Ilargi: The Taper And The China Credit Power Struggle Squeeze

Yves here. We described the funding mismatch with Chinese wealth management products during the first liquidity crunch earlier in the year, but given that most readers aren’t familiar with these structures, it’s good to have another summary as to how they work and and further discussion of why they pose a risk to the Chinese economy. They are troublingly similar to structured investment vehicles, which were one of the detonators of the credit crisis in the US and UK.

By Raúl Ilargi Meijer, editor-in-chief of The Automatic Earth, Cross posted from Automatic Earth

There is a crisis a-brewing in China that evolves around interest rates, with interbank rates as, let’s say, the initial center piece. The underlying cause of the crisis is that both official banks and the shadow banking system seek to escape the restrictions placed on the financial system by the government and the central People’s Bank of China (PBoC), who in essence want to set all interest rates and all policies. At the very moment the regulators recently decided to let markets set some interest rates, a move intended to cool things down, money market rates went up so fast that more action by the PBoC, after an initial refusal, was deemed necessary.

The PBoC has set the interest people can get on their deposits with banks so low they’re actually losing money. Many Chinese have bought newly built empty apartments as an investment, which can’t be rented out because that would make them no longer “new”, and hence less valuable. But people are still looking for other investment opportunities. And so are the banks, who are trying to prevent a mass outflow of deposits.

One major, relatively new, option banks offer are WMPs, or Wealth Management Products. And it all gets shady right off the bat here. Banks are not allowed to lend out money directly to real estate developers and local government financing platforms (LGFPs), which therefore pay higher interest rates. Trust companies, though, are free to lend to these parties. So what do the banks do? They (co-)create trust companies, or establish business deals with them, and repackage old loans, CDO-like, into WMPs, all of which sees them move very close to, if not enter, the shady territory shadow banking operates in.

Banks conduct complex reverse repurchase transactions, or repo’s, with the trust companies, which enables the latter to lend out to real estate and local governments, at 12+%. They move this entire process through WMPs, which allows the banks to offer their clients/investors a 6% interest on deposits, and divide the remaining 6+% between themselves and the trusts. Financial innovation of the kind that would make a Chinese Alan Greenspan proud.

But, you guessed it, there is a problem here (quite a few actually). Most importantly, there is a growing liquidity risk due to the different durations of WMPs and trust loans. Two thirds of WMPs have a three months or less duration, while durations of trust loans to real estate developers or local governments are often as long as a few years. Ergo, banks have a hard time recovering funds from trust loans quickly enough to repay maturing WMPs, which leads to a lack of capital. And the PBoC eventually caved in to pressure and conducted “short-term liquidity operations” (SLOs) to make sure banks had capital. That only helped up to a point: money market rates are still quite a bit higher than before. That has a lack of “trust” and “confidence” written all over it.

The essence, and this is something I haven’t really seen being discussed at all, is that what we’re looking at is a – pretty much ordinary – power struggle. The closest I saw anyone get was Patrick Chovanec, who was quoted at BI as saying:

The investment led growth model has made it so it’s almost like the PBoC has ceded control of monetary policy to the shadow banks.

The current overall understanding, both in Beijing and abroad, is still that the Chinese state, the Communist Party, owns the banks and dictates all policies, both through government offices and through the central People’s Bank of China. But what the government in China is learning in crash course fashion is that the “wealthier” a nation becomes, especially if that “wealth” is realized through large increases in credit/debt created in and sloshing through its economy, the harder it is to maintain not just control over the economy, but political control in general.

The shadow banking system makes up a huge chunk of the Chinese domestic economy (JPMorgan estimated it at $5.86 trillion, or 69% of GDP, earlier this year), and nobody really knows how risky and leveraged its “capital” is. The PBoC, from its own point of view, is right to put its foot on the break in order to lower the risk inherent in the system, but if that foot comes down too heavily, the entire economic machinery might seize up. Trying to lower the risk is a risky move. That’s a Catch 22 that greatly limits the real control Beijing has over China’s financial markets.

In order to achieve the growth it has seen recently, the leadership has relied heavily on the shadow banking system, and the credit it creates through leverage, to grease the wheels of the economy. Now that it wants to rein in that system, it finds that’s very hard to do. It wants to rein it in not just for political power reasons, but also because it fears the effects the high leverage levels and high risk in the “underground economy” can have on economical and social stability. The Chinese economy as a whole would likely start showing serious cracks if growth moves below 7% per year, and without shadow banking, it appears to have gotten practically impossible to maintain that growth rate.

It looks like Beijing has embarked its economy on a 7+% growth train, but neglected to include any breaks in the design of that train. When it tries to rein in the underground economy, it risks crumbling the walls of the Forbidden City, if you permit me the poetic licence, and thereby its own power, i.e. the political control of the country by the Communist Party.

Many party leaders are undoubtedly acutely aware of how this resembles what happened in the developed world, Europe, Japan, US, where once, like in China, the state owned the banks, but where now, effectively, the banks – financial institutions-, whether they are “official” or “shadow”, own the state (though we’re good at fooling ourselves that it’s not true, an illusion that serves just about everyone on all sides of the equation). Moreover, instead of fighting that development, most of the leaders will opt to jockey for position, to wiggle and scheme all they can in order to build and improve their own personal positions in this “new” world.

It is a universal truth that when you allow money to enter into politics, money will inevitable end up purchasing, and owning, the political system. This is no different in China than it is in the west. It’s no longer about actual power anymore (that’s largely been decided), but about individual politicians’ positions in the “new world”, about who gets most outside funding.

For a while longer, some, especially at the very top, will resist the new division of powers, simply because they feel, rightly or not, that that’s the best course of action for their own particular positions. And there lies a big risk. The men at very top may have less control over the economy than they think and/or desire, but they sure still control the army, and may well feel they have the right to use that army to defend their positions. That could lead China down a long and bloody road.

I can’t resist including a lengthy quote from an email Mish posted yesterday that made me laugh, sent to him by Michael Pettis, who like Patrick Chovanec works in China and brings an equally unique perspective. Although I’m sure this was in no way Pettis’s intention, the more I read of his mail, the more I was thinking: you can just about 1 on 1 replace “China” with “The US” here; same problems, same causes. The timing is off at times, for obvious reasons, and the US has no obvious manufacturing overcapacity, sort of for the same reasons: it’s further along in the whole process, but the role played by credit and leverage surely is eerily reminiscent, to the point where it gets to be outright funny.

Lines like

“China’s astonishing growth during the past three decades is partly the result of a system that subsidized growth with hidden transfers from the household sector.” or

“Debt matters, and the only time it can be safely ignored is when debt levels are so low, and the borrower is so credible, that it creates no financial distress costs and has a negligible impact on demand.” or

“The failure of many economists to recognize that wasted investment has a cost – even as they recognize that investment has been wasted – has caused them both to misunderstand the relationship between wealth creation and GDP and to understate the future impact of this overstated GDP.”

… they make me chuckle out loud when realizing this applies to the US every bit as much as it does to China.

Pettis on Debt, Malinvestments, Hidden Losses, and China’s GDP

It is widely acknowledged that perhaps the most important reason to change the Chinese growth model is its excessive reliance on debt to generate growth. Debt has soared in recent years, to the point where many economists simply look at credit growth in the current quarter in order to determine what GDP growth over the next few quarters are likely to be.

But as China deleverages, growth in demand must drop sharply. After all, if economic growth over the past several years has been goosed by rapid credit expansion, deleveraging must have the opposite effect. It is strange that economists who acknowledge that the current growth model is overly dependent on debt have failed to understand that its reversal will have the opposite impact. If it did not, it is hard to explain why anyone would consider debt to be a problem in the first place.

If China currently has wasted significant amounts of investment spending, it is clear that much of the accompanying bad debt has not been written down correctly. Bad loans are almost non-existent in the banking system – that is they have not been recognized in the form of reserves or write-downs.

But the failure to recognize the loss does not mean that the loss does not exist. The losses implicit in the bad loans must (and will) be written down over the future, either explicitly, in which case they will result in a direct deduction to GDP growth, or implicitly, in which case they will require implicit and hidden transfers from one part of the economy or another (usually the household sector) to cover the gap between the “real” cost of capital and the nominal (subsidized) cost of capital. This transfer must reduce future growth.

The point here is that if credit is a problem in China – something no one doubts – it must be a problem because of wasted investment that has yet to be recognized, otherwise it would have resulted in negative GDP growth today. Failure to recognize the investment losses will, of course, artificially boost GDP growth today, but it must also artificially reduce GDP growth tomorrow as the recognition of those losses is simply postponed, not eliminated. The failure of many economists to recognize that wasted investment has a cost – even as they recognize that investment has been wasted – has caused them both to misunderstand the relationship between wealth creation and GDP and to understate the future impact of this overstated GDP.

Debt matters, and the only time it can be safely ignored is when debt levels are so low, and the borrower is so credible, that it creates no financial distress costs and has a negligible impact on demand. Neither condition applies in China, and so any prediction that ignores debt is likely to be hopelessly muddled. In fact I would like to propose a simple rule. Any model that predicts China’s future GDP growth must include, if it is to be valid, a variable that reflects estimates of the amount of hidden losses buried in the banks’ balance sheets. If it does not, it cannot possibly be a valid model to describe China’s economy, and its predictions are useless.

China’s astonishing growth during the past three decades is partly the result of a system that subsidized growth with hidden transfers from the household sector. These transfers are at the root of the current imbalances, and once reversed, so that China can rebalance its economy towards healthier and more sustainable sources of demand, the very processes that turbocharged growth will no longer do so.

If growth has been healthy and sustainable, there would be no need for Beijing to change its growth model – in fact it would be foolish to do so. If growth has not been healthy and sustainable, this is almost certainly because it has been artificially propped up, and if the reforms are aimed at unwinding the mechanisms that artificially propped up growth, then subsequent growth rates must be substantially lower.

Low interest rates, low wages, an undervalued currency, nearly unlimited access to credit for state-owned enterprises, a relaxed attitude to environmental degradation, and other related conditions were both the source of China’s ferocious growth as well as of China’s unprecedented economic imbalances. Reversing these conditions will rebalance the economy, but will do so while lowering growth in the obverse way that these conditions had accelerated growth.

One of the most obvious places in which to see this is in excess capacity in a wide range of businesses. It is clear that Beijing recognizes the problem of excess capacity. Here is Xinhua on the subject: “Tackling excess capacity will be one of the top tasks on China’s economic agenda in 2014, as the issue becomes a major challenge to maintaining the pace and quality of economic growth”. “The Chinese economy still faces downward pressure next year,” the Central Economic Work Conference pointed out on Friday, citing the capacity issue weighing down some sectors as one of the major challenges facing the world’s second-largest economy.

It should be obvious that building excess manufacturing capacity, like building up inventory, is a way of propping up growth numbers today at the expense of tomorrow’s growth numbers. Closing down excess manufacturing capacity must be negative for growth in the same way that building it was positive.

These three conditions, which are the automatic consequences of the reform process – deleveraging, writing down unrecognized investment losses, and reversing policies that goosed growth rates – must lead to much slower growth. In theory these conditions can be counterbalanced by an explosion in productivity unleashed by the reforms.

But this is unlikely to be the case. For the net impact of the reforms on growth to leave China’s GDP growth unchanged, or even to accelerate, the amount of productivity that must be unleashed by the reforms is implausibly, even extraordinarily, high. What is more, the positive impact on productivity must emerge almost immediately. Longer-term productivity improvements – for example those generated by education, land, and hukou reforms, or reforms to the one-child policy, or a speedier and more efficient urbanization process – do not count.

I am so convinced that the implementing of these reforms must result in slower growth – if only because it is impossible to find a single relevant case in history in which the adjustment following a growth miracle did not include an unexpectedly sharp slowdown in growth – that I would propose that we can judge the forceful implementation of the reforms inversely with GDP growth. If China is able to impose an orderly adjustment quickly, its GDP growth rate will slow substantially for several years.

GDP growth rates of 7% or more, on the other hand, will suggest that credit is still rising too quickly and that China has otherwise been unable to implement the reforms, in which case China is likely to reach debt capacity constraints more quickly. Growth of 7% for the next few years, in other words, is almost prima facie evidence that China is not adjusting.

Yeah, the taper. I hear you, loud and clear. I can’t help thinking that what connects the taper (or QE in general) and the China squeeze is, more than anything else, the role each plays in the control a financial system seizes over a society and its political system. At least, since it hasn’t been settled yet, the Chinese can still hope for a voice in the battle for that control. Not that that is necessarily something to be envious of: these battles can be very nasty. But, then so are battles to seize it back once it’s been lost.

I don’t pretend to know how the battle over credit will run, or even end, in China. Other than to say that money is power. It’s all a matter of who ends up with most. Still, I’m not sure that 2014 will be a good year for overt absolute power, that looks a bit outdated. There’s a reason why real political control in the west is exerted from behind a curtain: it works better that way. And I’ve long said that visibility doesn’t rhyme with power. With that in mind, the Communist Party may have exhausted its options. But that doesn’t mean it’s ready to give up. Absolute power is a powerful drug.

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    1. financial matters


      “”However, as the government recognizes, growth by itself is not an adequate goal. Inclusive growth that reduces inequality is better but still not sufficient. As indicated by the PRC’s leadership, policy needs focus on quality over quantity, which implies articulating a myriad of policy actions ranging from strengthening safety nets to environmental sustainability. This means that moving forward policy needs to place greater weight on structural transformation while letting economic growth be a by-product of that transformation.

      Chinese policymakers have realized that solving problems such as unemployment and underemployment, a deteriorating environment, or increasing inequalities, will determine how well the country does in the next decades. Perhaps policymakers should think less in terms of a growth target and more in terms of employment creation (and unemployment/underemployment reduction) and structural transformation targets. Growth will be a by-product. Development is a path-dependent process and the PRC has acquired tremendous knowledge and competency that will allow it to continue thriving in the next decade.” (Felipe 2013)””


      “”low policy interest rates keep spending on interest low—benefiting debtors such as SOEs, small business, and local and national government. While the sovereign central government can always afford to pay higher interest, devoting a larger share of the budget to interest payment is probably not a good idea as interest income is likely skewed to higher income brackets. Instead, it is preferable to target central government spending to social programs””

      “”There should be no hurry to relax control over exchange rates or capital flows in the PRC. Today, the global financial system remains fragile, dominated by speculative flows. Another major financial crisis remains possible. While the West is discussing reigning-in financial excesses, it has not yet put in place the reforms that would attenuate excessively risky behavior.””

    2. Clive

      Normally I shy away from (and groan internally when I see) “you must read X- or you have to ready Y” type of suggestions, especially after wading through the best part of a thousand words on a topic which seems to cover all the bases. That said, the paper is definitely most interesting and does expand on Ilargi’s piece.

      You have to, as is often the case with these things, read between the lines of the dry academic tone. Such as on Pg. 14 when it states “We do not know if the reported
      (debt) data for local governments are accurate. It is possible that debt has been moved off balance sheets, or unreported.” — to which I can only reply that it’s also just possible there may be gambling in Casablanca and I’m shocked, shocked to the core, that such a thing might have happened.

      The reason why it might deserve a wider audience is in its discussion of the Middle Income Trap. Traditionally viewed as the ailment of a “developing” economy (the paper falls into this… erm… trap too), it’s not far from the truth to say that all economies — certainly the US, the UK, a lot of the Eurozone are also in a Middle Income Trap and the discussion of this phenomenon is valid potentially for these countries too.

      The paper also refers to Paul Krugman in parts. But don’t let that put you off.

  1. Clive

    Yes, this is a veritable “cut out and keep” summary of everything that is wrong with so-called capitalism today. The money (literally) sentence for me was

    “Low interest rates, low wages, an undervalued currency, nearly unlimited access to credit for state-owned enterprises, a relaxed attitude to environmental degradation, and other related conditions were both the source of China’s ferocious growth as well as of China’s unprecedented economic imbalances. ”

    You can just copy and past this one in so many different guises and apply it willy-nilly to pretty much every economy in the world right now. How’s about:

    “Low interest rates, low wages, an overvalued currency, nearly unlimited access to credit for state-protected enterprises (the TBTFs), a relaxed attitude to environmental degradation, and other related conditions were both the source of the US’ and the UK’s pseudo growth as well as of their unprecedented economic imbalances.”


    “Low interest rates, low wages, an undervalued currency, nearly unlimited access to the resultant current account surpluses for the big manufacturers, outsourcing of environmental degradation offshore, and other related conditions were both the source of Germany’s Euro-zone beating growth as well as of Germany’s unprecedented economic imbalances.”

    And by way of contrast (as an illustration of how crazy a certain set of “solutions” actually is):

    “High interest rates, low wages, an overvalued currency, nearly zero access to credit for state-owned enterprises, an unwillingness to submit to environmental degradation*, and other related conditions were both the source of Greece’s miserable growth (actually a depression) as well as of Greece’s unprecedented economic imbalances.”
    (*of course, I would never provide a premise which said that environmental degradation should in any way be encouraged, anywhere at any time; I merely point out that, in the flawed method of the calculation of GDP/growth, there’s money to be made in raping and pillaging your country’s environment.)

  2. NotSoSure

    This is just an uninformed opinion, but in my opinion there’s no power struggle. If the world economy is booming, I bet the Chinese government would have allowed those shadow banks go to the wall, allowing demand from the rest of the world to buffer the crisis, but nowadays I have a feeling that every big government is playing deck chair on the Titanic, not wanting to be the trigger for the next BIG CRISIS (which is surely coming). Once the fuse explodes somewhere though, I bet every country will allow their own specific crisis to unfold blaming some other country as the reason.

    1. NotTimothyGeithner

      I’m not so certain. Its still a one party state, and I suspect like many dictatorships the element which has moved to business hasn’t been looking to party membership. In an age where the children of the regime elders who opened the country up are gearing up for jobs in financial firms or where there are more non-party related opportunities, who is joining the Communist Party? The answer is true believers.

      Boom or no boom, I don’t think the maintenance of the state modus operandi has been looked at for some time by the powers that be. Local party bosses probably haven’t been receiving direction or aid for some time as top guys have moved on, and the communists have one ace in the whole: the general who ran the successful earthquake response operations is sympathetic to their concerns but not power hungry which gives them power without being seeing as a threat because they have a sleeping dragon in their corner. They can achieve their agenda without risking their status.

      Take even the fall of the Soviet Union. There were problems, but when Yeltsin and the other Presidents wanted to dissolve the Union, they didn’t face bureaucratic obstacles. Part of the reason was Stalin’s purges required a new generation to fill the USSR bureaucracy which was composed of veterans. By 1990, the USSR was controlled by 65 year olds with no successors in place. The younger generations had been cut out and had no representation in the existing state, so trying a new state didn’t really bother them. The promise of new wealth or to break the state out of its decrepit nature was enough

      The Democratic Party is a good example. Plenty of Blue areas fell in the 80’s and 90’s to entrenched candidates who had stopped running, winning on reputation alone, but they had taken their eye off candidate recruitment at local levels and coordinated campaigns. The result was a Republican beat down in ’94 despite ’92 being a huge win for the Democrats and the Republicans having terrible polling in ’94. The difference was the GOP had halfway credible candidates in the sense that they bothered to work hard for votes as opposed to writing a few op-ed pieces about voters being too stupid to understand their ideas or lack of ideas which is emblematic of modern Democrats. Not to mention, the Democratic establishment’s complete retreat in the wake of Watergate which resulted in the Democratic Party being taken over by the proto-DLC which led to Carter and Tip O’Neill.

      Admittedly, there are economic arguments behind these issues as well, but I’m reminded of the cheer “long live the king” because as long as the recognized king lives there isn’t the specter of civil war. No matter how good things are, a new king doesn’t just get to have power. The English dynasties with which we are familiar are rare, and even The War of the Roses was fought against the backdrop of growing prosperity. Two sides saw each other as a threat, and the new wealth wasn’t connected to the old wealth. The little people in England love that war because only the rich guys and the French died during short campaigns of small armies which paid for their supplies.

      Stream of consciousness and all, but I think Churchill’s point about democracy being the worst form of government was this. Democracy has problems implementing good policy, but the power struggles don’t happen when the king dies, sometimes suddenly, because the king leaves on a schedule and everyone has a shot at getting the next king.

  3. susan the other

    I like the word used yesterday: “degrowth.” It is a good mindset so that the world doesn’t confuse growth with healthy sustainable economies. Even 2% growth gets out of hand fast. If the goal of degrowth is to not driven by debt, as growth now is – throwing everything into a fast forward drive – then why isn’t sustainability possible in a degrowth economy? Plenty of socially beneficial achievement will be possible. So China is looking to find just the right amount of credit to infuse their economy with, and at the same time control or cajole the shadow bankers… good luck with that one. Since all debt, no matter how disguised, is sovereign debt in any nation, the only way to balance sustainable growth is to not use debt to achieve it. The other alternative is to allow yourself to be robbed blind by kleptocrats. They want to use money just like Bitcoin.

  4. William Neil

    I’m sure that Michael Hudson is smiling over the portions of having to deal with the debt overhang, and how much financialization has overtaken the Chinese economy, since it still has the aura of a manufacturing based economy, with everything “made in China.”

    1. Clive

      Yes, definitely. Why people keep thinking “China isn’t Bubble Era Japan” is quite beyond me. People kept thinking that Japan was a doyenne of manufacturing excellence (which it indeed was and still is). But it was far more a construction / financial engineering / leveraged edifice which in the end could only defy economic gravity for so long.

      Et tu, China ?

      1. NotTimothyGeithner

        Book sales. Catastrophic predictions about debt don’t sell as well if they were about the super-rich, but if they were about those dastardly red chinese…

        Even in the 1980’s when the Germans and the Japanese were going to ride Americans like horses for recreational purposes as they overtook our economy, part of that was driven by authors looking to sell to the same generation obsessed with World War II documentaries, the kids of World War II veterans. It gives them an excuse to blame young people for societies ills which is a time honored tradition.

        Even today despite the internet, much of our culture is shaped by people in their 50’s who pick the movies to be made and the books to be published, so what was happening in their 20’s? China was emerging. It was once the land where they were shamed about not eating their dinner or something, and they saw a country during the collapse of the Soviet Union as they moved into their 30’s crush a mass dissenter movement and moved on. International business competes with the Chinese. A person who turned 65 this year was 10 during the first year of the Great Leap Forward. A person who turned 55 may remember hearing about the failure of it or I have no doubt their opinions of the world and their place in it was shaped by half forgotten news stories.

        I don’t know what it would be called, but there is an emotional component at play with a mix of white man’s burden and bizarre American myths with the usual “my generation is the best generation who has observed untold wonders” mindset which shapes this.

        A rising non-U.S. alligned Russian led alliance wouldn’t sell well even if that was in the table because the Russians lost already in living memory, and we’ve seen on shows like NCIS* that the guys who were worried about Russia were dinosaurs compared to the guys worried about pick up trucks in the middle east.

        A story about China’s problems doesn’t sell well.

        *This isn’t a shot at NCIS which is probably the funniest show currently on television.

  5. NIQQY

    ADB paper to china solution is a variation of FED mortgage buying operation. if GDP measures are picked up by fed purchases, why is everyone surprised by GDP growth?
    if you measure the positives but ignore the negative, then coke addicts have no problems.

    also china’s duration mismatch is the outcome of china govt’s choice of choosing low interest rates to screw savers & distort financial decision making. Of course the Chinese are just copying the US. monkey see monkey do..

    1. Andrew

      I disagree. FED operations are a form of monetary policy not fiscal policy; they have an impact on the price of certain asset classes and hence interest income, but they don’t directly contribute to aggregate demand one way or the other.

      What the ADB paper primarily advocates is a relaxing of the federal budget so that growth can be less reliant on increasing corporate and local government indebtedness, in turn breaking the dependency on finance (shadow or otherwise).

      Not sure I follow the coke addict analogy; seems a bit of a non sequitur.

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