Vimal Gor

Head of Bond, Income & Defensive Strategies

The bear rules in the Year of the Monkey

The bear rules in the Year of the Monkey

The argument used by China bulls is that the government still has an incredible amount of control over all the risk factors that any crisis can be ‘managed through’, and while this can result in delay in the inevitable, the inevitable will come one day.

Proof of this control was evident in a new tool revealed to keep away those pesky speculators in the offshore CNY market. The leadership exercised control of liquidity conditions at Hong Kong banks, causing the HIBOR (the Hong Kong interbank lending rate) to spike to unprecedented levels. This caused the cost of being short the currency to skyrocket to a rate of over 100% overnight on an annualised basis. This is obviously more than enough to stop out even the most ardent of speculators, and once this occurred the currency started to stabilise.

The reality of China’s position now is that it is at a point where debt has grown to a monstrous level while the banks are clearly underreporting the amount of non-performing loans they have on their balance sheets. The local government merry-go-round of funding more debt with land sales, that only have worth when there are more new buildings to build, must end sometime. While there has been some progress towards shifting the economy away from fixed asset investment to services, current growth targets are wholly incompatible with an economy that isn’t growing debt as fast as it is now, which is exactly what it must stop.

Reforms aimed at increasing productivity to bolster growth to allow debt to continue growing at a faster rate have obviously failed, as a new reform package is set to be announced this year. A new plan is required, and the choices are incredibly slim, if there are any at all. A gradual weaning off from debt growth is required but this will take decades to achieve, and it’s not clear that there is enough time for the banks to survive in that instance.

The Chinese would have obviously learnt from Gorbachev’s era of ‘glasnost’ (openness) and ‘perestroika’ (reform) which was widely regarded as the final trigger for the dissolution of the Soviet Union. With Soviet economies struggling and food shortages a common occurrence, Gorbachev wanted to introduce some market based influences in the communist economy to achieve better production of consumer staples while still keeping a command economy.

While this was a clear step in the right direction, the issue was that this new era of openness uncovered high levels of corruption at nearly every level, resulting in revolt and the collapse of the Soviet Union. China’s rally against corruption is surely a learning from the past but is likely to only stop this on the surface, with the true extent of corruption only likely to be revealed in further reforms associated with moving to a truly market-based economy, and that’s not likely to happen soon.

If the collapse does happen in a similar way to Japans at the end of the 1980s then the script has already been written. The problem is that Japan’s collapse didn’t actually result in a large depreciation of the Yen. Both countries share the similarity of a huge current account surplus (China’s is in fact the biggest in the history of the world), which is known to be a good very long term indicator of currency performance. In Japan’s experience though, even dropping rates to zero from a high level didn’t depreciate the currency.

In addition to this, Japan was only half as large as China is now in terms of the share of world GDP before the collapse, and this hardly registered a blip in growth against other major economies.

Opinions about China are clearly different now. Perhaps global growth is far weaker now and globalisation far more ingrained so that a global effect is inevitable? We would suggest that this is the case but these are factors that are worth considering. The real differentiator however between Japan and China is the level of distrust and discontent for the Chinese leadership that we think exists in the top wealth percentiles within China. This is driving the capital outflow which has resulted in devaluation, but the real risk will be if it eventuates that a 20%+ devaluation doesn’t stop the flow of capital out of the country.

 

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