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Observing the steady
fall of the barometer, Captain MacWhirr thought, “There’s some
dirty weather knocking about.” This is precisely what he thought. He
had had an experience of moderately dirty weather — the term dirty as
applied to the weather implying only moderate discomfort to the seaman. Had
he been informed by an indisputable authority that the end of the world was
to be finally accomplished by a catastrophic disturbance of the atmosphere,
he would have assimilated the information under the simple idea of dirty
weather, and no other, because he had no experience of cataclysms, and belief
does not necessarily imply comprehension. The wisdom of his country had
pronounced by means of an Act of Parliament that before he could be
considered as fit to take charge of a ship he should be able to answer
certain simple questions on the subject of circular storms such as
hurricanes, cyclones, typhoons; and apparently he had answered them, since he
was now in command of the Nan-Shan in the China seas during the season of
typhoons. But if he had answered he remembered nothing of it.
Joseph Conrad, Typhoon
During the rout of
the past seven weeks, the multi-trillion epiphany which struck the rococo
temple of modern finance to its very foundations was that a whole stratum of
yield-hungry investment monies devoted to what had been marketed as fee-heavy
‘alpha’ had, in fact, compressed under its own sheer weight and
had undergone a metamorphosis to a dull and highly friable bedrock of disastrously
leveraged ‘beta’. As a result, in general terms, anything which
had risen in the heady days to the general peak in late July was left
headlong in the dust, while the meek — such as that universal whipping
boy, the yen — may not exactly have inherited the earth, but did at
least get a mention in the will.
Thus, the MSCI EM
equity index ran up a 27 per cent gain to July 24th, only to drop 8.2 per
cent thereafter. Metals, as a group, put on 10.6 per cent to the peak, then
shed 8.5 per cent once it arrived. The kiwi dollar soared 14.5 per cent
against the greenback, only to plunge 13 per cent from its pinnacle. True,
agricultural commodities were fairly oblivious to the credit rout as the
age-old factors of flood, drought, frost, and disease interacted with the
newer era influences of Asian meat and dairy consumption and Western biofuel
promotion to keep, in particular, wheat and the European contracts extremely
well bid. Nor did those perennial profiteers of the age of perpetual war
(hot, cold, or tepid) — the Military-Industrial complex — take
much notice, with the AMEX Defense index moving sideways from a 25 per cent
pre-crisis game score, but still up 665 per cent in absolute, and 920 per
cent in relative, terms since the tech bubble popped in March 2000.
But perhaps the most
significant divergence from the wrenching turn in the wheel of fortune was China where the 58 per cent gains, pre-credit crash, were augmented by another impressive
29 per cent climb in its aftermath. As the world comes to grips with the ramifications
of the debt death spiral, China is, of course, the first refuge of the
optimist who hopes that, even if America does slide into recession, the Asian
colossus can act as a counterweight.
Asked to justify his
beliefs, such an individual will chant a litany of positives, citing
China’s powerful economic momentum; its predominant role in both the
consumption of raw materials and the production of semi-processed and
finished goods; and its mountain of readily-deployable foreign exchange
reserves. Even the supposed advantage conferred upon China by being subject to the diktats of sage and far-sighted central planners, rather than being
buffeted by a messy and capricious free market as it shivers from the ague of
a malarial financial system, is something he will put forward in his defence.
However, the more one
looks at China, the less one sees that is different in substance —
rather than in superficial appearance — from any other instance of
widespread, credit-led excess, any where else in the world. Thus, a more
realistic assessment of China’s situation has to be that force-fed
(rather than just plain forced) industrialization has led to an Augean stable
of malinvestment to stink up the land of Elis, but without any sign of a
Heracles to clean it. Moreover, the speculative frenzy gripping China — and pushing the stock-market almost uniquely higher and higher into the
stratosphere of over-valuation — has seemingly become a pandemic. The
newspapers are full of lurid tales of the ordinary man avidly raising the
stakes with which he plays the market by colluding with his friendly bank
manager to divert what are ostensibly car or property loans to the purpose.
Just as in the last
stages of the Western tech boom, anecdotes abound that little real work is
being done in the teeming offices and factories of the coastal cities, until
the market has closed for the day. If there is any wider truth to such
reports, we can well imagine that, having racked up effortless gains in the
first few hours, the quality of the contribution thereafter will be
correspondingly lessened — and this at a time when labour and input
costs are rising and when quality control is already becoming a PR disaster
for the country (albeit a politically motivated one). More worryingly, the
reckoning has also been made that Chinese corporates are themselves being
sucked into this swirl of greed, rather than attending to the business of
business. Calculations done by Morgan Stanley recently estimated that whereas
13 per cent of reported profits were of the non-operating variety last year,
this has soared to over 30 per cent so far in 2007.
Giving credence to
this, the China Securities Regulatory Commission has just issued a warning
expressly directed against such practices, even if the impact of the
admonition was somewhat spoiled by its spokesman’s admission that he
would leave this to individual board members to act upon, should they see
fit! This syndrome is again reminiscent of the spiral of boot-strapped
‘profits’ reported when our own internet networking giants were
booking ever rising sales, even though these were increasingly attributable
to the soft, vendor finance extended to ultimately deadbeat start-up
companies in whom the big boys also took juicy pre-IPO equity stakes - thus
booking two sets of phantom returns along the way.
In the case of China, this latest twist is of even more concern since double counting of profits —
in addition to the normal macro-economic exaggeration of their nature when a
credit-led investment cycle is underway — was already seriously
overstating the health of the economic juggernaut. The first distortion
arises from the nature of the expansion itself for, from the (admittedly
suspect) official figures, we can ascertain that something of the order of 40
per cent-45 per cent of GDP is categorized as investment spending. The
significance of this is that at the macro-level investment spending must give
rise to larger aggregate profits, simply because the associated outlays
appear below the line in the investor’s books — a truism which
means that the revenues for the man filling the investment order are not
offset (in any one period) by the entirety of the costs attributable to the
man issuing it.
Given that credit
raised and spent this way also represents a direct boost to macro measures of
profitability (again, newly-created money used to buy
‘investment’ goods means summed revenues rise 100 per cent, but
costs increase perhaps 10 per cent), the whole superstructure of rapid,
hot-housed industrialization cannot fail to look like a riot of prosperous
advance to the undiscriminating eye of the top-down analyst or in the mind of
the contented little central planner, smugly clutching his copy of Samuelson,
back in his stuffy Beijing bureau. On top of this, as Weijian Shan of
Newbridge Capital made clear in his spat with the World Bank last year
(fought out in the pages of the Far Eastern Economic Review), the
pervasive cross-shareholdings of Chinese corporates mean that the same
‘profit’ can be counted multiply in the aggregated score.
Noting further that
the tally of profits did not deduct tax from the published numbers, he also
drew some scathing inferences about the role played by state-directed lending
in subsidising such companies. What he was too polite to mention was that,
alongside this particular source of corporate welfare, many factory bosses
may well have been effectively gifted the land on which the plant was built,
to boot, at the expense of the poorly-defined property rights of its former
rural homesteaders.
Estimates of the
scale of Chinese NPLs to which these practices have given rise vary widely. Moody’s
has put a figure of $600-odd billion on the size of the hole in bank balance
sheets; Ernst & Young had reckoned with over $900 billion (before being
browbeaten into an unconvincing, commercially-motivated retraction). Unofficially,
there are mutterings of even higher totals, reaching well upwards of 40 per
cent of GDP.
To put even the
smallest of these estimates in sharper context, not only does Moody’s
number amount to ALL the reported pre-tax profits earned during the period
1999-2005, it is also equivalent to the whole cumulative trade surplus
enjoyed from 1998 onwards! Even more ominously, this sort of calculation
suggests that unpaid credits could represent half of all banking assets,
however well disguised they are, in an environment of ongoing double-digit
loan book growth, by the simple trick of rolling principal and interest
forward into new loans the moment they come due on the old.
So, once we become
aware that while published real GDP has risen by a factor of 4.4 since 1990s,
with nominal GDP growing 11.2 times, M1 has simultaneously reached 18.1 - and
M2, 22.6 - times their starting levels, we can see that rampant credit
creation has been at the very root of the Chinese experience: a credit
creation, moreover, subject to very few of the tenets of best Western
practice in its utilization (however shamefaced we must currently be about
where we have allowed our own abuses of such norms to lead us, too!).
Reading the latest
monetary policy report from the People’s Bank of China with these
considerations in mind, we were struck by the following passages:
“In terms of
the maturity structure, there was a significant trend toward more short-term
fund sources but more long-term fund uses, especially in the first half of 2007. In terms of fund sources, enterprises, governmental entities, and households’ general
deposits tended to be demand deposits. At end-June 2007, demand deposits
accounted for 66.1 percent of the total deposits of enterprises…. [and]
accounted for 37.6 percent of total savings deposits.
In terms of fund
uses, lending tended to be long term. In the first half of 2007, medium and
long-term loans accounted for 54.8 percent of the total new loans… In
particular, the margins of the securities companies increased by many
times.”
Here is banking
inflation in spades: demand deposits (i.e. ‘money’) being used to
fund longer-term loans and employed for stock- exchange speculation. It is
also a potentially disastrous source of illiquidity should confidence falter.
Compounding this domestic maturity mismatch, foreign exchange exposures are
also rising markedly :
…due to
expectations of a RMB appreciation, the commercial banks preferred to hold
short positions of foreign exchange… At end-June 2007, the foreign
exchange assets of financial institutions totaled US$498.93 billion, whereas
the realized foreign exchange capital was only US$12.76 billion… [meaning]
the ratio of realized foreign exchange capital to foreign exchange assets was
2.56 percent… [This year] net foreign exchange forward sales…
grew rapidly, especially… over 1-year forward... Commercial banks
covered their forward positions on the spot markets… [and] borrowings
were concentrated on short-term borrowings, resulting in a large maturity
mismatch with their forward sales.
Maybe that $1.3
trillion hoard of supposedly redundant foreign reserves will come in handy,
after all. The irony here is that China has squandered much of its
people’s savings by throwing them at hopelessly inefficient and
corruptly motivated businesses, while allowing goods to be sold abroad at bargain
basement prices as a result of the hidden subsidies, the dollar-linked
currency, and the repressed inflation (such as fuel price caps) it practices
at home.
At the same time, its
Western customers have pretty much given up saving altogether and, hence,
have foregone the ability to strengthen their domestic industrial base. Instead,
they have chosen to indulge themselves on the grandest of scales with
consumer durables (especially homes) and being, the mere possession of which
will never be able to generate the cash flow required to service the debt
load incurred in their purchase.
Much of that debt
has, of course, been effectively contracted with China where it comprises the
swelling dollar receipts of that land’s over-developed export sector. These
dollars, through their role in the central bank’s balance sheet, have
also formed the backing for much of the reckless expansion of domestic
investment credit, so causing further disproportion in the economic mix. Thus,
much of what are known in official parlance as the current ‘global
imbalances’ is little more than an illusion backed by a conjuring trick
— the mirage of credit-subsidized Chinese producers servicing
credit-addled Western consumers, each thinking they are doing well out of the
deal.
As we are too well
aware, the most over-exposed of those Western consumers have been delivered a
final demand in recent weeks and financial markets across the globe have
creaked and groaned under the ensuing strain. Imagine what will happen,
however, if a wider, Occidental abstinence from credit-financed
over-consumption starts to shrink Chinese export earnings; stretches Chinese
company finances; and, perhaps, topples the overheated Chinese stock market,
too.
Then, the upward
tornado of financial self-reinforcement could easily invert into an
all-devouring maelstrom of self-empowering collapse in the same way it did
after the Tech bubble. More dramatically, given the underlying weakness of
the Chinese banks, direct parallels with 1990s Japan and 1930s Europe would shortly begin to suggest themselves as valuations fell below the event
horizon.
Ominously, the steep
rise in consumer prices (systematically understated as its is, thanks to the
presence of a number of price caps on key goods such as fuel), coupled with a
slight retardation of the rate of monetary growth, has reduced real money
supply sharply – something which would make an Austrian wince at the
likely import for the margined stock speculator, as the chart above shows.
With
Bloomberg-derived figures for the Shanghai B share index showing that it
boasts a lofty P/E of 88.2, despite producing a lowly margin on sales of 2.5
per cent and a paltry ROE of 3.2 per cent (comparable metrics for the S&P
are 16.6, 9.4 per cent, and 16.7 per cent, respectively), the Chinese stock
market should absolutely not be regarded with a sense of wondrous admiration,
much less be taken as a sign of China’s ultimate immunity to our current
problems (remember the Nikkei also looked invincible in the two years after
the Crash of ‘87).
Rather, Chinese
equities should be regarded with a suitably jaundiced eye, for the truth is
that they not only represent some of the riskiest of investments to the intoxicated
masses caught up in their specious glamour, but also a very real source of
danger to the material wellbeing of us all.
Sean Corrigan
Sean Corrigan is Chief
Investment Strategist at Diapason Commodities Management (Lausanne and
London)
Copyright © 2006 -
Copyright © Diapason Commodities Management - Sean Corrigan
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