Analysis of Chinas Economy: Debt Fueled Growth, Trade Deal to Test Trump, Risks of Shadow Banking, etc.
By Victor Sperandeo with the Curmudgeon
This is the third in a series of articles about China. The first two were: China Economy Expands but Debt and New Loans Soar; Trade Deal Revisited (01/19) and Phase One Trade Agreement Signed, but Tariffs Remain in Place (01/15).
Victor provides his comments and incisive analysis on the Chinese economy and Phase One trade deal in this piece. The Curmudgeon offers a perspective on Chinas shadow banking system and why it might be another debt bomb.
Analysis of China Economy (Victor):
Lets start by noting that no one who analyzes China professionally believes the economic statistics the Chinese government releases are accurate. The growth rate for the last several years is more likely on the order of 3% or less -- not 6+ % as reported by the government.
Chinas economic growth comes from debt. The debt comes from printed money by the People's Bank of China. Kyle Bass, founder of Hayman Capital Management, told CNBC: The Chinese print more money than any other country has printed, in gross terms, in world history Since 2001, theyve printed roughly $30 trillion worth of RMB (Chinese Yuan).
Moreover, the inflation rate in China is controlled by the government as one might expect. Chinas inflation averaged 5.13% from 1986 until 2019, reaching an all-time high of 28.40% in February of 1989 and a record low of -2.20% in April of 1999. [Source: National Bureau of Statistics of China]
Most of the average Chinese save a huge portion of their income. They buy gold, then hide it. That gold never leaves China.
Also understand that no property rights exist in China. Thereby, the government effectively owns most of its citizens net worth. That is why the greatest amount of effort and energy, for a so-called wealthy Chinese, is getting their money out of the country. Bitcoins, precious gems, paintings, and other assets are used to get money out of China. Due to government capital controls, only $50,000. per year per person, is permitted to be taken out of the country.
The U.S.-China trade deal is 90% perception (Victor):
No real U.S. GDP growth will come out of the Phase One agreement. Whatever China agreed to in the deal will likely not be done or executed. Furthermore, there is no enforcement mechanism to assure compliance.
China government officials want Trump out of office as he has made their life quite difficult. Trumps tariffs have greatly weakened Chinas economy, his administration has pressed the country to respect intellectual property rights and U.S. trade secrets, and he has banned Huawei and restricted component sales by U.S. companies to that company. In October 2019, the Financial Times reported that the Trump administration was considering options to crack down on shipments of contraband goods from China, adding a new point of friction with Beijing. Finally, the U.S. military was ordered to stand up to Chinas island building and provocations in the South China Sea while also sending guided-missile destroyer ships through the Taiwan strait (as reported in our January 19th post).
Expect China to test Trump by not adhering to their Phase One trade agreements. Remember that 2020 is an election year and Chinas government doesnt want Trump to be re-elected President so its in their interest to create havoc for his campaign.
Also, there is nothing in Phase one to curtail Chinas massive government intervention in their economy to turn China into a technological power (e.g. Huawei grants, subsidies and tax breaks as reported by the Wall Street Journal).
In summary, Phase one is a sham deal to stall and hope -with Chinas help -to get rid of Trump. Even perception doesnt do justice to the China trade deal.
Side Comment: Let me stress Trump is trying to save or create manufacturing jobs in the U.S. In this case, his intent is in the right place. It is the Republican establishment that does not care about the workers of America, but rather the corporate payoffs (which amounts to legal bribery) they get for keeping profits flowing to U.S. multinational corporations.
The Problems with Chinas Shadow Banking System (Curmudgeon):
Shadow banking refers to lending and credit intermediation outside of the typical banking system. Shadow banking in China is a vast ecosystem which connects thousands of financial institutions with companies, local governments and hundreds of millions of households. Its growth in recent years, fueled by asset management products and peer-to-peer lending, lifted a broad measure of shadow banking assets to an estimated $10 trillion. But then the crackdown came, prompted by a China government campaign to tackle risks in the financial industry that might threaten the wider economy.
Chinas shadow banking sector had grown rapidly in recent years but has recently slowed. The China Banking and Insurance Regulatory Commission (CBIRC) said in a notice published January 12th that the total assets of the countrys shadow banking sector had fallen by 16 trillion yuan over the past three years. The contraction in shadow banking sector was primarily led by continued decline in asset management business originated by banks and non-bank financial institutions, according to a Moodys Investors Service report.
The CBIRC has been trying to tackle growing financial risks in China, with dozens of small lenders under pressure as a result of the economic slowdown. The notice said loans to the real economy had continued to increase, reaching 17 trillion yuan in 2019, up nearly 7 percent compared to the previous year.
One of the main problems is that regular banks in China -- unlike in the U.S. -- are major participants, keeping shadow-banking assets off their balance sheets to sidestep regulatory constraints on lending.
A new worry is that products arranged by Chinas independent wealth managers will face mounting losses as Chinas economic slowdown continues and corporate defaults surge. Confidence in the industry has plunged since July 2019 when Noah Holdings Ltd. said that 3.4 billion yuan ($477 million) of credit products overseen by one of its units were exposed to an alleged fraud by a Chinese conglomerate.
Reuters Breakingviews reported on January 16th that the Chinese shadow banking is poised for a comeback. A recent survey by China Beige Book suggests a sharp revival in shadow credit in mid-2019, contradicting official data (remember that Victor stated you should not trust the China government economic data).
During the second quarter, the share of non-bank lending surged from 30% at the start of the year to 45% of total loans the highest on record - and has remained high since. Sources of credit ranged from non-bank state-owned companies, trusts, online services and individuals.
In a recent conversation with Breakingviews, one Chinese finance professional admitted to personally lending to small companies and spoke glowingly of double-digit returns. To compare, the one-year loan prime rate is just 4.15%. China regulators are trying to bring the cost of credit down, but Beige Book data shows interest rates for small and medium firms shot up 266 basis points quarter-on-quarter in the three months to December 2019.
Another headache for China officials is that such informal and mostly illegal loans are hidden from them, akin to the back-alley lending that fueled the private economy in the early days of reform. Unsurprising, the back-alley charges more for risk.
Because shadow bank lending is opaque and regulation is minimal or non-existent, nobody knows exactly how much money is at risk. The repercussions could be significant if losses on shadow banking products fuel a broader retreat from high-yield assets in China. That, in turn, poses risks for the wider Chinese economy because shadow banking is not subject to banking regulations which constrain risks. Hence, shadow banking losses and defaults could spread to negatively impact Chinas real economy.
Summary and Conclusions (Victor):
To reiterate, the whole China growth story is based on debt. The Chinese Communist Party (CCP) rules the country. Xi (pronounced SHE) Jinping is a Maoist. He can order the military (Peoples Liberation Army) to knock on any persons door and take 100% of what that Chinese citizen owns to pay down the government debt if so needed.
A wealthy Chinese citizen that has accumulated lots of Yuan, urgently wants to convert his or her savings to U.S. dollars that are held outside the country. That is why 25% of Vancouver, Canada population is Chinese and why Vancouver real estate is double what house prices should be there.
For the well off, it is not about making money in China, its about getting it out of CCP control. Thats analogous to U.S. corporate share buybacks which are not about making money for stockholders; its to boost the stock price so that insiders can cash out of their warrants and stock options with a hefty profit.
Rhetoric became reality last year, from Andrew Batson (head of research at Gavekal Dragonomics in Beijing) is the only phrase about China you need to know and remember.
We had a deepening slowdown in the (China) domestic economy last year and unprecedented pressures on the external front from the trade war with the U.S. In the face of all that, the Chinese leadership actually did very little, Batson added.
Closing Comment and End Quote:
It took 72 years for the USSR to fail. [See The Collapse of the Soviet Union]
The U.S. began its decline in 1971 48.5 years ago when Nixon took the U.S. off the Gold standard.
Deng Xiaoping began changing China in 1978. He is totally responsible for Chinas economic success. His quote speaks volumes:
Absorbing foreign capital and technology and even allowing foreigners to construct plants in China can only play a complementary role to our effort to develop the productive forces in a Socialist society. Of course, this will bring some decadent capitalist influences into China. We are aware of this possibility; it's nothing to be AFRAID of.
Deng Xiaopings meaning was that China can change very quickly. It will be interesting to see if any change will result from the sham trade deal.
Good luck and till next time .
Follow the Curmudgeon on Twitter @ajwdct247
Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.
Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.
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