“He who will not economize will have to agonize.”
Commentary & Analysis
Run China, run!
China continues to believe it can make its problems just disappear. Running a country via a committee leads to that conclusion. The latest attempts, so far successful, have been the disappearance of anyone who comes close to saying something considered offensive as judged by the Ministry of Harmonious Speech and Thought Crime, a huge growth industry in China. Since the MHSTC never defines its standard for judging what is ―offensive‖ to the all-loving State, everyone is fair game. Isn’t state ―capitalism‖ just grand!
I read recently that China’s internal security budget has surpassed its military budget. This regime would make Orwell proud on many fronts. [Given its ill-conceived domestic spying/lock you up and throw away the key act aka the Patriot Act, may mean the US isn't far behind...ugh.]
…but I digress…
Anyway, the question is this: Can China afford to make its inflation problem disappear?
I say ―afford to,‖ because if they really do reign in credit growth, it could be game over and that much prolonged boom will finally turn to bust. But I could be quite wrong on this; or just early as we analysts say when we are wrong. I should stop underestimating the ability of China’s politburo to make the laws of supply and demand and market consequences of many years of misallocated capital disappear too.
From George Soros, the brilliant global macro strategist–not the political nut-job he has morphed into:
"A strong economy tends to enhance the asset values and income streams that serve to determine creditworthiness. In the early stages of a reflexive process of credit expansion the amount of credit involved is relatively small so that its impact on collateral values is negligible. That is why the expansionary phase is slow to start with and credit remains soundly based at first. But as the amount of debt accumulates, total lending increases in importance and begins to have an appreciable effect on collateral values. The process continues until a point is reached where total credit cannot increase fast enough to continue stimulating the economy. By that time, collateral values have become greatly dependent on the stimulative effect of new lending and, as new lending fails to accelerate, collateral values begin to decline. The erosion of collateral values has a depressing effect on economic activity, which in turn reinforces the erosion of collateral values. Since the collateral has been pretty fully utilized at that point, a decline may precipitate the liquidation of loans, which in turn may make the decline more precipitous. That is the anatomy of a typical boom and bust."
…As the total amount of debt outstanding accumulates, the portion that has to be utilized for debt service increases. It is only net new lending that stimulates, and total new lending has to keep rising in order to keep net new lending stable.
Thus, I offer you a little circular flow model I created. It’s making its second appearance in these vaunted pages of global macro machinations, The China Treadmill–I think we are now in the vicious stage:
Because everyone is fighting hard for that relatively smaller share of the global demand pie, China has cranked up its investment dependence relative to export dependence [both of which lead to lower consumer demand dependence i.e. wealth transfer from the household sector. The result being China has to run faster on this treadmill by effectively lurching from more capital misallocation to more capital misallocation to ….
The feeding of this export dependence continues in earnest despite inflation being a real and present danger for China. Bank lending is still booming–proving the point this model is the only game in town. That’s not exactly a recipe for containing prices. There is politics and blowback here, as there is with everything done in China.
This from today’s Wall Street Journal:
On Thursday, the central bank reported that lending by financial institutions had expanded more rapidly in March than in February, and much faster than analysts anticipated–another sign that inflation may be accelerating. Forty-four percent of 3,000 bankers surveyed by the central bank in March said the economy is overheating.
In most countries, controlling inflation falls to a central bank. China has the People’s Bank of China, or PBOC, with a 63-year-old reformer, Zhou Xiaochuan, at the helm. But unlike the heads of the Fed, the European Central Bank and other major central banks, which are independent from politicians so they can take unpopular measures to thwart inflation, Mr. Zhou answers to China’s political leaders.
Oh that ever so pesky bank lending. Funny isn’t it, how huge the profits are, we are told, from Chinese banks. I have always referred to Chinese banks as nothing more than conduits of the central committee. Why? Because that is all they are!
From a recent missive by Professor Michael Pettis on the shape of Chinese banks; notice how his credit growth analysis very much mirrors Mr. Soros very astute view:
The reason debt levels always seem to grow unsustainably, I suspect, is that in the initial stages of the growth model much if not all of the investment is economically viable as it pours into building necessary infrastructure whose profits and externalities exceed the cost of the investment. The result is real growth. At some point, however, the combination of subsidies, distorted incentives (in which investment benefits accrue to those making the investment while costs are shared broadly through the banking system), and very cheap financing costs leads inexorably to wasted investment and debt rising faster than asset values. This is when the debt burden begins to rise in an unsustainable way.
By that point, however, the system is so addicted to investment-driven growth that it is not able easily to reverse or unwind the process until it is too late and debt levels have become a significant problem. Look at the economic ―miracles‖ of the past fifty years – the Soviet Union in the 1950s and 1960s, parts of Latin American and especially Brazil in the 1960s and 1970s, Japan in the 1970s and 1980s, the Asian Tigers in the 1980s and 1990s.
…Because much of China’s most obvious investment has been identified and funded over the past three decades, and in the last ten years the combination of socialized credit risk, very low interest rates, state-directed lending and tremendous pressure on the part of SOEs and local and municipal governments to generate employment and growth in the short term has increased the probability that the Chinese financial system may be misallocating capital on a dangerous scale. The growth in bank assets, in other words, would be less than the growth in bank liabilities if both were correctly valued as a function of discounted expected cash flows.
Why am I so sure? Aside from the many studies I’ve cited showing that profitability in many of China’s largest companies is substantially less than the value of the financing and other subsidies, and anecdotal evidence of unnecessary real estate and infrastructure projects, just imagine what would happen to banking deposits and stock prices if the government credibly removed all guarantees on loans extended by the banks, and furthermore removed interest rate controls. I suspect most investors and depositors would assume, correctly in my opinion, a surge in non-performing loans that would wipe out the banks’ capital base, and so would sell their stocks and withdraw their deposits.
The fact that this is unlikely to happen is irrelevant. It just means that the losses are hidden and transferred to the state, and via the state, to households. If that is the case, then since the banking system can no longer easily identify economically viable projects and is in fact wasting money, the usefulness of the bank-as-fiscal-agent model is much reduced. We need now to have banks in China that can correctly identify economically useful projects in which to invest and limit their credit growth to those projects.
No need to worry. This is all public information and already in the price, many say. Many with big investments in China that is…
As I discussed yesterday, fundamentals views are fleeting animals. Expectations based on these animals can often change overnight, as if someone in the market flipped a switch. In the world of boom-bust, the bust is extremely accelerated, as we should all know by now. But in case anyone missed the credit crunch, back to Mr. Soros again for why the bust is so fast:
Booms and bust are not symmetrical because, at the inception of a boom, both the volume of credit and the value of the collateral are at a minimum; at the time of the bust, both are at a maximum. But there is another factor at play. The liquidation of loans takes time; the faster it has to be accomplished, the greater the effect on the value of the collateral becomes compressed within a very short time frame and the consequences can be catastrophic. It is the sudden liquidation of accumulated positions that gives a bust such a different shape from the preceding boom.
Bada bing bada boom! Run China, run!