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Friday, 27 December 2013

Smaug: The Dragon In The Made In China Cage

China's debt problem is like having Smaug the dragon from the Hobbit locked up in a cage made in China. 

Since my return to Malaysia, a lot of people I spoke to have not really understood how China's debt binge is detrimental to regional stability in the Asian region.  The blame falls mainly on US monetary policy of low rates and quantitative easing.  They link the effects of asset bubbles (real estate in particular) in Asian markets on the flood of US dollars.  The impact of US monetary policy is actually less than you might think as a lot of this excess reserves (i.e. the result of flooding the market with cheap US dollars post Lehman) is parked at the Federal Reserve doing nothing.

Readers of my blog will know that I have highlighted China's runaway debt problems and how the newly minted debts cash have been making their way to fund the purchase of real estate around the world. 

I want to make it clear that China is not to be blamed for all the rise in asset prices.  The currency war, tooled up by zero interest rate policies (zirp) and quantitative easing, where countries race to debase their fiat currencies to protect their export industries is largely to blame.  It is not so much that real estate, vintage cars, diamonds and art work have risen but the value of currencies continue to head south.

Otherwise prudent economies have been sucked in to adopt low interest policies when not warranted.  The few countries that have resisted, particularly Australia up until second quarter of 2013, have finally succumb to the zirp gang.

While US, UK and latterly Japan seems to have taken flack for converting their paper claims to increasingly worthless pieces of toilet paper, China has largely escaped scrutiny as it had allowed its currency to rise against the greenback.  And so lulled many into thinking that it is a responsible member of the world community.

If only that were the case

As I mentioned in my previous article, China had lost control of the property market a long time ago.  According to Knight Frank, China now ranks the world's fastest growing real estate market after Dubai rising 22 percent from a year earlier.  What is laughable is that analysts and industry leaders still talk of 'lack of supply' especially in first tier cities.  I suggest they take a drive down Tian He area in Guangzhou and admire all those empty blocks after blocks of apartments.  Rather than focusing on the fact that property prices are way too high and the only way to increase supply would be to allow property prices to crash fall, the mantra continues to be deny and deflect, delay and pray and extend and pretend.

In fact, the current thinking amongst policy makers is more interference, the government intends to meet supply by building social housing for low incomes while leaving the private market to sort its own problems. 

Back to the issue of man's foolish ingenious attempt to cage Smaug - the runaway debt spiral.  The PBOC's attempt in June to tame Smaug by starving it of liquidity have caused serious spikes in China's interbank rates and rumours of Bank of China defaulted on an interbank payment circulated.  Not feeding Smaug have made it upset and the fear of Smaug thrashing its cage and escaping have led the PBOC to relent and give in - cash injection.

PBOC stopped short of admitting mea culpa assured market participants that such an event is unlikely to happen again.  In December 2013, Smaug started to rattle its cage once more.  Again its minders, the PBOC had no choice but to have another round of cash injection.

Market participants appear to be complacent.  The reason?  China has huge reserves and any blow out will not infect the world economy as it can easily be contained.  This has a calming effect similar to a love sick couple holding hands, taking a leisurely stroll in a manicured park, perfumed by clumps of flowers, a gentle spring breeze and the soft glow of an early morning sun light before a crashing jumbo jet appeared out of no where.

Media, foreign ones in particular, like to rationalize with soothing superlatives - short term orderly solutions, ample liquidity, sufficient cash injections, reverse repos etc and ending their reporting with sentences like 'the market is confident of the current leadership's ability to carry out long term market reforms'. 

Meanwhile, Chinese citizens in the thick of it don't believe the reassuring words coming out from China's propaganda machine.  So the government there again bans the use of the word cash/liquidity crunch like back in June 2013.  A case of desperate denial.  Problem solved.

The minders are of course tight lipped.  They must know that the cage will soon show signs of stress from the constant battering.

The drunken clown gives up juggling 

Short term measures such as banning toning down the use of the word liquidity crunch suggest than the government will soon find that direct cash injections, reverse repos and other short term fiscal measures will need to give way to more drastic measures such as bailouts and/or direct equity injections.  But these measures will be in gargantuan proportions given Chinese banks have increased their assets by US$15 trillion in the past five years.  In other words, China has expanded its financial balance sheet by 50% more than the assets of all global central banks combined.  This is China, they don't do things in small measures.

So lately, China's state controlled media, joined by the global financial community, drums up comforting remarks that long term reforms are required to resolve imbalances in the economy.  To you and me it feels like - I need to eat now if I am not going to starve to death but the rice is still growing in the padi fields.

The drunken clown that is China juggling ten balls instead of three will find this feat impossible to maintain as sadly there will be increasingly more frequent seize up in the interbank market until it just...breaks.

As I mentioned it is already too late to do anything about it.  Short of massive debt write offs and allowing for the market to clean up any massive misallocation of resources there is no other gentler solution.

PBOC alone cannot solve China's fund shortage

China indeed cannot rely solely on the People's Bank of China, the nation's central bank to sort out the mess.  Opinions from academia and government think tanks have argued for restructuring the real economy, promote market-oriented interest rate reform, and push for the combination of reforms in state-owned enterprises and local governments.  Long on rhetoric short on workable ideas, strategy and tactics.  The problem with this talk is that to do it, it is no different to sending a junky to a cold chamber to go cold turkey.  It is not going to be pleasant.

President Xi and Premier Li have nine more years in the hot seat to sort out the mess.  I think they know what needs to be done but doing so will start a revolt.  And the world will not like it.

I think the best that China can hope for is that they become like Japan.

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