts, by consistently setting the official value of the Yuan higher at consecutive fixings. Thus far these signals are not being read and fully understood.

The result of these warnings and the policy makers' response may be a new phase of fiscal and monetary support for some of those individuals who are suffering from the tightening economic conditions. The State Council recently warned that: "If new urban jobs shrink or the jobless rate jumps, (China) should step up fiscal and monetary policy support." The central government and the PBoC have thus been put on notice that the pace of economic reform is becoming politically unsustainable in some regions.

Controversy surrounding this emerging threat was highlighted when former Finance Minister Lou Jiwei suggested that some regions undergoing this reform should be allowed to default on their debt; thus signaling that the central government intends to proceed with its economic transformation plans. It should be remembered that when he was Finance Minister, Mr Lou was an enthusiastic economic reformer. His passion for reform has been subsumed under President Xi's desire for greater economic and political control, so that the reform message has been blunted of late. It appears that a new wave of reform is being gently applied rather than being bluntly administered as the central government tries to use its dwindling capital resources more productively. Since he is now head of Social Security, Mr Lou is no doubt preparing to mitigate the consequences of this latest reform push with compensation in the form of welfare payments.

(Source: CFR)

Despite or maybe in response to this emerging economic threat, PBoC Governor Zhou Xiaochuan stated that the economy is gliding towards a soft headline 6.5% GDP growth rate and that the risks to the financial system are contained. Deputy Governor Yi Gang also tried to draw a line under the unfolding carnage, much of it self-inflicted, in the capital markets; by saying that the banking sector's non-performing loan (NPL) and capital flight issues have largely been resolved. The economic soft patch, experienced in Q1 by most nations, has allegedly ended in China. Mr Yi was however being somewhat disingenuous. Whilst correctly noting that the NPL issue as a percentage of all loans outstanding is stabilizing, he failed to make clear that the denominator of total of loans outstanding is rising. This rise in the denominator thus keeps the rising number of NPL's flat as a ratio statistic. The NPL issue is therefore still rising in aggregate terms.

(Source: Bloomberg)

Evidence is emerging that recent Chinese capital controls are stemming the tide of capital flight. In April foreign exchange reserves rose for the third consecutive month, demonstrating the requisite number of data points to designate the beginning of an improving trend. Conversely, foreign acquisitions have dropped 67% year on year in the first four months of 2017. Capital outflows have conclusively been choked off for now.

After the recent abortive G20 meeting, that yielded no united commitment to global free trade, the PBoC Governor Zhou Xiaochuan put this issue back on the agenda for the next meeting. The Chinese position is overtly protective of the benefits that have accrued to its economy from globalization. China would like to preserve this global franchise; so it has adopted the position that something that exists cannot be broken. The last report observed that China is committed to its Belt and Road strategy. Any reversal to the trend of globalization will directly undermine this strategy. As Governor Zhou opined: "Globalization is something that has already happened". Some in Washington may take the view that it is already over.

(Source: Gallup)

Going into his inaugural meeting with President Xi Jinping, President Trump framed the encounter as fraught with problems. This negative framing was then embellished by Commerce Secretary Ross, who did not mince words when it came to pointing the finger of protectionism straight at China. According to Ross: "the United States is about the least protectionist of the major countries --and China is one of the most protectionist."

Having under-promised, President Trump over-delivered in terms of his assessment of how the meeting went and how an understanding between the two leaders has been achieved. In what is fast becoming his trademark of mixing and matching policy initiatives, in reaction to breaking events, President Trump then capitalized upon his showdown with North Korea by saying that he will link his refusal to label China as a currency manipulator to China's support in dealing with Pyongyang. President Trump also showed that he is not averse to some rhetorical currency manipulation of his own, with his comments about too much US Dollar strength that he balanced with a retraction of his labeling of China as currency manipulator.

Treasury Secretary Mnuchin similarly reversed his prior adversarial position, after meeting with his Chinese counterparts. Commerce Secretary Ross is less effusive and intends to work on the devil in the details of a negotiated trade agreement that gives American exports greater access to China, before he changes his adversarial position. He initially appeared to remain unshakeable in his criticism of China and the other nations that run trade surpluses with America. Secretary Ross's rhetoric may however just be a case of hard bargaining. His rhetoric has changed notably, since he recently negotiated a bilateral deal to allow American beef and natural gas exports in return for Chinese cooked poultry products and banking access to America. He referred to this deal as a "Herculean" success.

(Source: Financial Tribune)

Ahead of the recent showcase Silk Road Summit at which President Xi Jinping was expected to release details of his Belt and Road strategy that is being framed as his model of globalization all was not well. There was a growing sense that President Xi was employing his own domestic form a totalitarian control to his wider regional trade partners. A leaked draft communique showed as much, as it was principally a verbatim expression of Xi's intentions and capabilities to promote globalization on Chinese terms throughout the Belt and Road territories. The lack of consultation with trade partners sounded the alarm in their ranks and thus raised the risks for execution of this great project. Despite the snub to the other trade partners, Finance Minister Xiao Jie's emphasis of the importance of Iran threw another geopolitical spanner in the works for America. Strategists will no doubt be revisiting Brzezinski Doctrine as a go to guide for the perplexed to the Belt and Road strategy.

The very clear absence of America from the Belt and Road map contrasts very sharply with the financial Belt and Road of the twin deficits that connects it to China. This contrast presents the very clear picture of China diversifying away its financial and geopolitical risk with America and some say dethroning the latter and the US Dollar in the process.

The Silk Road Summit itself was choreographed to frame the event as China's commitment to free trade, rather than its commitment to construct a trading infrastructure network that guarantees its dominance of global trade. Said dominance is set to be financed by state controlled cheap loans to nations who will build the infrastructure. In the bigger picture China is creating an emerging market debt bubble in its Belt and Road partners, that is balanced by the deflation of its own domestic shadow banking bubble. Risk however is being transferred from the domestic economy to the Belt and Road partner economy, through a system of state underwritten loans which give China a claim on its partners' economies.

The PBoC recently signalled that, given the balance of risks discussed above, it has decided not to persist with the monetary squeeze. In its latest market operations, the central bank boosted cash injections and provided more seven-day funds, the cheapest form of financing it offers. A recently released quarterly report from the PBoC also signaled that officials see little need to drive interbank rates any higher; and that they have refrained from increasing borrowing costs since mid-March. This latest softening of monetary policy came on the conclusion of the recent Belt and Road Summit. The strategic conclusion to be drawn is that this summit was supposed to represent some starting point for a new phase of economic expansion.

Running into this new growth phase, policy makers have allegedly brought the economy down to a soft landing and expunged the excesses of the shadow banking bubble, just in time for launch of the new Belt and Road push. Premier Li Keqiang framed this optimistic view for the benefit of Christine Lagarde, on the sidelines of the recent Silk Road Summit; when he stated that China will also strike a balance between financial stability, gradual deleveraging and steady economic growth. Alternatively, one could say that the authorities do not wish to push the tightening of monetary policy any further at this point in time, for fear of triggering something much uglier that blows back into the real economy from the capital markets.

(Source: Bloomberg)

The contrast in perceptions of the situation, by domestic Chinese and offshore China investors, tells a story and creates a divergence in Chinese onshore and offshore equity markets. So painful and current is the memory of the severe domestic monetary policy clampdown that the animal spirits in the domestic equity markets are absent. Offshore investors are imbued with the tailwinds (admittedly rapidly vanishing) from improving economic conditions in developed economies. Offshore investors have observed the latent signals, of Chinese policy makers easing off the breaks, sooner than their onshore counterparts although this may have more to do with the positive global halo effect. Offshore investors are also more susceptible to the seductive rhetoric of President Xi's Belt and Road speeches.

Jim Chanos is one notable exception to the offshore positive frame of perception. Since his frame is always negative, by nature of the fact that he makes a living by short-selling, his cognitive bias is systemic and inflexible. A man with a hammer only sees nails. His view is informative however; and calibrates the inherent risks that the Chinese authorities are striving to currently manage. Chanos's latest view is that the loan-to-deposit ratio in the Chinese banking system is about 80% on aggregate. At the domestic level, new loans are just being made to service old ones rather than for new domestic growth opportunities. There is no underlying strength in the domestic economic growth rate to either service or pay down the growth in debt. This is a red light for him.

Presumably, Chinese policy makers are not asleep at the wheel and also see the same light as Jim Chanos flashing on their domestic consoles. They must therefore be circumspect on both how much to tighten monetary policy, for fear of triggering a bank run, whilst at the same time being at least as circumspect on how much more to inflate the credit bubble within the banking system. The great moderation in economic growth, enabled by the ample supply of credit from the PBoC is no different from that which is going on in the developed economies under the influence of QE from their central banks. Chinese policy makers may have found a catalyst for growth however by going global, whilst developed nation policy makers turn inwards to fight the forces of Populism.

The transfer of risk from the domestic banking system to emerging economies, with higher potential growth rates along the Belt and Road infrastructure, is possibly one way that Chinese policy makers can mitigate the risk of domestic debts that are running way ahead of slowing domestic economic growth. It would therefore seem that China has acknowledged that the only way to grow out of its current debt problem is to go global. Chanos may be right in the long run, but that long run may be quite a long time in coming to a violent end as China is now embarking on a new phase of economic expansion. In a clear divergence from the developed economies that are becoming Populist and introspective, through erecting trade barriers, China is going global. China is in effect expanding into the void that the developed economies are vacating.

Only Britain, which out of the accidental practical necessity of the Brexit, seems to be the one developed economy to be hitching itself to this Chinese bandwagon. There's a new B in BRIC. With the risk of the collapse of Nafta, there may also be more italics added to the BRIC handle. As America gives notice that it is about to renegotiate Nafta, the Mexicans are already threatening that they will let China fill the void. Trade relations between Canada and the United States have also deteriorated markedly. The Belt and Road may then extend to the hemisphere of American influence on America's borders to the North and South.

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.

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