Identifying Vectors Influencing China’s (and International) Markets

I’ve been loath to say much about the Chinese market turmoil, due to the difficulty in getting a decent handle on what is going on via the English language media. And given the huge incentives for Chinese officialdom to engage in heavy applications of porcine maquillage, it’s not clear that one would know all that much more by reading the presumably pretty-well-controlled Chinese press.

It’s thus a bit of a relief to see a Western media outlet actually admit that analysts at a loss in reading the Chinese terrain. From Why It’s Getting Harder to Understand China, in the Wall Street Journal:

The quickening pace of depreciation in the Chinese yuan spilled over into global markets this week, raising concerns about global growth. It’s exposing the increasing difficulty of getting a firm reading on the world’s second-largest economy.

“The sheer size of China’s economy and financial markets make it one of the key countries to watch,” Peter Marber, head of emerging markets investments at Boston-based Loomis Sayles, said in an e-mail. “But the economy’s opacity and China’s distorted financial system makes it incredibly difficult for investors to know exactly what to watch.”

What may have investors most rattled is the impression that Chinese leaders have hit the panic button. They spend lots of foreign exchange reserves propping up the renminbi late last year so as to not derail its inclusion in the IMF’s Special Drawing Rights basket, even though the decision to include the renminbi was clearly political (as in there were key respects in which the currency did not qualify for inclusion). The Chinese central bank has let the renminbi depreciate sharply in the new year, while bizarrely trying to deny responsibility. From an earlier Wall Street Journal article, on the closure of China’s stock markets for a second day as they hit circuit-breaker limits twice, first a 5% fall, which led to a 15 minute halt, then a second fall when trading reopened, which quickly reached the 7% “no more for the day” threshhold:

“The plunge in stocks was mostly caused by expectations that the yuan will depreciate further, which will raise worries over the country’s economic conditions,” said Qian Qimin, a senior analyst at Shenyin Wanguo Securities….

As Chinese stocks tumbled, China’s yuan fell as much as 0.6% onshore. In the offshore market, where the yuan is traded freely, the yuan fell as much as 0.9%.

The onshore-traded yuan is now down 1.5% for the year, after posting its largest annual loss last year. The daily fix was set at 6.5646 against the U.S. dollar, its weakest level since 2011. While traders had expected the yuan to weaken this year, the pace of depreciation has taken many by surprise.

“They’ve confused enough people this week,” said Ashley Perrott, head of pan-Asia fixed income at UBS Global Asset Management in Singapore. “Sentiment is incredibly fragile.”

The offshore yuan is now down 2.7% for the year, at a record low against the U.S. dollar.

China’s central bank attempted to soothe investor nerves and clarify its position, stressing the need to keep the yuan stable and at an equilibrium level, while attributing the yuan’s moves to speculators.

Its statement, released Thursday morning, said “some speculative forces are trying to reap gains from playing [the] renminbi,” using another name for the yuan.

Those trading activities “have nothing to do with [China’s] real economy” and have only caused “abnormal fluctuations” in the currency, the PBOC said.

By letting the yuan depreciate, Beijing is acknowledging that the economy faces greater challenges this year and any boost that a weaker currency gives to exports would help, economists said.

While Chinese leaders have been trying to keep the economy on a measured path downward, investors are betting that the government will have to let the yuan fall further to maintain growth momentum.

Some analysts late last year fingered a fall in the renminbi as the greatest risk to international markets, both because it would export deflation (Chinese buyers of commodities, who are the biggest drivers of demand, would have less in real terms to spend with a weaker currency) and due to the damage it would do to companies and investors who had borrowed in foreign currencies, seeking a dangerous bargain by betting they’d save enough on lower interest rates to offset the FX risk. There is a third possible vector, that of capital flight as Chinese investors try to get out of the renminbi and get into investments in currencies that have better prospects. But anecdotal reports indicate that Chinese buying of foreign real estate, one of the most prized foreign assets, had already fallen off as Chinese investors were feeling less flush by virtue of volatility in the Chinese stock market and a deteriorating market for investment real estate in China.

So rather that try to come up with answers, which is perilous in the absence of sufficient information, I’ll instead throw out what amounts to informational chum and see if readers have additional data or facts that seem germane. Keep in mind that some of the factors are not analytically discrete; they overlap a tad, but one frame for defining a vector might be more analytically useful than another

Some Knowns

There are some things that are known about China, even if only at a pretty high level:

No significant economy has gone through a smooth transition from being export and investment led to being consumption led. Unfortunately, orthodox economic thinking has strongly encouraged developing economies to focus on export-led growth, rather than a more balanced growth model. The problem with trying to make the shift is that more consumption requires consumption infrastructure, like bigger houses and lots more retail stores. One big impediment to Japan increasing its domestic consumption was its small houses and apartments (you have no idea how small until someone has invited you to have a look, a perspective foreigners seldom get). China winds up in a similar spot by virtue of the need to build retail infrastructure. Rather than go down that path in a serious way in the last decade, China instead doubled down on its existing national strategy. While exports as as share of GDP have fallen somewhat, investment as a percent of GDP has risen relative to its pre-crisis level. So China is either by accident or design fighting the economic evolution it needs to make.

China has used borrowings in a very big way to fuel growth, both before and after the global financial crisis, and that borrowing has become less and less productive in terms of how much in incremental growth it has delivered. There is nothing wrong with borrowing to generate growth, but one has to be mindful of investing in unproductive or insufficiently projective projects. Aside from various analyses that have shown declining productivity of Chinese borrowing, the media has been awash in pictures of ghost cities and other projects that look like white elephants (please don’t tell me that peasants need housing. They do, but this is not peasant housing. It’s speculative investment. And even if there is eventually enough of a Chinese middle class in 20 years to fill all this relatively high end housing, is anyone going to want to buy housing that is 20 years out of date in terms of appliances and other amenities? It would probably need to be upgraded in a serious way then to be competitive).

Similarly, industrial investment looks to have questionable payoffs. China has been investing heavily in higher-value-added manufacturing, often well in advance of demand. An August 2015 article by Jayati Ghosh gives a sense of the scale:

Between 2007 and 2014, total debt in China (in absolute Renminbi terms) went up four times, and the debt- GDP ratio nearly doubled. At around 282 per cent of GDP, this makes debt in China relatively much larger than in, say, the United States. Corporate debt increased to reach 125 per cent 2 of GDP; provincial governments are also highly leveraged for infrastructure investment; and debt held by households has gone up nearly threefold to a hefty 65 per cent of GDP. Fully half of the debt (much of it coming from the unregulated shadow banking institutions that were allowed to flourish) was oriented directly or indirectly towards the real estate market and housing finance, fuelling property bubbles in major Chinese cities that began to burst around a year ago.

A great deal of this borrowing has occurred through what amounts to a shadow banking system. In very simple terms, local real estate authorities have been major borrowers, and the debt has been used as the grist for various “wealth management products.” Some of these are better structured than others. The central government intervened at the end of 2014 when this market looked rocky.

The Chinese stock market is highly geared, which means a crash can produce nasty knock-on economic effects. It’s astonishing that China, which prided itself on the wisdom of its central planning, allowed high levels of margin lending. The 1929 crash was a decisive demonstration of the cost of letting too much money be sucked into stock market speculation via access to borrowed money, and the high cost when the investors not only lost their money in the crash, but lenders took huge, and sometime terminal hits too. And this was an even more reckless policy in China, where the Chinese culturally love gambling. It’s like letting an alcoholic have access to an open bar.

Chinese leaders were trying to pump up the stock market last year to prop up growth. This was a not-well-recognized warning of desperation. As we’ve repeatedly pointed out, the strategy of using asset bubbles to produce more consumption, which was explicit policy in Japan in the later 1980s, has a very poor track record. Again from Ghosh as of last August, emphasis ours:

The subsiding of the froth in the housing market led to investor focus on the stock market, which then began to sizzle. The past year showed how irrational such markets can be, as stock market indices went up by more than one and a half times in around a year, reaching a peak in early June. For some stocks, the price-equity values crossed 200. This was clearly crazy and begged for a correction, which was bound to happen. But that correction was untidy in the extreme. Since 12 June, stocks have plummeted, and on the worst day in early July they were trading on average at nearly 50 per cent lower than the peak. Worse still, at first various emergency measures of the government – from suspending trading in stocks of nearly 800 companies, through forcing brokers not to sell their shares, to indirectly buying shares on a mass scale through the China Securities Finance Corporation and sovereign wealth funds–did not work in stemming the downslide and may even have backfired by adding to the sense of panic.

Thereafter, there has been some stabilisation, although this is clearly artificially created and the market is likely to remain jittery for some time. In any case, the inflated stock prices have still not come down to what could otherwise be called reasonable levels given the crazy increases during the bubble phase, and so there may be more “correction” required. This has created a problem for the Chinese state, whose aura of economic omnipotence has taken a severe battering, because it is no longer clear how exactly they should best deal with this situation. Having talked up the stock market, extolled it as a sign of China’s growing economic strength and encouraged much greater participation in it by relatively small retail investors who are now suffering, they will find it difficult to allow it to decline any further, yet may be powerless to prevent it in the medium term.

Other reports flagged the influx of newbie small investors in 2015, often a warning that a market top is nigh.

Some Possible Factors

China may be caught between its international leadership aspirations and its growth model. China benefitted by running tightly controlled financial markets, particularly by having de-facto capital controls. But a major driver of its liberalization of its financial markets appears to have been its international ambitions, since playing a bigger role in the various perceived-to-be-important international clubs required China having more open capital markets. Recall that we’ve repeatedly cited the forced* liberalization of Japanese banking regulations and its capital markets as a major, and arguably the major, driver of its joint real estate/stock market bubbles and their eventual implosion (I saw first hand how ill equipped Japanese banks and investors were to analyze and manage the risks they were suddenly allowed to take).

Economist Victor Shih flagged a danger of liberalization: capital flight. From Ed Harrison’s summary of a 2011 presentation by Shih (trust me, it was a radical point of view at the time):

China has three structural causes of capital flight. First, wealth in China is highly concentrated. Using three different

methodologies based on survey data, data on large share holders of listed company, and data on the total financial and real estate assets in China, the wealthiest 1% urban households command between 2 and 5 trillion USD in wealth.

A 20% reallocation of this wealth overseas would cause a substantial but likely controllable drainage of China’s foreign exchange reserve.

A 30-40% reallocation of this wealth overseas would see the depletion of China’s foreign exchange reserve by close to 1 trillion USD or more.

Second, underground banks, false trade invoicing, and now an experimental scheme to allow individual investors to invest overseas provide multiple channels for capital to circumvent China’s exchange control.

Third, real deposit interest rates are negative and will remain so in the foreseeable future, thus prompting wealthy households to speculate overseas on a large scale if relative returns suddenly decrease in China.

If the top 1% of households in China reallocates 1 trillion USD of their wealth overseas, the central bank then will be faced with a choice between large scale quantitative easing and an illiquid banking system.

In the short term, China’s only recourse to reduce the volatile state of its foreign exchange reserve is to bring real interest rates back to positive territory.

And an additional key point via FT Alphaville from the underlying paper (the original is no longer at the link):

If the foreign exchange reserve is depleted by capital flight, the central bank will need to resume large scale money creation, as it did in the 1980s and the 1990s, to maintain the solvency of the banking sector.

The nasty bit here is the “large scale money creation” to save the banks conflicts with the officialdom’s desire and need to lower inflation, both to preserve domestic stability and to get real interest rates into positive territory to stop further capital flight. If you’ve watched Chinese action over the last year or so, it’s been schizophrenic: episodes of being tough on inflation seem to lead all too quickly to “support the banks and/or the markets” exercises which look to be contrary to the effort to tampen down inflation (keep in mind inflation is also a negative for competitiveness: inflation produces increase in nominal wages and finished goods prices, which unless the currency depreciates by a corresponding amount, translates into higher purchase prices for importers, making Chinese goods less attractive). So navigating a soft landing is tantamount to treading through a minefield. It might be possible to pull it off, but it is a more fraught operation than most analysts have seemed willing to concede.

The risk of political instability may be greater than is widely perceived. The government is acutely aware that its legitimacy rests on producing increasing prosperity, which means among other things, rising levels of wages and high levels of employment. The great increase in living standards in the last generation may have raised expectations that cannot be met, even before you get to the high odds that the current Chinese growth model has hit its sell-by date. In China, unhappy workers riot. Moreover, there’s also rising discontent with the health cost of high levels of pollution, yet addressing that in a serious way will (at least in the short term) conflict with the employment mandate.

There are signs of strains on businesses. We’ve heard stories of manufacturers taking no-profit orders to keep from cutting jobs, with the owners (unlike Americans) taking the point of view that they have a duty to maintain employment. Similarly, Lambert has pointed out that the horrific explosions at Taijin were ultimately caused by margin pressures.

Mind you, I’m not proposing that this list of factors is either definitive or complete. I’m offering it instead as what consultants call a “forcing device,” a set of ideas and observations intended to elicit discussion and debate. So I hope readers will have at it!


* Forced by the US. Under Reagan, making the world safe for America’s investment bankers became a big policy priority. Japan, as a US military protectorate, was hardly in a position to say no, particularly since the banks themselves didn’t understand the issues. While they correctly assessed that gaijin would not make much headway with Japanese corporations and investors, they were clueless as to how successful the gaijin would be in seducing them into participating in markets and products where they would be the marks. And that’s before you get to all the self inflicted damage…like by being wiling to lend 100% against the market value of urban land which never traded for tax and other reasons, hence the “market” prices were a complete fiction.

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  1. Skippy

    Bit of a re-post but thought it might apply, amends…

    Albeit a lot of dramas are purely the results of manipulating FER for political or more aptly put ideological reasons i.e. are supposed to pop little bubbles, tho some screw with it and allow HUGE bubbles which then require all kinds of excessive capital and social destruction – distortions. Not to mention some people can make huge fortunes in the run up and in the collapses.

    Which can also be traced back to stuff like Stones (SAM), which is formed w/ computable “equilibrium model” e.g. TOT.

    If I might I would like to use a mates comment on another platform to highlight this perspective…

    “a rules based pegged system sounds very much like the PoBc model to me. The problem is that Governments intervene when the politics are pressing and not when the economics are in need of adjustment. and screw up the stabilizers of floating exchange rates. China is finding out very quickly that a pegged exchange rate costs somewhere, sometime and it’s a struggle to find that equilibrium – like chasing a greased pig around the oval – lot’s of noise and effort and no result t the end of it, unless someone puts a bullet in the pig.

    Nah, the global floating exchange/fiat currency monetary system has been bastardized by political interference via central banks. China will find that they will have to let the elite financial parasites take a bath – we haven’t seen anything yet. The next Fed rise will deliver them a big one up the poo shooter again because they are pegged to the USD. Compare that with the battler and you can see that intervention is not required – it will float to it’s own level based on the real economy. Sure, the currency speculators will give it a nudge around the park, but if left alone it will eventually find it’s value. What Governments fail to understand is that they need to let the financial economy adjust – China are finding that out now and are forcing the issue. The Fed has finally woken up to the Chinese game. We should follow the same lead.

    Fixing exchange values is a slippery slope to economic oblivion. Global fiat currencies rely on a float. China has been an anomaly – but you can see the impacts of oversupply and central control taking effect now and they can’t control world currencies – China GDP of 6%? Forget it, they will be under 5% before too long as their financial reserves disappear down the gurgler.” – H/T Malcolm

    Skippy…. I would only add that I disagree with the term “equilibrium” – where ever its evoked – is erroneous, I prefer the term stored potential adverse.

  2. ambrit

    Thank you for this accessible précis of the China Problem.
    One phrase used jumped out at me; “In China, unhappy workers riot.” This could actually be a strength in the Chinese society. Here, in The West, our system appears to be mired in an antiquated, regressive system. What forces are actively opposing the Wealth Inequality trend? If workers in, say, America or the U.K. were to riot a bit, perhaps some more than cosmetic remedies would be tried, out of necessity. This same ‘riot policy’ is effecting the Chinese Authorities’ policies vis a vis Chinese domestic economics. At present, it seems the CCP is trying to ‘serve two masters,’ the Chinese people and foreign banks etc. As the Emperor Mao showed in the Great Leap Forward and other internal programs, China was and perhaps is now, willing to ‘upset the apple cart’ in pursuit of Chinese interests. There is the key; China still gets that it is, after all, a Sovereign State, not a vassal to The City or Wall Street. I would not be at all surprised to wake up some morning soon to discover that the Chinese Authorities have made the decision to make “trouble” their main export.

  3. Benlu

    What happen to the overwhelming claims(including by PK) that The rmb was hugely undervalued and that due to China’s manipulation?

    1. Yves Smith Post author

      As of last year, a lot of economists were saying the renminbi was no longer undervalued. Years of inflation (increasing prices in China in nominal terms) took care of that.

  4. craazyboy

    It’s obvious to me that China’s 1% will take their 2-5 trillion USD and move to the US where they can read Ayn Rand novels in relative peace and quiet and buy US politicians for pets. It’s what everyone else does.

    China goes poof, and we don’t hear from them for another 20 years. Or maybe not. It’s hard to tell.

    1. craazyman

      with 700 billion guys and only 389 women, they need more strip clubs.

      that could be the “next Big Thing” (no pun intended) for China groaf.

      the problem is, where will all the women come from? Not China.

  5. B Tilles

    Business Insider this am posted an interesting chart re China: “job-offers-to seekers-ratio in (China’s) urban areas vs GDP growth indicating that suddenly job availability has begun to evaporate. It’s a BofA/ML chart. Supports your thesis about the government’s recent concerns re social stability.

  6. vlade

    china just removed the circut breakers. we’ll see tomorrow what happens. I think it’s binary – either a large fall, or govt (directly or not) stepping in. PPT is real (at least in China..)

    Chnese govt run into a trap of its own making. it positioned itself as economically almost omnipotent, so now it has to spend massive resources on the stock market which in terms of real economic impact in china is negligible.

    the best solution chinese govt could do is to force majority holders to take all the companies back private (even if it hd to provide them with loans secured against the stock), but I doubt it has the guts to do that…

  7. Keith

    China is now the workshop of the world.

    China’s problems clearly illustrate the lack of global demand.

    China manufactures its products from imported raw materials from other emerging economies, so these in turn suffer from the lack of global demand for China’s finished goods.

    Global commodity prices and the Baltic Dry Index are at record lows illustrating this collapse in demand.

    “There’s class warfare, all right, but it’s my class, the rich class, that’s making war, and we’re winning.” Warren Buffett

    The 1% went to war on the 99% (aka the global consumer), very silly really.

    Before they win, everyone loses.

    Capitalism is like Siamese twins at war with each other.

    The 1% and 99% always fighting each other to get more, but if either side win they destroy each other.

    The 1% were in the ascendency in the 1920s and blew it up with a Wall Street Crash in 1929.

    The 99% were in the ascendency in the 1970s and blew it up with constant strikes making individual nations uncompetitive.

    The 1% are in the ascendency again and have already caused another Wall Street Crash (2008) plunging the world into a global recession that seems without end.

    The 1% haven’t worked out that they have gone to war against the consumers that buy their products and services.

    Obviously this was all spotted by Marx a long time ago, but he had never seen the results of the 99% in power (Pol Pot’s Cambodia, Stalin’s Russia, Mao’s China, etc …). He came from a wealthy family and was only too aware of the greed, self-interest and hypocrisy in his own class. It doesn’t seem to matter which ideology you try and follow the psychopaths always end up in the positions of power.

    Capitalism is an endless fight between the two sides, but neither side can win, to do so destroys themselves.

    A more balanced approach is needed but the very thing that makes Capitalism work, self-interest and greed, ensures neither side is ever happy with their lot and always wants more.

    In our wonderful new, supply side, trickle down world we have taken our eye off the global consumer.

    How is the global consumer these days?

    1) The once wealthy Western consumer has had all their high paying jobs off-shored. As a stop gap solution they were allowed to carry on consuming through debt. They are now maxed out on debt.

    2) Japanese consumers have been living in a stagnant economy for decades.

    3) Chinese and Eastern consumers were always poorly paid and with nonexistent welfare states are always saving for a rainy day. Western demand slumped in 2008 and the debt fuelled stop gap has now come to an end.

    4) The Middle Eastern consumers are now too busy fighting each other to think about consuming anything and are just concerned with saying alive.

    5) South American and African consumers are busy struggling with economies that are disintegrating fast.

    Oh dear, no wonder there is no demand for Chinese products or any other products for that matter.

    Commodities that real things are made from?

    No one needs them, the 1% have laid waste to the global consumer.

    1. Synoia

      Sigh. Good but misguided. Here’s why:

      The 99% were in the ascendency in the 1970s and blew it up with constant strikes making individual nations uncompetitive

      No the 99% were not in ascendancy. Nor were they here:

      (Pol Pot’s Cambodia, Stalin’s Russia, Mao’s China, etc …)

      There is always management: That is, there are always workers, who are governed, managed, or ruled, whichever word one would like to use.

      Workers respond to their “management.” Management get the attitude and behavior from the worker that is dissevers.

      In the UK the labor strife of the 60s and 70s was a direct result of the contempt of the management for the workers, irrespective of the Government, Conservative or Labor. When a labor Government was elected, with the primary objective of full employment, management behavior (based on attitudes driven by the British Class system) did not change.

      1. Keith

        In the 1970s the workers probably had as much power as they will ever have in a Capitalist system.

        Most revolutions are actually driven by disaffected members of the middle class who have the necessary spare time and broad intellectual outlook to realise things could be different.

        Often the working class are not even aware of the limitations of their freedom in a socially stratified society.

        In Pol Pot’s Cambodia they set about killing off the Bourgeoisie and so the 99% were definitely in the ascendency but the new leaders, taken from the 99%, became even more tyrannical than the ruling class they had exterminated.

        Most revolutions descend into tyranny.

        Once it is seen that a set of ideas are the only way things can be, any means are seen as acceptable to achieve the desired goal.

        For this very reason, idealism that aims to achieve a perfect society has been seen as dangerous (Positive Liberty), it always seems to lead to tyranny.

        Today’s ideal is Negative Liberty, where you are free to do what you want and fulfil your needs through the market (providing you can afford them).

        Ideals seem to be absent today because that is the way it is supposed to be.

        “The Trap” by Adam Curtis gives a good insight into positive and negative liberty and why positive liberty is feared.

        Part 3 — We Will Force You To Be Free

      2. Keith

        In the 1970s the workers probably had as much power as they will ever have in a Capitalist system.

        Most revolutions are actually driven by disaffected members of the middle class who have the necessary spare time and broad intellectual outlook to realise things could be different.

        Often the working class are not even aware of the limitations of their freedom in a socially stratified society.

        In Pol Pot’s Cambodia they set about killing off the Bourgeoisie and so the 99% were definitely in the ascendency but the new leaders, taken from the 99%, became even more tyrannical than the ruling class they had exterminated.

        Most revolutions descend into tyranny.

        Once it is seen that a set of ideas are the only way things can be, any means are seen as acceptable to achieve the desired goal.

        For this very reason, idealism that aims to achieve a perfect society has been seen as dangerous (Positive Liberty), it always seems to lead to tyranny.

        Today’s ideal is Negative Liberty, where you are free to do what you want and fulfil your needs through the market (providing you can afford them).

        Ideals seem to be absent today because that is the way it is supposed to be.

        “The Trap” by Adam Curtis gives a good insight into positive and negative liberty and why positive liberty is feared.

        Part 3 — We Will Force You To Be Free

  8. Steve H.

    In’t real sophisticated about this stuff, but it sure seems that China holding over a trillion in U.S. bonds is somehow relevant. Feel free to reassure me that’s not a problem for u.s.n’s.

  9. PlutoniumKun

    Thanks for the nice overview, and its refreshing to see someone admit that they don’t really know whats going on in China. I’ve long come to the conclusion that as it used to be said about Northern Ireland politics ‘If you claim to understand whats going on, thats proof that you know nothing’.

    My random thoughts as a casual China watcher since the late 1990’s when I first visited:

    1. The stock market crash was my first real ‘uh-oh’ moment – not because it happened – but because of the inept response. The CCP have been impressively competent at managing the countries economy for many years (although it should also be said that they had a lot of luck). This was the first visible sign that they may actually not know what they are doing. And several hundred million Chinese took note.

    2. I can’t claim to be an expert on the ‘shadow banking world’, but my anecdotal observation is that it is truly vast – and much bigger than nearly every source claims. There are literally millions of ‘one (wo)man banks’ in China. These are individuals who invest or lend on behalf of friends and acquaintances. Most of this is money raised by public or ex-public employees who got their homes super cheap in privatisations, and so found themselves with assets worth several hundred thousand, as so tried to convert this to an income stream (I know several people who retired at remarkably young ages on this basis). For 20 years or more these mini-informal one (wo)man banks have been giving out annual returns of 10-15%, which sounds remarkable, but is actually quite achievable in lending in the shadow markets. But of course some are ponzi schemes. A lot of people depend on this income to live. Even if these shadow banks don’t vanish overnight if things go bad, they will inevitably have to drop their returns to ‘normal’ interest rates, which will leave a lot of people impoverished. And this is even assuming the majority are not scams. I’ve talked to educated, financially literate Chinese people who consider this type of arrangement to be entirely normal and safe (‘oh, all the loans are backed with collateral, so there’s no problem’ as one said to me).

    3. It is a mistake to take individual policy moves as evidence that China is, or is not, moving to a balanced economy. There seems a default assumption in the West that China is highly centralised and autocratic, and that if the Party says one thing, it happens. In reality, China is highly fractured and decentralised – it is entirely possible for the Party and its direct governmental branches to be doing one thing, while the very powerful cities and provincial governments are doing something else entirely. Or even two government ministries to be doing contradictory things. In other words, China is just like nearly every other country.

    4. From my reading of Michael Pettis, who is the one writer I’d trust most to get it right, China is very unlikely to have a financial crash – the country has sufficient reserves to bail out almost any degree of domestic debt crisis. What is far more likely is a sustained long term period of stagnant growth and deflation. What is uncertain, is how long the country can avoid political crisis if this happens. My suspicion is, not long at all. A whole generation of Chinese have grown up expecting growth, and because of high debts they will hit the streets if even a modest recession occurs.

    5. The big uncertainty is capital flight. Almost every Chinese person of any net worth has an exit plan. Quite simply, nobody, from the local shopkeeper with a little nest egg, to the biggest internet billionaire trusts the government, and most assume that in the event of an economic stall, there will be widespread repression and a deliberate policy of creating scapegoats to deflect attention from the government (from long before Mao, this has been the default act of Chinese despots in trouble). I am personally surprised that the government is allowing devaluation of the Yuan because this is highly likely to act as a trigger for the rich to hit the lifeboats. My suspicion is that if it happens, it won’t be a slow process. It will be very rapid and chaotic.

    6. Despite what some bears say, the transition to a consumption based economy is happening, and it is happening surprisingly fast. Go to Shanghai or Beijing and it is very visible. However, it may not be happening anywhere near fast enough to make up for the huge over investment binge since 2008, and it may be that something entirely different is happening in the more obscure smaller Tier 2 and 3 cities around the country. Stresses always show up first in the provinces. A lot of western analysts views are I think biased from spending too much time in Shanghai in particular – it really is a different world.

    7. Speaking of Shanghai, I think if fractures occur, one thing we are likely to see are traditionally strong cities try to maintain order by becoming little Singapores – effectively insulating themselves from poor provinces politically and economically. There are deep divisions in China’s polity between the prosperous coastal areas and the poorer inland areas, and in particular between the big traditional urban areas – its difficult to overemphasises how much, to take one example, average Chinese dislike and distrust Beijingers and Shanghainese, and its mutual. China could end up resembling renaissance Italy – powerful city states surrounded by chaotic and poor rural areas. The question is, who gets the nukes….

    8. A lot of manufacturing companies seem to have spent years stockpiling metals and other resources, taking advantage of cheap loans – they’ve seen it as a sort of hedge against recession. But with collapsing commodity prices everywhere, this may seem an extremely bad, and pro-cyclical bet. One sign of deep trouble in manufacturing might well be an even greater collapse in metal prices as companies desperately try to sell warehouses full of copper or rare earth metals.

    1. MyLessThanPrimeBeef

      A few years ago, we occasionally read about riots (ethnic/labor), some in the rich coastal export zones.

      Maybe many more did not make it to the media here.

      What is the current situation, on that front, over there?

      1. PlutoniumKun

        There are protests and mini-riots almost every day in China – its surprisingly common. In contrast to the way china is seen from the outside, the authorities can often be surprisingly laid back about it – its seen as a way of letting off steam. Usually what happens is that someone senior comes along, overrules whatever local leader annoyed everyone, and there is some sort of compromise. The CCP are very experienced at identifying the difference between local issues that can be ignored or tolerated, and genuinely serious threats to them. Its the latter they deal with ruthlessly. I think there are probably a lot of unwritten rules about protesting and rioting in China which are not apparent to outsiders. I always get the impression in China that there is a sort of ritualistic element to protesting – people will go far, but not far enough for things to get really dangerous. I think its one reason why things can get particularly nasty in Tibet – the Tibetans don’t get ‘the rules’ and so regularly overstep the bounds. The same probably applies with the Uighur.

        I don’t live in China, but I understand that things have been pretty quiet for a year or two. I think there is a lot of nervousness with the new leader, nobody wants to be the first to be ‘made an example of’. I also get the impression that people are genuinely impressed with him – Xi Jinping has a lot of charisma and people are willing to give him the benefit of the doubt. But thats just a ‘feeling’ I have about it from speaking to my Chinese friends, I am not remotely close to having my finger on the pulse there.

    2. Yves Smith Post author

      I need to think this through more, but your fragmented shadow bank system argues for, not against, the possibility of a financial crash.

      The reason the US could bail out the financial system is we had the mechanisms by which we could do that. But we had to do things like have Morgan Stanley and Goldman become banks so the US could backstop them. So even for us, some critically placed players were not readily rescued. And let us not forget the laundering of bailout money through AIG. We had large, concentrated players we could rescue.

      By contrast, the US S&L crisis was the collapse of a bunch of small fry. We did have an organized resolution system, so we could prevent the loss of depositor money and resulting damage to the system. China has nothing remotely like that for shadow banks. We sorta did because a lot of the shadow bank liability had commercial or investment banks on the other side, or we just plain stepped in and made shit up. We could do that in the case of AIG, and Fannie and Freddie because they were very large, critically placed players. You can’t do that with disparate players that are set up in a ton of different ways.

      A lot of the lending has taken place through local governments and private players around them.

      China may in theory have the capacity to shore up its financial system, but it may not have the channels to do so.

      1. PlutoniumKun

        Yes, I realise its contradictory – I suppose its the difference between my anecdotal experience (i.e. talking to Chinese friends), and what fairly level headed observers like Michael Pettis says – he seems convinced that even in a worst case scenario, the government can and will cover deep losses in the formal banking system (I don’t think he’s ever addressed the shadow banking system but I can stand corrected on that).

        The one thing I don’t know is to what extent the ‘shadow banking system’ as I’ve seen described in the literature actually counts the informal system that so many Chinese people have described to me. On the one hand its not a ‘real’ banking system in the sense that it seems a form of moving cash around, rather than using leverage for investment, so the total impact could be neutral in the financial system. On the other hand I could see that it has huge potential to set of a chain reaction, running from the informal network in the ‘real’ economy.

        When a friend first described it to me, it sounded like a ponzi scheme. She and her husband have a ‘friend’ who they’ve entrusted cash given by their parents (not wealthy people, but they had a good apartment they sold), and he’s been giving them something like 12% returns every year for quite a few years. Another friend, who is a professional investor and very financially savvy, told me that people like the ‘friend’ are simply bundling cash and lending it out to small businesses for short term high interest loans, usually people they know – its the whole ‘friendship guangxi’ system that the Chinese trust far more than the government. There would be little leverage, and there would be an element of trust that there is always some sort of asset backing the debt. My immediate thought, was that the particular asset could be anchoring any number of cumulative loans. As a third friend said to me ‘everyone in my town owes money to each other, everyone knows everyone else business’.

        Anyway, I’m sure someone, somewhere, has quantified the extent of this, but I’ve always surprised that when ‘shadow banking’ is discussed in relation to China, this type of lending rarely seems to be raised. My worry about it is not so much the absolute quantum of money involved (as there seems to be little leverage involved, it may not be that huge), but I think it has huge potential for creating unrest if a collapse in asset prices sets off a chain reaction of bad loans, which could impoverish many millions of people overnight. And I don’t see how those debts could be covered by the government even if it wanted to, as they are all off the books.

  10. Jim Haygood

    ‘If [China’s] foreign exchange reserve is depleted by capital flight, the central bank will need to resume large scale money creation, as it did in the 1980s and the 1990s, to maintain the solvency of the banking sector.’

    Unfortunately, China can’t print USD. And China isn’t imprudent enough to vaporize its forex reserves, trying to defend a misaligned currency peg.

    Chinese faces the same problem that Hong Kong has faced periodically since the HK$ was linked to the USD in 1983: most of the time, America’s easy money policy — aimed at administering a spoonful of Geritol to the ‘mature’ U.S. economy — is way too easy for Hong Kong and China. This produces monster real estate bubbles in H.K., where the supply of land is rationed. In China, imported easy money policy fuels vast overcapacity.

    But from time to time — and one of those times is now — U.S. policy is too tight for China. Hell, it may be too tight for the U.S. also, but that’s another story.

    China can’t just stay lashed to the mast of a too-strong dollar peg. China’s conservative leaders are loathe to do anything drastic, with Senator Chuck E. Cheese Schumer (a lawyer who possesses the economic sophistication of a typical 2nd grader) constantly threatening to punish China as a currency manipulator.

    But the other horn of China’s dilemma is that letting its domestic economy crater threatens the political control of its unelected rulers. Something has to give. And China’s dollar peg looks like a weak link.

    1. Yves Smith Post author

      Good catch. I think there is a hidden assumption in the comment re money creation, that the US would open up currency swap lines. It might even appeal us to get a whip hand over China. But you are right that the author may simply have failed to think things through.

    2. flora

      Nov. 30th, the IMF recently added the Chinese yuan to its basket of world reserve currencies, joining the US dollar, euro, pound and yen. Standard Chartered PLC thinks $1 trillion global reserves will switch to Chinese assets as a reserve currency. I can’t evaluate that claim. My question is: does China need to print USD if it can draw on the IMF’s asset buying?

      1. Jim Haygood

        The IMF’s move looks like an attempt to co-opt China by telling it, ‘You’re a big boy now with a seat at the table and a share in the currency basket, so be responsible.’

        China’s inclination IS to be responsible. But pressure on the yuan may be slipping out of its control.

        Meanwhile, the IMF’s inclusion of the yuan in its currency basket probably won’t have much influence on capital flows, which are driven more by trade and investment rather than by IMF diktat.

  11. RUKidding

    Thanks, Yves, and commenters. I came here today mainly to see what was said about What’s Up with China. This sheds some light, even if most are still groping in the dark a bit. Helpful insights. I guess the operative word is: stay tuned… (or is it: hang onto your hats, my friends, it’s going to be a bumpy ride?).

  12. susan the other

    the rest of the developed world would be wise to take this opportunity to shift the COP21 into high gear – manufacture in China for sustainability – we need a complete remodeling and voila! – when the economy is crashing the solution appears

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