Category: Economy

Cold War Reboot or Electoral Rhetoric? There’s a lot to lose this time around?

And where would America’s traditional clients stand?

A Cold War could be emerging between the U.S. and China as the rhetoric out of Washington becomes increasingly belligerent according to media commentators. In fact, the relationship between the world’s two largest economies could be at its lowest point since the Nixon-Kissinger rapprochement of the 70s.  Luckily, so far, both have refrained from escalating to a major blow-up but the ongoing fallout from the Corona Virus might threaten that.

Some had last year referred to increasingly frosty U.S.-China ties as a new Cold War, but that is an entirely inaccurate description. Firstly, the original Cold War was premised on (the largely U.S) notion that the Soviet Union posed an existential threat to the existence of Western Europe as a democratic alley and the was intent on the spread of Communism as an ideology around the world.

The current situation between China and the U.S. is fundamentally different. The conflict between Washington and Beijing is counterbalanced by the two nations’ economic interdependence. A dependence Washington never had with Moscow.

This extensive web of trade and investment relationships developed over the last three decades force the U.S. to counterbalance more extreme positions.

In fact, until recently even officials of the Trump administration did their best to play down sometimes overblown rhetoric.

But unfortunately, those mitigating factors are dissipating somewhat in the wake of the Corona Virus and the talk from Washington is becoming increasingly hostile.

As the devastation from Covid-19 accumulates in the U.S., arguably exposing the failure of decades of underinvestment in infrastructure, healthcare and the growth of the wealth gap, the number American fatalities is now nearly double that of the Vietnam War – a conflict that lasted longer than a decade.

And increasingly, voices in the U.S. government are turning to blame China with the view that the CCP should be held accountable for the devastation gaining ground. Those that support the view distrust China’s narrative (and the CCP in general) of the outbreak.

The problem is, this line of arguing is increasingly looking like a direct assault on the very nature of the CCP not just its handling of the Covid-19 Crisis. Whether this is simply election-year rhetoric remains to be seen. But Washington looks, and more importantly sounds, serious.

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 On the Chinese side, the accusations are providing ammunition for the propaganda machine that claims the communist regime is superior to the disorganized Western democracies, pointing out how Western nations are still struggling to get a handle on the crisis and how a panicked Trump administration is using the Virus as part of a blame game; deflecting from their own societal shortcomings.

Either way, these are alarming signs at a time when the world most needs to pull together to tackle a problem that has no interest in borders, nationalities or ideologies.

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But so long as the two countries remain bound by the interlocking forces of globalization and their own interdependencies then there is a limit to how far this could go.

The problem is, the Pandemic could be at risk of undoing those ties and decoupling the economies. According to Reuters, the U.S. government is now considering all kinds of measures to lessen dependence on China including tax breaks for companies that relocate their production and procurement facilities across a broad range of sectors.

The US has already barred telecom provider Huawei from a stake in its 5G network and pressured its clients follow suite with varying degrees of success and looks like trying to push China out of all America considers ‘it’s sphere of influence.’ And could lead to serious consequences.

 Perhaps lurking in the back of some policy maker’s mind’s in the U.S. is Xi Jinping’s bold declaration at the that:

“China will be a global superpower by 2050.”

CCP congress in October 2017

Since then Beijing has rolled out a strategically ambitious project through massive spending on military and civilian technologies.

The perceived expansion of Xi’s power through the Belt and Road infrastructure project is undoubtedly another thorn in the side of foreign policy planners.

The Belt and Road Economies from its initial plan

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One obvious problem this situation represents is for those caught in the middle; Washington’s traditional clients, especially in Europe. A recent survey shows that Germans are now almost equally divided on who represents a more important partner – Washington or Beijing? A significant shift over 2019 which put Washington 26 points ahead.

Although many Germans are unhappy about China’s handling of the Corona-Virus and have suspicions it could have been better handled they don’t wholesale blame all CCP for the chaos being wreaked around the world.

And while traditionally, the German attitude to the US usually reflects who is sitting in the white house the Trump administration’s current perceived mishandling of the crisis; increasing belligerence toward the CCP and the WHO; and the increasing calls for Europe to pay for its own defense are putting traditional allies in a difficult position.

If the U.S. escalates the current spat into a full-blown soft-reboot of the cold war it could find itself in a lonely place with former client states between a rock and a hard place.

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More worryingly, a new Cold War between the U.S. and China could have a far larger global impact than that with the USSR.

China is far more economically powerful and technologically advanced than the Soviet Union was, and is catching up with the U.S. in other areas. That could make them dangerous rivals if some kind of accommodation can’t be reached and the world goes down that road.

With Factory Deflation Deepening, external demand wavering does China’s first real recession loom?

China’s Producer Price index, that measures the average changes in prices received by domestic producers for their output, fell at its sharpest rate in four years indicating a global slowdown in demand for Chinese goods, according to figures released last week.

That same data showed an unexpected growth in exports in April – perhaps helped by low oil prices – but also showed a stronger than unexpected decline in imports signaling weaker domestic demand.


Producer Prices in China decreased to 96.90 points in April from 98.50 points in March of 2020.

For China this is uncharted territory. It is the first time the NBS has released quarterly negative growth figures since they were first published in the 1990s. The January to March quarter was clearly a supply driven event as China closed down huge sectors of its economy to combat the lethal Coronavirus.

These figures, with the explosion of virus transmission and control measures beyond China’s border, the swelling ranks of unemployed in the US coupled with Washington’s increasingly belligerent stance toward Beijing could be signs of a potentially external demand driven recession could be looming.


China Producer Prices Change

The dire economic impact of the Corona-Virus has prompted the Vice-Premier, Li Keqiang, to to make the unprecedented measure to forgo issuing an annual GDP target.

Some analysts believe the rate at which the PPI are falling will give Beijing room to loosen fiscal measures to stimulate demand. But without the true cost of the epidemic yet known it is difficult to predict how those measures will work. However, with inflation fears diminishing now could be a good time for the BoC to cut borrowing rates.

3bn RMB in Consumption vouchers?

In an effort to re-float the economy after the draconian – but effective – shutdown that all but rid China of the Covid-19 scourge, many local administrations have begun issuing digital consumption vouchers similar to Groupon style activities through the nations’s mobile payment platforms to boost the coronavirus-hit economy, but some experts seem skeptical.

Consumption vouchers, some of which are digital and accessible through platforms including Ant Financial Services Group’s Alipay and Tencent Holdings Ltd.’s WeChat Pay, have been distributed across 28 provincial-level regions and over 170 prefecture-level cities, according to Wang Bingnan, a deputy head of the Ministry of Commerce last week.

Wang said that the value of the already distributed vouchers, which can mainly be used for retail and catering spending, amounted to over 19 billion yuan ($2.7 billion). A sharp contrast to the trickle down stimulation efforts by western governments.

Revaluing the RMB Part 1

Last week, the Shanghai interbank offered rate (Shibor), China’s once-anonymous version of London’s LIBOR, made news around the world when it suddenly spiked at all time high. Expected to lower this rate by injecting cash into struggling Chinese banks, the People’s Bank of China (the country’s equivalent of the Fed) instead did nothing, leading to speculation that China’s leaders were finally prepared to tackle the economy’s overheating problem. In the process, the media appears to have finally taken notice of the potential dangers that lurk within the byzantine industry that is Chinese finance. Reviewing the headlines, a series of arcane, sinister terms leap out: off-balance sheet lending, inter-corporate finance and shadow banking.  

Such terms, nebulous as they may be, are keeping Chinese policy makers up at night: According to Fitch, China’s shadow banking sector may be hiding as much as $2 trillion worth of risky assets in off-balance sheet lending. But what does that really mean? And, more importantly, how did China find itself in this situation? Before we can answer these questions, it’s worth going back and having a look at what shadow banking really is, and how it presents a risk to China  — and the world economy as a whole.

Firstly, the concept of shadow banking has an unfortunate reputation and is in dire need of rebranding. Despite the macabre connotations its name conjures, it’s not inherently a bad thing. Generally, shadow banking simply refers to the lending and borrowing –- basic financial activities — that occur outside the traditional deposit and loan model; that is, anything other than putting money in the bank and occasionally borrowing for things like buying a house. In Western nations such as the U.S, hedge funds, venture capital firms and private equity – all forms of shadow banking — form a major part of economic life. In China, however, the structure of shadow banking is very different.

Until around 2007-8, conventional banks, in the form of loans, undertook the vast bulk of all lending in China, and because the Communist Party controls the vast majority of banks, this structure allowed the government to retain a handle over the economy at large. However, in the aftermath of the financial crisis, as export-oriented businesses — the companies that form a major pillar of the Chinese economy — saw markets shrink, two important things happened.

First, in response to the global financial crisis in 2008, the Chinese government enacted a stimulus package worth $586 million, more than half of which was financed through new bank lending. This package won praise around the world for its speed and decisiveness and kept the country on track in the short term, in noted contrast to a similar plan implemented by the United States.  But the stimulus also flooded the economy with cheap credit, thereby fuelling a speculative housing bubble, propping up inefficient state-owned enterprises (SOEs), and undoing years of work spent trying to instil China’s banks with financial discipline.

In the two decades leading up to the financial crisis, a lot of hard and sincere work was done to try to teach profligate SOEs, local governments, and banks to live and work within their means, but that doesn’t mean these institutions suddenly forgot how to take advantage of a free lunch. In fact, it probably heightened their appetite for it. As a result, much of the money was sunk — almost literally — into local government financing vehicles (LGFVs), which are municipal government-owned companies often responsible for infrastructure investment.  These companies, for the most part, exist to keep local government debt off the books — since local governments have a very limited capacity to borrow money directly — by allowing them to borrow indirectly and finance construction projects through companies they own, built on land often acquired and sold below market price by them.

Surprisingly, this system constituted a huge source of revenue for cash-strapped local governments, which have few real sources of tax revenue. Less surprisingly, it is also an endemic, institutionalized form of corruption. A recent OECD report estimated that total public debt reached 57 percent of GDP by the end of 2010, with LGFVs accounting for about three quarters of this figure. Given that some people familiar with LGFVs see them as little more than holes in the ground into which seemingly endless amounts of perfectly good money are poured, it is likely this borrowing generated a wave of future defaults.

***

How, and why, was the money spent this way? To answer this question, it’s important to understand the love affair between the Chinese government and infrastructure projects. Over the past two decades, Beijing has relied on building roads, power grids, and other fixed assets in order to facilitate the rapid expansion of the economy, but this method of growth inevitably leads to declining returns over time. As a result, Chinese policy makers understand that to decrease the economy’s dependence on investment and export markets (which depend too much on the whims of the global economy) domestic consumption needs to pick up the slack. Unfortunately, however, this “rebalancing” is tricky.

One problem is this: Contrary to popular belief, China’s manipulation of the yuan isn’t the golden goose Western critics make it out to be. Even if the currency were allowed to float freely, Chinese labor would still cost a fraction of what it does in the U.S. This discrepancy is mainly achieved through the hukou, a household registration system that prevents workers from becoming fully entitled residents in the regions to which they have migrated to work, as well as restricting the rights of children born in these regions to services like education and health care.

In short, the hukou ensures that workers remain in the shadows — and wages remain low — by constantly recycling labor out of factories and back to the place of registration. Factors like this have made it increasingly difficult to rebalance the economy and have contributed to the yawning wealth gap in Chinese society. Though Chinese leaders have hinted at reforming the hukou, they nonetheless face a vexing dilemma: How do they increase domestic demand without significantly upsetting a social order upon which the economy depends for its competitive advantage?

***

Historically, the answer to this question was infrastructure development, and for good reason: Infrastructure is politically neutral, theoretically benefits the whole of society, is generally dominated by massive State and quasi-State owned enterprises, and in the past generated massive returns. However, over the last four years, the GDP growth generated by each yuan of additional loan has fallen from 0.85 to 0.15, an indicator that the limits of debt-fuelled growth are being reached. In effect, the very engine that caused China’s growth ––fixed asset investment fuelled by local debt — wasn’t sustainable, and the government began to worry about the negative consequences of an overheating economy: inflation, real estate bubbles, and overcapacity.

So in 2009 they slammed on the breaks. An economy that was addicted to credit needed to go somewhere else to get its fix.  This was where shadow banking came in.

Desperate for credit, banks began working closely with trust companies and other entities to refinance bad loans by bundling them up and repackaging them as “wealth management vehicles”, or WMVs. These vehicles, which require a tenure ranging from a year to a few days, offered a higher rate of return than conventional bank deposits. They also allowed banks to keep their lending off their balance sheets and were sold through their branches or online, effectively turning banks into middle men between recipients and investors. In theory, this should have solved the problem of obtaining local financing. But the problems have only begun.

***

As more and more of these loans turned bad they were simply recycled into high yield WMVs, a fact that China’s policy makers have acknowledged. In an uncharacteristically stark warning aired in a China Daily op-ed, Xiao Gang, the former head of the Bank of China, said that there are more than 20,000 WMPs in circulation — compared with “a few hundred” five years ago. Worse, many of these WMPs lack transparency or are linked to empty real estate, long term infrastructure projects or collections of assets which have no sure fire way of generating the revenue needed to repay them at the given time, creating the real possibility of a liquidity crisis.

Has this crisis already begun? There’s evidence that banks and trusts have colluded to circumvent a shortage of liquidity by issuing ever greater numbers of WMVs — with still higher rates of return to attract the cash necessary to finance the short fall. But if the music stops and investors pull their money or stop purchasing new issuances, then the rollover for the bank to pick up could potentially be huge. The consulting firm KPMG estimates that shadow banking and WMVs overtook insurance to become China’s second largest financial sector in 2012 and represent assets roughly equivalent to 15 percent of total commercial bank deposits.

This situation has arisen in a country whose people, facing restrictions on investing abroad and nervous about China’s volatile stock market, have so few other investment options. In addition, most simply don’t believe banks will let them lose their money and will support their investments, no matter how risky they are: the basic ingredients of a Ponzi scheme. The Shibor rate hike and the government’s refusal to step in with additional funds, then, is a not-so-subtle statement that the party’s over and that it’s time to solve debt addiction the old fashioned way — cold turkey. The question, then, is this: how bad was the addiction, and how big will the comedown be?

Shadow Banking

Last week, the Shanghai interbank offered rate (Shibor), China’s once-anonymous version of London’s LIBOR, made news around the world when it suddenly spiked at all time high. Expected to lower this rate by injecting cash into struggling Chinese banks, the People’s Bank of China (the country’s equivalent of the Fed) instead did nothing, leading to speculation that China’s leaders were finally prepared to tackle the economy’s overheating problem. In the process, the media appears to have finally taken notice of the potential dangers that lurk within the byzantine industry that is Chinese finance. Reviewing the headlines, a series of arcane, sinister terms leap out: off-balance sheet lending, inter-corporate finance and shadow banking.  

Such terms, nebulous as they may be, are keeping Chinese policy makers up at night: According to Fitch, China’s shadow banking sector may be hiding as much as $2 trillion worth of risky assets in off-balance sheet lending. But what does that really mean? And, more importantly, how did China find itself in this situation? Before we can answer these questions, it’s worth going back and having a look at what shadow banking really is, and how it presents a risk to China  — and the world economy as a whole.

Firstly, the concept of shadow banking has an unfortunate reputation and is in dire need of rebranding. Despite the macabre connotations its name conjures, it’s not inherently a bad thing. Generally, shadow banking simply refers to the lending and borrowing –- basic financial activities — that occur outside the traditional deposit and loan model; that is, anything other than putting money in the bank and occasionally borrowing for things like buying a house. In Western nations such as the U.S, hedge funds, venture capital firms and private equity – all forms of shadow banking — form a major part of economic life. In China, however, the structure of shadow banking is very different.

Until around 2007-8, conventional banks, in the form of loans, undertook the vast bulk of all lending in China, and because the Communist Party controls the vast majority of banks, this structure allowed the government to retain a handle over the economy at large. However, in the aftermath of the financial crisis, as export-oriented businesses — the companies that form a major pillar of the Chinese economy — saw markets shrink, two important things happened.

First, in response to the global financial crisis in 2008, the Chinese government enacted a stimulus package worth $586 million, more than half of which was financed through new bank lending. This package won praise around the world for its speed and decisiveness and kept the country on track in the short term, in noted contrast to a similar plan implemented by the United States.  But the stimulus also flooded the economy with cheap credit, thereby fuelling a speculative housing bubble, propping up inefficient state-owned enterprises (SOEs), and undoing years of work spent trying to instil China’s banks with financial discipline.

In the two decades leading up to the financial crisis, a lot of hard and sincere work was done to try to teach profligate SOEs, local governments, and banks to live and work within their means, but that doesn’t mean these institutions suddenly forgot how to take advantage of a free lunch. In fact, it probably heightened their appetite for it. As a result, much of the money was sunk — almost literally — into local government financing vehicles (LGFVs), which are municipal government-owned companies often responsible for infrastructure investment.  These companies, for the most part, exist to keep local government debt off the books — since local governments have a very limited capacity to borrow money directly — by allowing them to borrow indirectly and finance construction projects through companies they own, built on land often acquired and sold below market price by them.

Surprisingly, this system constituted a huge source of revenue for cash-strapped local governments, which have few real sources of tax revenue. Less surprisingly, it is also an endemic, institutionalized form of corruption. A recent OECD report estimated that total public debt reached 57 percent of GDP by the end of 2010, with LGFVs accounting for about three quarters of this figure. Given that some people familiar with LGFVs see them as little more than holes in the ground into which seemingly endless amounts of perfectly good money are poured, it is likely this borrowing generated a wave of future defaults.

***

How, and why, was the money spent this way? To answer this question, it’s important to understand the love affair between the Chinese government and infrastructure projects. Over the past two decades, Beijing has relied on building roads, power grids, and other fixed assets in order to facilitate the rapid expansion of the economy, but this method of growth inevitably leads to declining returns over time. As a result, Chinese policy makers understand that to decrease the economy’s dependence on investment and export markets (which depend too much on the whims of the global economy) domestic consumption needs to pick up the slack. Unfortunately, however, this “rebalancing” is tricky.

One problem is this: Contrary to popular belief, China’s manipulation of the yuan isn’t the golden goose Western critics make it out to be. Even if the currency were allowed to float freely, Chinese labor would still cost a fraction of what it does in the U.S. This discrepancy is mainly achieved through the hukou, a household registration system that prevents workers from becoming fully entitled residents in the regions to which they have migrated to work, as well as restricting the rights of children born in these regions to services like education and health care.

In short, the hukou ensures that workers remain in the shadows — and wages remain low — by constantly recycling labor out of factories and back to the place of registration. Factors like this have made it increasingly difficult to rebalance the economy and have contributed to the yawning wealth gap in Chinese society. Though Chinese leaders have hinted at reforming the hukou, they nonetheless face a vexing dilemma: How do they increase domestic demand without significantly upsetting a social order upon which the economy depends for its competitive advantage?

***

Historically, the answer to this question was infrastructure development, and for good reason: Infrastructure is politically neutral, theoretically benefits the whole of society, is generally dominated by massive State and quasi-State owned enterprises, and in the past generated massive returns. However, over the last four years, the GDP growth generated by each yuan of additional loan has fallen from 0.85 to 0.15, an indicator that the limits of debt-fuelled growth are being reached. In effect, the very engine that caused China’s growth ––fixed asset investment fuelled by local debt — wasn’t sustainable, and the government began to worry about the negative consequences of an overheating economy: inflation, real estate bubbles, and overcapacity.

So in 2009 they slammed on the breaks. An economy that was addicted to credit needed to go somewhere else to get its fix.  This was where shadow banking came in.

Desperate for credit, banks began working closely with trust companies and other entities to refinance bad loans by bundling them up and repackaging them as “wealth management vehicles”, or WMVs. These vehicles, which require a tenure ranging from a year to a few days, offered a higher rate of return than conventional bank deposits. They also allowed banks to keep their lending off their balance sheets and were sold through their branches or online, effectively turning banks into middle men between recipients and investors. In theory, this should have solved the problem of obtaining local financing. But the problems have only begun.

***

As more and more of these loans turned bad they were simply recycled into high yield WMVs, a fact that China’s policy makers have acknowledged. In an uncharacteristically stark warning aired in a China Daily op-ed, Xiao Gang, the former head of the Bank of China, said that there are more than 20,000 WMPs in circulation — compared with “a few hundred” five years ago. Worse, many of these WMPs lack transparency or are linked to empty real estate, long term infrastructure projects or collections of assets which have no sure fire way of generating the revenue needed to repay them at the given time, creating the real possibility of a liquidity crisis.

Has this crisis already begun? There’s evidence that banks and trusts have colluded to circumvent a shortage of liquidity by issuing ever greater numbers of WMVs — with still higher rates of return to attract the cash necessary to finance the short fall. But if the music stops and investors pull their money or stop purchasing new issuances, then the rollover for the bank to pick up could potentially be huge. The consulting firm KPMG estimates that shadow banking and WMVs overtook insurance to become China’s second largest financial sector in 2012 and represent assets roughly equivalent to 15 percent of total commercial bank deposits.

This situation has arisen in a country whose people, facing restrictions on investing abroad and nervous about China’s volatile stock market, have so few other investment options. In addition, most simply don’t believe banks will let them lose their money and will support their investments, no matter how risky they are: the basic ingredients of a Ponzi scheme. The Shibor rate hike and the government’s refusal to step in with additional funds, then, is a not-so-subtle statement that the party’s over and that it’s time to solve debt addiction the old fashioned way — cold turkey. The question, then, is this: how bad was the addiction, and how big will the comedown be?