It Is China We Need To Worry About
Pleading “guilty” in advance to the charge of excess hubris, I will start this piece with a quote from my last Dismal Optimist:
"I am not calling for a major collapse of the Chinese economy. But the Chinese economy is no longer a shining star. Unfortunately nobody really knows how bad things might be in China and there is a real chance things could be worse than I am expecting. George Soros has said the Chinese economy represents the greatest risk to the global economy. I would agree with this."
Truer words have not been written even if the above quote – with its disclaimer of ignorance of the true state of the Chinese economy – is part cop out. Make no mistake. The recent reversals in the world stock and foreign exchange markets are due entirely to the perception that the Chinese economy is slowing and that the Chinese financial system may be facing some kind of crisis.
Two news items were largely responsible. One, the HSBC and official Purchasing Manager Index (PMI) statistics for China have been signaling weakness. In particular,China's flash HSBC Purchasing Managers' Index fell to 49.6 in January, compared with a final reading of 50.5 in December.
Two, the largest shadow banking default in Chinese history looms on the horizon, i.e., a RMB 300 billion trust product issued by the China Credit Trust Co. Ltd. (CCT), due to mature Jan 31, 2014. The trust product was marketed through the branch system of the Industrial and Commercial Bank of China (ICBC), one of China’s largest state owned banks. The trust was set up to invest in coal mines, but unfortunately not all the licenses for the mines have been issued and the CEO of the venture was reportedly arrested in 2012. Not good.
Whether, as the media is reporting, this unhappy trust product will get bailed out in some fashion remains to be seen. ICBC legally is not a guarantor nor is the Shanxi local government where the mines are located. Meanwhile, the due date falls on Chinese New Year, when conveniently the Chinese markets will be closed. The world will be watching to see if any red envelopes are coming the way of investors.
The Chinese economy is now the world’s second largest economy. On a per capita income basis of course China is still way down there compared to the US or Western Europe. But there are 1.3 billion Chinese. So nowadays China really counts in the global economy. Its economy is significantly integrated with those of Western Europe and the US. China is now the largest consumer of commodities in the world. China’s massive consumption of commodities like for example iron, copper, coal and agricultural products have been the engine that has pulled along such disparate commodity oriented economies like Canada, Australia, Argentina, Brazil, Chile and South Africa. If reports are to be believed, China with its government (Communist Party) directed capital allocation system, has massively overinvested in some of these commodities.
China’s state owned banks and shadow financial system have made an enormous quantity of loans to local government entities and state owned enterprises. A substantial portion of these loans may not be repaid and the financial system will require bailing out. In response to significant financial repression whereby Chinese savers can only get below market interest rates at China’s banks, a huge off balance sheet shadow banking system has arisen. Historically, unregulated shadow banking systems have unhappy endings.
Internationally, the pessimists fear that the day of reckoning may be at hand, that the Chinese appetite for commodities may be dimming and that its financial system may be imploding.
It does not help that figuring out what is really happening in China is not easy and that events in China may therefore be subject to rumors and exaggeration. Chinese GDP statistics in particular are notoriously unreliable. Information in China in general is does not move freely as in the West. And unlike India for which English is the language of business and to a large extent government, China operates in a language that most esteemed foreign investment gurus can neither read nor even guess at.
In the absence of reliable official information from China, foreigners look for clues of various sorts. I have one. I spend considerable time in Hong Kong. For the last few years, Mainlanders have been coming over the border and buying massive amounts of European and American luxury brands. Hong Kong has become the Great Mall of China. I have joked that consumerism – I call it Louis Vuittonism – has replaced Communism (which earlier replaced Buddhism) as China’s religion.
But now we see a new phenomenon. The Mainlanders are coming over the border to buy food and pharmaceutical drugs. They are filling the malls in Kowloon and the New Territories (which are near the border) and lining up with suitcases at the pharmacies and supermarkets. Reportedly they do not trust the food and drugs available in China itself.
To me this is a little scary. It is one thing when Mainlanders come to free trade Hong Kong to buy expensive imported luxury goods which are priced dramatically lower than the same goods in China which are burdened with large import tariffs. It is another when they are buying low priced essentials. The latter behavior shows a basic distrust of their entire economic system.
The Current Malaise Does Not Originate on the Periphery
Emerging market stock markets and currencies have taken a pounding in the last few days. But in my opinion, this is not a banking/overvaluation crisis a la Mexico in 1996 or Asia in 1997. The problem, to use an old fashioned term, does not originate in the periphery. It originates in China, which is no longer in the periphery. Attempts by some in the media to turn last week’s stock and currency declines into an emerging market crisis in my opinion are misguided.
Let’s make a quick review on a country by country basis. Well run commodity exporting countries, like Australia, Canada and Chile, have seen their currencies decline in recent months. A rational move by the markets anticipating a China slowdown, but not a crisis.
The financial media has given last week’s devaluation of the Argentine peso a lot of attention. But Argentina is a special case. Like Venezuela, it is a populist kleptocracy that has been on a path of self-destruction for years. The world economy does not rise and fall on what’s happening in Argentina. Argentina is not the lead domino to fall as was Thailand in 1997. Neighboring Brazil is not having a currency crisis and the Brazilians should be happy for the decline in their currency since they have been complaining about the appreciating real for months.
Turkey and Thailand are two countries that deserve special mention. Both are basically sound countries that are having big problems. But their problems are the result largely of their own internal politics. Turkey is suffering from a corruption scandal and a turn to a more Islamic environment. Thailand is in the throes of a major division in the country between the populist supporters of Thaksin Shinawatra in the North and royalist Thaksin opponents in the capital. (There is however an eerie parallel between Thailand and Argentina. In 1955 a popularly elected populist president of Argentina, Juan Peron, was overthrown by the military representing conservative elites. Like the song says, Peron never really left and he dominated Argentine politics for seventeen years from his exile in Spain. Thaksin Shinawatra is Thailand’s popularly elected populist who was tossed out by the military. Will Thaksin play a Peron-like role from his exile in Dubai? )
The Markets Are Not Having a Taper Tantrum
It is taken as a given in both learned academic and unlearned financial circles that a cutback in the Federal Reserve’s Quantitative Easing program, a.k.a. “tapering”, will cause a rise in US interest rates and a flow back of funds to the United States. The effect will be to produce a decline in foreign (especially emerging market) stock, bond and currency markets. The global market malaise of the last few days was therefore largely in response to the Fed’s announced tapering program.
I believe this above explanation is incorrect. The problem is China, not Argentina, not tapering.
US interest rates have gone down, not up over the last week. Exactly the opposite of what the Taper theory would suggest.
The Taper is overrated as contractionary program. As I have argued in previous essays, the Federal Reserve, regardless of its convoluted legal ownership structure, should be viewed as part of the Federal Government. Its spending and bond purchases therefore should be consolidated with that of the Federal Government. It finances these purchases by creating high powered money. In its Quantitative Easing program, the Fed is mostly buying US government debt and government guaranteed mortgage securities (which in an honest accounting should also be added to government spending) Therefore the Taper does little to lower US government spending, calculated in an economic sense as I have suggested. The Fed’s government and government guaranteed security purchases just get consolidated out. As QE is withdrawn, the Federal government It simply transfers its funding of its spending from Federal Reserve’s interest free high powered money creation to bond market Federal borrowing. So the Federal government’s claim on goods and services of the economy remains more or less unchanged.
In contrast to the US, the Hong Kong and Shanghai stock markets both underperformed in 2013. Other markets, notably some in Europe, were very strong. The message in my opinion was that China is slowing. Not Taper fears.